PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC. Global Investment Outlook & Strategy August 2015 After Greece Relief Rally, Stocks to Grind Higher with Reduced Grexit Risk, Draghi Liquidity Put, Further China Stimulus, Easing by Other CBs, Modest Fed Rate Hikes, Improved GDP Growth & Solid Q2 Earnings. Stocks Cheap Relative to Bonds Bond Yields to be under Upward Pressure with Solid GDP Rebound & Easing Risk Aversion John Praveen, PhD Chief Investment Strategist John Praveen s Global Investment Outlook for August 2015 expects global stock markets to grind higher in the near term with Grexit avoided. Further, stocks remain supported by ECB liquidity put, fresh China stimulus, easing by other central banks, modest Fed rate hikes, improved GDP growth, Q2 earnings upside surprises, and stocks cheap relative to bonds. Stocks: Global stock markets declined in early July on a sharp increase in Grexit risk and the China correction continued. Stock markets enjoyed a relief rally in mid-july with easing of Grexit risk and a short-lived stabilization of the Chinese market. Stocks ended July on a soft note as Chinese stocks started to struggle again despite policy makers efforts to stabilize the market. Developed markets rose 2.4% in July taking YTD gains to 5.5%, while emerging markets declined -4.6% taking YTD returns to -0.6%. The Chinese Shanghai Composite was down -14.3%in July, trimming YTD gains to 15.7%. With reduced Grexit risk, stocks are likely to grind higher. Further stock market gains are likely to be driven by: 1) Liquidity & low rates with Draghi Put and the ECB expanding liquidity lifeline to Greece, China continues to undertake aggressive easing measures to stabilize markets, rate cuts by other central banks, and the Fed preparing markets for modest rate hikes with a lift-off likely in September; 2) Improving global growth with a rebound in the U.S. and U.K., and Eurozone weathering the Greek crisis; 3) Solid Q2 earnings with U.S. companies beating expectations, and improved earnings outlook in H2 with GDP rebound and weak currency tailwinds for Eurozone & Japan earnings; 4) Valuations Stocks cheap relative to bonds, P/E multiples around fair value; 5) Easing risk aversion with Grexit avoided. However, while Chinese policy makers continue to take steps to stabilize markets with conventional and unconventional measures, success has been limited. FOR MORE INFORMATION CONTACT: Theresa Miller Phone: 973-802-7455 Email: theresa.miller@ prudential.com Bonds: After rising in June, global bond yields declined in July on increased Grexit risk in early July, and the decline in oil prices putting downward pressure on inflation expectations in late July. Looking ahead, bond yields are likely to be under modest upward pressure from: 1) Solid Q2 GDP rebound in the U.S. and U.K., and Euro zone weathering the Greek crisis; 2) Easing risk aversion with Grexit avoided, but Chinese policy makers struggle to stabilize markets; and 3) Risk of Fed tightening tantrum with solid U.S. GDP growth and strong labor market data prompting a reassessment of Fed rate hike expectations; However, bonds remain supported by: 1) Fed rate hikes likely to be modest with low inflation and lingering uncertainties, especially in China; 2) Inflation remaining low in the Eurozone, U.S. and U.K. and likely to be under renewed downward pressure with another leg-down in energy prices; 3) The ECB s QE buying, liquidity lifeline for Greece and Draghi Put for financial markets, and BoJ likely to expand QE in October. 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 Greece Relief Rally, Stocks to Grind Higher with Reduced Grexit Risk, Further China Stimulus, ECB Liquidity Put, Easing by Other CBs, Modest Fed Rate Hikes & Improved GDP Growth. Q2 Earnings Upside Surprises. Stocks Cheap Relative to Bonds Bond Yields Face Upward Pressure with Solid GDP Rebound, Easing Grexit Risk Stock Market Outlook (August): Global stock markets declined in early July as the sell-off from late June continued on a sharp increase in Grexit risk and as the China correction continued. Stocks sold off as Greek voters rejected by a big margin a bail-out deal offered by the Creditors in the July 5th referendum. China s stock market sell-off intensified in early July with the CSI 300 index declining a sharp -18.1% through July 8th. The Chinese government took a range of measures to support the stock market and arrest the decline. The measures helped stabilize the Chinese stock market. The sharp China losses were a drag on the emerging markets index. In Greece, after the voters rejected the bailout deal in the July 5th referendum, the Greek government went back to the EU with a fresh request for another bailout. In a turnaround, Tsipras agreed to the bail-out conditions and secured approval of the reform measures by the Greek parliament on July 17th following intense, heated debate and riots in the streets of Athens. Subsequently, the Eurogroup agreed in principle to grant Greece a three year ESM loan. This gave the ECB the green light to extend a liquidity lifeline, increasing ELA by 900mln for Greek banks, paving the way for banks to reopen. Stocks enjoyed a relief rally with Grexit avoided for now, and a short-lived stabilization of the Chinese market. Stocks ended July on a soft note as Chinese stocks started to struggle again despite policy makers efforts to stabilize the markets. Developed markets rose 2.4% in July taking YTD gains to 5.5%, while emerging markets declined -4.6% taking YTD returns to -0.6%. The Chinese Shanghai Composite was down -14.3%in July, trimming YTD gains to 15.7%. With reduced Grexit risk, stocks are likely to grind higher over the summer amidst the Q2 earnings season with upside earnings surprises. Stocks remain supported by liquidity and low interest rates with ECB s liquidity lifeline for Greece and Draghi Put for Eurozone financial markets, and Chinese policy makers determined to keep markets stable after the June-July sell-off. The Fed is preparing markets for a September lift-off, but rate hikes are likely to be modest and gradual. Several other developed and emerging central banks are likely to cut rates. Stocks are also supported by improved Q2 GDP growth and even stronger GDP growth in H2. The earnings outlook is being revised higher with improving GDP growth. On the valuation front, stocks remain cheap relative to bonds but P/E multiples are close to fair value in most markets and expensive in certain countries and sectors. 1) Fed Preparing Markets for Rate Lift-off in September, ECB Expands Liquidity Lifeline to Greece & Draghi Put, China Continues Aggressive Easing Measures to Stabilize Markets, Rate Cuts by Other Central Banks: Global central banks continue to provide liquidity and keep interest rates low, with the PBoC and ECB taking measures to stabilize the Chinese and Eurozone markets. The ECB provided a liquidity lifeline to Greece, increasing ELA by 900mln for Greek banks after the Greek parliament approved the reforms demanded by the Creditors. At the July meeting the ECB signaled that it is ready to act and use all available tools in its mandate in case there is an unwarranted tightening of financial conditions the Draghi Put. In China, the PBoC delivered another interest rate cut in late June and also announced RRR cuts for select financials institutions. The PBoC, the CSRC and other Chinese policy makers have undertaken several measures to control leverage and stabilize the Chinese stock market (Shanghai Composite) which fell around 32% from early to early July. The Shanghai Composite lost 14% in July. The U.S. Federal Reserve has started to prepare markets for interest rate lift-off in H2 2015. At the July meeting, the Fed left policy on hold and its statement was largely unchanged from June, but with modest adjustment to the discussion about the timing of future rate hikes. The July Statement indicates that the Fed will raise rates when they have seen some further improvement in the labor market and are reasonably confident inflation will go back to the 2% target. While the July statement does not provide any firm guidance, Fed speeches are providing further insight. Atlanta Fed President Dennis Lockhart has given a speech suggesting that it would take a significant deterioration in the labor market to delay a September rate hike. This has significantly boosted market expectations of a hike. Fed Chair Yellen gave a relatively upbeat assessment of the U.S. economic outlook and indicated that "economic conditions likely would make it appropriate at some point this year to raise the federal funds rate. Thus, we expect the Fed to start rate hikes 2 For informational use only. Not intended as investment advice.
in September with a solid Q2 GDP rebound, GDP on track to strengthen further in H2 to over 3% and the economy adding over 200,000 jobs per month. In U.K., the BoE appears on track to start raising rates but is likely to hold off hikes until the Fed s rate lift-off. The August meeting statement suggests the BoE may delay rate hike to late 2015 or early 2016, given muted inflationary pressures and strong pound sterling. In Japan, the Bank of Japan (BoJ) made no changes to its policy rate at its July meeting. The BoJ revised down its outlook for the economy and lowered its expectation for core inflation. The BoJ is likely to act in late Q3 or early Q4 to further increase the overall size of its QE buying or change its composition of asset purchases in an effort to boost inflation expectations. 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. While Brazil's central bank (BCB) continues to hike rates to fight inflation, it appears to be close to the peak of the current tightening cycle, given the GDP contraction. 2) Improved Global Growth in Q2, on Track to Strengthen in H2: Global GDP growth is expected to show a solid improvement in Q2 with a rebound in the U.S. and U.K., and Eurozone appears to have weathered the Greek crisis. U.S. GDP growth rebounded in Q2 to 2.3% while Q1 GDP was revised up to 0.6% (from -0.2%). 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 grew a solid 2.6% YoY after Q1 GDP was revised up to 2.9% (from 2.4%). Eurozone posted an upside growth surprise in Q1 and appears to have weathered the Greek crisis. The ECB remains optimistic that Eurozone recovery will broaden with the transmission of easy monetary policy to the economy. Eurozone GDP growth is expected to improve in Q2 with a rebound in Germany which underperformed in Q1. However, Japanese growth expectations for Q2 have been revised lower to a -1.5% decline, after Q1 GDP growth was revised higher to 3.9%. The Q2 weakness is driven by a fall in consumer spending and exports. However, growth is expected to rebound in H2. China s Q2 GDP surprised to the upside, growing 7% YoY, higher than consensus expectations of 6.8% and on par with Q1 pace of 7%. Q2 growth was supported by an increase in services sector activity. However, exports remained sluggish through Q2 on weaker-than-expected external demand and property and construction investment remained sluggish. India GDP growth is expected to remain around 7.5% in Q2 after improving to 7.5% in Q1 from 6.6% in Q4 2014. Looking ahead, global GDP growth is on track to strengthen further in H2. U.S. GDP growth is on track to rebound to over 3% in H2 on improving consumption with healthy wage growth and low oil prices. Business spending is expected to improve as energy capex drag fades. Housing remains healthy and there is no fiscal drag. In Eurozone, after the H1 growth surprise, GDP is expected to strengthen further in H2 with ECB QE stimulus, improving financial conditions, falling unemployment and weak Euro boost to exports. Growth in Japan is expected to rebound in H2 with a recovery in consumption spending, further improvement in business investment spending, and exports supported by a weak yen. GDP growth in EM Asia is expected to improve led by India. China growth remains stable with aggressive PBoC stimulus. GDP growth in Latin America & EM Europe is expected to improve as the drag in Brazil and Russia fades. 3) Improved Earnings Outlook: Improved Earnings in H2 with GDP Rebound, Stabilizing Oil Prices, Weak Currency Tailwinds for Eurozone & Japan Earnings; U.S. Q2 Results Likely to Beat Low Expectations: Global earnings outlook has been revised slightly lower over the past month due to renewed decline in energy prices and the impact of uncertainty in Greece and China. Current expectations are for global earnings to grow around 3% in 2015. U.S. Q2 earnings season has started on a strong note and results excluding energy are tracking around 9%. U.S. earnings are expected to strengthen further in H2 as U.S. GDP growth improves to over 3% and the energy drag fades. Eurozone earnings outlook has been modestly revised lower to 10% as a result of Greece uncertainty but improving growth and weak euro are expected to support earnings. Japanese earnings growth expectations have been revised higher to around 17% for 2015 from 14% driven by the weak yen and low financing costs with BoJ QE. Emerging Markets earnings outlook has been revised lower to just 3% for 2015 after 3% growth in 2014. While EM Asia earnings are expected to post solid 3 For informational use only. Not intended as investment advice.
growth, expectations in LatAm and EM Europe have been revised lower. UK earnings are expected to decline -8% in 2015 with drag from the large energy sector and strong pound sterling. 4) Valuation - Stock Market Multiples Decline in June & Early July With Equity Losses: Stock market P/E multiples declined in developed markets (DM) and emerging market (EM) as stocks fell during the month. The P/E multiple for developed markets (DM) fell to 19.2X from 19.8X as the DM index declined -3.1% in June. DM valuations are well below the long-term average of 21.2X but still above the 18X level at the end of 2014. Emerging Market (EM) stock valuations decreased slightly to 14.2X from 14.5X in May. While the EM index posted a -2.8% decline during the month, earnings results were a drag and resulted in a smaller decline in the multiple. EM multiples are expected to improve as earnings growth stabilizes and improves. Stocks remain cheap relative to bonds. The earnings yield gap (EYG) between U.S. stocks-bonds has decreased to 3.14% from 3.26% in May, but the yield gap still remains above the long-term average yield gap of 1.2% (20-year average). Eurozone stocks remain cheap relative to bonds on EYG basis but the yield gap narrowed to 3.63% from 3.82% in May as the earnings yield on Eurozone stocks has moved up to 4.39% from 4.30%, while the 10-year Bund yield increased to 0.76% from 0.49% in May. The Eurozone EYG remains well above a long-term average of 3.4% (10-year average). The Japanese stocks earnings yield gap rose to 4.95% in June after fallen for four consecutive months but still remains above the long-term 10-year average of 4.0%. Bottom-line: Global stock markets declined in early July as the sell-off from late June continued on a sharp increase in Grexit risk and as the China correction continued. Stock markets enjoyed a relief rally in mid-july with easing of Grexit risk as the Greek parliament approved the reforms demanded by the Creditors as a precondition for the bailout. Subsequently, the Eurogroup agreed in principle to grant Greece a three year ESM loan, giving the ECB the green light to extend a liquidity lifeline to Greek banks. Market was also relieved following a short-lived stabilization in China. Stocks ended July on a soft note as Chinese stocks started to struggle again despite policy makers efforts to stabilize the markets. Developed markets rose 2.4% in July taking YTD gains to 5.5%, while emerging markets declined -4.6% taking YTD returns to -0.6%. The Chinese Shanghai Composite was down -14.3% in July, trimming YTD gains to 15.7%. Stock markets enjoyed a relief rally in mid-july with easing of Grexit risk and a short-lived market stabilization in China. With reduced Grexit risk, stocks are likely to grind higher with Q2 earnings beating expectations, liquidity and low interest rates, improved Q2 GDP growth and even stronger GDP growth in H2. Further stock market gains are likely to be driven by: 1) Liquidity & Low Rates with the PBoC and ECB taking measures to stabilize the Chinese and Eurozone markets. The ECB provided a liquidity lifeline to Greece, and stands ready to use all available tools to offset an unwarranted tightening of financial conditions. In China, rate cuts and easing measures by the PBoC and other measures by Chinese policy makers are likely to stabilize and support the Chinese markets. Further, several developed (Australia, Canada, and NZ) and emerging central banks (India, Korea, and Russia) are likely to cut rates. While the U.S. Fed and U.K. BoE have started preparing markets for interest rate lift-off in H2 2015, the rate hikes are likely to be modest and gradual; 2) Global Growth Rebound in Q2, on Track to Strengthen in H2: Global GDP growth is expected to show a solid improvement in Q2 with a rebound in the U.S. (+2.3%) and U.K. (+2.6%), and Eurozone appearing to have weathered the Greek crisis. China s Q2 GDP came in better than expected (7%) and India remains solid (7.5%). Looking ahead, global GDP growth is on track to strengthen further in H2. 3) Improved Earnings Outlook: U.S. Q2 earnings results are beating lowered expectations. Japan earnings expectations have been revised higher. Improved earnings in H2 with solid GDP growth in U.S. and U.K., and weak currency tailwinds for Eurozone & Japan Earnings. EM Asia earnings remain solid with healthy growth and low commodity prices. Earnings likely to be weaker in LatAm & EM Europe; 4) Valuations stocks cheap relative to bonds, P/E multiples around fair value: Stocks remain cheap relative to bonds but the earnings yield gap continues to narrow with the rise in bond yields. Further, while P/E multiples remain below long-term averages, multiples have risen sharply in some markets and sectors raising concerns about overvaluation; 5) Easing Risk Aversion with a resolution of the Greek crisis and Grexit avoided, at least for the short-term. However, while Chinese policy makers have unleashed a barrage of conventional and unconventional measures, success has been limited. 4 For informational use only. Not intended as investment advice.
While stocks enjoyed a relief rally after avoiding Grexit and China market stabilization and are likely to post further gains over the summer, there are a number of risks which could keep markets volatile: These include: a) Despite preparing the markets, there could be another episode of Fed tightening tantrum with solid U.S. GDP growth and strong labor market data prompting a reassessment of the pace of Fed rate hikes; b) Continued volatility in the Chinese market as the policy makers struggle to stabilize the market, with limited success; c) another leg-down in oil and commodity prices destabilizing the energy sector earnings and credits; and d) While Grexit has been avoided, for now, there is a risk of political uncertainty in Greece if the Tsipras government falls due to internal revolt from radical and leftleaning members of the Syriza party and the ruling coalition over the terms of the bailout. Bond Market Outlook: Bond Yields Creep Higher in June. Yields to be under Upward Pressured with Solid GDP Rebound, Easing Risk Aversion with Grexit Avoided & Fed Rate Lift-off Likely in September Global government bond yields declined in July after rising in June. Bond yields fell in early July on safe haven demand with increased risk of Grexit following the NO vote in the Greek referendum. However, yields rose in mid-july with easing of Grexit risk as the Greek parliament approved the reforms demanded by the Creditors as a precondition for a third bailout. In late July, the sharp decline in oil prices put downward pressure on inflation expectations, pushing yields lower. By July-end U.S. Treasury 10-year yields fell to 2.18% from 2.35%, Eurozone yields fell to 0.61% from 0.77%, and JGB yields inched lower to 0.4% from 0.45%. Looking ahead, bond yields are likely to trend modestly higher with reduced safe haven demand, improved Q2 GDP growth and rate lift-off by the Fed and BoE, but offset by low inflation, and QE buying by the ECB and BoJ. Yields are likely to be under modest upward pressure from: 1) Solid Q2 GDP rebound in the U.S. (+2.3%) and U.K. (+2.6%), and Eurozone appears to have weathered the Greek crisis. China s Q2 GDP came in better than expected (7%) and India remains solid (7.5%). Looking ahead, global GDP growth is on track to strengthen further in H2; 2) Easing risk aversion with a resolution of the Greek crisis and Grexit avoided, at least in the short-term, while Chinese policy makers have succeeded in stabilizing markets with a barrage of conventional and unconventional measures; and 3) Fed tightening tantrum with solid U.S. GDP growth and strong labor market data prompting a reassessment of the pace of Fed rate hikes. However, bonds remain supported by: 1) While the Fed has started preparing markets for a September lift-off, rate hikes are likely to be modest with low inflation and lingering global financial market uncertainties; 2) Inflation remaining low in the Eurozone, U.S. and U.K. and likely to be under further downward pressure with another legdown in energy price; 3) The ECB s QE buying, liquidity lifeline for Greece and Draghi Put for financial markets, and BoJ expected to expand QE. Investment Strategy: Asset Allocation: Stocks vs. Bonds - Stocks to grind higher with reduced risk aversion, ECB liquidity Put & Q2 earnings surprise Stocks Remain Overweight as stocks likely to rise further with reduced risk aversion with Grexit avoided, Q2 earnings beating expectations, liquidity and low interest rates, improved Q2 GDP growth and even stronger growth in H2. Stocks cheap relative to bonds. Bonds Modest Underweight as yields likely to face upward pressure with solid Q2 GDP rebound in U.S. & U.K., GDP strengthening in H2, easing risk aversion with Grexit avoided & Fed rate lift-off likely in September. However, bonds supported by low inflation & ECB & BoJ QE buying. Global Equity Strategy: Raise Eurozone to Overweight as Grexit Avoided & Draghi Put. Keep Overweight in EM Asia & Japan. Lower U.K., Latin America & EM Europe to Underweight. Remain Underweight in U.S. Eurozone: Upgrade Eurozone to overweight with Grexit avoided as Greece approved the terms of the bailout, the ECB s liquidity lifeline for Greece and Draghi Put for Eurozone financial markets. Improving GDP growth with scope for upside surprise, solid earnings growth with weak Euro. 5 For informational use only. Not intended as investment advice.
Emerging Markets: Overweight in Emg Asia with further PBoC stimulus, improved growth in several economies; Lower LatAm & EM Europe to Underweight with further decline in oil & commodity prices, Brazil & Russia in recession. Japan: Modest Overweight. Solid earnings with weak yen tailwinds, GPIF increased equity buying. BoJ likely to increase QE. However, Q2 GDP disappointment a negative. U.K.: Lower U.K. to Underweight with BoE likely to start rate hike and renewed drag from Energy sector offsetting solid GDP rebound. U.S.: Remain Underweight mainly to fund overweight in Eurozone and Japan. Modest equity gains with Q2 GDP rebound and Q2 earnings upside surprise. Fed preparing markets for September rate hike, but risk of tightening tantrum. Global Bond Market Strategy: Yields under Modest Upward Pressure with Solid Q2 GDP Rebound & Easing Grexit Risk Japan JGBs: Remain Overweight as inflation undershooting target raises odds of BoJ expanding QE. GDP growth solid, but slower after strong Q1. Eurozone: Raise to Overweight with Grexit avoided, ECB s liquidity lifeline for Greek banks and Draghi Put, modest GDP growth, and low inflation. U.K. Gilts: Lower to Neutral with strengthening GDP growth and BoE on track to start raising rates with inflation low for now, but on track to rise. EM Debt: Remain Neutral as easing risk aversion with Grexit avoided offset by fresh decline in oil prices and risk of Fed tightening tantrum. U.S. Treasuries: Modest Underweight with solid Q2 GDP rebound and growth strengthening further in H2 and risk of Fed 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 Q2 GDP rebound, growth strengthens to over 3% in H2 & Fed starts rate hikes in September); & Sterling (BoE set to start U.K. rate hike with solid GDP growth); Underweight: Euro (Grexit avoided, but Euro remains weak with continuing ECB QE while Fed starts rate hikes, modest GDP growth)& 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. 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