Q2 2013 » Putnam PerspectivesCapital Markets OutlookPutnam’s outlookArrows in the table indicate the changefrom the previous quarter.UnderweightSmallunderweightNeutralSmalloverweightOverweightAsset classEQUITYU.S. large cap lU.S. small cap lU.S. value lU.S. growth lEurope lJapan lEmerging markets lFIXEDINCOMEU.S. government lU.S. tax exempt lU.S. investment-grade corporates lU.S. mortgage-backed lU.S. floating-rate bank loans lU.S. high yield lNon-U.S. developed country lEmerging markets lCOMMODITIES lCASH lCURRENCY SNAPSHOTDollar vs. yen: DollarDollar vs. euro: Neutral (from favor euro last quarter)Dollar vs. pound: NeutralThe first-quarter rally wasimpressive, but not persuasiveThe year began with a flourish in stocks, whichsoared more than 10% on a mix of fundamen-tals and optimism. While the past three yearshave started with rallies, the 2013 versionseems more meaningful because both theDow Jones Industrial Average and the S&P500 Index set new records above levels theyhad last reached before the 2008 crisis. Smallcaps also rose, and Japan’s stock marketsurged as well. While Europe did not keeppace, its more modest gains overcame theturmoil of the deadlocked Italian electionsand the tortuous road to a banking sectorrescue in Cyprus.We view this advance somewhat skepti-cally, because the behavior of other assetclasses has not confirmed it as a typical bullmarket (Figure 1). In the U.S. market, defen-sive stocks with stable cash flows led cyclicalsmore geared to economic growth. Commodi-ties had flat results. Stocks in emergingmarkets generally lost ground, with only ahandful of countries posting gains. A bullmarket usually has broader support.An alternative view of this rally wouldattribute it to the positive but less-lastingeffects of activist central banks around theworld that have subdued three great globalmacro risks. The U.S. economy has avoideda double-dip recession. The eurozone hasremained intact. And worries about China’sexport economy have eased.Key takeaways• The first-quarter rally was impressive, but not persuasive.• Economic uncertainty may resurface in the second quarter.• The potential for missteps by policymakers remains asignificant risk.Jason R. Vaillancourt, CFACo-Head of Global Asset Allocation
2Q2 2013 | Capital Markets OutlookFrom this perspective, the first-quarter rally can beseen as the later innings of global macro risk-normal-ization rather than the beginning of a new upswing inearnings. This view is more consistent with the expansionof stock price multiples in the first quarter. While valua-tions remain reasonable, further price appreciation wouldbe more convincing if it came with the support of greaterearnings and revenues.Earnings reports due out in April will be very important.The markets will need to see that the improvement in theglobal growth environment reflects more than optimism,and that better economic performance is translating intorising earnings.Economic uncertainty may resurfacein the second quarterWhile the U.S. economy merits a degree of optimism,as the recovering housing sector has supportedimprovement in the labor market and consumer spending,we question the outlook for the balance of 2013. A keyindicator in our research reveals that expectations aregetting ahead of themselves. The Economic SurpriseIndex measures the difference between forecasts ofseveral types of economic data and the eventual reportsof that data (Figure 2).We do not expect smooth sailing on the horizon.Although first-quarter GDP may have expanded at a 3%annual rate, up from the previous quarter’s 0.4% pace, theeconomy may hit an air pocket in the second quarter.Figure 1. Q1 U.S. stock rally lacksparticipation from other risk assets.9095100105110SP GSCI Industrial Metals TR IndexSP 500 IndexEuropean Periphery Equities/Core EquitiesU.S. Cyclicals/U.S. Defensives2/131/13 3/13Relative weakness in cyclical stocks,European peripheral markets, andcommodities cast doubt on thestock market rally.Source: Bloomberg. Past performance is not indicative of futureresults. Each index is numerically rebased to equal 100 as of 12/31/12.SP GSCI Industrial Metals Total Return Index reflects the industrialmetals components of the SP GSCI Index. European PeripheryEquities/Core Equities reflects the ratio of the performance of stocksin Italy and Spain to the performance of stocks in Germany and France,with each country represented by Equal Weighted Primary Indices:FTSEMIB (Italy), IBEX (Spain), DAX (Germany), and CAC (France).U.S. Cyclicals/U.S. Defensives reflects the ratio of the performance ofstocks in equal-weighted SP GICS sectors, with Cyclicals comprisingthe consumer discretionary, financials, technology, industrials, mate-rials, and energy sectors, and Defensives comprising the consumerstaples, health-care, telecom, and utilities sectors.The full effect of the federal fiscal consolidation nowunderway — the higher payroll taxes that went into effectat the beginning of the year, and the spending cuts thatbegan in March — will not be clear in economic reportsuntil well into the second quarter. We forecast that federalfiscal consolidation will likely reduce 2013 GDP by abouthalf of one percent. That would not cause a recession, butcould undermine growth in corporate earnings. Also, asthe calendar moves into the spring months, the seasonaladjustment factors applied to the data become morechallenging. Uneven economic data could easily promptgreater market volatility than we saw in the first quarter.Also, we remain concerned about Washington’sfailure to reach budget agreements, even if the stockmarket shrugged off this problem in the first quarter.Both parties expected to negotiate a smarter approachto spending cuts than through the sequester, but it didnot happen, and there appears to be no progress on along-term plan to bring spending and revenues in line.Late in March, Congress quietly extended the continuingresolution that keeps the federal government operating,but this set the stage for a battle over the debt ceiling thissummer. A similar showdown in 2011 led to a downgradeof U.S. debt.
PUTNAM INVESTMENTS | putnam.com3The potential for missteps by policymakersremains a significant riskThe market context continues to be framed by accommo-dative central bank policy in many regions, which meansthat, while macro risks have abated, markets remainvulnerable to simple human error.The Fed is likely to soon find itself suffering fromwinner’s curse. In its December minutes, the FederalOpen Market Committee (FOMC) moved the condition-ality of the zero-interest-rate policy from a fixed timehorizon — to keep rates low until 2015 — to one thatdepends on incoming economic data. The key targetset by the Fed — an unemployment rate of 6.5%, withcontained inflation — has triggered a debate about whenand how policy will normalize. Aside from interest rates,the end of the Fed’s Large-Scale Asset Purchase programconstitutes a bigger challenge, as a number of variablessurround the end of asset purchases, such as timing, pace,and contingencies. Members of the FOMC are alreadyfloating ideas in public speeches. The sensitivity of thiscommunication strategy will almost surely elevateboth interest-rate and stock market volatility fromrecent low levels.Outside the United States, European authorities alsoplay an important role in keeping market volatility at bay.The recent handling of the Cyprus bailout prompted yetanother set of “unique circumstances,” renewing concernsabout the consistency and predictability of eurozone poli-cies. The credibility of the ECB’s guarantee to protect theeuro and sovereign credit markets needs to be maintained.Meanwhile, Italy’s political paralysis demonstratesthe risks involved with austerity policies. When imposedupon a nation by external authorities, and with a harshadjustment period, austerity can provoke a backlash. InEurope, it could damage popular support for the commoncurrency. Also, in Asia, the bold moves by the Bank ofJapan to reflate the nation’s economy and reinvigorateexports have done wonders for Japanese stocks, but thedepreciation of the yen can provoke conflicts in globaltrading relationships. In addition, geopolitical saber-rattling on the Korean peninsula is another source ofglobal instability, along with the conflicts simmeringin the Middle East.Figure 2. Economic Surprise Index suggestsoptimism is ahead of fundamentals.979899100101102103OutputOutlookSurprise Index1/11 6/1212/116/11 12/12 4/13The U.S. Economic SurpriseIndex has been lifted byoutlook data, not by actualoutput.Source: Bloomberg is the source of actual and consensusvalues, and the calculation of the Surprise Index is a Putnammethodology. Past performance is not indicative of futureresults. The Outlook component comprises ChicagoPurchasing Managers Index, Philadelphia Business OutlookSurvey, The Conference Board Consumer Confidence,University of Michigan Consumer Confidence Index,ISM Manufacturing Index, ISM Services Index, and TheConference Board U.S. Leading Indicators. The Outputcomponent comprises Advance GDP, industrial production,and U.S. census housing starts.
4Q2 2013 | Capital Markets OutlookAsset class viewsEquityU.S. equity Domestic equities continued their advancein the first quarter, as investors, relieved that a worst-case fiscal cliff scenario was averted, welcomed 2013with renewed enthusiasm. Stocks advanced with fewmeaningful pullbacks and limited volatility. The SP 500Index and Dow Jones Industrial Average both closed thequarter at record highs, with the Dow marking its bestfirst-quarter return in 15 years. Despite the overall strengthof the rally, the leading sectors were defensive ones,including consumer staples and health care. This may bean indication that investors, while willing to return to equi-ties, remain cautious and skeptical about the prospects forU.S. economic growth.With respect to corporate earnings growth, we areseeing some stabilization in estimates, which had beentrending downward in each of the past seven quarters.The 2012 fourth quarter also brought some positiverevenue surprises for the first time in three quarters. Whileinvestors have lower expectations for revenue trends,we believe there is potential for mid- to high-single-digitearnings growth in 2013.In light of the U.S. market’s extended advance,opportunities have narrowed for equity investors today.In contrast to a year ago, when stocks in many sectorswere offering considerable valuation dislocations,these anomalies have largely healed themselves. At thesame time, we are past the early stages of an economicrecovery, in which cyclical sectors rebound from theirlows with considerable earnings growth rates. Investmentopportunities become less obvious as growth ratesconverge, correlations decline, and valuations are moresimilar across the market. Despite — or perhaps becauseof — the greater stock selection challenges, we remainconstructive in our outlook for U.S. equity investmentopportunities.Non-U.S. equity One of the most pronounced areasof strength among non-U.S. equities has been Japanesestocks, which have climbed approximately 50% in thepast six months. With the yen depreciating versus theU.S. dollar by approximately 20% in the same time frame,Japanese equities have been among the world’s bestperformers in U.S.-dollar terms.Importantly, a variety of Japanese companies mayhave become far more competitive in light of the yen’spronounced decline versus a range of currencies, from theU.S. dollar to the South Korean won. Market share gains,expanding profit margins, and significant earnings growthpotential may all now be within reach of Japanese compa-nies, which implies a potentially long runway for growthfor selected stocks in this market.China-related stocks performed well for a portion ofthe fourth quarter, but they have pulled back somewhatin the first quarter of 2013 as business conditions havemoderated. There is a debate over whether the source ofthe slowdown is largely seasonal or secular, but in eithercase, we may well see continued volatility in China’sgrowth pattern, which could amplify fluctuations in China-related investments. On balance, Chinese equities are lessattractive now than elsewhere in the emerging markets,including Brazil and Southeast Asia, we believe.Figure 3. The sequester is having an impacton the economy.U.S. GDP as of Q4 2012 (updated 1/31/13)Sources: Congressional Budget Office and Bureau of Economic Analysis.The federal sequester will take asmall bite from GDP during 2013,but is unlikely to cause a recession.$15.8 trillionSequester represents less than 1% of U.S. GDP Defense: $42.7 billion Non-defense — discretionary: $28.7B Non-defense — Medicare: $9.9B Non-defense — other: $4.0B
PUTNAM INVESTMENTS | putnam.com5MARKET TRENDSIndex name (returns in USD) Q1 1312 monthsended3/31/13EQUITY INDEXESDow Jones Industrial Average 11.93% 13.37%SP 500 10.61 13.96Nasdaq Composite 6.25 3.72MSCI World (ND) 7.74 11.86MSCI EAFE (ND) 5.15 11.27MSCI Europe (ND) 2.71 10.56MSCI Emerging Markets (ND) -1.84 1.73Tokyo Topix 8.72 8.68Russell 1000 10.96 14.43Russell 2000 12.39 16.30Russell 3000 Growth 9.82 10.42Russell 3000 Value 12.26 18.71FIXED INCOME INDEXESBarclays U.S. Aggregate Bond -0.12 3.77Barclays 10-Year Bellwether -0.31 6.20Barclays Government Bond -0.16 3.01Barclays MBS -0.05 1.97Barclays Municipal Bond 0.29 5.25BofA ML 3-Month T-bill 0.02 0.12CG World Government Bond ex-U.S. -3.83 -2.16JPMorgan Developed High Yield 3.13 13.12JPMorgan Global High Yield 3.01 13.06JPMorgan Emerging Markets GlobalDiversified -2.26 10.11SP LSTA Loan 2.11 7.91COMMODITIESSP GSCI 0.55 -4.96It is not possible to invest directly in an index. Past performance is notindicative of future results.European stocks have lagged so far this year,particularly European financials. In the second halfof 2012, European stocks led many other markets, partlyas a result of expectations that Europe was turning acorner on its debt-related issues. But while the region hasgenerally stabilized due to the creation of a frameworkthat allows policymakers to manage Europe’s debt,politics have shown their potential to upset nearly anyfiscal balancing act.In the second quarter, areas of concern for non-U.S.equities include debt problems bringing down Europeanmarkets; suspicions that the Chinese property market istoo frothy; and fears that Japan could slide backward intoits longtime deflationary slump. But despite these issues,we see a variety of scenarios in which markets could risematerially from current levels. Particularly against thebackdrop of continued low — and not necessarily abso-lutely flat — long-term interest rates, we see the potentialfor substantially higher price-to-earnings multiples inbroad areas of non-U.S. equity markets.Fixed incomeThe first quarter marked a continuation of the rally inso-called spread sectors of the bond markets. By way ofbackground, on January 1, Congress passed last-minutelegislation to avoid the across-the-board tax hikes asso-ciated with the fiscal cliff, although no compromise wasreached to modify the approximately 2% sequestrationspending cuts that began in March. Our own estimatesanticipate a negative impact on GDP, but overall we’reforecasting growth in line or slightly above that of 2012.Outside the United States, Europe reclaimed headlinesafter Italy’s elections failed to produce a majority govern-ment and Cyprus’s banking system, teetering on the brinkof collapse, agreed to a substantial restructuring and EUbailout. These events were generally understood to benegative developments on the world stage, but we believethe muted market reaction is telling.As recently as a year ago, such developments wouldhave been much more likely to spark a widespread selloff,with a concurrent flight to U.S. Treasuries — a patternmarkets experienced many times during the past fewyears. The fact that investors have remained more focusedon longer-term opportunities rather than the short-termnews cycle suggests to us that they are much moreattuned to the potential opportunity costs of remainingon the sidelines.
6Q2 2013 | Capital Markets OutlookTo that end, we’ve seen significant outflows fromcash investments in recent months as investors havemoved back into equities and continued to allocate tofixed-income spread sectors, many of which have beenexperiencing substantial inflows for some time. Webelieve this type of environment — one in which declininginterest rates are not the primary driver of returns and therisk-on/risk-off trade does not overshadow fundamentalsin the market — provides an abundance of opportunitiesfor active managers. We believe our holistic, bottom-upapproach to securities, sectors, rates, and currenciespositions Putnam well for the market environment thatwe now see unfolding.Tax exempt Within the tax-exempt market, wecontinue to favor essential service revenue bonds overlocal general obligation bonds. The BBB-rated segmentof the curve continues to offer attractive relative valueopportunities, in our analysis, and in terms of maturities,we find 10 to 15 years to be the optimal part of the yieldcurve in today’s environment. For several months now,we have maintained a slightly higher than normal cashweighting in our portfolios, which has helped to offsetsome of the recent interest-rate volatility. We anticipatemaintaining that stance through the spring, which tends tobe a seasonally slower period for new issuance, and whichwill allow us a greater degree of flexibility as issuancepicks back up in the summer months, as historically hasbeen the case.Overall, we maintain our constructive outlook formunicipal bonds, though we believe that returns in 2013will be less about price appreciation and more aboutcoupon income in the tax-exempt market. While spreadsare much narrower than they were at their peak, theyremain attractive, in our opinion. Technical factors inthe market also have been positive — specifically, higherrefunding activity and strong investor demand — and webelieve that technicals should remain supportive in 2013.CommoditiesOne of the biggest issues in commodity investing overthe past several years has been the strong correlationbetween stocks and the overall commodity asset class.At times, it has seemed like having a separate opinionon commodities was not even worthwhile because thetwo asset classes moved in tandem. We started to seea degradation of this relationship in 2012, and the firstquarter of 2013 confirms it more convincingly.With momentum a signal in our commodity fore-casting process, the more constructive view we had goinginto 2013 has now diminished considerably. We have anoverall neutral view of the asset class, with a slight posi-tive expectation only for the energy sector. An overallpositive global economy indicator is now cancelled out byweak emerging-market stock performance and implieddemand for resources.Even in gold, which we had favored for some time, weadvocate a neutral position. Over the past several years,gold has been seen as a great downside market hedgeand a safe-haven asset. But that negative market correla-tion has become the exception. Just as there was a longperiod of popularity in gold investing driving prices upprior to 2012, we continue to see the reverse trend. We nolonger advocate for a position in precious metals relativeto any other commodity sectors.CurrencyWith several central banks in developed markets nowpursuing highly accommodative monetary policies, it islikely that several currencies could weaken.The Fed’s easy monetary policy would normally leadto a weaker U.S. dollar against most currencies. However,continued improvement in the U.S. labor market is likelyto keep currency markets concerned about the timingfor ending or tapering off asset purchase programs andproviding support to the dollar against the euro, thepound sterling, and the yen.
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