Q4 2013 » Putnam Perspectives
Capital Markets Outlook
Jason R. Vaillancourt, CFA
Co-Head of Global Asset Allocation
• If U.S. politics do not derail the recovery, pent-up demand
can drive faster economic growth.
If U.S. politics do not derail the
recovery, pent-up demand can
drive faster economic growth.
U.S. small cap
U.S. large cap
U.S. tax exempt
U.S. investment-grade corporates
U.S. floating-rate bank loans
U.S. high yield
Non-U.S. developed country
Dollar vs. euro: Favor euro (from favor dollar last quarter)
Dollar vs. pound: Neutral (from favor dollar last quarter)
Dollar vs. yen: Neutral (from favor dollar last quarter)
Arrows in the table indicate the change
from the previous quarter.
• Fixed-income outflows appear likely to continue, pushing
The Federal Reserve’s Open Market
Committee (FOMC) has enough smarts and
market savvy to realize that it had a green
light to begin the slow exit from its Large
Scale Asset Purchase (LSAP) program at
its September meeting, but they chose to
pass up the opportunity. This should be
viewed as a somewhat troubling development since it seems to suggest that the Fed
interprets current economic data as showing
that slow growth and the risk of deflation
remain problematic. Evidence for this concern
could include the fact, as we pointed out last
quarter, that the rate of unemployment has
been falling primarily because the labor force
participation rate has continued to decline, not
because of robust hiring.
Perhaps the move by the Fed to delay
tapering foreshadowed the likelihood that
Janet Yellen would take the helm at the Fed
once Larry Summers was out of the picture.
The evidence would suggest that Yellen is
even more of a policy dove than Bernanke.
It is also quite likely that the Fed anticipated
that some market disruption might arise from
the then-looming partial federal government shutdown and a potentially messy
debate regarding extension of the debt
ceiling. Indeed, in a number of speeches since
September, FOMC voting members have
expressed an offset to fiscal policy as a reason
to delay tapering, suggesting that politics has
become a factor that the Fed must consider in
setting policy. Understanding the subtleties of
this shift in strategy and communication will
be of critical importance in upcoming quarters
Q4 2013 | Capital Markets Outlook
Figure 1. � ousehold formation and capital
expenditures have been slow to rebound
Beyond watching the actions of the Fed, we are also
carefully monitoring our indicators of global growth. U.S.
GDP growth during the recovery, underway since the
middle of 2009, is among the weakest in recent history,
averaging a little over 2% for the past four years, well
below the previous long-term trends of 3% to 3.5%. For
years, investors have been looking for the economy to
shift to a faster gear, what economists sometimes refer to
as “escape velocity.”
It would take additional
spending, driven by
rising expectations, for
the economy to provide
the setting for stronger
Percentage change in
occupied housing units
Net percentage of business
owners planning new
Source: U.S. Census Bureau and National Federation
of Independent Business. Household formation data
represent monthly year-over-year percentage change in
occupied housing units from February 2003 to June 2013.
Capital expenditures data represent the net percentage
of business owners planning a capital expenditure over
the next 3–6 months, based on NFIB monthly surveys
from February 2003 to September 2013.
The good news is that a reacceleration into 2014 seems
to be on track, with the litany of global macro risks beginning to recede, provided that U.S. politics does not derail
the recovery. The thrust that could push the economy
higher may come from pent-up demand from households
and businesses. Household formation fell sharply during
this downturn and only began to pick up again in 2012 as
more people felt confident to move into their own apartments or to buy houses, which are the preconditions for
future growth in consumer spending. Businesses, similarly, have been slow to ramp up capital expenditures and
hiring. The big question today is whether CEOs and CFOs
perhaps see the same signals that the Fed perceived. Do
they have high expectations warranting greater investment and hiring, or do they detect weakness that calls
for continued caution? It would take additional spending,
driven by rising expectations, for the economy to provide
the setting for stronger earnings growth.
Such a shift appeared likely in mid 2011, until the escalation of the European sovereign credit crisis, Japanese
tsunami, and U.S. credit downgrade triggered turmoil.
Hopes also increased in 2012, before Europe again
tottered on the edge of a deleveraging crisis and the U.S.
government went to the precipice of the fiscal cliff. In both
cases, the pace of GDP growth declined, bordering on
what might be called “stall speed.”
The difference between a 2% and a 3% growth rate may
not seem like much, but it influences what has historically
been a strong relationship between real GDP growth and
corporate profits. Over the past five quarters, the revenue
growth of S&P 500 companies has barely been above 1%,
providing little impetus to bottom-line earnings growth.
PUTNAM INVESTM ENTS | putnam.com
Fixed-income outflows appear likely to
continue, pushing rates higher.
strategy becomes much more important. The Fed has
been grappling with a communications strategy in subsequent meetings. The process of normalizing monetary
policy actually began at the end of 2012 when the Fed
adopted a more data-dependent strategy for keeping
rates low, as opposed to its previous approach, a fixed
time commitment. This process continued at the end of
April 2013 when the first hints emerged that the Fed might
begin to slow its asset purchase program. The next step
would be to actually begin to taper, leading to an eventual
cessation of QE, and then to the ultimate step of removing
its zero interest-rate policy.
A reasonable rule of thumb is that over time, 10-year
government bond yields can be approximated by the
long-term rate of real growth in the economy, plus both
an inflation premium and a term premium (what investors
should be paid for moving further out on the yield curve).
By this metric, U.S. Treasury yields have been substantially
below where they “should” be. This has largely been the
case since the Fed initiated extraordinary policy measures
in 2008, in the middle of the financial crisis, when the
federal funds rate went to an unprecedented range of
0%–0.25%. Extraordinary measures reached a high point
in mid 2012 with larger bond purchases and the openended commitment to low interest rates, at a time when
the 10-year Treasury yield reached the historic low of
Two things that seem relatively certain given the
unprecedented monetary stimulus in place are, first, that
when the cost of money is distorted, market dislocations
will eventually emerge, and, second, that volatility will
be higher. Fund flows offer a possibility for dislocation.
Fixed-income mutual funds took in nearly $1 trillion from
2009 to 2012. Should this money flow out again at a rapid
pace, it could have major implications across fixed-income
sectors. We continue to keep a watchful eye out for where
those vulnerabilities might eventually surface, as we also
look for opportunities to capitalize on higher volatility.
After the 2012 Economic Policy Symposium at Jackson
Hole, Wyoming, a paper presented by Columbia University Professor Michael Woodford had a substantial impact
on FOMC thinking. The paper argued that once interestrate policy has reached the zero bound, communication
Figure 2. � xtraordinary policies have held
Treasury yields below fair value
Actual 10-year Treasury yield vs. hypothetical fair-value yield
When the cost of money
is distorted, market
dislocations will eventually
emerge, and volatility will
Hypothetical fair-value yield
10-year Treasury yield
Sources: Putnam Global Asset Allocation and Bloomberg.
Fair Value Model represents hypothetical yield of Treasury
calculated by adding the trailing 5-year average real GDP
growth (Source: U.S. Bureau of Economic Analysis), and the
University of Michigan Survey of one-year forward inflation expectations (Source: University of Michigan Survey
Q4 2013 | Capital Markets Outlook
Asset class views
In Europe, the sharp austerity measures put in place a
few years ago are now less of a drag on growth, and the
economy is consequently emerging from its recession.
Like the United Kingdom, tough economic conditions have
forced Continental European companies to restructure as
never before, bolstering their ability to improve earnings
and operate more efficiently. Stocks in Europe have risen
but are still cheap relative to fixed-income investments and
U.S. stocks, in our opinion, and are also likely to show better
earnings momentum as Europe’s economy recovers.
U.S. equity U.S. equities continued to advance, but not
without turbulence, particularly in the final week of the
quarter, when investors were distracted by Washington’s
budget debate and the threat of a government shutdown.
Uncertainty about Federal Reserve policy also influenced
equities throughout the quarter, until the S&P 500 Index
surged to a record high following the Fed’s September
announcement that it would postpone tapering for at
least another month.
Japanese equities look reasonably attractive to us when
we consider company valuations and earnings momentum.
As long as the yen remains relatively weak — which it has
done since the rollout of the government’s aggressive
monetary and fiscal stimulus toward the end of 2012 — a
variety of companies in Japan will likely exhibit attractive
business characteristics. Autos and industrials performed
well in the third calendar quarter, and we think there is
room for share-price gains in these areas.
In a trend that we view as positive, cyclical sectors
again outperformed defensive stocks as investors
appeared to shift their focus from safety and yield to
fundamentals and valuation. Equity valuations are generally at the midpoint of their historic ranges, and they are
more equivalent in that price-earnings multiples are in a
tighter range across companies and sectors. In this environment, investment opportunities remain, but they are
less obvious, and fundamental research and bottom-up
stock selection become more critical, in our view.
Emerging markets have been the weakest-performing
equity class for four consecutive years. This year, the
underperformance has been substantial. While we are
generally finding better opportunities in developed
markets, we believe the current broad-based sell-off in
emerging markets, which began roughly in May, does
open the door to certain opportunities. We think spending
in the consumer sectors, including health care, could be
increasingly strong over time. In addition, given China’s
significant pollution and other environmental problems,
we believe spending on pollution remediation and control
could be significant going forward, even if China’s overall
growth continues to disappoint.
In terms of corporate earnings, given the relatively
modest rate of recent U.S. economic growth, it is compelling that businesses have been able to deliver current
levels of profit growth. In another promising development
for equity markets, U.S. businesses have focused on structural improvements to enhance profitability, rather than
rely on revenue growth.
Our outlook has become more balanced and is less
constructive than it had been several quarters ago when
we believed the U.S. equity universe offered many exploitable opportunities. While we would not describe equities
as expensive from a historical perspective, we are seeing
far fewer pockets of anomalous valuations — areas in
which stocks are extraordinarily inexpensive.
U.S. fixed income Interest rates, after spiking higher in
June, remained elevated for most of the third quarter, due
to uncertainty about when the Federal Reserve would
begin scaling back quantitative easing. However, seeing a
more uneven economic climate than it expected, including
a weak September non-farm payroll report along with the
potential for fiscal discord in Washington, the Fed decided
to keep its $85 billion-a-month bond-buying program in
place. Following this surprise mid-September decision,
bonds rallied and interest rates declined.
Non-U.S. equity The global economy is finding new
engines of growth in the developed markets. In the United
Kingdom, we see what we consider to be the proper
balance of fiscal retrenchment and stimulative monetary
policy, which is lending support to key sectors such as
financials. This has contributed to the momentum of the
country’s overall recovery as well as to our conviction in
several “self-help” opportunities, where companies are
pursuing aggressive internal restructuring actions that
should result in meaningfully improved profitability.
PUTNAM INVESTM ENTS | putnam.com
With the Fed’s decision, investors also showed a
renewed appetite for credit risk, and sought to capitalize on the wider yield spreads offered by corporate
securities. Securitized bonds, such as interest-only
collateralized mortgage obligations (IO CMOs), also
performed well. Mortgage credit holdings — most
notably, commercial mortgage-backed securities
(CMBS) — delivered modestly positive performance,
aided by stable-to-rising commercial property values.
Index name (returns in USD)
Dow Jones Industrial Average
MSCI World (ND)
MSCI EAFE (ND)
MSCI Europe (ND)
MSCI Emerging Markets (ND)
Russell 3000 Growth
Russell 3000 Value
Barclays Government Bond
Barclays Municipal Bond
BofA ML 3-Month T-bill
CG World Government Bond ex-U.S.
JPMorgan Developed High Yield
JPMorgan Global High Yield
JPMorgan Emerging Markets
S&P LSTA Loan
The desire among policymakers and investors alike
is for the financial markets to return to a more normalized environment over the medium term. Consequently,
the Fed would prefer to transition from aggressively
providing liquidity to the markets to letting the markets
function on their own again. As the markets make
this transition, there will continue to be periods of
From a fundamental point of view, we see underlying
strength in the economy and among corporates. For
this reason, we believe we are likely to see rates continue
an upward march. As rates shift to higher levels, it could
entail a pickup in volatility, though we expect that some
stabilization of rates may be achieved by late in the year,
along with tighter credit spreads.
FIXED INCOME INDEXES
Barclays U.S. Aggregate Bond
Barclays 10-Year Treasury Bellwether
Non-U.S. fixed income The global macroeconomic
environment, though less solid than the United States,
appears to be stabilizing. This is particularly the case in
Europe, which we see emerging from its recession, and
in Japan, which is pursuing an aggressive policy agenda
to weaken the yen and pull the economy out of a multidecade period of deflation. China, too, reported positive
manufacturing data above economists’ expectations
late in the third quarter.
In emerging markets more generally, the Fed’s
tapering discussion caused emerging-market debt to
sell off late in the second quarter of 2013, and outflows
from this sector continued through the third quarter.
As that has happened, other issues have been exposed
that may prove to be obstacles for this asset class.
Those countries that did not use the recent era of global
quantitative easing to improve their fiscal policies now
appear to have relatively poor fundamentals and are
faced with a negative environment for raising additional
capital. However, we do not see at present a repeat
of past emerging-market crises — such as the Asian
currency crisis of 1998.
It is not possible to invest directly in an index. Past performance is not
indicative of future results.
Q4 2013 | Capital Markets Outlook
Tax exempt We continue to have a constructive
outlook for municipal bonds, especially as part of a diversified portfolio and for long-term investors seeking tax-free
income. The third quarter proved to be a very volatile time
for municipal bonds, and market conditions remain less
than robust. It is worth noting that while spreads are much
narrower than they were at their peak, we believe the
recent sell-off has created more attractive opportunities in
a dislocated municipal market.
We are taking relatively less risk in active currency strategies, as the Fed’s decision not to taper its stimulative
bond-buying program and the shutdown of the U.S.
government have created an environment with fewer
opportunities, in our view. At this writing, it appears likely
that a last-minute deal on the debt ceiling will keep the
government from a technical default; however, the very
small tail risk of default has quite severe implications for
asset markets. In these conditions we have a neutral view
toward the U.S. dollar.
In our view, technical factors in the market are the
big wild card at this point. Tax-exempt municipal fund
outflows have really put a lot of downward pressure on
prices in the market. Although we have seen some institutional crossover buyers come into the market to help
support prices, we think it is unlikely that we will see volatility subside until outflows and rate volatility diminish. The
overall fundamental credit outlook of municipal bonds
appears solid. With regard to tax policy, while investors
gained certainty on tax rates for 2013, many issues remain
unresolved, including federal budget sequestration, the
debt ceiling, and the potential for broader tax reform — all
of which could affect the value of municipal bonds. As
always, we are monitoring the situation closely and positioning the portfolios accordingly, based on our analysis.
We favor a slight overweight to the euro as cyclical
economic growth is improving and the European Central
Bank (ECB) policy remains accommodative. The Fed’s
decision to maintain asset purchases has given the ECB
time by helping to lower the global term premia, relieving
pressure on European short-term interest rates, and
reducing the need for more dovish rhetoric. At the same
time, we are less negative on the British pound sterling
as U.K. economic growth data remain strong and are
challenging the forward guidance as laid out by the Bank
Our view on the Japanese yen has become more
neutral. Over the medium term, it is expected that the
Bank of Japan will have to do much more monetary
easing than currently slated, which should provide further
impetus for the dollar to rally versus the yen. We also
believe the yen and Japanese stocks may be more aligned
than was the case earlier this year.
Our fourth-quarter outlook for commodities is negative.
We anticipate flat results in energy markets, believing that
the geopolitical tensions that made oil more expensive
before easing in September are fully reflected in current
price levels. Geopolitical risk in the Middle East represented an upside risk for an oil spike last quarter, but it is
now a potential downside risk for oil going forward.
Elsewhere, we now favor a slight overweight to the
Australian dollar and an underweight to the Canadian
dollar. In emerging markets, we favor a relative value
positioning. The surprise by the Fed and the probability
that Janet Yellen will succeed Ben Bernanke as Chairman
increases the chance of much more benign changes to
U.S. monetary policy, but large structural long positions in
local emerging debt markets remain in place, which leaves
some emerging-market currencies more susceptible to
capital outflows, we believe.
For the rest of the commodity complex outside of
energy, our signals are pointing toward a negative quarter.
Momentum has largely been negative, emerging markets
have been weak, and performance of commodity currencies suggests a further downtrend. Where we have
policy-driven investments in commodities, we would
continue to favor energy-heavy indices such as the S&P/
One of the more interesting developments for
commodity investors has been the sharp fall in correlation with equities. Commodities historically represented a
great diversifier and alternative investment, but over the
past decade, the correlation with equities has risen. The
correlation weakened considerably over the third quarter
of 2013, and we have no reason to predict that it will jump
back up to higher levels. While the long-term bull market
for commodities has faded, the portfolio construction
case could well be rising again.
PUTNAM INVESTM ENTS | putnam.com
The Barclays Government Bond Index is an unmanaged index of U.S. Treasury and
government agency bonds.
The Barclays Municipal Bond Index is an unmanaged index of long-term fixed-rate
investment-grade tax-exempt bonds.
The Barclays 10-Year U.S. Treasury Bellwether Index is an unmanaged index of U.S.
Treasury bonds with 10 years’ maturity.
The Barclays U.S. Aggregate Bond Index is an unmanaged index used as a general
measure of U.S. fixed-income securities.
The Barclays U.S. Mortgage-Backed Securities (MBS) Index covers agency
mortgage-backed pass-through securities (both fixed-rate and hybrid ARM) issued by
Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC).
The BofA Merrill Lynch U.S. 3-Month Treasury Bill Index consists of U.S. Treasury bills
maturing in 90 days.
The Citigroup Non-U.S. World Government Bond Index is an unmanaged index
generally considered to be representative of the world bond market excluding the
The Dow Jones Industrial Average Index (DJIA) is an unmanaged index composed
of 30 blue-chip stocks whose one binding similarity is their hugeness — each has sales
per year that exceed $7 bilÂ�Â�lion. The DJIA has been price-weighted since its inception
on May 26, 1896, reflects large-cap companies representative of U.S. industry, and
historically has moved in tandem with other major market indexes such as the S&P 500.
The JPMorgan Developed High Yield Index is an unmanaged index of high-yield
fixed-income securities issued in developed countries.
The JPMorgan Emerging Markets Global Diversified Index is composed of U.S.
dollar-denominated Brady bonds, eurobonds, traded loans, and local market debt
instruments issued by sovereign and quasi-sovereign entities.
JP Morgan Global High Yield Index is an unmanaged index of global high-yield
The MSCI EAFE Index is an unmanaged list of equity securities from Europe and
Australasia, with all values expressed in U.S. dollars.
The MSCI Emerging Markets Index is a free-float-adjusted market-capitalizationweighted index that is designed to measure equity market performance in the global
The MSCI Europe Index is an unmanaged list of equity securities originating in any of 15
European countries, with all values expressed in U.S. dollars.
The MSCI World Index is an unmanaged list of securities from developed and emerging
markets, with all values expressed in U.S. dollars.
The Nasdaq Composite Index is a widely recognized, market-capitalization-weighted
index that is designed to represent the performance of Nasdaq securities and includes
over 3,000 stocks.
The Russell 1000 Index is an unmanaged index of the 1,000 largest U.S. companies.
The Russell 2000 Index is an unmanaged list of common stocks that is frequently used
as a general performance measure of U.S. stocks of small and/or midsize companies.
Russell 3000 Growth Index is an unmanaged index of those companies in the broadmarket Russell 3000 Index chosen for their growth orientation.
Russell 3000 Value Index is an unmanaged index of those companies in the broadmarket Russell 3000 Index chosen for their value orientation.
The S&P GSCI is a composite index of commodity sector returns that represents a
broadly diversified, unleveraged, long-only position in commodity futures.
The S&P/LSTA Leveraged Loan Index (LLI) is an unmanaged index of U.S. leveraged
The S&P 500 Index is an unmanaged list of common stocks that is frequently used as a
general measure of U.S. stock market performance.
The Tokyo Stock Exchange Index (TOPIX) is a market-capitalization-weighted index of
over 1,100 stocks traded in the Japanese market.
You cannot invest directly in an index.
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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
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