Prudential International Investments Advisers, LLC. Global Investment Strategy & Outlook For 2009 December 17, 2009 By John Praveen, Chief Investment Strategist For Market Commentary Interviews Contact: Lisa Villareal, 973-367-2503/lisa.villareal@prudential.com Macro & Investment Outlook 2009 Overview 2009 Macro Outlook: Growth: Recession continues in developed economies in H1, slow recovery in H2. Sharp slowdown in emerging economies. Inflation: Headline inflation continues to fall, close to zero, with low oil and commodity prices, favorable base effects and recession in developed economies. The collapse in headline inflation fuels deflation fears. Interest Rates & Fiscal Policy: Fiscal stimulus and further monetary stimulus - traditional rate cuts and quantitative easing - to stabilize financial markets and help the GDP recovery. Currencies: Dollar strong in H1 2009 with recession and financial crisis continuing. Dollar weakens in H2 2009 as financial markets stabilize and GDP recovers. Yen strong in H1 and weakens in H2 as carry trade resumes with fall in risk aversion. 2009 Investment Outlook: Stock Markets H1 2009: Stocks Struggle, Volatility High with Global Recession and Earnings Decline Recession continues in U.S., Europe and Japan, sharply slower growth in Emerging Markets; Earnings decline with GDP recession, lower oil and commodity prices, continued loss write-downs at Financials; Risk aversion remains high as credit markets remain under stress; Fiscal stimulus and further monetary stimulus traditional rate cuts and quantitative easing positive for stocks. H2 2009: Stocks Recover in Anticipation of Recession End & Earnings Recovery Recession trough with further rate cuts, fiscal stimulus and lower oil prices, and credit markets stabilizing; Earnings recovery led by Financials; Attractive valuations and multiple expansion; Plenty of liquidity fuels stock recovery. Bond Markets H1 2009: Modest Bond Gains Government bond yields fall with recession, deflation fears and further interest rate cuts; Risk aversion remains high as credit markets still under stress. H2 2009: Bonds Under Pressure, Yields Rise GDP recovery. Interest rate cut cycle ends. Deflation fears ease; Equity markets recover. Credit market stabilization reduces bond s safe haven appeal. Macro Outlook Recession in Developed Markets. Sharply Declining Inflation. Further Rate Cuts Growth Recession continues in the U.S., Europe and Japan in H1 2009. Sharply slower growth in China, India, and other Emerging Markets. Modest recovery in H2 2009 with further monetary stimulus via traditional rate cuts, quantitative easing and other unconventional measures, sizable fiscal stimulus, lower oil and commodity prices, and financial market stabilization. U.S. remains in recession in Q1 2009 (-3 percent). A massive fiscal stimulus by the Obama administration ($500 700 billion), monetary stimulus through Fed s quantitative easing and credit market stabilization should help GDP recover in late Q2 / early Q3. Growth however remains below trend with banks reluctant to lend aggressively, housing continuing to remain a drag on growth, and rising unemployment, falling wealth and rising savings restraining consumer spending. Eurozone, U.K. and Japan are expected to remain in recession longer through late Q3 due to smaller fiscal stimulus and less aggressive monetary easing. China, India and other Emerging Markets should also begin to recover in H2 2009 with fiscal and monetary stimulus reviving domestic demand, while recovery in the developed economies should boost exports. For Informational Use Only. Not Intended As Investment Advice. Page 1
Inflation - Inflation continues to fall dramatically in early 2009 due to sharply lower oil and commodity prices, favorable base effects and sharply slower global growth. Various leading indicators of inflation point to a threat of deflation. Headline inflation likely to dip to around zero (in YoY terms) in the U.S. and Europe in early 2009 fuelling deflation fears. However, deflation fears are likely to dissipate as the developed economies pulls out of recession in H2. Expect headline inflation to average around 1 percent in the U.S., around 1.5 percent in Eurozone and the U.K., and under 0.5 percent in Japan in 2009. Core inflation should decline further in 2009 with the increased slack in the global economy, lower energy prices, and contained labor costs. Expect core inflation in 2009 to average around 1.5 percent in the U.S., Eurozone and U.K., and around 0.5 percent in Japan. Interest Rates & Fiscal Policy - Further monetary stimulus in H1 2009 in developed economies to pull them out of recession and avert deflation. Additional rate cuts in Emerging Markets to boost growth. Fed uses quantitative easing after cutting rates to zero. ECB and BoE to cut rates to new lows. BoJ continues to inject liquidity. Further fiscal stimulus both in Developed and Emerging Markets including a massive $500-700 billion package in the U.S. by the Obama administration. Currencies - U.S. dollar and Japanese yen remain strong in H1. Dollar and yen weaken in H2 as equity markets recover, credit markets stabilize and recession ends. Investment Outlook Stocks: Struggle in H1 2009 with Recession & Earnings Decline. Recovery in H2 2009 is likely to be another volatile year for stocks. Stocks are likely to struggle in H1 2009 with a challenging macro backdrop and earnings decline. In addition, continued stress in credit markets and high risk aversion are other challenges for stocks in H1. Stocks are likely to recover in Q2/Q3 as the recession troughs in the U.S. and other major economies, earnings begin to recover, led by Financials, credit markets stabilize and deflation fears ease. The macro backdrop for stocks remains challenging in H1 2009 with GDP recession in developed economies, sharply slower growth in emerging economies, and headline inflation falling sharply fueling deflation fears. The macro backdrop for stocks improves in H2 with the recession bottoming in Q2/Q3 and deflation fears easing with further aggressive monetary stimulus and sizable fiscal stimulus. Earnings decline is expected to continue in H1 with further financial loss write-downs and earnings weakness spreading to other sectors with recession, lower oil and commodity prices, weak pricing power and stronger dollar. Earnings are likely to start recovering in H2, led by Financials, with the recession ending. Stocks Valuations at Multi-Year Lows with the markets posting steep losses in 2008. Developed Market P/E multiples are trading at multi-year lows, with the U.S. P/E multiple at the lowest since 1990, the Eurozone is trading at the lowest since 1981 and Japan s P/E multiple is at the lowest since 1971! Stocks likely to struggle in H1 with recession, earnings decline, and continued credit market stress. Stocks are likely to recover in H2 as growth improves, earnings recover, and credit markets stabilize. Bonds: Modest Bond Gains in H1 2009. Bond Yields Rise in H2 After solid safe-haven gains in 2008, bonds are expected to post further gains in H1 2009. Bonds are likely to be supported in H1 by recession continuing in the developed economies, a sharp decline in headline inflation fueling deflation fears, further monetary stimulus both traditional rate cuts and quantitative easing - continued stress in credit markets, and elevated risk aversion. However, low level of yields are likely to limit bond gains. Bonds are likely to come under pressure in H2 as GDP growth begins to recover, deflation fears ease, central banks finish cutting rates, stocks post sustained gains, financial markets stabilize, and risk appetite increases. Increased supply of government bonds due to increased fiscal spending are likely to pressure yields. Bonds are likely to post modest gains in H1 2009 with GDP recession, continued financial market stress, further rate cuts and deflation fears. Bonds are expected to come under pressure in H2 as growth improves, deflation fears abate, financial markets stabilize and central banks finish cutting rates. Investment Strategy Asset Allocation: Stocks vs. Bonds: H1 2009: Neutral Stocks; Neutral - Bonds & Cash. H2 2009: Overweight Stocks; Underweight - Bonds & Cash. For Informational Use Only. Not Intended As Investment Advice. Page 2
Global Equity Strategy: Global Investment Strategy & Outlook For 2009 H1 2009: Overweight: U.S. Underweight: Emerging Markets, Eurozone, U.K. and Japan. H2 2009: Overweight: Emerging Markets, Japan, Eurozone and U.K. Underweight: U.S. USA: H1: Overweight H2: Underweight. With global equity markets continuing to struggle in H1 2009, U.S. equity market is likely to outperform other equity markets in H1 given its defensive characteristics. Further, more aggressive monetary stimulus and a bigger fiscal stimulus should pull the U.S. out of recession earlier than other economies. U.S. earnings are also likely to recover faster than other markets led by Financials. U.S. stocks are likely to underperform other markets in H2 as GDP growth recovers in other markets. Other equity markets are likely to outperform the U.S. with more attractive valuations. Dollar strength in H1 is likely to be a negative for stocks. Emerging Markets: H1: Underweight H2: Overweight. Emerging Markets (EM) have historically underperformed when OECD leading economic indicators are in a downtrend. Hence these markets are likely to struggle in H1 with OECD LEI down sharply in negative territory. Further, heightened risk aversion remains a drag on EM stocks during H1. The macro outlook is negative with sharply slower GDP growth in H1 while the earnings outlook continues to deteriorate. Emerging Markets are likely to rally in H2 with OECD LEI expected to turn positive, while EM GDP growth and earnings are likely to recover. EM central banks are likely to continue cutting rates. Fiscal measures adopted by governments are another positive. Valuations have become attractive relative to Developed Markets and a key support for EM stocks. While EM earnings growth is likely to be sharply slower from the robust pace in previous years, EM earnings are likely to relatively better than in developed markets. U.K.: H1: Underweight H2: Overweight. U.K. stocks struggle in H1 with sharply negative GDP growth and earnings decline. U.K. stocks are likely to post gains in H2 with growth recovery in late H2 following aggressive BoE rate cuts and additional fiscal stimulus. Valuations are attractive both on a historical and current basis. Sterling weakness against the U.S. dollar is another positive for stocks. Eurozone: H1: Underweight H2: Overweight. Eurozone stocks struggle in H1 and rally in H2. Eurozone remains in recession till late 2009 and the earnings outlook remain negative in H1 given the weak growth outlook both domestically and for the global economy. The ECB is likely to cut rates to historic lows, well into 2009. Valuations have become very attractive after the current sell-off. Euro depreciation is a positive for Eurozone equities. Japan: H1: Underweight H2: Overweight. GDP recession and negative earnings outlook are likely to keep Japanese stocks pressured in H1. GDP likely to remain in recession through late 2009. Earnings sharply lower in 2009 with slower global growth. Further, yen strength is a negative for earnings, especially for exporters. Stocks are likely to recover in H2 with recession ending, support from fiscal and monetary stimulus, and attractive valuations. Yen weakness in H2 a plus for earnings. Global Bond Strategy: Government Bonds versus Corporate Bonds. Overweight government bonds and underweight corporate bonds in H1 2009. Government bonds outperformance is likely to continue in H1 with GDP recession, deflation fears, further rate cuts, and safe haven gains with continued stress in credit markets. Although valuations of corporate bonds have become attractive in H2 2008, corporate bonds are likely to struggle in H1 with default fears and elevated risk aversion. In H2, corporate bonds should begin to outperform government bonds with the stabilization in credit markets and the modest recovery in GDP growth. Further, increased fiscal spending by governments is likely to increase the supply of government bonds, putting pressure on yields. USA: H1- Overweight. H2 - Underweight. In H1, Treasuries are likely to outperform other bond markets with the Fed undertaking aggressive Quantitative Easing and keeping long-term rates low. Continued credit market stress, elevated risk aversion and deflation fears are also likely to benefit Treasuries. In H2, Treasuries are likely to underperform other bond markets with U.S. GDP growth likely to recover faster than in Europe and Japan. Further, stabilization in credit market, reduction in risk aversion, and easing of deflation fears reduce safe haven appeal of Treasuries. Increased Treasury supply due to big fiscal spending is also likely to pressure yields. Eurozone: H1 - Underweight. H2 - Overweight. Eurozone bonds expected to underperform U.S. Treasuries in H1 due to more aggressive monetary policy response by the Fed relative to the ECB. Eurozone bonds are likely to outperform Treasuries in H2 with Eurozone economy likely to remain in recession longer than the U.S. and further rate cuts by the ECB. UK: H1 - Underweight. H2 - Overweight. U.K. Gilts underperform U.S. Treasuries in H1 with more aggressive policy easing by the Fed relative to the BoE. Gilts are likely to outperform in H2 with U.K. GDP recession continuing longer than U.S. recession and the BoE remaining in an easing mode. For Informational Use Only. Not Intended As Investment Advice. Page 3
Japan: H1 - Underweight. H2 - Overweight. Japanese JGBs underperform Treasuries in H1 with Fed more aggressive policy easing relative to the BoJ. JGBs likely to outperform Treasuries in H2 with a longer recession in Japan and bigger decline in inflation. H1 2009: Overweight: Government Bonds. Underweight: Corporate Bonds. Overweight: U.S. Underweight: Eurozone, U.K. and Japan. H2 2009: Overweight: Corporate Bonds. Underweight: Government Bonds. Overweight: Eurozone, U.K. and Japan. Underweight: U.S. Global Sector Strategy Healthcare: H1 - Overweight. Defensive sector, continues to benefit from heightened risk aversion. H2 - Neutral. Decreasing risk aversion reduces sector s attraction. Still weak GDP growth likely to remain a support. Financials: H1 - Neutral. Aggressive policy measures and attractive valuations are offset by continued loss write-downs. H2 - Overweight. Recovery in earnings and earlier monetary policy actions boost Financials. Consumer Staples: H1 - Overweight. Heightened risk aversion and slower economic growth continue to support the sector. H2 - Underweight. Sector underperforms GDP growth recovery. Info. Technology: H1 - Neutral. Global tech demand remains very weak and further downward earnings revisions expected. H2 - Overweight. Sector likely to benefit from increased fiscal spending in tech infrastructure and recovery in GDP growth. Telecomm Services: H1 - Neutral. Defensive sector earnings are offset by higher valuations and GDP recession. H2 - Neutral. GDP growth recovery is a positive, but offset by higher valuations. Utilities: H1 - Overweight. Sector benefits from defensive nature and attractive dividends in a very weak economy. H2 - Underweight. Recovering GDP growth removes the benefit of defensiveness as investors move to sectors geared to the economic recovery. Consumer Discretionary: H1 - Underweight. Consumer fundamentals are challenging with weak employment conditions and anemic income growth. H2 - Neutral. Fiscal spending and likely tax cuts are positives for the sector. But labor market conditions still remain weak. Industrials: H1 - Underweight. Developed economies remain in recession and slower growth in emerging economies. H2 - Underweight. Increased fiscal spending is a positive. But, GDP growth recovers only modestly towards the end of the year. Energy: H1 - Underweight. Energy prices likely to remain low due to sharply reduced global demand. H2 - Neutral. Energy prices are likely to recover, although modestly, with recovery in global GDP growth. Materials: H1 - Underweight. Commodity prices remain low with the sharp decline in global GDP growth. H2 - Overweight. Commodity prices rise due to the recovery in global GDP and increased infrastructure spending. Investment Strategy Summary Asset Allocation: H1 2009: Neutral Stocks, Neutral - Bonds & Cash. H2 2009: Overweight Stocks, Underweight - Bonds & Cash. Equities: H1 2009: Overweight: U.S. Underweight: Emerging Markets, Eurozone, U.K. and Japan. H2 2009: Overweight: Emerging Markets, Japan, Eurozone and U.K. Underweight: U.S. Bonds: H1 2009: Overweight: Government Bonds. Underweight: Corporate Bonds. Overweight: U.S. Underweight: Eurozone, U.K. and Japan. H2 2009: Overweight: Corporate Bonds. Underweight: Government Bonds. Overweight: Eurozone, U.K. and Japan. Underweight: U.S. Sectors: H1 2009: Overweight: Healthcare, Consumer Staples, Utilities. Neutral: Financials, Telecomm, Information Technology. Underweight: Consumer Discretionary, Industrials, Energy, and Materials. H2 2009: Overweight: Financials, Info. Technology, Materials. Neutral: Consumer Discretionary, Energy, Telecomm, and Healthcare. Underweight: Consumer Staples, Industrials, and Utilities. For Informational Use Only. Not Intended As Investment Advice. Page 4
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