Government Bonds Have Never Looked Less Attractive OUTLOOK Executive Summary Kenneth J. Taubes Chief Investment Officer, US Economic Outlook US GDP growth may lead growth among developed nations, at approximately 2.% over the next year and over 2.% for the second half of 216. Solid employment should continue to support consumption and the housing market; inventory restocking and government spending should also contribute to growth. The Brexit leave decision may have a modest negative impact on global growth, but this negative impact may be offset by improving growth in emerging markets. Global economies will continue to be supported by easy global monetary policy. Following on improving economic data and easier financial conditions, we believe the Federal Reserve may consider increasing rates in 216. It may, however, take a cautious approach to rate increases, monitoring international developments and particularly the impact of Brexit on global growth, thereby reducing the possibility of sharp dollar appreciation. Market Outlook Most developed market sovereigns, including US government debt, offer little value, with negative nominal yields or in the case of the US, negative or very low real yields. Corporate and structured credit remain attractive based on relative value and fundamentals Select emerging market sovereigns are attractive, with reasonable valuations, stabilized commodity prices and improving growth prospects. The US dollar should trade in a range, given less hawkish Federal Reserve policy. We favor US equities over fixed income, based on more attractive relative value. US earnings growth, while limited, is improving. US Economic Outlook: Improving GDP Growth Recent US economic data indicate that the US may deliver growth of over 2% as well as modestly higher inflation for the second half of the year, for overall 2.% GDP growth over the next 12 months. While second quarter GDP growth came in below expectations at 1.2%, real final sales (GDP less inventories) rose at a solid 2.4%, as consumer spending increased 4.2%. Inventory destocking accounted for the major drag on second-quarter GDP, reducing total GDP growth by 1.2%. The inventory component has now reduced growth in each of the past five quarters, representing the most extended period in 6 years. As corporations liquidated excess inventories, they saw little need for capital spending, resulting in the worrisome decline in non-residential (business) investment at -2.2%, including -7.9% for structures and -3.5% for equipment. On a contribution basis, non-residential investment reduced GDP by -.3% and has now detracted from GDP growth for the past three quarters. Corporations may have deferred investment in the face of heightened uncertainty caused by Brexit and the upcoming US election. In addition, rig counts of US energy firms only bottomed in May. The sector has accounted for a significant portion of recent fixed investment over the past five years.
As oil prices stabilize at higher levels, and with receding risks from Brexit, we anticipate a rebound in inventories and a potential increase in fixed investment in the second half of the year. Key employment indicators suggest continued economic strength. Positive Momentum Over the next six months, US GDP may advance on multiple fronts, with the US consumer continuing to drive growth. The Citi US Economic Surprise Index has reflected this positive momentum, coming off its near-term May low of -4. to 1. as of 8/23/16. Key employment indicators suggest continued economic strength. Non-farm payrolls rebounded in July for an average gain over the past three months of 19, and both ISM manufacturing and services employment indices recovered to over 5.. The four-week moving average of weekly initial jobless claims, a leading employment indicator, has fallen to near 4-year lows. Labor Market Showing Strong Gains Net Change (Persons in s) 6 4 2-2 -4-6 -8-1 25 26 27 28 29 21 211 212 213 214 215 216 Non-Farm Payroll 12 month Average 3 month Average Source: Bloomberg, latest data point 7/31/16 Importantly, while employment gains have decelerated as the economy nears full employment, monthly payrolls gains need not match the 23, average of the past few years to achieve further declines in the unemployment rate. As long as non-farm payroll employment grows by at least 1, per month, the unemployment rate should continue to decline. As indicated in the chart below, the size of the labor force is a major determinant of nominal GDP growth. In July, the US labor force grew by 1.4% year over year. Adjusted for the participation rate, it grew by 1.7%, which represents the second strongest rate of change in eight years. Labor Force and GDP Growth 2 Nominal GDP (%) 12 3.5% 11 3% 1 9 2.5% 8 7 2% 6 1.1% 5 4 1% 3 2.5% 196 1965 197 1975 198 1985 199 1995 2 25 21 215 US Labor Force YoY Change (5yr moving average, right) Source: Bloomberg. Last data point 7/31/16 NGDP YoY Change (5yr moving average, left) Labor Force
It is the recent surge in retail sales, however, that represents the most important current consumption-related data. Rising employment, wage growth, low mortgage rates, increased household formation and easing credit standards have underpinned strong consumer spending. New and existing home sales stand at respective 8-year and 9-year highs, and housing starts have recently broken out above average 215 levels. While down from last year, auto sales remain solid. It is the recent surge in retail sales, however, that represents the most important current consumption-related data. Having lagged earlier in the year, retail sales came in well above expectations in June, delivering a meaningful recovery in total real consumption of 4.2% for the second quarter, compared to 1.6% for the first quarter. Although consumption continues to drive growth, government spending may also contribute significantly to growth over the next year. Second half government spending should improve, as the benefits of the 215 budget bill come on stream, after falling.9% in the second quarter. Furthermore, both US presidential candidates, Hillary Clinton and Donald Trump, have indicated significant commitment to infrastructure spending in the next administration, which would further bolster the contribution from government spending. We believe that the moderating US dollar and recovering oil prices have enabled a bottoming, and even a modest recovery, in manufacturing and business investment, which reduced GDP growth in 215 and in the first half of 216. The June and July manufacturing ISM rose well above consensus to 53.2 and 52.9, respectively, buoyed by respective gains in new orders to 57. and 56.9, up from the December low of 48.. The non-manufacturing ISM surged to 56.5 and 55.7 in June and July, with new orders even stronger at 59.9 and 6.3, respectively. New Orders Helped Buoy Manufacturing Manufacturing Index 7 6 Index Level 5 4 3 2 Dec-99 Dec-4 Dec-9 Dec-14 Manufacturing Index Manufacturing New Orders Non-Manufacturing Index 7 6 Index Level 5 4 3 2 Dec-99 Dec-4 Dec-9 Dec-14 Non-Manufacturing Index Non-Manufacturing New Orders Source: Bloomberg, last data points 7/31/16 3
June and July industrial production came in well above expectations, reflecting in part the turnaround in mining (which includes oil exploration and production). The mining sector rose.7% in July compared to the prior month. Although current $47 oil prices have fallen from their recent $51 high, they have recovered significantly from their $26 low in early February. Business investment may benefit as higher oil prices encourage higher rig counts; US rigs have already increased by 15% from their May lows. Inflation may increase over the second half of the year. Wage inflation, which is closely watched by the Fed, continues to grind higher. Inventory destocking was a primary cause of low second-quarter GDP. However, we anticipate that inventories may also add to growth over the next few quarters, given improved second quarter real final sales of 2.4% (they tend to lead inventories by three to six months) 1 and our expectation that manufacturing and energy have stabilized. Higher Inflation Inflation may increase over the second half of the year. CPI and core CPI rose.8% and 2.2% respectively, year-over-year in July, compared to.7% and 2.1% at year-end 215, as the dollar has moderated, wages have increased and energy prices have recovered. Core PCE, the preferred inflation measure of the Fed, rose 1.6% year-over-year in June, and is up 1.9% year-to-date, annualized, compared to 1.4% in December, 215. Wage inflation, which is closely watched by the Fed, continues to grind higher. The employment cost index (ECI) has risen from 1.9% year over year in the first quarter of 216, to 2.3% in the second quarter. Average hourly earnings (AHE) have increased steadily to the current 2.6% year over year as of July, from 2.3% in 215 and 2.1% in 214. Finally, the Atlanta Fed s wage tracker indicates that median wage growth has climbed from less than 2.% in 212 to 3.6% over the past year. Median Wage Growth 6. 5. % Change 4. 3. 2. 1.. Mar-97 Mar-98 Mar-99 Mar- Mar-1 Mar-2 Mar-3 Mar-4 Mar-5 Mar-6 Mar-7 Mar-8 Mar-9 Mar-1 Mar-11 Mar-12 Mar-13 Mar-14 Mar-15 Mar-16 Source: Atlanta Federal Reserve Bank, June 216 1 Source: Barclays US GDP and annual revisions as of 8/5/216. 4
The global growth in money supply has helped reduce yields and the cost for credit. While the ECI and AHE levels are atypically low at this point in the cycle, the continued upward trend is significant. We believe GDP growth and inflation may increase in the wake of easier financial conditions, which will continue to support the US consumer. In particular, the moderating dollar, a rising global money supply, higher energy prices, easier lending conditions, and lower corporate spreads and lower mortgage rates have created a favorable environment for growth. The global growth in money supply has helped reduce yields and the cost for credit. Global Growth in Money Supply USD (B) US 14 12 1 8 6 4 2 24 26 28 21 212 214 216 EUR (M) EU 3, 25, 2, 15, 1, 5, 24 26 28 21 212 214 216 JPY (B) 2, Japan 15, 1, 5, 24 26 28 21 212 214 216 CNY (B) China 3, 2,5 2, 1,5 1, 5 24 26 28 21 212 214 216 GBP (M) UK 7, 6, 5, 4, 3, 2, 1, 24 26 28 21 212 214 216 INR (B) India 1,4 1,2 1, 8 6 4 2 24 26 28 21 212 214 216 Source: Datastream, last data point 6/3/16. Currencies expressed in USD-US dollar, EUR-euro, JPY-Japanese yen, CNY-Chinese yuan, GBP-Great British pound, INR-Indian rupee. Given this constructive outlook for GDP and inflation, we believe that the September 21, 216 meeting may represent a live meeting for the Federal Open Market Committee (FOMC), as indicated by Vice Chairman William Dudley. However, ultimately they will only discuss raising rates at this meeting. We believe that December 14, 216 represents the more likely date when the Fed will increase rates. Fed Chair Janet Yellen began making the rate case at her August 26, 216 Jackson Hole speech. 5
Market Outlook We continue to believe credit sectors offer value compared to government securities. Fixed Income We continue to believe credit sectors offer value compared to government securities. With approximately 35% of the global treasury market trading at negative nominal yields and US Treasuries of 1 years and below trading at negative real yields (using core PCE as the inflation measure), government securities have never looked less attractive. We have never believed that it makes sense to pay a borrower for the privilege of lending them money. Corporate credit continues to be moderately attractive. Corporate balance sheets are strong and profits may increase as economic growth improves, the value of the dollar moderates and energy prices stabilize. Second quarter earnings, although still weakened by the energy sector, have come in better than expected with 7% of companies reporting positive earnings surprises, compared to a long-term average of 63%. In addition, the US Bureau of Economic Analysis (BEA) increased its estimate of first quarter corporate earnings growth in its annual 216 adjustment. Corporate Profits Percent Change from Previous Period, SAAR 4% 3% 2% 1% % -1% -2% -3% 33.1% 14.3% 4.1% 3.6% -6.6% -3.2% -1.% -11.5% -22.3% Q114 Q214 Q314 Q414 Q115 Q215 Q315 Q415 Q116 Source: Bureau of Economic Analysis, last data point 3/31/16. SAAR Seasonally Adjusted Annual Rate 6
Corporate Fundamentals Are Normal Earnings leverage ratios remain within normal ranges, and coverage ratios benefiting from low rates have risen to near all-time highs. Although investment grade and high yield spreads have narrowed recently to levels below long-term averages, high yield default rates, excluding the energy sector, should remain well below long-term averages over the next few years. The par-value high yield default rate in June, excluding the energy and metals and mining sectors, was a mere.53%. 2 We see particular value in bank loans, where BB and B yield to maturities are only modestly lower than the corresponding ratings in the high yield market, but without the duration risk. Yield to Maturity: BB HY Loans vs. Bonds 12. 1. 8. % 6. 4. 2. Dec-1 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 BB Loans BB HY Bonds Yield to Maturity: B HY Loans vs. B HY Bonds 12. 1. 8. % 6. 4. 2. Dec-1 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 B Loans B HY Bonds Source: Bloomberg, last data point 7/27/16 Non-agency structured credit is attractive in light of the strong housing and commercial real estate markets in the US. We continue to find high quality non-agency mortgage-backed securities jumbo prime new issues attractive. Although supply remains limited, with banks retaining the bulk of this underwriting on their balance sheets, these credits trade approximately 2.5% behind like-coupon agency pass-through securities. Select higher yielding emerging market sovereigns are attractive, with reasonable valuations and stabilized commodity prices. Most recently, emerging market issues have rallied, as investors have viewed these economies less vulnerable to the Brexit fallout than the UK and European markets. 2 JP Morgan Default Monitor, July 1, 216. 7
Despite the recent uptick in value stocks, US growth should continue to outperform in this low growth environment. A Moderating US Dollar After its record appreciation in 213-215, we believe the US dollar should trade in a range, given less hawkish Federal Reserve policy. We believe the FOMC could raise rates this year. That said, the latest FOMC statement in July, while more positive, shows continued caution with respect to rate increases. Even post-brexit, with anticipated easing among non-us central banks, the dollar has not retraced to its October highs. Equities We favor US equities over fixed income as valuations are relatively better. US earnings growth, while limited, is improving. However, after the strong performance of US equity over the last five years, absolute valuations are becoming higher while international equity is starting to become more attractive. Adjusted for inflation, earnings yields are significantly more attractive than real bond yields. Even 1-year US Treasuries, when adjusted for inflation, offer a negative real yield. Despite the recent uptick in value stocks, US growth should continue to outperform in this low growth environment. Sector Weights: Russell 1 Growth Index vs. Russell 1 Value Index Russell 1 Growth Index Russell 1 Value Index 35 3 25 2 % 15 1 5 Consumer Discretionary Consumer Staples Energy Financials Health Care Industrials Technology Materials Telecommunications Utilities Source: Pioneer Investments and Bloomberg. As of 6/3/16. Russell 1 Growth Index measures the performance of large cap US growth stocks. Russell 1 Value Index measures the performance of large cap US value stocks. Indices are unmanaged. It is not possible in invest directly in an index. Within value, we believe demand for income-oriented securities will continue as long as the low rate environment persists. We favor large- over small-cap companies in the US, as we believe market leadership is shifting toward large cap after a 15-year run in small cap. There are also opportunities in mid-cap stocks, many of which have solid prospects and should do well in a slow growth environment. 8
Unless otherwise stated, all information contained in this document is from Pioneer Investments and is as of July 31, 216. The views expressed regarding market and economic trends are those of the author and not necessarily Pioneer Investments, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Pioneer Investments product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. Indices are unmanaged and their returns assume reinvestment of dividends and do not reflect any fees or expenses. You cannot invest directly in an index. This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service. Pioneer Investments is a trading name of the Pioneer Global Asset Management S.p.A. group of companies. Date of First Use: 8/25/16 Pioneer Investments 6 State Street, Boston, Massachusetts 219 216 Pioneer Investments us.pioneerinvestments.com 297--816