PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC. Global Investment Outlook & Strategy February 2016 Equity Market Turmoil in Early 2016 on Oil-Induced Recession Fears. Stocks Likely to Stabilize with Fresh ECB & BoJ Put, China Stimulus & Fed Rate Hikes on Pause. Recession Fears Exaggerated as Global Economy on Modest Growth Path. Valuation Improve Bond Yields Fall on Safe Haven Demand with Recession Fears. Bonds Supported by ECB-BoJ Easing, Fed on Pause & Deflation Concerns John Praveen s Global Investment Outlook for February 2016 expects global stock markets to stabilize with fresh ECB & BoJ stimulus, China rate cuts & Fed putting further rate hikes on pause. The global economy remains on a modest growth path and fears of an oil-induced recession seem exaggerated. Equity valuations have become attractive following the January/early February market correction. John Praveen, PhD Chief Investment Strategist Stocks: Global stock markets are in turmoil in early 2016, triggered by China concerns (growth, currency and policy) and oil price collapse. Stocks recovered in late January with the ECB signaling an increase in QE asset purchases in March and the BoJ surprised markets by cutting rate into negative territory. However, the rally faded on growing fears of a recession through a negative feedback loop from oil-induced stress in the credit markets and banking system into the real economy. Developed market stocks declined -12.6% (as of February 11) while Emerging market stocks fell -8.8%. Looking ahead, while fear appears to be overwhelming fundamentals, stock markets are likely to stabilize driven by: 1) The Draghi-Kuroda Put, China Stimulus & Fed Pause. The Bank of Japan (BoJ) surprised markets by cutting rate into negative territory and is likely to ease policy again. The ECB signaled in January that it is likely to expand QE stimulus at the next meeting in March. The Fed has put further rate hikes on pause, while the BoE has pushed U.K. rate hikes indefinitely into late 2016. China s PBoC is likely to undertake fresh easing measures after the lunar New Year break; 2) Easing Recession Fears with the U.S. and U.K. on track to a healthy rebound in Q1, Eurozone continuing to improve, and Japan expected to recover. Growth in China remains stable around 7%. Fears of a recession appear to be exaggerated; 3) Valuations have improved as equity P/E multiples fell with the market correction. In addition the decline in bond yields has increased the relative attractiveness of stocks; 4) Earnings Outlook remains positive, excluding the energy sector. FOR MORE INFORMATION CONTACT: Theresa Miller Phone: 973-802-7455 Email: theresa.miller@ prudential.com Bonds: Global bond yields fell in January on safe haven demand as stocks fell sharply. Yields fell even further in early February with a rate cut in Japan and growing fears of recession. Looking ahead, bonds remain supported by: 1) Fresh QE Stimulus: The ECB is set to expand QE stimulus in March while the BoJ is likely to adopt further easing measures after the January rate cut. The Fed is likely to pause its rate hike process, while BoE rate hikes are pushed out indefinitely into late 2016; 2) Low inflation with the recent plunge in oil prices renewing deflation fears; 3) Recession fears with the risk of a negative feedback loop from oil induced stress in the credit markets and banking system into the real economy; and 4) Safe haven demand with elevated geopolitical tensions and terrorism fears. However, yields could face modest upward pressure from: 1) Easing of recession fears with Q1 GDP rebound in the U.S. and U.K., signs of further improvement in Eurozone and recovery in Japan; 2) Bond valuations remain very expensive relative to stocks especially after the recent plunge in bond yields. 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 Plunge in Early 2016 on Oil-Induced Banking Stress & Recession Fears. Stocks Likely to Stabilize with Fresh ECB & BoJ Put, China Stimulus & Fed Rate Hikes on Pause. Recession Fears Exaggerated as Global Economies Remain on Modest Growth Path. Valuation Improve with Equity Correction. Healthy Earnings, Excluding Energy Bond Yields in Free Fall on Equity Turmoil, Oil Plunge & BoJ Rate Cut. Bonds Supported by Recession & Deflation Fears, Safe Haven Demand & ECB-BoJ Put Stock Market Outlook (February): Global stock markets are in turmoil in early 2016 with a sharp correction in January before a late January rally pared losses for the month. The rally was shortlived and the sell-off accelerated in early February. The January sell-off was triggered by China concerns (growth, currency and policy) and a renewed plunge in oil prices as both WTI and Brent crude fell below $30 on fear of increased glut in the oil market with the lifting of Iran sanctions. Stocks recovered in late January with the ECB signaling an increase in QE asset purchases in March and the BoJ surprised markets by cutting rate into negative territory. However, the rally faded and turmoil in global stock markets intensified in February with growing fears of the global economy slipping into recession through a negative feedback loop from oil-induced stress in the credit markets and banking system into the real economy. Developed market stocks declined -12.6% (as of February 11) while Emerging market stocks fell -8.8%. While global stock markets remain in the grip of fear of recession and oil-induced stress in the credit markets and banking system, recession fears appear to be exaggerated. The oil-induced stress in the credit market and banking system while potentially significant, the overall impact is expected to be limited and unlikely to push the global economy over the cliff, as the sub-prime crisis morphed into the great recession in 2008. Thus, we expect stock markets to stabilize with: 1) The Draghi-Kuroda Put with the BoJ cutting rates into negative territory and likely to ease policy further, the ECB set to expand QE, the PBoC likely to cut rate after the Lunar New Year break, the Fed putting U.S. rate hikes on pause; 2) Recession Unlikely as the U.S. and U.K. are on track to a healthy rebound in Q1, Eurozone continues to improve steadily, Japan is expected to recover. Growth in China remains stable around 7%, while India and other oil importers are on track to improve; 3) Improved Equity Valuations as P/E multiples declined following the market correction. Further stocks have become more attractive relative to bonds with yields falling sharply; 4) The earnings outlook remains positive, excluding the energy sector. 1) Liquidity & Interest Rate Support with Fresh Dragi-Kuroda Put, Fed Rate Hikes on Pause, BoE Hikes Pushed out Further, Further Easing in China: The global liquidity and interest rate backdrop is favorable with ECB s Draghi and BoJ s Kuroda providing a fresh Put and the Fed likely to delay further rate hikes after starting the rate normalization process in December. Meanwhile, the BoE pushed off U.K. rate hikes indefinitely into 2016. China s PBoC is likely to cut rates and undertake other easing measures after the Lunar New Year holidays. The Bank of Japan (BoJ) surprised markets with a rate cut at the late January meeting. The BoJ announced negative interest rates and will now charge banks -0.1% on excess overnight deposits. The BoJ joins the ECB, and central banks of Sweden, Denmark and Switzerland in using negative rates on excess commercial bank reserves as a policy tool. With Japanese inflation currently struggling around zero, the BoJ adopted negative interest rates in a renewed effort to boost inflation and achieve its 2% inflation target. The negative 0.10% interest rate will augment the BoJ s ongoing massive quantitative-qualitative easing (QQE). The BoJ made no change to its 80tn asset purchase program (QQE). This suggests that Kuroda is keeping powder dry for further easing through expanding QE buying in the next few months. The ECB signaled in January that it is likely to expand QE stimulus at the March meeting. The ECB s Governing Council acknowledged that since the start of 2016, downside risks have increased again amid heightened uncertainty about emerging market economies growth prospects, volatility in financial and commodity markets, and geopolitical risks. In light of the increased downside risks, ECB President Draghi indicated that it will therefore be necessary to review and possibly reconsider our monetary policy stance at the next meeting. Draghi added that by the next meeting in March, 2 For informational use only. Not intended as investment advice.
work will be carried out to ensure that all the technical conditions are in place to make the full range of policy options available for implementation, if needed. Given these signals, it is likely that the ECB will cut the deposit rate by another -10bps (to -0.4% from -0.3%), increase the size of asset purchases by an additional 20bn (to 80bn from 60bn currently), and expand it into investment grade corporate debt. The Fed left U.S. rates unchanged at its January meeting. The Fed s statement acknowledged U.S. Q4 GDP slowdown, attributing it to the drag from trade and inventories, but highlighted that labor market conditions improved further. Given the heightened turmoil in financial markets from the beginning of January, the Fed assured that they are monitoring market volatility and assessing the implication of it on unemployment and inflation. However, with the BoJ rate cut into negative territory, the ECB on track to expand QE in March, increased global growth and financial turmoil and their potential impact on the U.S. economy, the Fed is likely to delay the next rate hike beyond March. The People s Bank of China (PBoC) is expected to cut rates again in early 2016, likely after the Chinese New Year. Given the recent financial tightening impact from sharp equity market sell-off and capital outflow, further counter-cyclical policy easing is needed to continue to support aggregate demand and stabilize the macro-backdrop. On the fiscal front, the government is expected to continue spending on key infrastructure projects, tax cuts to reduce corporate costs and fiscal support to aid structural reforms. Other Emerging central banks are on hold in India, Korea, Turkey, Russia, Hungary (1.35%), Poland (1.5%) and Czech Republic (0.05%), after cutting rates to record lows in 2015. 2) U.S. & U.K. on Track to Q1 Rebound after Weak Q4, Modest but Improving Growth in Eurozone, Japan Recovering from Weak Q4. China Stabilizing, India Improving but Brazil & Russia remain in Recession: Global growth slowed in late 2015 with the U.S. economy hitting a soft patch, U.K. growth slowed and Japan continued to struggle. However, Eurozone remained on modest growth path. Growth concerns were exacerbated in early 2016 with the sharp correction in equity markets and the continued fall in oil prices. The relentless decline in oil price in late 2015 to below $35 and further to below $30 in January stoked fears of weak demand and the health of the global economy even though 80% of global GDP is produced in oil importing countries who stand to benefit from lower oil prices. The oil price plunge took a toll on energy Capex with a collapse in drilling activity and shale implosion. Also fuelling growth concerns are fears of a negative feed back loop into the real economy from stress in the credit markets and banking sector with energy exposure. However, in the developed markets, especially U.S., the spillover impact on the real economy from the stress in the credit markets and banks - while potentially significant - is expected to be overall limited as the credit stress is concentrated among the smaller shale producers. Hence, the threat is not seen as systemic. Consequently, fears of a recession are exaggerated. In fact, the U.S. and U.K. are on track to a healthy rebound in Q1, Eurozone remains on track to steady improvement and Japan is expected to recover after the weak 2015. Growth in China remains around 7%, while India is on track to improve. The U.S. economy ended 2015 on soft note with Q4 GDP growth slowing to 0.7% annualized (advance estimate) from 2% in Q3. However, full-year 2015 growth was still healthy at 2.4%. The Q4 GDP slowdown was led by negative contributions from net exports (-0.5%), inventories (-0.45%) and nonresidential Capex (-0.2%). However, there were healthy contributions from personal consumption (+1.5%), residential investment (0.3%) & government spending (0.1%). U.S. GDP growth is on track to rebound to around 2% in Q1 with an inventory rebuild and a rebound in consumer spending with solid labor market, lower energy prices and unusually warm winter. Eurozone GDP grew 1.2% annualized in Q4 2015, driven by Germany and France. Looking ahead to 2016, GDP is expected to improve steadily with further easing by the ECB and weak euro. U.K. GDP grew 2% QoQ annualized in Q4, up from 1.6% in Q3. Looking ahead, U.K. GDP growth is expected to continue at a solid quarterly pace in 2016, supported by solid employment growth. Japan s GDP is expected to grow a modest 1% in Q4 2015. Earlier Japanese Q3 GDP growth was revised higher to +1% from earlier reading of -0.8%, which means Japan avoided being in technical recession. Looking ahead, Japanese GDP growth is likely to recover in Q1 with consumption spending remaining solid and business investment spending posting a modest recovery. The Emerging economies growth outlook remains uncertain with China stabilizing, India improving but Brazil and Russia in recession. 3 For informational use only. Not intended as investment advice.
3) Global Earnings Revised Lower on Slower Global Growth & Weaker Oil & China Impact. U.S. Q4 Earnings Dragged Lower by Sharp Decline in Energy Earnings. Eurozone & Japan Earnings Outlook Remains Solid. EM Earnings Remain Weak: Global earnings expectations have been revised lower to 5% in 2016 from earlier expectations of 8% while estimates for 2015 have been revised lower to 0% from 1%. The downward revision reflect the impact of slower global growth, continued weakness in oil & commodity prices and China impact. U.S. Q4 earnings season is underway with earnings expected to decline -4.1% dragged lower by the decline in the Energy sector. Eurozone earnings growth expectations for 2016 have been revised lower to 7% from 10%. However, Japanese earnings expectations for 2016 have been revised higher to 10% from around 8%. Emerging Markets earnings are expected to post around 7% growth in 2016 while estimates for 2015 have been sharply revised lower to -8% from -2% earlier. 4) Valuations More Attractive - Stocks become Cheaper as Equity Multiples Fall & Bond Yields Decline: Stock market P/E multiples continued to decline in January with a sharp decline in global equity markets, continuing the correction from late December. The Developed Markets (DM) P/E multiple declined further in January to 18X from 19X in December and 19.3X in November as the MSCI World Index declined -5.5% for the month. DM valuations are now in line with the valuation levels at the end of 2014 and well below the long-term average of 20.5X (20 years average). In the Emerging Market (EM), valuations improved with the P/E declining to 12.7X in January from 13.3X in December as EM stocks declined -5.3% for the month. The current EM multiple is slightly below the 13.2X multiple at the end of 2014 and well below its long term (20-year) historical average of 15.2X. The valuation discount between EM and DM stocks has tightened slightly to 5.3X from 5.7X due to a larger decline in DM valuation multiple in January relative to EM. Stocks became even cheaper relative to bonds as Earnings Yield Gap widens as stock multiples decline and bond yields fall. The earnings yield gap (EYG) between U.S. stocks and bonds increased further in January after widening slightly in December. The earnings yield on U.S. stocks increased to 5.8% in January from 5.5% in December while the 10-year Treasury yield dropped to 1.92% from 2.27% in December. The yield gap between U.S. stocks-bonds increased to 3.8% in January from 3.2% in December, well above its long-term (20-year) average of 2%. Eurozone stocks remain cheap relative to bonds on EYG basis with the yield gap widening to 4.1% from 3.6% as Eurozone stock yield rose to 4.5% in January from 4.2% in December while 10-year Bund yield fell to 0.3% from 0.6% in December. The Eurozone EYG is well above its long-term average of 3.4% (10-year average). The Japanese stocks earnings yield gap rose to 6.4% at the end of January from 5.7% in December, as JGB yields plunged to 0.10% from 0.26% following the surprise BoJ rate cut. The EYG remains well above its long-term 10-year average of 4.1%. Bottom-line: Global stock markets are in turmoil in early 2016 with a sell-off triggered by China concerns (growth, currency and policy) and oil price collapse. Stocks recovered in late January with the ECB signaling an increase in QE buying in March and the BoJ surprising markets by cutting rate into negative territory. However, the rally faded and the January turmoil intensified in early February with growing fears of the global economy slipping into recession through a negative feedback loop from oil-induced stress in the credit markets and banking system into the real economy. Developed market stocks declined -12.6% (as of February 11), while Emerging market stocks fell -8.8%. Global equity markets remain in the grip of fear with continued China uncertainty, oil prices struggling and fear of a recession through a negative feedback loop from stress in the credit markets and banking system into the real economy. However, recession fears appear exaggerated. While the oil-induced stress in the credit market and banking system is potentially significant, the overall impact is expected to be limited and unlikely to push the global economy over the cliff, as the sub-prime crisis morphed into the great recession in 2008. We expect stock markets to stabilize with: 1) The Draghi-Kuroda Put with the BoJ cutting rates into negative territory and likely to ease policy further, the ECB set to expand QE, the PBoC likely to cut rate after the Lunar New Year break, and the Fed putting U.S. rate hikes on pause; 2) Recession unlikley as the U.S. and U.K. are on track to a healthy rebound in Q1, Eurozone continues to improve steadily, Japan is expected to recover. Growth in China remains stable around 7%, while India and other oil importers are on track to improve; 3) Equity valuations have improved and stocks have become more attractive as P/E multiples declined with the market correction. In addition the decline in bond 4 For informational use only. Not intended as investment advice.
yields has increased relative attractiveness of stocks with the earning yield gap widening; 4) The earnings outlook remains positive, excluding the energy sector. Global earnings expectations have been revised lower to 5% in 2016 reflecting the impact of slower global growth, continued weakness in oil & commodity prices and China impact. However, earnings excluding energy remain healthy as seen in the Q4 earnings results currently underway. Bond Market Outlook: Bond Yields Fall on Safe Haven Demand with Recession Fears. Bonds Supported by ECB-BoJ Easing & Fed on Pause, Deflation Concerns Global bond yields fell in January with increased safe haven demand as equity markets fell sharply. Further, the renewed plunge in oil prices stoked fresh fears of deflation. Finally, yields came under downward pressure with the BoJ cutting rates to negative, the ECB signaling QE expansion in March, the BoE pushing out U.K. rate hikes into late 2016, and the Fed putting further rate hikes on pause. At January-end, U.S. 10-year treasury yields fell to 1.92% from 2.27% at the end of December. Eurozone yields fell to 0.32% from 0.63%, while U.K yields sunk to 1.56% from 1.95%. Japanese yields eased to 0.10% from 0.26%. Yields fell further in early February with growing fear of recession and concerns about stress in the banking system. As of February 11 th, U.S. 10-year treasury yields fell to 1.7%, Eurozone yields fell to 0.2%, U.K yields declined to 1.4% while JGB yeilds sunk to 0.01% Looking ahead, bonds remain supported by: 1) Fresh QE Stimulus: The ECB is set to expand QE stimulus in March while the BoJ is likely to adopt further easing measures after the January rate cut. The Fed has paused further rate hike, while BoE rate hikes are pushed out indefinitely into late 2016; 2) Low inflation in the U.S., Eurozone, U.K. and Japan with the recent leg down in oil prices likely to renew deflation fears; 3) Growth concerns and recession fears with the risk of a negative feedback loop from oil induced stress in the credit markets and banking system into the real economy; and 4) Safe haven demand with elevated geopolitical tensions in the Middle East and terrorism fears. However, yields could face modest upward pressure from: 1) GDP rebound & easing of recession fears with the U.S. and U.K. on track to a healthy rebound in Q1 after the weak Q4. Eurozone remains on track to steady improvement, Japan is expected to recover in 2016, and growth in China remains stable around 7%; 2) Bond valuations remain expensive relative to stocks especially after the recent sharp decline in bond yields. Investment Strategy: Asset Allocation: Stocks vs. Bonds - Stocks Volatile but likely to Stabilize with Draghi-Kuroda Put. Bonds Supported by Growth Fears Stocks Reduce Overweight as equity markets are likely to remain volatile with continued China uncertainty, oil struggling and recession fears. However, keep modest overweight with fresh ECB & BoJ Put, Fed rate hikes on pause & fresh China stimulus. Global growth remains modest, recession fears exaggerated. Valuations have improved. Healthy earnings excluding Energy. Bonds Raise to Modest Overweight as bonds remain supported by GDP concerns and recession fears, low inflation with the recent leg down in oil prices likely to renew deflation fears, fresh ECB-BoJ Put and safe haven demand on elevated geopolitical tensions. Global Equity Strategy: Overweight in Eurozone & Japan. Raise U.S. to Neutral; Keep U.K. at Neutral; Lower EM Asia to Neutral, Remain Underweight in Latin America & EM Europe; Eurozone: Remain overweight with ECB likely to cut rates and expand QE in March, solid earnings outlook, modest but improving GDP growth. Japan: Overweight with BoJ rate cut and likely to expand QE, strong earnings growth on weak yen tailwinds, GPIF stock buying. 5 For informational use only. Not intended as investment advice.
Emerging Markets: Lower EM Asia to Neutral with China uncertainty, capital outflows; Underweight in LatAm & EM Europe with Brazil & Russia in recession and weak oil & commodity prices. U.K.: Remain Neutral with BoE rate hikes pushed out further into late 2016 and Q1 GDP rebound offset by drag from weak energy sector earnings. U.S.: Raise to Neutral on safe haven demand amidst market turbulence, Fed rate hikes on pause, GDP rebound after weak Q4, healthy earnings excluding Energy, improved valuations. However, strong dollar headwinds and weak energy earnings remain drags. Global Bond Market Strategy: Yields Fall in January. Bonds Supported by GDP Concerns, Low Inflation, Safe Haven Bid & ECB-BoJ Put Eurozone: Remain Overweight with ECB likely to cut rates and expand QE in March, low inflation and modest GDP growth. Japan JGBs: Modest Overweight with BoJ rate cut and likely to expand QE, low inflation and modest GDP growth. U.K. Gilts: Remain Neutral with Q1 GDP rebound after weak Q4 offset by low inflation and BoE rate hikes pushed out further into late 2016. EM Debt: Remain Underweight with China uncertainty, capital outflows, Brazil & Russia in recession and weak oil & commodity prices. U.S. Treasuries: Modest Underweight with U.S. GDP rebound in Q1 after soft Q4 but Fed rate hikes on pause, safe haven demand. Global Sector Strategy: Overweight: Consumer Discretionary & Information Technology; Modest Overweight: Industrial; & Neutral: Consumer Staples, Healthcare, Financials; Underweight: Energy, Materials, 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.