Prudential International Investments Advisers, LLC. Global Investment Strategy February 2010 By John Praveen, Chief Investment Strategist For Market Commentary Interviews Contact: Lisa Villareal, 973-367-2503/lisa.villareal@prudential.com Financial Market Outlook & Strategy: Stocks to Recover as Strong Macro & Earnings Fundamentals Overcome Interest Rate & Debt Fears John Praveen s Global Investment Strategy February 2010 expects stock markets to recover from the late January/early February correction and post gains during H1 2010 as solid macro data and strong earnings rebound should overcome the European debt fears and Asian interest rate concerns. However, equity markets volatility will remain high in the near-term with debt problems in Greece, Spain and Portugal, concerns about interest rate tightening in China, India and other emerging economies, and regulatory noise from Washington. Bonds are likely to continue to enjoy safe haven gains in the near-term with the southern European debt problems. However, the resolution of the debt crisis is likely to improve risk appetite, decreasing the attractiveness of bonds. Further, solid GDP growth and elevated headline inflation are likely to push bond yields higher. However, the rise in yields is likely to be capped by developed central banks remaining on hold through late 2010. Among global stock markets, we remain overweight Emerging Markets and the U.K. We have upgraded Japan to modest overweight and downgraded Eurozone to neutral. We remain underweight on the U.S. Among global government bond markets, we remain overweight in Japan and Emerging Markets, and neutral on Eurozone. We have downgraded U.K. to neutral and remain underweight in U.S. Treasuries. Among global sectors, we remain overweight in Energy, Materials, Industrials, Financials, and Info. Technology. We remain neutral in Consumer Discretionary and underweight in Consumer Staples, Healthcare, Telecomm, and Utilities. Financial Market Outlook: Stocks to Recover with Solid GDP Growth & Strong Earnings Rebound Stocks: Equities to Recover from Jan/Feb Sell-off as GDP & Earnings Recovery Overcome Interest Rate & Debt Fears After a strong start to 2010, the global equity rally was cut short as strong earnings and macro data were trumped by a confluence of negative news-flow: concerns about tightening in China, Obama s proposed new regulations for U.S. banks, fears about a Greek debt default, and uncertainty over Bernanke confirmation. The Developed Markets Index was down -3.7% and Emerging Markets fell - 4.5% in January. The macro backdrop for stocks remains favorable with GDP growth strengthening, deflation fears easing, core inflation remaining low, and developed central banks on hold through late 2010. Stock market volatility increased in early 2010 with intensification of the tug of war between changing interest rate expectations and strong GDP growth and earnings rebound, combined with the worsening of the debt problems in Greece, Spain & Portugal. GDP growth strengthened in Q4 with strong growth in the U.S., Japan, China, Brazil, India, and other Emerging Markets. However, GDP growth disappointed in the U.K. and is estimated to rise modestly in Eurozone. We expect solid growth in the developed economies and strong growth in emerging economies in H2 2010. Headline inflation has risen across the globe and is likely to remain under pressure in early 2010 with continued volatility from oil price base effects. However, core inflation remains low with high unemployment and low capacity utilization. Corporate earnings are on track to a solid rebound in 2010 and likely to surprise on the upside. Current expectations for global EPS to grow around 29% for full-year 2010. Solid GDP growth in developed economies and strong growth in emerging economies are likely to boost top line revenue growth. Margins are expected to widen with falling unit labor costs and other efficiency gains. Equity market valuation multiples improved in January as stock markets posted a sharp correction during the month after the solid gains during Q4 2009. Trailing P/E multiples improved in January for the Developed Market Index (27.5X), U.S. index (27.5X), Eurozone (19.1X), U.K. (12.4X), and Emerging Markets (20.1X). P/E multiples are expected to improve in coming quarters as corporate earnings are recovering sharply. Bottomline: Debt problems in Greece, Spain and Portugal, concerns about interest rate tightening in China, India and other emerging economies, and regulatory noise from Washington are likely to keep equity markets volatile in the nearterm. However, we expect the strong macro and earnings fundamentals to overcome the European debt fears and Asian interest rate concerns, pushing stocks higher. We expect stock markets to recover the late January/early February losses and post gains during H1 2010 driven by: 1) Solid, sustained GDP growth in H1 2010; 2) Strong earnings growth with rising revenues, wider margins & improved pricing power; Positive earnings surprises likely; 3) Despite volatility in headline inflation, core inflation remains under control; 4) Developed central banks keeping rates low through late 2010; Emerging central banks undertaking gradual policy normalization not aggressive tightening. For Informational Use Only. Not Intended As Investment Advice. Page 1
Bonds: Safe Haven Gains from Greek Problems. GDP Rebound & Positive Inflation to Push Yields Higher Global government bonds posted modest gains in January as risk aversion rose following a sharp widening of Greek sovereign bond spreads. U.S. bonds posted solid gains in January, while Eurozone, U.K., and Emerging Markets bonds posted more modest gains. Looking ahead, the debt problems in Greece, Spain and Portugal are likely to keep downward pressure on bond yields in the shortterm. Barring any other unforeseen crises, the resolution of the southern European debt crisis will improve risk appetite, decreasing the attractiveness of bonds. Further, solid GDP growth and elevated headline inflation are likely to push bond yields higher. Within bond markets, macro factors are most favorable for Japan due to growth uncertainty, the persistence of deflation and the BoJ expected to remain on hold through 2010. Modest growth in Eurozone and U.K. should support their bonds relative to Treasuries. U.S. Treasury yields are likely to be under pressure relative to other bond yields with stronger U.S. GDP growth relative to Europe and Japan. Elevated real yields are a positive for Japan, while low real and nominal yields are a negative for U.K. Gilts. Japanese bonds are also more attractively valued relative to Japanese stocks, than U.S. and U.K. bonds are to their respective stock indices. Finally, as the Greece situation is resolved, EM spreads are likely to narrow further with increased risk appetite and strong EM growth. Investment Strategy: Stocks to Recover as Strong Macro & Earnings Fundamentals Overcome Rate & Debt Fears ASSET ALLOCATION: Stocks vs. Bonds Stocks - Remain Overweight: Debt problems in Greece, Spain and Portugal, concerns about interest rate tightening in China, India,and other emerging economies, and regulatory noise from Washington are likely to keep equity markets volatile in the near-term. However, we expect strong macro and earnings fundamentals to overcome the European debt fears and Asian interest rate concerns and push equity markets higher. Bonds - Remain Underweight: The debt problems in Greece, Spain and Portugal are likely to keep downward pressure on yields in the short-term. The resolution of the southern European debt crisis will improve risk appetite, decreasing the safe haven appeal of bonds. Further, solid GDP growth and elevated headline inflation are likely to push bond yields higher. GLOBAL EQUITIES Overweight: Emerging Markets, U.K. 1) E.M.: GDP growth strong in Q1 after solid Q4. Earnings expectations are being revised up with recovery in external demand, solid consumption growth and solid oil and commodity prices. However, EM now trades at a premium to DM on some valuation measures. 2) U.K.: Surge in manufacturing PMI suggests economic recovery is gaining momentum. Valuations and sector composition are attractive. BoE expected to remain on hold until late 2010. Modest Overweight: Japan Earnings are recovering strongly. BoJ remains on hold. However, recent yen strength and stock valuations are negatives. Japan s economic recovery on track to soften in Q1 with fiscal stimulus phasing out. Neutral: Eurozone Eurozone Q1 GDP growth tracking 1.2%. Increased risk aversion due to Greek debt situation is a negative. Eurozone earnings expected to rise sharply in Q1 and 2010. Eurozone stocks attractively valued and trading at a discount to U.S., Japan and EM. Underweight: U.S. GDP is expected to rise 3.5% in Q1. Q4 earnings season better than expected, but valuations still remain expensive relative to other markets. Greek debt problems and regulatory noise from Washington are likely to keep stocks volatile. GLOBAL BONDS Overweight: EM, Japan 1) EM spreads are likely to be pressured upwards in the near-term due to increased risk aversion, but should narrow later given the outlook for strong GDP growth in emerging economies and firm oil and commodity prices. 2) Relatively weak economic outlook and persistence of deflation favors JGBs. The BoJ is expected to remain on hold through 2011. Valuations are attractive. Rising fiscal deficit and bond supply is a negative. Neutral: UK, Eurozone 1) Relatively weaker GDP recovery should support U.K. Gilts. BoE is unlikely to raise rates until late in 2010 and they are unlikely to unwind their QE program significantly. However, inflation is expected to be elevated in early 2010 before falling in Q2. 2) Greek debt situation is likely to be the primary driver of Eurozone yields until the crisis is resolved. GDP growth is expected to rise modestly. Inflation expected to remain below levels in the U.S. or the U.K., though it will be stronger than in Japan. Underweight: U.S. Treasury yields likely to be under relatively greater pressure with a solid GDP growth in Q1 and elevated headline inflation. However, Treasuries are supported by elevated risk aversion and demand from commercial banks. GLOBAL SECTORS Overweight: Energy, Materials, Industrials, Financials, Info. Technology. Neutral: Consumer Discretionary. Underweight: Consumer Staples, Healthcare, Telecomm, Utilities. CURRENCIES Overweight: U.S. Dollar; Neutral: Yen, EM currencies; Underweight: Sterling, Euro. For Informational Use Only. Not Intended As Investment Advice. Page 2
The U.S. dollar should continue to remain in an uptrend against most developed currencies in the near-term. Relatively stronger U.S. growth will be favorable for dollar appreciation. Further, the dollar is likely to benefit against the euro until the Greek debt crisis is resolved. Relative to euro and pound, the yen s outlook is relatively better with a stronger growth outlook and banking system. Regional Equity Strategy Emerging Markets (EM): Most emerging economies posted solid Q4 GDP growth with over 10% in China, around 8% in India and Brazil. However, the strong growth momentum has prompted several emerging central banks to start draining liquidity from the financial system, raising concerns about a sharper-than-expected slowdown in these economies. However, we expect emerging central banks to undertake gradual policy normalization not aggressive tightening. Emerging Asia continued to be driven by the recovering external demand and strong domestic demand. Emerging Europe and Latin America are benefitting from the solid oil and commodity prices. Emerging Market earnings growth for 2010 is expected around 30%, around 34% in China and 20% in India. Earnings growth in EM Europe and EM LatAm is expected to post a solid rebound in 2010. However, EM now trades at a premium to DM on some valuation measures. Currency appreciation is a further negative for EM stocks. Remain Overweight. U.K.: The U.K. economy finally exited the recession in Q4, but GDP growth continued to disappoint, rising just 0.4% after falling -0.6% in Q3. The surge in U.K. PMI manufacturing confidence in January suggests that the industrial recovery is gathering momentum. Valuations and sector composition remain positives for U.K. stocks. The BoE held the U.K. bank rate at 0.5% in February and completed Gilt purchases as part of its asset purchase program. Remain Overweight. Japan: The Japanese economic recovery is on track to soften in Q1, after 1.2% QoQ in Q4, with the fiscal stimulus phasing out while consumer fundamentals remain soft and the outlook for capex remains weak. Recent yen strength is another headwind for Japan s recovery. The BoJ left its target overnight call rate unchanged at 0.1% in January, and is likely to remain on hold through 2010. Japanese earnings are expected to rise around 95% in 2010, partly due to base effects and also likely to get a boost from the continued recovery in the GDP growth in 2010. However relative valuations remain expensive. Hence, upgrade Japan to modest overweight. Eurozone: Eurozone GDP in Q4 came in at a slower than earlier expected 0.4% annualized rate due to expiry of the auto incentive programs. Eurozone GDP growth is expected to remain anemic in Q1 2010, around 1.2% as auto purchase programs roll off in other countries and deficit reduction plans in Greece, Spain and Portugal. The ECB continue to hold rates at their record low of 1% at the February meeting and is likely to remain on hold through late 2010. Eurozone earnings are expected to rise around 28% in 2010 driven by solid recovery in sales and wider margins. Eurozone stocks are still attractively valued and trading at a discount to the U.S., Japan and Emerging Markets. Increased risk aversion due to the debt problems in Greece, Spain, and Portugal are a negative..downgrade to Neutral. U.S.: U.S. GDP growth surged in Q4, rising 5.7% QoQ annualized following the 2.2% growth in Q3. We expect U.S. GDP growth to come in around 3.5% in Q1 with inventories likely to turn positive and positive contributions from fiscal stimulus, business investment spending and housing investment. The Fed left rates unchanged at the January meeting and remains on a path of winding down its temporary emergency liquidity programs, while leaving the key Fed funds rate unchanged. U.S. earnings are expected to rise 206% YoY in Q4 and 35% in Q1 and 27% for full year 2010. With U.S. GDP rising 5.7% in Q4 and expected to rise around 3.5% in Q1, revenue growth is expected to improve further contributing to earnings growth. Remain Underweight. Regional Bond Strategy Emerging Markets: The debt crisis in Greece and other Southern European countries is currently a major drag on EM bond returns due to the decline in risk appetite. Hence, over the short-term there are risks that EM bonds will underperform due to the risk of contagion. Over a longer period, we expect the debt issues in Greece, Spain and Portugal to be resolved and risk appetites to return. Growth in emerging economies is on track to accelerate with exports growing, suggesting a further narrowing of spreads as the crisis is resolved. There is still room for spreads to narrow, since they are still higher than they were before the crisis. Commodity prices have corrected sharply recently, but further increases in prices could put downward pressure on yields. After a long period of cutting rates sharply, EM central banks are mostly on hold, but some (like China) are beginning to remove the monetary stimulus. Remain Overweight. Japan: Macro factors are most favorable for Japanese bonds with growth uncertainty, the persistence of deflation and the BoJ expected to remain on hold through 2010. Elevated real yields are also positive for Japan. Japanese bonds are also more attractively valued relative to Japanese stocks, than U.S. and U.K. bonds are to their respective stock indices. Japan s economic recovery continued in Q4 with GDP estimated to have risen over 1.2% QoQ or 5% annualized. However, GDP growth is on track to soften in Q1 to around 2% with the fiscal stimulus phasing out while consumer fundamentals remain soft and the outlook for capex remains weak. Deflation remains entrenched with core inflation at -1.3% YoY in December, and headline inflation around -1.7%. Prices outside food and energy (or the core core inflation) remained depressed, falling to -1.2% in December. The BoJ left its target overnight call rate unchanged at 0.1% in late January, as expected. The bank continued to highlight that they will maintain the extremely accommodative environment and warned that there is not yet sufficient momentum to support a self-sustaining recovery in domestic demand. Remain Overweight. U.K.: The outlook for U.K. Gilts is mixed. Economic growth in the U.K. is expected to be improve later in the year, but still remain relatively weak. U.K. GDP continued to disappoint, rising just 0.4% QoQ annualized in Q4 after falling -0.6% in Q3. However, U.K. headline CPI inflation jumped up to 2.8% YoY in December from 1.9% earlier, with roughly equal help from base effects and strongly rising core inflation. Core inflation also jumped to 2.8% in December. Inflation is expected to be elevated in early 2010 before falling in Q2. When inflation begins to fall, this will be a positive for U.K. Gilts. Finally, the BoE is unlikely to raise rates until very late in 2010 and they are unlikely to unwind their QE program significantly. This is a positive for U.K. bonds. Downgrade to Neutral. Eurozone: Eurozone yields are likely to be driven by debt problems in Greece, Spain & Portugal until the crisis is resolved. The announcement that the EC supported the Greek deficit reduction plan put downward pressure on Greek spreads in early February, but Portuguese spreads have widened. Looking beyond the debt problems in Southern Europe, GDP growth in Eurozone is expected to rise modestly, much slower than the U.S. as Greece, Spain and Portugal (which together account for 16% of Eurozone GDP) undertake For Informational Use Only. Not Intended As Investment Advice. Page 3
aggressive spending cuts and tax increases to sharply reduce their fiscal deficits and debt levels. Further, Eurozone headline inflation rose to 1% YoY in January from 0.9% in December. Eurozone inflation is expected to remain below levels in the U.S. or the U.K., though it will be higher than in Japan. On balance, the outlook for Eurozone bonds is mixed. Remain Neutral. U.S.: Treasury yields are likely to back-up with solid GDP growth in H1 combined with relatively elevated headline inflation. U.S. GDP is on track to solid GDP growth around 3.5% annualized in Q1, slower than the 5.7% pace in Q4. U.S. headline consumer prices jumped up to 2.8% YoY in December from 1.9% in November. Headline inflation is likely to remain elevated during H1. Further, nominal yields are low and Treasury valuations are still unattractive relative to U.S. stocks. However, the rise in yields is likely to be limited by elevated risk aversion due to the Greek debt problems, easing core inflation, the Fed remaining on hold, and strong demand for Treasuries, particularly from domestic commercial banks. Over the next few months, the Fed will begin outlining its exit strategy, eliminating a major factor holding back long-term yields. This suggests a relatively mixed outlook for U.S. Treasuries in the short-term driven by the Greek debt situation, but a more negative outlook later on. Remain Underweight. Global Sector Strategy Our global sector model ranks sectors on a comparative basis using macro factors, valuation, earnings and risk measures. Energy - Oil prices declined on dollar strength and the worries about a larger than expected slowdown in EM demand. Fundamentals are still positive for oil with the recovery in OECD demand while EM demand remains solid. IEA oil demand forecast is for +1.7% YoY growth in 2010. Energy's earnings expected to rise 36% in 2010. Remain Overweight. Materials - Commodity prices tumbled in January. However, base metal demand is expected to recover, supported by OECD restocking in H1. Supply side bottleneck a further support for commodity prices and is a positive for Metal & Mining industry. Sector valuation is expensive. Sector earnings expected to surge 65% in 2010. Earnings revision remains high. Remain Overweight. Information Technology - Earnings expected to surge 38% in 2010. Orders for Tech products continues to improve. Earlier than expected commercial PC refresh cycle a positive for the PC hardware industry. More economically levered Info Tech segments such as semiconductors and hardware should outperform less levered segments such as software. Remain Overweight. Financials - Financials earnings expected to rise 42% in 2010. Capital market and M&A activities recovering. Banks should benefit from the decline in write-offs. Valuation is expensive, but set to improve once earnings normalize. Obama Administration s proposal to limit risk-taking at banks are negative for U.S. financials. Greek debt crisis a negative for European banks. Remain Overweight. Industrials - Business confidence and industrial production continues to improve globally. Global Industrials earnings expected to rise 27% in 2010 as global growth recovers. Improvement in the macro outlook to translate into positive revenue and earnings revisions for the sector in the coming months. European Industrials benefiting from high EM exposure. Remain Overweight. Consumer Discretionary - Sector fundamentals remain negative with elevated unemployment rates globally. Consumer confidence remains mixed in major markets. Recovery in consumer net worth likely support consumption. Sector earnings expected to rebound 59% in 2010. Earnings revisions are high at 9.4% in January. Discretionary likely to outperform Staples in the coming months. Remain Neutral. Consumer Staples - Sector earnings remain resilient with expectations of 11% growth in 2010. Sector s valuation remain attractive. The sector offers attractive dividend yields while low payout ratios indicating further potential for dividend increase. Recent market volatility is positive for the sector, but any improvement in risk appetite is negative for the sector. Remain Underweight. Healthcare - The surprise election of Republican Scott Brown has altered the U.S. healthcare reform agenda, making the dramatic reform in the healthcare less likely, thus a positive for most of the sector. However, regulatory and product uncertainties are likely to continue to pressure the sector. Sector valuations are attractive. Earnings are expected to rise 9% in 2010. Remain Underweight. Telecomm Services - Telecomms are underperforming as the early stage economic recovery favors other cyclical sectors. Sector valuation are attractive with a high dividend yield. However, increasing competition has put downward pressure on margins. Negative consumer fundamentals still a drag for the sector. Earnings expected to rise 7% in 2010. Remain Underweight. Utilities - Rising risk appetite remains a key headwind for the sector. Further, firm energy prices are likely to cut into profit margins. Sector earnings are expected to rise just 7% in 2010. Valuations are attractive with Utilities offering an attractive dividend yield, which is above its historical average. Remain Underweight. Strategy Summary: Asset Allocation Remain Overweight: Stocks. Remain Underweight: Bonds. Global Equities Overweight: Emerging Markets & U.K.; Modest Overweight: Japan; Neutral: Eurozone; Underweight: U.S. Global Bonds Overweight: Emerging Markets & Japan; Neutral: U.K. & Eurozone; Underweight: U.S. Global Sectors Overweight: Energy, Materials, Industrials, Financials, Info. Technology Neutral: Consumer Discretionary. Underweight: Consumer Staples, Healthcare, Telecomm, Utilities. Currencies Overweight: U.S. Dollar; Neutral: Yen, EM currencies; Underweight: Sterling, Euro. For Informational Use Only. Not Intended As Investment Advice. Page 4
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