PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC. Global Investment Outlook & Strategy May 2016 Stocks under Shadow of Brexit Risk & Weak Earnings but likely to Grind Higher with Central Bank Put. Bonds Supported by Weak GDP Growth, Low Inflation, Dovish Fed & ECB Stimulus John Praveen s Global Investment Outlook for May 2016 expects global stock markets to grind higher with central bank put as the Fed remains dovish, the ECB, BoJ & China s PBoC continue to provide stimulus and rate cuts in other Emerging Markets. However, stocks remain under Brexit cloud and face headwinds of weak earnings & soft growth which are likely to keep markets volatile and limit gains. John Praveen, PhD Chief Investment Strategist FOR MORE INFORMATION CONTACT: Mayura Hooper Phone: 973-367-7930 Email: Mayura.hooper@ prudential.com Stocks: Stock markets declined in late April/early May after the rally in March/early April amidst global growth concerns with weaker-than-expected Q1 GDP growth in the U.S. and U.K., mixed Q1 earnings growth and increased Brexit risk. Developed market stocks fell -0.6% (as of May 16th) taking YTD declines to -2.4%. Emerging market stocks fell - 2.9% for a modest YTD loss of -0.8%. Looking ahead, global stock markets are likely to grind higher with continued central bank put offset by heightened Brexit risk, weak earnings and modest GDP growth. Stocks are likely to be supported in the near-term by: 1) Central bank put with ECB rate cuts and QE buying and the Fed remaining dovish with fewer rate hikes in H2. Further, the BoJ is likely to expand QE buying, the BoE is on hold with Brexit uncertainty and may be forced to cut rates if Brexit tips the U.K. into recession. China s PBoC and India s RBI maintain an easing bias and the Fed s dovish stance gives Emerging central banks room to cut rates; 2) Easing of recession fears with the U.S. economy on track to rebound in Q2 after the weak Q1, and Eurozone expected to grow at a healthy pace in Q2 after the solid GDP growth in Q1. Japan s Q1 GDP came in better-than-expected at 1.7% annualized and growth is expected to remain solid on strengthening consumption and a boost from government spending; In the U.K., economic activity likely to reaccelerate in H2 in the event of no Brexit ; and 3) Reasonable Valuations as stock market P/E multiples remain around long-term average. However, stocks face headwinds from: 1) Increased market uncertainty ahead of the June 23rd referendum on UK membership in the EU and risk of Brexit ; 2) Weak earnings outlook; and 3) Lingering growth concerns. These risks are likely to keep markets volatile and limit stock market gains. Bonds: Global bond yields rose modestly in April with the BoJ disappointing market expectations of QE expansion. Yields edged up in the U.S. (1.83%), Eurozone (0.27%) and U.K (1.60%) but declined in Japan (-0.09%). Looking ahead, bonds remain supported by: 1) Continued central bank support with ECB stimulus, the Fed remains dovish, the BoJ likely to expand QE buying, and the BoE may be forced to cut rates if Brexit tips the U.K. into recession; 2) Weak Q1 GDP growth in the U.S. (0.5%) and U.K. (1.6%); 3) Low Inflation in the U.S. (1.1%) and U.K. (0.5%), and below 0% in Eurozone and Japan; and 4) Safe haven demand with increased Brexit risk. However, yields face modest upward pressure from: 1) Improving Q2 growth outlook with GDP rebound in the U.S., growth in the Eurozone and Japan remaining solid, and U.K. growth likely to reaccelerate in H2 in the event of no Brexit; 2) Bond valuations remain expensive relative to stocks with bond yields remaining low. 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: Stocks likely to Grind Higher with Central Bank Put as Fed remains Dovish, ECB, BoJ & China s PBoC provide Stimulus, Rate Cuts in Other Emerging Markets. However, Stocks remain under Brexit Cloud and Face Headwinds of Weak Earnings & Soft GDP Growth Bonds remain Supported by ECB-BoJ Stimulus, Dovish Fed, Low Inflation, Modest GDP Growth, & Safe Haven Demand with Increased Brexit Risk Stock Market Outlook (May): Global stocks declined in early May following the strong rally in March/early April amidst global growth concerns with weaker than expected Q1 GDP growth in the U.S. and U.K., and mixed Q1 earnings growth data. Developed market stocks fell -0.6% (as of May 16th) taking YTD declines to -2.4%. Emerging market stocks fell -2.9% for a modest YTD loss of -0.8%. Looking ahead, stock markets are likely to grind higher with central bank put offset by heightened Brexit risk, weak earnings and modest GDP growth. Stocks are likely to be supported in the near-term by: 1) Central bank Put with continued stimulus and low interest rates; 2) Easing of recession fears and improving growth outlook; and 3) Reasonable valuations. However, stocks face headwinds from: 1) Increased risk of Brexit market uncertainty ahead of the June 23rd referendum on UK membership in the EU and; 2) Weak earnings outlook; and 2) Weak GDP growth. These cross currents are likely to keep markets volatile and limit stock market gains. 1) Central Banks Put with Dovish Fed, Aggressive ECB Stimulus, QE Expansion by BoJ, Easing Measures in China, India and Other EM Central Banks: The global liquidity and interest rate backdrop remain accommodative with ECB rate cuts and QE buying and the Fed remains dovish with fewer rate hikes in H2. In Japan, the BoJ is likely to expand QE buying over the next few months after disappointing markets in April. The BoE remains on hold with Brexit uncertainty and may be forced to cut rates if a vote to exit the EU tips the U.K. economy into recession. China s PBoC maintains an easing bias and India s RBI is likely to cut rates. In addition, the Fed s dovish stance takes pressure off Emerging central banks to raise rates and even gives them room to cut rates to support domestic growth. The Fed left U.S. interest rates unchanged at their late-april meeting, as widely expected, with rates in a range between 0.25-0.5%. The Fed statement acknowledged that U.S. growth appears to have slowed with moderating consumer spending. The Fed also became more sanguine about global conditions and dropped earlier warning that "global economic and financial developments continue to pose risks". By removing language emphasizing global risks being on the downside, the Fed appeared to have left the door open for a rate hike in June. However, the weak May labor market report, soggy Q1 GDP data and Brexit vote in June caused markets to lower odds of a June hike. More recently, the minutes of the June meeting suggest that the Fed is keeping its option open for a June rate hike if incoming data confirms that the economy is improving. The Bank of Japan (BoJ) left policy unchanged at late April meeting, disappointing market expectations of expanding monetary stimulus. However, the bank is still likely to announce further easing measures in the coming months with the yen remaining strong, below 110/$, and inflation remaining negative. The bank is expected to increase QE buying and further cut interest rate. The ECB left interest rates and QE asset purchase unchanged at the April meeting after announcing aggressive stimulus measures in March. The ECB left the refinancing rate at 0%, the marginal lending facility at 0.25% and the deposit rate at -0.4%, and kept asset purchase unchanged at 80bn. However, President Draghi reiterated that the ECB has scope for additional stimulus and that it is not out of ammunition. Draghi also reassured that the ECB stands ready to use all instruments available, including additional rate cuts, if needed. Draghi also indicated that rates are likely to remain at present or lower levels for an extended period of time. The BoE left monetary policy unchanged at its mid-may meeting as U.K. gears up for the June 23rd referendum on continued membership in the EU. BoE Governor Mark Carney highlighted the negative consequences of Brexit, warning that Brexit could lead to a materially lower path for growth and a notably higher path for inflation, and could push 2 For informational use only. Not intended as investment advice.
the U.K. economy into a technical recession. The Bank also cautioned that it has limited ability to offset the short-term impact of Brexit as any monetary policy response would take time to work. The People s Bank of China (PBoC) in its Q1 monetary policy report in early May acknowledged positive changes in the economy, but also cautioned that fundamentals are not very strong and downward pressure still exists. The report suggests that monetary policy is likely to remain accommodative with more targeted credit easing. The Reserve Bank of India (RBI) is likely to remain on hold at its June meeting as inflation has crept higher recently, above the RBI s target. However,the bank is likely to cut rates again in H2 as inflation eases and the government maintains fiscal discipline. Brazil's central bank (BCB) left rates unchanged at 14.25% at their late April meeting. With lower house and senate voting to impeach President Rouseff, Vice-President Temer has taken over as interim President and is expected to nominate a new central bank Governor. Inflation continues to show signs of moderation, especially in services inflation, which could provide the central bank room to cut rates, likely in Q3. Other Emerging central banks cut rates in Taiwan, Turkey and Hungary. Mexico s central bank remains on hold in tandem with the Fed. 2) Improving Growth Outlook after Weak Q1 GDP Growth in U.S. & U.K., Eurozone & Japan Q1 GDP Solid & EM Growth Outlook Improves: The U.S. economy is on track to rebound in Q2 after the weak Q1, with improving consumer spending on steady job gains, healthy wage growth, and solid housing sector. Japan s Q1 GDP growth surprised on the upside at 1.7% annualized and is expected to remain solid with strengthening consumption and a boost from government spending. In the U.K., while Q2 GDP growth is likely to be weak with Brexit uncertainty, the BoE expects economic activity to reaccelerate in H2 in the event of no Brexit. The exception among the developed economies was Eurozone which posted solid growth of 2% with upside growth surprises in France, Spain and Germany. Eurozone is expected to grow at a healthy pace in Q2, building on the solid Q1 GDP growth. The Emerging economies growth outlook is improving with China stabilizing, oil and commodity prices recovering, and India on track to strengthen. In Brazil, political uncertainty is likely to ease with the impeachment of President Dilma Rouseff and a fresh agenda of the new Temer government. The U.S. economy slowed sharply in early 2016 with Q1 GDP growing at a disappointing 0.5% annualized rate, slowing from 1.4% growth in Q4. The Q1 GDP slowdown was broad-based with slower consumption spending, weak business investment spending (especially energy capex) and continued drags from inventories and trade. The Q1 weakness follows a now familiar pattern of slower GDP growth in the first quarter for the past several years, with Q1 growth around -0.8% slower than the other three quarters. Looking ahead, U.S. GDP is on track to rebound in Q2 with improving consumer spending on steady job gains and healthy wage growth, solid housing sector, and easing drag from business investment spending. Eurozone economy had a good start to 2016, with Q1 GDP growing a solid 2.0% QoQ annualized, up from 1.2% in Q4. While full details are not yet available, it appears that domestic demand - and more specifically private consumption - was the main driver of Q1 growth, while net trade balance was a small drag. Eurozone s solid Q1 GDP growth was driven by upside surprises in France, Spain and Germany. Eurozone GDP growth is expected to build on the solid Q1 with ECB stimulus, improving global growth, and weaker euro. U.K. Q1 GDP growth slowed to 1.6% annualized, from 2.4% in Q4 with Brexit uncertainty taking a toll on spending decisions. The BoE expects Q2 GDP to slow sharply ahead of the June referendum, but economic activity is likely to reaccelerate in case of no Brexit. Japan s Q1 GDP growth came in better-than-expected at 1.7% annualized with solid consumption driven largely by leap-year effect. Among Emerging Markets, China s economic outlook remains supported by policy easing and property market recovery in coming months. Earlier, China s Q1 GDP growth slowed modestly to 6.7% YoY from 6.8% in Q4 2015. India s GDP growth is expected around 7.5% in Q1 2016 after 7.3% in Q4 2015 driven by improving consumption spending and solid business investment spending. Brazil remains in recession with GDP expected to decline -6.2% YoY in Q1 but growth is likely to get a boost with impeachment of President Dilma and the new Temer government likely to pursue a fresh agenda. Mexican GDP grew 2.7% YoY in Q1, stronger than expectations, and up from 2.5% in Q4. Russian economy remains weak but recent macro data is improving. 3 For informational use only. Not intended as investment advice.
3) Earnings Outlook Remain Weak, Earnings Expectations Continues to be Revised Lower with Slower Global Growth: Global earnings outlook remains weak and earnings expectations continue to be revised lower, to around 2% in early May on soft global growth. In the Q1 earnings season currently underway, U.S. earnings continue to beat lowered expectations with Q1 earnings tracking -5%, better than the expected decline of -9%. Eurozone earnings outlook has been further revised lower on slower growth outlook and uncertainty around Brexit but remains supported by the weak euro and ECB easing measures. Japanese earnings expectations have been revised further lower following the sharp appreciation of the yen but remains positive on cost controls. The Emerging Markets earnings outlook has slightly improved over the past month driven by the recent uptrend in oil and commodity prices. 4) Valuation - Stock Market P/E Multiples Remain Relatively Stable in April-May: Stock market P/E multiples were largely stable during April-May as stocks were range bound after the sharp gains in March. The Developed Markets (DM) P/E multiple rose to 19.8X in April from 19.3X in March as the MSCI World Index gained 1.1% for the month. After the recent stock market gains, DM valuations are now closer to the long-term average of 20.4X (20 years average). Emerging Market (EM) stock P/E multiples rose to 13.8X in April from 13.7X in March with EM stocks gaining 0.7% for the month. However, the EM P/E multiple still remains below its long term (20-year) average of 15.1X. The valuation discount between EM and DM stocks has widened in April to 6.0X from 5.6X in March as DM valuations have increased more than EM valuations. Stocks-Bonds Earnings Yield Gap has remained stable in April-May with stocks earning yields largely unchanged and modest changes in bond yields. Bottom-line: Global stock markets declined in late April/early May following the strong rally in March/early April amidst global growth concerns with weaker-than-expected Q1 GDP growth in the U.S., U.K. and Japan, mixed Q1 earnings growth and increased Brexit risk. Developed market stocks fell -0.6% (as of May 16th) taking YTD declines to -2.4%. Emerging market stocks fell -2.9% for a modest YTD loss of -0.8%. Looking ahead, stock markets are likely to grind higher with cross currents of central bank 'put offset by heightened Brexit risk, weak earnings and modest GDP growth. Stocks are likely to be supported in the nearterm by: 1) Central bank put' with ECB rate cuts and QE buying, and the Fed remaining dovish with just one or two rate hikes likely in H2. Further the BoJ is likely to expand QE buying over the next few months despite disappointing markets in April. The BoE is on hold now with Brexit uncertainty and may be forced to cut rates if Brexit tips the U.K. into recession. China s PBoC maintains an easing bias and the Fed s dovish stance gives Emerging central banks room to cut rates; 2) Easing recession fears and improving growth outlook with the U.S. economy on track to rebound in Q2 after the weak Q1. Eurozone is expected to grow at a healthy pace in Q2 building on the solid Q1 GDP growth. In the U.K., economic activity is likely to reaccelerate in H2 in the event of no Brexit. Japan s Q1 GDP growth surprised on the upside at 1.7% annualized and growth is expected to remain solid in Q2 and improve further in H2 with strengthening consumption and a boost from government spending. Further, the stabilization of oil prices has reduced the tail risk of a negative feed back loop into the real economy from energy-induced stress in the credit markets and banking sector; and 3) Reasonable Valuations as stock market P/E multiples remain around long-term average. Further, stocks remain cheap relative to bonds as the earning yield gap between stocks and bonds remains wide, despite recent narrowing. However, stocks continue to face headwinds from increased Brexit risk, earnings disappointments and weak global growth: 1) Increased Brexit risk (U.K. leaving the EU) with the rise in the odds of a NO Vote in the June referendum on U.K. membership in the EU. In addition to financial market turmoil, the BoE has warned that Brexit could lead to a materially lower path for growth and a notably higher path for inflation, and could push the U.K. economy into technical recession ; 2) Weak earnings outlook as U.S. Q1 earnings are on track for a sharp decline with drags from Energy and Materials combined with profit recession in cyclicals such as Financials, Industrials and Info Tech. Eurozone earnings outlook has also been revised down driven by financial market volatility and adverse impact of negative interest rates on bank earnings. Japanese earnings expectations have been revised lower as the sharp appreciation of the yen takes a toll on profits. While earnings expectations are low, potential downside earnings surprises are likely to weigh on markets; and 3) Lingering growth concerns as the global economy struggled in Q1 with disappointing GDP growth in the U.S. (0.5%) 4 For informational use only. Not intended as investment advice.
and U.K. (1.6%). In addition, U.K. growth is expected to slow further in Q2 as Brexit uncertainty takes a toll on household and business spending, and could tip into recession in case of Brexit. These cross currents are likely to keep markets volatile and limit further stock market gains. Also likely to contribute to market volatility are: a) Renewed oil price uncertainty as excess supply persists with OPEC failing to agree on supply freeze/cuts and oil demand remains sluggish with soft global growth; b) Lingering concerns about Chinese growth (level and mix), leverage, currency policy; c) Questions about NPL problem among European banks and the impact of negative interest rates on bank profitability; d) Continued geo-political tensions. Bond Market Outlook: Bond Yields Inch Higher in April with Central Banks on Hold. Bonds remain Supported by Low Inflation, Modest GDP Growth & Safe Haven Demand with Increased Brexit Risk Global bond yields rose modestly in April with the BoJ disappointing market expectations of QE expansion, the ECB downplaying expectations of further stimulus and the Fed leaving the door open to resuming rate hikes in June. U.S. 10- year treasury yields rose to 1.83% at April end from 1.77% at the end of March, Eurozone yields increased to 0.27% from 0.15%, and U.K. yields rose to 1.60% from 1.42%. Japanese yields declined to -0.09% from -0.05%. EM yields also declined to 5.02% from 5.12%. Looking ahead, bonds remain supported by: 1) Continued central bank support with ECB rate cuts and QE buying and the Fed remains dovish with just one or two rate hikes likely in H2. Further, the BoJ is likely to expand QE buying despite disappointing in April, and the BoE is on hold now with Brexit uncertainty and may be forced to cut rates if Brexit tips the U.K. into recession; 2) Weak GDP growth with disappointing Q1 GDP growth in the U.S. (0.5%) and U.K. (1.6%). In addition, U.K. growth is expected to slow further in Q2 with Brexit uncertainty; 3) Inflation remains low in the U.S. (0.9%) and U.K. (0.5%) and below 0% in the Eurozone and Japan; and 4) Safe haven demand with increased Brexit risk in the count down to the June U.K. referendum & geopolitical tensions; However, yields could face modest upward pressure from: 1) Easing recession fears and improving growth outlook with the U.S. track to rebound in Q2 after the weak Q1, the Eurozone and Japan are expected to grow at a healthy pace in Q2 building on the solid Q1 GDP growth, U.K. economic activity likely to reaccelerate in H2 in the event of no Brexit; 2) Bond valuations remain expensive relative to stocks with bond yields remaining low. Investment Strategy: Asset Allocation: Modest Equity Gains as Stocks under Brexit Cloud but supported by Central Bank Stimulus Stocks Modest Overweight as stock markets remain under the shadow of increased Brexit risk, weak earnings and soft GDP growth but likely to grind higher with central bank put as the Fed remains dovish with just one or two rate hikes in H2, and the ECB, BoJ & China s PBoC providing stimulus. Bonds - Modest Overweight as bonds remain supported by ECB-BoJ stimulus, dovish Fed with fewer rate hikes in H2, modest GDP growth, low inflation & safe haven demand with increased Brexit risk in the countdown to UK referendum on EU membership. Global Equity Strategy: Raise U.S. to Neutral & Remain Underweight in U.K. on Brexit Risk. Remain Overweight in Eurozone. Overweight in Emg Mkts with Dilma Impeachment in Brazil. Remain Neutral in Japan on BoJ Uncertainty Eurozone: Remain overweight with ECB ready to provide further stimulus, solid Q1 GDP growth and relatively better earnings outlook; Emerging Markets: Remain Modest Overweight with improving growth outlook on stabilization of oil and commodity prices, accommodative monetary policy in China India & other EMs, Brazil s political uncertainty ends with impeachment of President Rouseff and new Temer administration; 5 For informational use only. Not intended as investment advice.
Japan: Keep at Neutral on BoJ QE expansion uncertainty and strengthening yen hurting earnings growth and exports; U.K.: Keep Underweight with increased Brexit uncertainty and risk of U.K. tipping into recession in addition to global financial turmoil; U.S.: Raise to Neutral on renewed safe haven demand with increased Brexit risk, and Fed remains dovish with just one or two rate hikes in H2. However, Q1 GDP disappoints at 0.5%, Q1 earnings weak with drag from energy and strong dollar headwinds. Global Bond Market Strategy: Bonds Supported by Low Inflation, Modest GDP Growth, Central Bank Support & Safe Haven Demand with Brexit Risk Eurozone: Remain Overweight with low inflation, ECB ready to provide further stimulus & rates likely to remain low for an extended period of time ; Japan JGBs: Modest Overweight with low inflation and the BoJ likely to expand QE after disappointing markets in April; EM Debt: Keep Modest Overweight with improving growth outlook on stabilization of oil and commodity prices, accommodative monetary policy in China India & other EMs, Brazil s political uncertainty ends with impeachment of President Rouseff and new Temer administration; U.S. Treasuries: Modest Underweight as outlook for U.S. Treasuries less favorable relative to Eurozone and Japan with GDP growth rebound in Q2 and inflation creeping higher. However, Treasuries supported by dovish Fed with fewer rate hikes in H2; U.K. Gilts: Keep Underweight with increased risk of Brexit and potential for financial market turmoil and U.K. tipping into recession. Global Sector Strategy: Overweight: Information Technology; Modest Overweight: Industrials, Energy & Materials; Neutral: Consumer Discretionary, Financials; Underweight: Healthcare, Consumer Staples, Telecomms & Utilities. 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. 2016 Prudential Financial, Inc. and its related entities. Prudential, the Prudential logo and the Rock symbol are service marks of Prudential Financial Inc and its related entities registered in many jurisdictions worldwide 6 For informational use only. Not intended as investment advice.