PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC. Global Investment Outlook & Strategy September 2015 Stock Market Volatility likely to Remain Elevated in Near-term on China Concerns & Fed Uncertainty. Stocks likely to Recover with ECB s QE & Draghi Put, Solid GDP Growth in U.S. & U.K., Healthy Earnings Growth & Improved Valuation Bond Yields Range-bound as Elevated Risk Aversion, Low Inflation & ECB & BoJ QE Buying Offset by Solid U.S. Growth & Fed Uncertainty John Praveen, PhD Chief Investment Strategist FOR MORE INFORMATION CONTACT: Theresa Miller Phone: 973-802-7455 Email: theresa.miller@ prudential.com John Praveen s Global Investment Outlook for September 2015 expects global stock markets to remain volatile in the near term with China turbulence, Fed uncertainty and fresh Greek risks. However, stocks are likely to recover with support from liquidity and low interest rates, solid GDP growth in the U.S. & U.K., healthy earnings growth and improved valuation following the sharp correction in July and August. Stocks: Global stock markets fell sharply in August with the Chinese market continuing to struggle, the surprise Yuan devaluation and the renewed decline in oil and commodity prices. After a vicious sell-off through August 24th, the People s Bank of China cut interest rates on August 25th sparking a global relief rally. Whether the PBoC rate cut rally is the start of a stabilization process remains to be seen as earlier measures by Chinese policy makers have had limited and short-lived success. Developed markets fell -6.8% in August taking YTD losses to -1.7%, while emerging markets declined -6.7%, down -7.2% YTD. Looking ahead, stocks are likely to remain volatile in the near term on China concerns, Greek risks and Fed uncertainty. Market turbulence is likely to continue until Chinese policy makers succeed in stabilizing the market and ease fears about the economy, and the Fed manages to engineer a smooth rate lift-off. Looking beyond the current struggles, stocks are likely to recover driven by: 1) Liquidity & Low Interest Rates: Global central banks continue to provide liquidity with ECB & BoJ QE buying and possible expansion, while China s PBoC and other policy makers continue to take measures to stabilize Chinese market and boost growth. Further, Fed rate lift-off is likely to be delayed; 2) Improved Growth in Developed Economies: While there are concerns about growth in China and other Emerging Markets, GDP growth in U.S. and U.K. remains solid and Eurozone and Japan are on track to improve; 3) Solid Earnings Outlook: Q2 earnings came in better than expected and the earnings outlook is expected to improve in H2 with solid GDP growth; 4) Improved Valuations: P/E multiples have improved after the recent sell-off in stocks. Further, stocks remain cheap relative to bonds with the earnings yield gap widening. Bonds: Global bond yields were volatile in August, falling with the equity sell-off and renewed decline in oil prices. Yields rose as the China rate cut sparked a relief rally in global stock markets. Looking ahead, bond yields are likely to be range bound. Bonds remain supported by: 1) Safe haven demand with elevated risk aversion on China and Greece concerns; 2) QE buying and possible expansion by ECB & BoJ; & 3) Low inflation. However, Yields are likely to be under modest upward pressure from: 1) Solid GDP growth in the U.S. and U.K., and improving growth in Japan and Eurozone; 2) Potential Fed tightening tantrum; 3) Valuations relative to stocks have deteriorated with the rise in equity yields on falling P/E multiples. 1 *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.
Market Outlook: After a Sharp Sell-off, Stocks Stage Relief Rally in late August with China Easing. Equity Volatility likely to Remain Elevated on China Concerns & Fed Uncertainty. Stocks Likely to Recover with ECB QE, Solid GDP in U.S. & U.K., Healthy Earnings & Improved Valuation Bond Yields Range-bound with Elevated Risk Aversion, Low Inflation & ECB & BoJ QE Buying but Offset by Solid Growth in U.S. & U.K. & Fed Rate Uncertainty Stock Market Outlook (September): Global stock markets fell sharply in August on China and Emerging Markets (EM) growth concerns, a renewed decline in oil and commodity prices, and Fed uncertainty in the run-up to the September FOMC meeting. Global equity markets fell sharply through August 24th, but staged a relief rally after the People s Bank of China (PBoC) cut interest rates and lowered the required reserve ratio (RRR). The rate cut sparked a global relief rally, helping equity markets to erase some of the losses. Developed markets declined -6.8% in August taking YTD losses to -1.7%, while emerging markets declined -6.7%, down -7.2% YTD. Looking ahead, stocks are likely to remain volatile in the near term with growth concerns in China and other emerging markets, Fed rate uncertainty and another Greek drama. Stock market turbulence is likely to continue until Chinese policy makers succeed in stabilizing the stock market and ease fears about the economy, the Fed manages to engineer a smooth rate lift-off and the Greek elections on September 20 th does not jeopardize the bail-out deal. Looking beyond current struggles, stocks are likely to recover, driven by central bank liquidity and continued low interest rates, solid GDP growth in the U.S. & U.K. & growth improvement in Eurozone & Japan, healthy earnings growth and improved valuations following the recent decline: 1) China Easing, ECB & BoJ QE Buying and Possible Expansion, Fed likely to Delay Rate Lift-off, U.K. Rate Hikes Pushed out, Rate Cuts by Other Central Banks: Global Central banks continue to provide liquidity and keep interest rates low with China s PBoC taking easing measures to stabilize the Chinese market and the economy, while the ECB and BoJ continue QE buying and are likely to expand QE. In response to a sharp sell-off in stock markets through August 24th, the People s Bank of China (PBoC) cut interest rates and lowered the required reserve ratio (RRR) for banks for the second time in two months. The PBoC cut the one-year benchmark bank lending rate by 25bps to 4.6% and reduced RRR by 50bps to 18%. The RRR cut is expected to inject around RMB 700bn of liquidity. With economic indicators pointing to continued weak Chinese demand, further monetary easing and fiscal stimulus steps such as tax cuts and infrastructure spending are likely in the near-term to boost growth. Earlier, in a surprise devaluation move on August 11 th, the PBoC lifted the daily USD/RMB exchange rate fixing and has allowed the RMB to depreciate around 4% against the US$. While the currency depreciation may provide some help, the policy focus has been more on mobilizing credit and other funding sources for public investment purposes. The count-down to the U.S. Federal Reserve s September meeting continues with uncertainty regarding rate liftoff. Recent Fed statements have been mixed and minutes of the last Fed meeting does not provide definitive guidance that the Fed is on the cusp of rate lift-off in September. The meeting minutes show that while Fed members acknowledged progress in economic activity and employment, they remained uncertain about inflation. Since the last Fed meeting, U.S. domestic activity and employment have continued to improve (Q2 GDP revised up to 3.7%), supporting the Fed s expectations that economic conditions would strengthen and prevent inflation from weakening further due to the renewed decline in energy and commodity prices. Improved data supports the case for the Fed to initiate rate lift-off in September. However, given the recent sell-off in global stock markets, the Fed may choose to delay the start of rate normalization so as not to add to market turbulence. Whether the Fed starts lift-off in September or in Q4, the rate hikes are likely to be modest and gradual. The ECB left monetary policy unchanged at their early September meeting. The ECB made minor changes to their asset purchase policy, giving it more flexibility to expand QE if necessary. Specifically, the ECB increased the share of bonds it can purchase to 33% of each issue from 25%. At the press conference, President Draghi renewed the ECB 2 For informational use only. Not intended as investment advice.
Put and assured that the ECB could expand its stimulus program if slowdown in large emerging economies and turbulence in financial markets makes it difficult to lift inflation to the ECB s 2% target. The ECB s message in September reiterates its reassurance in July that it stands ready to use "all the instruments available within its mandate" and adjust the size, composition and duration of its QE program to provide stimulus. In the U.K., the BoE left monetary policy unchanged in August. Recent BoE communications suggest that with muted price pressures, rate hikes in the U.K. have been pushed out to late 2015 or early 2016. The Bank of Japan (BoJ) made no changes to its monetary policy in August and also maintained its outlook for the economy and inflation, despite the Q2 GDP contraction. The BoJ is likely to expand QE stimulus with GDP growth weakening and with inflation expected to turn negative again in coming months. Several developed and emerging central banks have been cutting rates. Among Emerging central banks, India, Russia, Korea, Hungary, have cut rates and further easing measures are likely. Brazil's central bank appears to have reached a peak of the current tightening cycle, given the GDP contraction 2) Solid H2 Growth in U.S. & U.K., Japan & Eurozone on Track to Improve. Emerging Economies Struggle: Global growth remained uneven in Q2 with a solid GDP rebound in the U.S. (+3.7%, revised up from 2.3%) and U.K. (+2.8%) while Japan GDP contracted (-1.6%) after a strong Q1 (+4.5%). Eurozone weathered the Grexit crisis but Q2 GDP came in below expectations (1.2%). Emerging markets continued to struggle with Brazil and Russia in recession, and slower growth in other EM. China GDP growth was stable around 7% but recent soft data and the Yuan devaluation are raising concerns about Chinese growth. Looking ahead, GDP growth is expected to remain solid in the U.S. and U.K. with upside risks. U.S. Q3 GDP growth is tracking over 3%, building on the solid Q2 rebound. The outlook for U.S. consumer spending remains solid with rising employment and strengthening consumer confidence. The outlook for investment spending is improving with solid ISM business confidence both in manufacturing and services. Housing is also contributing to growth. U.K. GDP is expected to grow at a solid pace in H2 with rising investment spending supported by business confidence and BoE rate hikes pushed out to late 2015 or early 2016. After a strong Q1, Japanese Q2 GDP contracted -1.6% QoQ annualized driven by a decline in consumer spending and exports. However, Japanese GDP growth is expected to rebound to around 2% in H2 as both consumption spending and net exports are expected to recover and with further improvement in business investment spending. In addition, the government is also likely to step up spending and support GDP growth. The Eurozone economy appears to have weathered the Greek crisis with Q2 GDP growing 1.2% annualized just below Q1 pace of 1.6%. Eurozone growth was led by Spain and Germany, and a growth surprise in Greece. However, French and Italian GDP growth disappointed. Looking ahead to Q3, Eurozone growth is likely to remain modest, around 1.6%, with consumption supported by falling unemployment and low oil prices and exports supported by the weak Euro. However, a likely plunge in Greek Q3 GDP is expected to dent Eurozone GDP. 3) Healthy Earning Growth: Earnings results in Q2 were better than expected in the U.S. and Eurozone and the earnings outlook for H2 is good with solid growth in the U.S., and weak currency tailwinds in Eurozone and Japan. However, EM earnings outlook is revised down further with weaker growth. U.S. earnings results for Q2 were stronger than expected and are likely to improve in H2 with U.S. GDP growth remaining solid. However, energy earnings drag remains a risk for U.S. earnings. Eurozone Q2 earnings results were stronger than expected and the outlook is revised higher to 11% with the weak euro tailwinds and Grexit uncertainty easing. Japanese earnings are expected to grow at a solid 16% pace. Emerging Markets earnings growth outlook has been revised lower on weaker growth. EM Asia earnings expectations have been revised down to 9%, while earnings are expected to decline in EMEA (-14%) and LatAm (-11%). 4) Valuation - Stock Market Multiples Improve in August after Sharp Decline in Stock Prices: Stock market P/E multiples declined in both Developed & Emerging Markets in August with the sharp equity market correction. The P/E multiple for the S&P 500 declined to 17.4X at August-end from 18.6X at the end of July with the index falling -6.3% in 3 For informational use only. Not intended as investment advice.
August. Emerging Market (EM) stock valuations also improved in August with sharp declines across markets. The Chinese CSI 300 index fell -11.8% in August resulting in the P/E falling to 13.7X from 16.6X at the end of July. Stocks remain cheap relative to bonds. The earnings yield gap (EYG) between U.S. stocks and bonds improved in August as the earnings yield on U.S. stocks rose 5.7% after the August sell-off from 5.4% in July, while the 10-year Treasury yield is around 2.2%. The yield gap between U.S. stocks-bonds improved to 3.5% in August from 3.2% in July and is well above its long-term (20-year) average of 1.2%. Eurozone stocks remain cheap relative to bonds on EYG basis with the yield gap improving to 4% from 3.7% at the end of July as the yield on Eurozone stocks moved up to 4.7% from 4.3% in July, while the 10-year Bund yield actually rose to 0.8% from 0.64%. The Eurozone EYG remains above its long-term average of 3.4% (10-year average). The Japanese stocks earnings yield gap rose to 4.7% in August from 4.25% in July and has improved significantly above its long-term 10-year average of 3.6%. Bottom-line: Global stock markets fell sharply in August with the Chinese market continuing to struggle, the surprise Yuan devaluation raising fears of a currency war, and the renewed decline in oil and commodity prices. After a vicious sell-off through August 24th, the People s Bank of China (PBoC) cut interest rates and lowered the required reserve ratio (RRR) on August 25th. The rate cut sparked a relief rally in global equity markets. However, past measures by Chinese policy makers have had limited and short-lived success. Hence, whether the PBoC rate cut rally is a dead-cat bounce or the start of a stabilization process remains to be seen. Looking ahead, stocks are likely to remain volatile in the near term on China concerns, Fed rate uncertainty and another Greek drama: 1) China Concerns: Market concerns remain about China growth with the recent Yuan devaluation spooking markets by raising fears of a China hard landing and the risk of a destabilizing currency war. Further, markets seem to have less confidence in the will and the ability of the Chinese policy makers to stabilize markets and boost growth; 2) Fed Uncertainty: The count-down to the U.S. Federal Reserve s September meeting continues. Given the recent sell-off in global stock markets, the Fed may choose to delay lift-off so as not to add to market volatility. However, delaying the rate normalization process carries its own risks by prolonging uncertainty; 3) Oil & Commodity Prices: The renewed decline in August has raised the risk of destabilizing the energy sector with declining earnings and increased defaults, and exacerbating deflationary pressures; 4) New Greek Drama: Greece faces fresh uncertainties with the resignation of PM Tsipras and snap elections in September with the risk of the bailout deal unraveling in case of a strong showing by the radical, break-away faction of the Syriza party, denying Tsipras a mandate. Looking beyond the current struggles, stocks are likely to recover driven by: 1) Low Interest Rate & Liquidity: While the Fed is set for rate lift-off, other global central banks continue to provide liquidity and keep interest rates low. China s PBoC and other policy makers continue to take measures to stabilize markets and boost growth. The ECB renewed the Draghi Put reassuring that it could expand its QE stimulus program if slowdown in large emerging economies and turbulence in financial markets makes it difficult to lift inflation to the ECB s 2% target. Given the recent sell-off in global stock markets, the Fed is likely to delay rate lift-off in September so as not to add to market volatility. Further, whether the Fed starts hiking in September or in Q4, the rate hikes are likely to be modest and gradual; 2) Improved Growth in Developed Economies: While there are concerns about growth in China and other EM, growth in U.S. and U.K. remains solid with Q3 GDP tracking around 3%. Japanese GDP growth is expected to rebound to around 2% in H2 after contracting in Q2. Eurozone growth is likely to remain modest, around 1.6% in Q3, after having weathered the Greek crisis. However, the Emerging Economies are struggling as concerns about China growth casts a shadow on the growth prospects of the other EMs, especially those dependent on exports to China. Brazil and Russia remain in recession; 3) Solid Earnings Outlook: U.S. Q2 earnings came in better than expected despite strong dollar headwinds and drag from energy earnings and the earnings outlook is expected to improve in H2 with solid GDP growth. Eurozone earnings expectations are revised higher on weak Euro tailwinds and lower energy costs. Japan earnings outlook remains solid, boosted by the weak Yen; 4) Improved Valuations: Stocks remain cheap relative to bonds with the earnings yield gap widening as bond yields have fallen recently. Further, P/E multiples have improved after the recent sell-off in stocks. 4 For informational use only. Not intended as investment advice.
While the stock market recovery is supported by liquidity and low interest rates, healthy GDP in the developed economies, solid earnings and improved valuation, equity markets are likely to remain turbulent until Chinese policy makers succeed in stabilizing the Chinese market and ease fears about the economy, the Fed manages to engineer a smooth rate lift-off, and the Greek bail-out deal does not unravel following the September elections. Bond Market Outlook: Bond Volatile in August on Equity Sell-off. Yields Range-bound with Elevated Risk Aversion, Low Inflation & ECB & BoJ QE but Offset by Solid U.S. Growth & Fed Rate Uncertainty Global bond yields were volatile in August. Yields trended lower in the first half of August as equity markets struggled on China and EM growth concerns, and deflation fears resurfaced with a renewed decline in oil and commodity prices. Yields plunged on safe haven demand in mid-august as China led a vicious global equity sell-off. However, bond yields rebounded in late August as a rate cut by the People s Bank of China on August 25th sparked a relief rally in global stock markets and oil prices rebounded on stronger U.S. GDP data. By August 31 st, U.S. and Japanese yields were largely unchanged at 2.22% and 0.38%, respectively, while Eurozone yields edged up to 0.73% from 0.61%. Looking ahead, bond yields are likely to be range bound with safe haven demand from global uncertainties (China growth, Greek elections and Washington budget fight), low inflation and QE buying by the ECB and BoJ are offset by solid GDP growth in the U.S. and U.K. and potential Fed tightening tantrum. Bonds are supported by: 1) Safe haven demand with elevated risk aversion on continued Chinese market turmoil and growth concerns, potential for the Greek bailout deal to unravel following September elections, Middle East tensions with violence and political uncertainty in Turkey; 2) QE Buying: While Fed is set for rate lift-off, the ECB and BoJ continue QE buying and are likely to expand QE; and 3) Inflation remains low in the Eurozone, U.S. and U.K. and is likely to be under further downward pressure with the renewed decline in oil and commodity prices. However, yields are likely to face modest upward pressure from: 1) Improved growth in the Developed Economies: While Emerging Markets struggle with China slowdown concerns, GDP growth remains solid in the U.S. and U.K., while Japanese GDP is expected to rebound in Q3 after contracting in Q2. Eurozone growth is on track to improve, having weathered the Greek crisis; 2) Potential Fed tightening tantrum: Given the recent sell-off in global stock markets, the Fed may choose to delay lift-off from September so as not to add to market volatility. However, delaying the rate normalization process is likely to prolong uncertainty. Further continued strong U.S. GDP and labor market data could result in reassessment of Fed rate expectation; 3) Bond valuations relative to stocks have deteriorated with stock yields rising on falling P/E multiples, while bond yields remain low. Investment Strategy: Asset Allocation: Stocks vs. Bonds - Stocks likely to Remain Volatile with China Concerns & Fed Uncertainty. Bond Yields likely to be Range-bound Stocks Reduce Overweight as stocks are likely to remain volatile on China growth concerns and market turbulence and Fed lift-off uncertainty. Stocks are likely to recover with ECB QE & Draghi Put, solid GDP growth in the U.S. & U.K., healthy earnings growth & improved valuation after recent sell-off. Bonds Raise to neutral as yields are likely to be range-bound with elevated risk aversion on China and Greek concerns, low inflation & ECB & BoJ QE buying offset by solid GDP growth in U.S. & U.K., and Fed rate uncertainty. Global Equity Strategy: Modest Overweight in Eurozone & Japan. Lower EM Asia to Underweight on China concerns; Raise U.K. to neutral with rate hikes delayed; Underweight in Latin America & EM Europe; Remain Underweight in U.S. Eurozone: Modest overweight with Grexit avoided, ECB QE and Draghi Put for Eurozone financial markets, solid earnings growth with weak Euro. Improving GDP growth but China slowdown a risk to Eurozone exporters. Japan: Modest Overweight. Strong earnings with weak yen tailwinds, GPIF increased equity buying. BoJ likely to increase QE. GDP rebound in Q3 after Q2 contraction. 5 For informational use only. Not intended as investment advice.
Emerging Markets: Lower EM Asia to Underweight on China market turmoil and growth concerns despite policy makers efforts, including another PBoC rate cut in August. Underweight in LatAm & EM Europe with weak oil & commodity prices, Brazil & Russia in recession, and political turmoil in Brazil. U.K.: Raise U.K. to Neutral as BoE rate hikes delayed to late 2015/early 2016 and solid GDP growth offset by drag from the large Energy sector. U.S.: Remain Underweight with increased uncertainty around Fed rate lift-off and risk of tightening tantrum. U.S. Q2 earnings came in better than expected but face strong dollar headwinds and energy earnings drag. Q2 GDP rebound at 3.7% and growth in H2 is expected to remain solid, above 3%. Global Bond Market Strategy: Yields Range-bound with Elevated Risk Aversion, Low Inflation & ECB QE offset by Solid U.S. GDP & Fed Rate Uncertainty Japan JGBs: Remain Overweight with the BoJ likely to expand QE with low inflation. GDP contracts in Q2 but likely to rebound in H2. Eurozone: Remain Overweight with Grexit avoided, ECB s QE and Draghi Put, modest GDP growth and low inflation. U.K. Gilts: Remain Neutral with strengthening GDP growth but offset by low inflation and BoE rate hikes pushed out into late 2015 or early 2016. EM Debt: Lower to Underweight on negative outlook with Fed rate uncertainty, China volatility and a new Greek drama. U.S. Treasuries: Modest Underweight with solid growth momentum in H2 after Q2 GDP rebound (3.7%), Fed uncertainty & risk of tightening tantrum. Global Sector Strategy: Overweight: Consumer Discretionary, Healthcare, Financials & Information Technology; Modest Overweight: Industrials; Underweight: Energy, Materials, Consumer Staples, Telecomms & Utilities. Currency Strategy: Overweight: U.S. Dollar (solid growth in H2 (over 3%) & Fed on track to start rate hikes); Neutral: Sterling (BoE rate hikes delayed with low inflation but GDP growth solid); Underweight: Euro (ECB s continuing QE while Fed starts rate hikes, modest Eurozone GDP growth, fresh Greek uncertainty) & Japanese Yen (BoJ likely to expand QE stimulus with falling inflation, Fed starts U.S. rate hikes & relatively stronger U.S. GDP growth). Follow us on Twitter: www.twitter.com/prustrategist 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. 2015 Prudential Financial, Inc. and it related entities. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial, Inc. and it related entities, registered in many jurisdictions worldwide. 6 For informational use only. Not intended as investment advice.