By John Praveen, Chief Investment Strategist of Prudential International Investments Advisers, LLC.*
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1 By John Praveen, Chief Investment Strategist of Prudential International Investments Advisers, LLC.* Financial Market Outlook: Stocks Supported by Renewed Central Bank Put but Face Headwinds from Continued Eurozone Uncertainty, Global Growth Concerns & U.S. Fiscal Cliff Fears. Bond Yields Likely to Remain Range-bound. Bonds Expensive but Supported by Growth Concerns & Central Bank Easing John Praveen s Global Investment Outlook August-September 2012 expects stocks to remain in an uptrend, supported by expectations of QE and other stimulus measures from global central banks. Further, markets continue to expect Eurozone policy makers to come up with a game-changer to resolve the debt crisis. Looking ahead, while stocks remain underpinned by central banks renewing their put, global equity markets face risks/challenges. The strong run since the June lows have been fuelled largely by expectations of further central bank stimulus and a game changer from European policy makers. Delays and disappointment from central banks or continued incremental measures by European policy makers could precipitate a market correction. In addition, global growth concerns and fears about U.S. fiscal cliff are likely to be headwinds and weigh on markets. Hence, further equity gains are likely to be modest until global growth fears ease, there are signs that the U.S. policy makers will avert the fiscal cliff, and Eurozone policy makers come up with a game changer to resolve the crisis. Global bond yields are likely to remain range-bound in the near-term. Bond yields have fallen to very low levels in the past few months in major bond markets with risk aversion spiking on escalation of the Eurozone crisis in Greece and Spain. Bonds are thus very expensive relative to their own historical average and relative to stocks. Further, bonds yields are likely to be under upward pressure with the Eurozone crisis easing, especially if policy makers come up with a game changer. However, bonds remain supported by weakening global growth outlook and growing expectations and pledges that major central banks will undertake additional stimulus, including expanding asset purchases and QE. In addition, continued incremental measures by European policy makers could lead to another escalation of the Eurozone crisis and fuel safe haven demand for bonds. Fears about U.S. fiscal cliff are also likely to support bonds. Market Outlook: Renewed Central Bank Put Keep Stocks in Uptrend. However, Global Growth Concerns, Slow Eurozone Progress, & U.S. Fiscal Cliff Likely to Limit Gains Bond Yields Likely to Remain Range-bound. Bonds Expensive but Supported by Growth Concerns & Central Bank Easing Stock Market Outlook (August-September): Global stock markets posted further gains during July extending the gains from June. Markets brushed aside disappointing economic data and instead focused on central bank reflation measures and pledges of further stimulus. Further, Q2 earnings results came out better than expected; however, there was a share of earnings disappointments which kept stocks volatile. Eurozone fears rose again in the second half of July as the situation in Spain worsened leading to fears that Spain might need a national bailout, beyond the bank bailout. However, a bold declaration from ECB President Draghi that ECB the will do "whatever it takes" to protect the Euro boosted stocks towards the end of the month. The Developed Market (MSCI World) index rose 1.2% (US$) in July, taking YTD gains to 5.8%. Emerging Market stocks rose 1.6% (US$) and finished with YTD gains of 3.9%. Stock markets pulled back in early August when the ECB left policy unchanged at their August meeting, disappointing market expectations of aggressive action. However, the ECB indicated that it is likely to announce new measures over the next few weeks. Further, the U.S. Fed promised to provide additional accommodation as needed to promote a stronger economic recovery. These renewed pledges of additional stimulus pushed stock markets higher through mid-august. *Prudential International Investments Advisers, LLC. (PIIA) is a business of Prudential Financial, Inc., (PFI), which is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom. For Informational Use Only. Not Intended As Investment Advice. See Disclosures on the last page for important information. Page 1
2 Looking ahead, stock markets are likely to be supported by expectation of fresh stimulus measures and assurances from global central banks, especially the ECB, the Federal Reserve and the People Bank of China. The ECB is expected to announce new policy measures which could include expanding its bond purchase program (SMP) and other non-standard measures. These measures could go a long way in helping reduce borrowing costs and easing the Eurozone crisis. However, stocks face risks/challenges. Equity markets have had a strong run up since the June lows, mostly on expectations of further central bank stimulus and a potential game changer from European policy makers. Delays and disappointment from central banks or continued incremental measures by European policy makers could precipitate a market correction. In addition, global growth concerns and fears about U.S. fiscal cliff could limit equity market gains. Hence, while stocks remain underpinned by the renewed central bank put, further stock market gains are likely to be modest until global growth fears ease, there are some signs that the U.S. will avert the fiscal cliff, and Eurozone policy makers will come up with a game changer to resolve the three year old crisis. 1) Eurozone Crisis - Incremental Steps or Game-Changer? As the Eurozone sovereign debt crisis enters its third summer, markets continue to look for a game changer from the Eurozone policy makers and the ECB. From the financial markets perspective, a Eurozone game changer needs to include: 1) Expanding the ECB s mandate so it could freely buy sovereign bonds. If the ECB could become the Eurozone s lender of last resort, it could effectively put a floor under Greek, Spanish and Italian bonds, reducing their perceived riskiness and lowering borrowing costs for these beleaguered countries; 2) Greater integration of the European banking system; and 3) Movement toward greater fiscal federalism in Eurozone. As markets continue to look for a Eurozone game changer, in the near-term, market focus is likely to be on the ECB and its expanded role as bond buyer of last resort as progress is likely to be slow on the other two issues (greater integration of the European banking system, and movement toward fiscal federalism in Eurozone), given reservations and opposition in Germany. ECB President Draghi pledged in late July that the ECB will do "whatever it takes" to protect the Euro. This fuelled market expectations of aggressive action in the near-term. While the ECB disappointed markets by not taking immediate, aggressive measures in August, it indicated that new policy measures will be announced "over the coming weeks. These measures are expected to include: 1) The ECB expanding its bond purchase program (SMP); and 2) Other non-standard measures to repair the monetary policy transmission. Further, the ECB indicated that it stands ready to make two changes that could make future bond purchases more effective than in the past: 1) The ECB will not necessarily sterilize future bond purchases by taking offsetting deposits from the region s commercial banks. This would mean that the ECB could effectively be conducting full-blown quantitative easing and increasing the monetary base; and 2) The ECB would relinquish its previous status as a preferred creditor for future purchases. This could prompt a greater reduction in government borrowing costs by reducing private bondholders fears of being last in the queue in the event of a sovereign default. These measures, if implemented, could go a long way to helping reduce borrowing costs and easing the crisis. However, the ECB has tied its intervention to strict conditionality, specifically, that national governments have to meet their commitments and the EFSF/ESM need to fulfill their roles. Specifically, before the ECB reactivates the SMP and steps in to buy bonds on the secondary market (Spanish and Italian bonds), these national governments will first have to seek formal assistance from the ESM/EFSF (Eurozone s government bail-out fund) to purchase their bonds. Following the request to the EFSF, the ECB will step in to buy bonds. Unfortunately, at present, both Spain and Italy are very reluctant to seek EFSF support due to the onerous austerity and structural reform conditions that this would entail. Thus, it appears that the ECB is likely to remain on standby until Spain and Italy ask for EFSF help. 2) Central Banks Renew Put : In addition to the ECB s measures, other global central banks are also likely to implement fresh stimulus measures. In the U.S., while the Federal Reserve refrained from undertaking QE3 in For Informational Use Only. Not Intended As Investment Advice. Page 2
3 August, it promised to provide additional accommodation as needed to promote a stronger economic recovery. With the Fed on hold in August, the odds of the Fed undertaking another round of asset purchases or QE 3 over the next few months have increased. Market focus is now on the Federal Reserve s annual Central Bank Conclave in Jackson Hole, Wyoming in late August for clues about fresh Fed stimulus. In the U.K., the BoE is also likely to undertake additional monetary stimulus with the U.K. in recession and the inflation outlook improving. Emerging central banks remain in an easing mode to offset soft domestic demand and weak external environment. Thus stocks remain supported by interest rate and liquidity tailwinds. 3) U.S. Headed for Fiscal Cliff?? Fed Chairman Bernanke warned U.S. Congress that it risked taking the U.S. economy over a massive fiscal cliff of large spending cuts and tax increases in A total of $543bn (3.5% of GDP) of fiscal adjustment is set to occur in January 2013 as a result of the expiration of the Bush tax cuts ($280bn, 1.8% of GDP), expiration of the payroll tax holiday ($125bn, 0.8% of GDP) and temporary unemployment benefits ($40bn, 0.3% of GDP), and budget cuts ($98bn, 0.6% of GDP). With the elections due in November and the nation polarized, it appears unlikely that any agreement will be reached on extending the tax cuts or preventing the spending cuts. However, it is possible that some last minute deal will be struck after the elections and before yearend. However, the uncertainty about the fiscal cliff is likely to be another headwind for the stock market. 4) Stocks Still Cheap - Attractive Valuations: Equity market multiples rose in July with stocks posting gains during the month on central bank reflation measures. However, stock valuations still remain cheap relative to their history and are just modestly above the valuation levels at the end of Stocks trade at a discount to their long-term averages. The trailing P/E multiple for the Developed Market index (MSCI World) rose modestly to 13.9X in July after declining to 13.7X at the end of June from 14.8X at the end of Q1. The trailing P/E of the DM index remains just above the 13.2X multiple at the end of 2011 and well below its long term (since 1971) average of 17.9X. Emerging Markets (EM) P/E multiple rose modestly to 11.5X in July from to 11.3X in June. Stocks remain very cheap relative to bonds. 5) Deteriorating Growth Outlook: Stock markets face fresh anxieties about the weakening global growth outlook with decelerating growth in the developed economies. GDP growth in Q2 slowed sharply in the U.S. (1.5%) and Japan (1.4%). Meanwhile, Eurozone continues to struggle with Q2 GDP contracting -0.7% QoQ annualized. While GDP growth in some of the core countries, while weak, came in better than expected, the periphery remains in deep recession. The U.K. economy is also in recession with GDP contracting for the third successive quarter. In the emerging economies, GDP growth was soft in H1, but growth is likely to have bottomed in Q2 and appears on track to improve in H2 in response to interest rate cuts and relief from lower oil prices. 6) Earnings Uncertainty: The Q2 earnings season is currently underway and U.S. and Japanese earnings results are coming in better than expected, while Eurozone results are weaker. While Q2 earnings are surprising on the upside, global earnings growth is expected to slow due to the recession in Eurozone and the weaker global growth. Earnings expectations for the rest of 2012 continue to be revised down earnings are now expected to come in around 5% in the U.S. (down from 8%), 8% in Emerging Markets (down from 9%), around 8% in Japan, 1% in Eurozone (down from 2%) and -3% in U.K. (down from flat). Bottom-line: Global stock markets remain in an uptrend since the June lows, brushing aside disappointing economic data and instead focusing on central bank reflation measures. Looking ahead, stock markets remain underpinned by expectations of QE and other stimulus measures from global central banks, especially the ECB, the Fed and the Chinese central bank. Further, markets continue to expect Eurozone policy makers to come up with a game-changer to resolve the debt crisis. However, stocks face risks/challenges. The strong run since the June lows have been fuelled largely by expectations of further central bank stimulus and a game changer from European policy makers. Delays and disappointment from central banks or continued incremental measures by European policy makers could precipitate a market correction. In addition, global growth concerns and fears about U.S. fiscal cliff are likely to be headwinds and weigh on markets. For Informational Use Only. Not Intended As Investment Advice. Page 3
4 Hence, while stocks remain underpinned by central banks renewing their put, further equity gains are likely to be limited until global growth fears ease, there are signs that the U.S. policy makers will avert the fiscal cliff, and Eurozone policy makers come up with a game changer to resolve the three year old crisis. Bonds: Yields Likely to be Range-bound. Bonds Expensive but Supported by Growth Concerns & Further Central Bank Easing Global bond yields are likely to remain range-bound in the near-term. Bond yields have fallen to very low levels in the past few months in major bond markets with risk aversion spiking on escalation of the Eurozone crisis in Greece and Spain. Bonds are thus very expensive relative to their own historical average and relative to stocks. Further, bonds yields are likely to face upward pressure with the Eurozone crisis easing, especially if policy makers come up with a game changer. However, bonds remain supported by weakening global growth outlook and growing expectations and pledges that major central banks will undertake additional stimulus, including expanding asset purchases and QE. In addition, continued incremental measures by European policy makers could lead to another escalation of the Eurozone crisis and fuel safe haven demand for bonds. Fears about U.S. fiscal cliff are also likely to support bonds. Investment Strategy: Stocks Supported by Renewed Central Bank Put but Face Headwinds from Weak Global Growth, Eurozone Uncertainty & U.S. Fiscal Crisis Fears. Hence Remain Modest Overweight in Stocks. Asset Allocation: Stocks vs. Bonds Stocks Maintain Modest Overweight: Stocks remain underpinned by renewed central bank put with the ECB set to expand bond purchases, Fed likely to launch QE3 and rate cuts in China and other EM central banks. However, continued incremental steps by European policy makers, global growth concerns and fears about U.S. fiscal cliff are headwinds. Hence, further equity gains likely to be modest until growth fears ease, there are signs U.S. policy makers will avert the fiscal cliff, and Eurozone policy makers come up with a game changer. Bonds Remain Neutral: Yields likely to remain range-bound. Bond yields have fallen to very low levels and are thus very expensive relative to their own historical average and relative to stocks. Further, bonds yields are likely to be under upward pressure with the Eurozone crisis easing. However, bonds remain supported by weakening global growth outlook and expectations of additional stimulus. Global Equities: Global Bonds Global Sectors Currencies Modest Overweight: Emerging Markets Reduce Japan & U.K. to Neutral Remain Neutral Eurozone Remain Underweight U.S. Remain Overweight Eurozone Bonds & U.K. Gilts Remain Underweight U.S. Treasuries & JGB s Overweight: Industrials, Consumer Discretionary Modest Overweight: Healthcare & Information Technology Neutral: Financials, Telecoms & Energy Underweight: Consumer Staples, Materials & Utilities Overweight: U.S. Dollar; Neutral: EM Currencies, Yen; Underweight: Euro and Sterling For Informational Use Only. Not Intended As Investment Advice. Page 4
5 The U.S. Dollar is likely to remain firm against the euro and sterling but range-bound against the yen. The euro continues to face risks associated with the sovereign debt crisis. While the decline in sovereign spreads has been a positive, fresh concerns and weak GDP growth will likely keep the euro under pressure. The sterling is likely to be impacted by the ending of the Olympics and its strong correlation with the euro. The yen is likely to remain rangebound with relatively strong fundamentals, but offset by BoJ easing and risk of currency intervention. The outlook for EM currencies is neutral with risks associated with the Eurozone sovereign debt crisis, but a still solid growth outlook. Follow us on Twitter: For more information contact: Lisa Villareal: , lisa.villareal@prudential.com Disclosures: Prudential International Investments Advisers, LLC. (PIIA), a Prudential Financial, Inc. (PFI) company, is an investment adviser registered with the Securities and Exchange Commission of the United States. Pramerica is a trade name used by PFI and its affiliated companies in select countries outside of the United States. PFI, a company incorporated and with its principal place of business in the United States of America is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom. The commentary presented is for informational purposes only, and is not intended as investment advice. This material has been prepared by PIIA on the basis of publicly available information, internally developed data and other third party sources believed to be reliable. However, no assurances are provided regarding the reliability of such information. All opinions and views constitute judgments of PIIA as of the date of this writing, and are subject to change at any time without notice. There can be no assurance that any forecast made herein will be realized. Distribution of this information to any person other than the person to whom it was originally delivered and to such person s advisers is unauthorized and no part of this material may be reproduced or distributed further without the written approval of PIIA. These materials are not intended for distribution to, or use by, any person in any jurisdiction where such distribution would be contrary to local law or regulation. The companies, securities, sectors and/or markets referenced herein are included solely for illustrative purposes to highlight the economic trends, conditions, and the investment process, but may or may not be held by accounts actually managed by PIIA. The strategies and asset allocations discussed do not refer to any service or product offered by PIIA or by its affiliates The global asset and strategy allocation models presented are hypothetical allocation models shown for illustrative purposes only, and do not necessarily reflect the management of any actual account. Following the allocation recommendations presented will not necessarily result in profitable investments. Past performance is not an assurance of future results. Nothing herein should be viewed as investment advice to adopt any investment strategy, nor should it be considered an offer to provide investment advisory or other allocation services. The Rock symbol is a service mark of PFI and its related entities, registered in many jurisdictions worldwide. Copyright 2012 For Informational Use Only. Not Intended As Investment Advice. Page 5
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