Putnam Perspectives: Equity Outlook Q1 2014


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The U.S. equity market’s 2013 advance was top quartile by historical measures; our outlook is more tempered heading into 2014. Rarely do we see equities with more homogeneous valuations than they have today. Recovery, restructuring, and emerging-market rebound potential support the outlook for international stocks. A continuing U.S. recovery would provide a helpful external boost to non-U.S. stock markets.

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Putnam Perspectives: Equity Outlook Q1 2014

  1. 1. Q1 2014 » Putnam Perspectives Equity Outlook Robert D. Ewing, CFA® Simon Davis Nick C. Thakore Shep Perkins, CFA® Co-Head of U.S. Equities Co-Head of U.S. Equities Co-Head of International Equities Markets post a year for the record books Key takeaways • The U.S. equity market’s 2013 advance was top quartile by historical measures; our outlook is more tempered heading into 2014. • Rarely do we see equities with more homogeneous valuations than they have today. • Recovery, restructuring, and emerging-market rebound potential support the outlook for international stocks. • A continuing U.S. recovery would provide a helpful external boost to non-U.S. stock markets. Earnings snapshot After moving sideways for two years, corporate earnings may be poised to reaccelerate. Annual EPS growth (%) 12% Co-Head of International Equities S&P 500 Index MSCI EAFE Index MSCI World Index 8 4 0 2012 2013 1Projected. Sources: Standard & Poor’s, MSCI. PROUD SPONSOR 2014* A strong fourth quarter and continued economic growth helped U.S. equities extend their rally and deliver their best annual performance since the 1990s. Despite skepticism about the cyclical recovery and concerns about Federal Reserve policy and U.S. government fiscal woes, investors appeared willing to set macroeconomic worries aside and embrace equities. Throughout 2013, equity indexes achieved and surpassed their all-time highs several times, with relatively low volatility. The market’s advance was interrupted by only a few bouts of turbulence, with the most notable declines occurring in June and October. The second-quarter downturn followed a Fed policy meeting that signaled a possible cutback in quantitative easing — the Fed’s monthly bond-buying program. While anxiety over Fed tapering plans weighed on equities sporadically throughout the year, the market responded favorably in late December when the first modest reduction in asset purchases was announced. Another notable market pullback occurred in October — with a sharp, but brief, decline in response to the congressional budget debate, which led to a 16-day partial shutdown of the federal government. Non-U.S. stocks have banner year With the exception of emerging-market stocks, non-U.S. stock markets also made substantial gains in 2013. While some market observers question whether non-U.S. stocks still have room to run, we see several reasons to believe that these markets may continue to show strength well into 2014 and possibly beyond. Although interest rates may continue
to rise, modestly higher rates would still mean we would find ourselves in a historically low-interest-rate range. Low interest rates are
  2. 2. Q1 2014 |  Equity Outlook Market scorecard Outside emerging markets, global stocks uniformly posted strong returns in 2013. Select equity index performance as of 12/31/13 Q4 2013 (cumulative) 1 year 3 years (annualized) 5 years (annualized) 10.51% 32.39% 16.18% 17.94% 7.41% 8.66 36.80 16.28 21.77 9.81 10.01 32.53 16.06 16.67 7.58 MSCI World Index (ND) 8.00 26.68 11.49 15.02 6.98 MSCI EAFE Index (ND) 5.71 22.78 8.17 12.44 6.91 MSCI Europe Index (ND) 7.88 25.23 9.89 13.36 7.28 MSCI EM Index (ND) 1.83 -2.60 -2.06 14.79 11.17 Index name S&P 500 Index Russell 2500 Index Russell 1000 Value Index 10 years (annualized) Sources: Standard & Poor’s, Russell, MSCI. U.S. equities conducive to higher-than-average price-to-earnings (P/E) multiples — which implies room for stock price appreciation. Furthermore, we believe that coordinated global growth would generally lead to an increase in corporate profitability and earnings growth, which would support stock price appreciation. While U.S. shares advanced, valuations became more homogenous One of the interesting features of today’s U.S. equity market is that valuations are at an unusual level of parity. Rarely do we see equities with more homogeneity than they have today. To put it simply, most stocks are trading at a price-earnings ratio of around 15x earnings, meaning that valuations are essentially the same across all market sectors. This signals an environment in which fundamental research and bottom-up stock selection become more critical, and suggests that investors should pay closer attention to growth potential than to valuation. Many of the concerns that have hindered global markets since the financial crisis of 2008 — including
the potential for a prolonged recession in
 the eurozone, tensions in the Middle East, and the prospect of Fed policy error — appear to us to carry less risk today. Of course, the Fed’s tapering of monetary stimulus may potentially weigh on markets in early 2014, but our feeling is that remaining fears of the stimulus going away are overdone. Opportunities arise as correlations drop Our research is not revealing any sectors that look extraordinarily attractive, either from a valuation or a growth perspective. However, we believe investors may benefit from another notable trend in today’s market: retreating equity correlations. In the years following the 2008 financial crisis, equity correlations rose to record highs. More recently, they have declined dramatically and stocks are performing more independently. As share prices deviate from each other, fundamentals begin to matter more. This is an environment, we believe, that demands a researchbased approach to portfolio construction, and one in which active managers should benefit from the market’s renewed focus on fundamentals. 2
  3. 3. PUTNAM I NVESTM ENTS |  putnam.com A corporate earnings renaissance? Rising to the challenge of rising rates After moving sideways for the past two years, U.S. corporate earnings may be poised for reacceleration in 2014. While the growth is likely to be modest, we believe investors may be overlooking the potential for improvement. There appears to be a general belief that earnings are entirely dependent on external factors such as the Federal Reserve stimulus, and that margins have peaked with nowhere to go but down. While there is a cyclical component to earnings, it seems unlikely that margins are peaking when U.S. hard-goods spending is well below trend and factory utilization also remains low. Historically, rising interest rates have posed challenges for equity investors. However, unless rates begin to move up quite quickly, we do not expect an overly negative effect on the market in the near term. The equity market tends to perform well when short-term rates are rising from low levels, in part because rising rates typically signal an improving economy. As for the impact of rising rates on the housing recovery, it is important to note that even if mortgage rates rise dramatically from current levels, housing affordability would still be above average by historical standards. We are mindful of the risk of an inflationary scare and rates spiking, and that dislocations in other areas of the market due to interest-rate shifts could have an indirect impact on the equity market. If modest global economic growth continues, we believe margins can move higher from current levels, and thereby help to push up earnings. Earnings growth in the third quarter of 2013 was the highest we have seen since early 2012, and issues that had been weighing on earnings — such as the double-dip recession in Europe and slowing growth in China — have abated. Revenue growth has also shown signs of improvement, and we believe high-single-digit earnings growth is possible in 2014. Foundation remains solid for U.S. equities, cyclical sectors When we consider the combination of valuation, fundamentals, and sentiment in today’s environment, we believe the U.S. equity market’s 2013 advance was rational. However, this performance was top quartile by historical measures, and our outlook is more tempered heading into 2014. Equity valuations are at the middle of their historical range. With stocks at average valuations, our expectation should be for average returns. 2013 asset flows favored stocks While sentiment surveys show higher levels of bullishness, the data on flows suggest that many investors still have not returned to equities. Monthly flows into long-term open-end mutual funds $60,000 $40,000 $20,000 $0 -$20,000 -$40,000 U.S. equity funds International equity funds Bond funds   -$60,000 -$80,000 Jan ’13 Feb ’13 Mar ’13 Apr ’13 May ’13 Jun ’13 Jul ’13 Aug ’13 Sep ’13 Oct ’13 Nov ’13 Dec ’13 Source: Strategic Insight. 3
  4. 4. Q1 2014 |  Equity Outlook Valuation and earnings yield Non-U.S. stocks are somewhat cheaper than their U.S. counterparts. As of 12/31/13 Index 12-month trailing P/E 12-month forward P/E Earnings yield S&P 500 Index 22.21 15.38 1.99% MSCI EAFE Index 17.23 12.91 3.11 MSCI World Index 19.93 14.36 2.47 Sources: Standard & Poor’s, MSCI. Non-U.S. equities Entering 2014, we believe the most attractive opportunities can be found in cyclical sectors, such as technology, where stocks offer better growth characteristics. The least attractive stocks, in our view, are those in defensive sectors such as telecommunications, utilities, and staples — areas that investors have embraced almost exclusively for their yield potential and that have become too expensive. For dividend-paying stocks, we believe favoring dividend growth potential over dividend yield will be beneficial in the current environment. That is, companies with the potential to grow their dividends may perform better than those already paying high dividends. Out of darkness: factors supporting European market strength While the recovery in the United States has built momentum, albeit slowly, since June 2009, Europe until early 2013 had repeatedly appeared to be on the verge of disintegration and financial disaster. With a staggering government debt load, Greece serially flirted with default and the prospect of departing the eurozone. Unemployment in Spain soared as high as 27%, while 10-year Italian government bond yields came close to hitting an unsustainable 7.5% in November 2011. The ongoing debate over northern Europe’s fiscal responsibility in connection with its flailing neighbors to the south has threatened to derail policymakers’ attempts to provide bailout funds while exacting promises of fiscal austerity. So while the United States slowly built the foundation of its current recovery, Europe was stalled in comparative economic darkness, and occasional market rallies were frequently beset by sharp pullbacks on the renewal of fiscal and political fears. The stadium is only half full As confidence in the economy improved and interest rates rose in 2013, U.S. equity investors appeared to shift their focus from safety and yield to fundamentals and valuation. As a result, in the closing quarters of the year, many stocks in cyclical sectors of the market rebounded considerably. In our view, this was a positive transition that may still be in its early stages. Another transition — in investor sentiment — may also bode well for equities in 2014. While sentiment surveys show higher levels of bullishness, the data on flows suggest that many investors have not yet returned to equities. When the stadium is only half full, it is unlikely that the game is over, and we are optimistic about even more asset flows returning to equities in 2014. With many and obvious risks to a positive economic scenario emerging in Europe — and by extension, the global economy — it took contrarian insight to see that companies might be oversold relative to their long-term franchise value. In our research, for example, we found a variety of high-quality companies that had what we considered promising growth prospects and strong longer-term potential. While we thought short-term macroeconomic data would remain weak and keep upward pressure on market volatility, we also believed we could take advantage of a variety of opportunities. Fast-forward to year-end 2013. Improving economic data in Europe, along with declining fears over U.S. Fed tapering and renewed evidence of a path to sustainable growth in China, lent major support to European equities, particularly in the latter half of the year. In the wake 4
  5. 5. PUTNAM I NVESTM ENTS |  putnam.com Other potential tailwinds for Japanese stocks of a 25% rise in the MSCI Europe Index through the end of 2013, we are not alone in believing that we may be past the worst risks for the eurozone and peripheral European economies. On balance, we see attractive investment opportunities in Japan in 2014. Part of our view is based on our belief that the yen is likely to weaken further due to the Bank of Japan’s continued efforts to expand its balance sheet. Earnings growth in Japan, we believe, will be relatively attractive in a global context, and will be led by exportfocused companies. A tailwind for the Japanese economy may also arise to the extent that there is economic improvement in those countries and regions to which Japan exports its goods. Looking forward, we expect the European economy will move more decisively into recovery in 2014, though there may be temporary setbacks as global markets navigate the unwinding of quantitative easing in the United States and as Europe pushes forward with its own accommodative policy stance. Primarily, our outlook is made more optimistic by Europe’s progress in its struggle with sovereign debt issues. As European countries gradually reduce the intensity of their fiscalausterity programs, there will likely be a weaker fiscal drag, which should result in better GDP growth, improved revenue growth for corporations, and better margins for companies that streamlined their operations during the period of austerity. There is also potential upside from Japanese structural reform, rising wage inflation, and improved domestic consumption. Japanese structural reform includes a list of challenging agenda items, such as raising the consumption tax, making changes to employment laws, forging a transpacific trade pact, and reforming key domestic industries. Markets are not yet giving credit for progress on these issues, so to the extent the administration of Prime Minister Shinzō Abe delivers on its ambitions, markets are likely to respond positively. Sustained yen weakness, building economic strength in Japan Economic recovery and renaissance outside the United States have not been limited to Europe. The conventional wisdom with respect to Japan, for example, seems to be that “Japan is back.” With the MSCI Japan Index (ND) registering a 55% gain in 2013 in local-currency terms — and the closest countries tracked by MSCI at 45% (Greece) and 40% (Finland) — the market clearly found reasons to cheer Japan’s rise from its multi-decade deflationary spiral. Regulatory change and transformative technologies While gains in developed market equities in 2013 were notable, we remain excited about opportunities for continued growth. Companies in the financials sector have withstood significant regulatory pressure for the past five years. While there is a long way to go, we think some of that pressure has lifted. Over the past 12 months, in fact, we have seen an inflection point for the global financial industry, which we believe is facing a horizon of higher profitability than at any time since the 2008 financial crisis. While we believe that the Bank of Japan’s extremely loose monetary policy has the potential to drive up asset prices even further, we also believe that it may prove difficult for the Japanese government to implement the requisite structural adjustments that the economy needs while simultaneously addressing the nation’s overextended fiscal position. In our view, Japan’s economic situation will be exacerbated by demographics, as the workforce is likely to decline by nearly one percent per year over the next 10 years and with the overall population aging at an unprecedented pace. Hence, we remain cautious about Japanese equities over the long term, although we think that in the short to medium term the policy mix will be supportive of asset-related stocks. We are also interested in the way companies in a variety of industries and regions use technology to streamline operations and deliver products quickly and efficiently to customers. Automakers offer a good example, as a number of companies began to see the fruit of their research and development. Automakers in the United States and internationally can now deliver new car models more efficiently and profitably than ever. At one time, large automakers would have a few dozen “platforms,” or production frameworks of specific parts, for each type of car model produced. But with the aid of better supply-chain-management techniques and streamlined design where more parts can be shared among different models, automakers can assemble and deliver a greater number of car models on fewer platforms at a lower total cost. While gains in developed market equities in 2013 were notable, we remain excited about opportunities for continued growth. 5
  6. 6. Q1 2014 |  Equity Outlook Emerging markets — attractive points of entry? International stock opportunities proliferate For the past four years, emerging-market equities have substantially underperformed their developed-market counterparts. While some investors continue to shy away from emerging markets given their uninspiring track record, we think the prolonged weakness has opened the door on certain opportunities. China, for example, is clamping down on corruption and pollution, as well as slowing its headlong multi-year investment in fixed assets. As it shifts its economy in the direction of domestic consumption and the improvement of its citizens’ quality of life, we think China could offer interesting opportunities for investors. Sustainable domestic-led growth in China, in other words, has the potential to command higher price-to-earnings multiples for Chinese stocks. Assuming transparency and corporate trustworthiness can improve as well, Chinese markets would stand to be rated higher by many market participants. We feel that international stocks offer broad opportunities to investors at the present time, particularly relative to U.S. equities and to other asset classes. Earnings recoveries, restructuring opportunities, and emerging-market rebound potential are all supporting the outlook for international stocks. We are also constructive on international equities because we think the U.S. economy will continue to improve. A continuing U.S. recovery would provide a helpful external boost to the United Kingdom, Europe, and Japan, among others. In Japan, we think earnings growth will continue to accelerate, in large part because of our expectation of continued yen weakness. Emerging markets, we believe, will continue to grow, but in our view are not likely to be the primary drivers of global growth as 2014 gets under way. There are headwinds in the short term, of course. U.S. Fed tapering led to substantial outflows from emerging markets in 2013, though select emerging markets in Asia and Latin America began to rebound sharply in the latter portion of the fourth quarter. As tapering gets under way in 2014, the potential for further capital outflows remains, so we must wait and see whether these recoveries are intermittent or can be sustained. On the other hand, the capital outflows one might expect do imply potential investment opportunities may arise among long-term franchise winners. Invariably, some companies will be unduly punished by recurring bouts of broad-based and indiscriminate selling of emerging-market assets. In this context, we believe careful fundamental research can help investors identify and exploit strong and sustainable emerging opportunities. 6
  7. 7. PUTNAM I NVESTM ENTS |  putnam.com Index definitions MSCI EAFE Index is an unmanaged index of equity securities from developed countries in Western Europe, the Far East, and Australasia. Active management, fundamental research, and new insights to capture the growth potential of equities MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. MSCI Europe Index is an unmanaged index of Western European equity securities. Equity investing at Putnam features a tenured and talented team of portfolio managers backed by an integrated group of research analysts with worldwide reach. Our research organization is structured to focus fundamental analysis — including the fixed-income perspective — on the factors that matter most in global equity markets. Putnam research yields insights driving performance across our U.S. and global equity portfolios. MSCI World Index is an unmanaged index of equity securities from developed countries. Russell 1000 Value Index is an unmanaged capitalization-weighted index of large-cap stocks chosen for their value orientation. Russell 2500 Index is an unmanaged index of those companies in the small-cap Russell 2000 Index chosen for their growth orientation. S&P 500 Index is an unmanaged index of common stock performance. Indexes assume reinvestment of all distributions and do not account for fees. It is not possible to invest directly in an index. Simon Davis Co-Head of International Equities Investing since 1988 Joined Putnam in 2000 Robert D. Ewing, CFA® Co-Head of U.S. Equities Investing since 1990 Joined Putnam in 2008 7 Shep Perkins, CFA® Co-Head of International Equities Investing since 1993 Joined Putnam in 2011 Nick C. Thakore Co-Head of U.S. Equities Investing since 1993 Joined Putnam in 2006
  8. 8. The views and opinions expressed are those of the authors (Simon Davis and Shep Perkins, Co-Heads of International Equities, and Robert D. Ewing and Nick C. Thakore, Co-Heads of U.S. Equities) as of December 31, 2013, are subject to change with market conditions and are not meant as investment advice. Consider these risks before investing: International investing involves certain risks, such as currency fluctuations, economic instability, and political developments. Investments in small and/or midsize companies increase the risk of greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond investments are likely to fall if interest rates rise. Bond investments also are subject to credit risk, which is the risk that the issuer of the bond may default on payment of interest or principal. Interest-rate risk is generally greater for longer-term bonds, and credit risk is generally greater for below-investment-grade bonds, which may be considered speculative. Unlike bonds, funds that invest in bonds have ongoing fees and expenses. Lower-rated bonds may offer higher yields in return for more risk. Funds that invest in government securities are not guaranteed. Mortgage-backed securities are subject to prepayment risk. Commodities involve the risks of changes in market, political, regulatory, and natural conditions. Investors should carefully consider the investment objectives, risks, charges, and expenses of a fund before investing. For a prospectus, or a summary prospectus if available, containing this and other information for any Putnam fund or product, call your financial representative or call Putnam at 1-800-225-1581. Please read the prospectus carefully before investing. Putnam Retail Management putnam.com CMO300 285255 1/14