Q3 2013 » Putnam Perspectives
Capital Markets Outlook
Arrows in the table indicate the change
from the previous quarter.
U.S. large cap l
U.S. small cap l
U.S. value l
U.S. growth l
Emerging markets l
U.S. government l
U.S. tax exempt l
U.S. investment-grade corporates l
U.S. mortgage-backed l
U.S. floating-rate bank loans l
U.S. high yield l
Non-U.S. developed country l
Emerging markets l
Dollar vs. yen: Dollar
Dollar vs. euro: Dollar (from neutral last quarter)
Dollar vs. pound: Dollar (from neutral last quarter)
The Fed’s tapering talk could
cause more volatility.
If anyone doubted that policy moves markets,
skyrocketing bond yields in the second
quarter helped resolve the debate.
At the beginning of May, the yield of the
10-year Treasury was close to 1.6%, near
historic low levels. By the end of June, the yield
had risen to approximately 2.6%, still remark-
ably low in historical terms, but 57% higher in
the space of only seven weeks. Rising yields
caused volatility in spread sectors and global
bond markets, and eventually even dragged
the S&P 500 down from record high levels.
Yield movements like this are rare, espe-
cially when the economy is growing below
its capacity and generating little inflationary
pressure. The markets were reacting to
signals that the Fed might begin tapering
its monthly asset purchases of $85 billion. In
June, Fed Chairman Ben Bernanke announced
a possible reduction in these purchases by $10
billion each month, beginning later this year,
with the entire program ended by mid 2014, if
the economy continues to behave as the Fed
We regard the jump in yields during the
second quarter as an overreaction to the
tapering plan, given current economic perfor-
mance. It demonstrated just how much sway
policymakers have over the fortunes of inves-
tors in the near term.
The communication strategy employed
by the Fed will be a critical component
of monetary policy as we move forward.
Foreshadowing the introduction of tapering
was likely meant, at least in part, as a
deliberate way to reintroduce volatility to
the bond market. Volatility, like yields, had
• The Fed’s tapering talk could cause more volatility.
• In a steady economy, deflation lurks.
• Risk assets deserve the benefit of the doubt.
Jason R. Vaillancourt, CFA
Co-Head of Global Asset Allocation
PUTNAM INVESTMENTS | putnam.com
One troubling trend behind this impressive decrease
in unemployment is that the labor force participation rate
has not risen, as it normally would at this point in the cycle.
This anomaly is likely due to the fact that the United
States, like most developed economies, is beginning to
experience the effects of an aging population. This key
statistic bears closer attention as we continue to be on the
lookout for signs of deflation.
Risk assets deserve the benefit of the doubt.
Viewing policy issues and market fundamentals together,
we favor continuity in investment positioning going
into the third quarter. Equities and high-yield credit, we
believe, offer more attractive total return potential than
other interest-rate risk and inflation-sensitive assets,
including TIPS and commodities. We also have a some-
what sanguine view of looming U.S. policy risks. Although
Congress and the President will likely face off again to
raise the debt ceiling, rising tax receipts have reduced
the political sensitivity of the deficit. We do not antici-
pate theatrics that will derail the economy. Similarly, any
tapering by the Fed — either real or implied — is unlikely to
raise the risk of recession.
On a global scale, we regard U.S. and Japanese
equities to be among the most promising assets. The
reforms launched by Japan’s prime minister Shinzo Abe
have sparked both controversy and volatility in equity,
currency, and debt markets. However, we believe Abe
appears poised to consolidate his grip on policy in July’s
elections to the Diet’s upper house, which should allow
him to follow through on the “third arrow” of his agenda,
adding structural reforms to the monetary and fiscal policy
changes already instituted. Given that structural change
would bring the deepest and most sustainable benefits,
we favor a tilt toward Japanese equities as these poli-
cies make their way into legislation over the next several
months. Importantly, expectations are low for true and
sweeping reforms, so any progress on this front would
likely generate a positive surprise.
We have less optimism for Europe and emerging
markets. While the threats of a European deleveraging
event or a hard landing in China remain severely dimin-
ished, we have some concerns about credit conditions in
European peripheral markets and in China’s banking sector.
Meanwhile, China’s economic deceleration is quite clear,
and has implications for a range of other emerging markets
linked to China by trade. One consequence has been a drop
in commodity prices this year, which has contributed to the
underperformance of emerging markets.
Overall, the world is still starved for yield-generating
investments as the major central banks keep policy rates
extremely accommodative. Their efforts are at least
partially in response to the fact that deflation remains a
threat to the global economy. So long as policy measures
can prevent deflation, portfolios should favor equity and
other risk assets over more interest-rate-sensitive bonds.
Figure 2. �Buying a home is easier today than
it has been in more than a generation
National Association of Realtors Home Affordability
Composite Index, 1/31/89–4/30/13
19921/31/89 200420001996 2008 2012 4/30/13
Dynamics of the housing
market include low prices,
low mortgage rates, high
pent-up demand, and insti-
Sources: Bloomberg, National Association of Realtors. An
index above 100 signifies that a family earning the median
income has more than enough income to qualify for a loan
on a median-priced home.
Q3 2013 | Capital Markets Outlook
Asset class views
U.S. equity In late May, shortly after closing at an all-time
high, the S&P 500 Index pulled back sharply following a
Fed policy meeting that signaled a possible cutback in the
Fed’s bond-buying program. In the weeks that followed,
stocks declined more than 6% before recovering in the
final days of the quarter.
A notable shift from the previous quarter was a pull-
back in the performance of defensive stocks. As investors
became more confident about an improving U.S. economy,
they appeared willing to take on more risk, and cyclical
stocks rebounded. We regarded this development posi-
tively. As equity markets focus more on fundamentals and
valuations, the opportunity to achieve returns at the indi-
vidual stock level appears greater than it has for some time.
Despite relatively sluggish revenue growth for U.S. busi-
nesses, our outlook is constructive for corporate earnings.
In our view, the bulk of profitability is the result of struc-
tural improvement and is likely to be sustainable over time.
In addition, relatively low levels of durable-goods spending
and factory utilization suggest that profit margins have yet
to peak and can move higher from current levels.
While it is important to consider the potential impact of
rising interest rates on U.S. equities, we don’t view this as a
significant risk. At the close of the quarter, long-term rates
still remained near all-time lows, and rising short-term rates
can be beneficial for equity performance, in part because
they typically signal an improving economy. Despite
a slightly less bullish stance overall, our view remains
constructive for U.S. equities, and for the universe of
cyclical stocks in particular, which has yet to fully rebound
and continues to offer many exploitable opportunities.
Non-U.S. equity Rising interest rates, declines
among dividend-paying stocks, and an outflow of capital
from emerging markets all accelerated after the Fed’s
announcement in mid June, and sapped global equity
Despite these macro fears, we see exciting funda-
mental developments among non-U.S. equities in terms of
product cycles, business model improvement, and break-
through technologies. Innovation is happening across a
variety of sectors, and may hold important implications
for companies’ top-line growth. This cuts across tradition-
ally innovation-driven areas, such as biotech, and newer
zones of innovation like “big data.” But it extends as well to
more stable industries, such as food and beverage, where
Figure 3. �People staying out of the job hunt
might be a sign of an aging workforce
U.S. Labor Force Participation Rate, 12/31/89–6/30/13
199212/31/89 200420001996 2008 2012 6/30/13
The labor force participation
rate has not risen as it
normally would at this point
of the cycle.
Source: Bureau of Labor Statistics. This rate represents the
percentage of the civilian population participating in the
labor market, either employed or seeking jobs.
PUTNAM INVESTMENTS | putnam.com
Index name (returns in USD) Q2 13
Dow Jones Industrial Average 2.92% 18.87%
S&P 500 2.91 20.60
MSCI World (ND) 0.64 18.58
MSCI EAFE (ND) -0.99 18.62
MSCI Europe (ND) -0.51 18.86
MSCI Emerging Markets (ND) -7.88 2.87
Tokyo Topix -0.05 16.64
Russell 1000 2.65 21.24
Russell 2000 3.08 24.21
Russell 3000 Growth 2.19 17.56
Russell 3000 Value 3.14 25.28
FIXED INCOME INDEXES
Barclays U.S. Aggregate Bond -2.33 -0.69
Barclays 10-Year Bellwether -4.57 -4.20
Barclays Government Bond -1.88 -1.51
Barclays MBS -1.96 -1.10
Barclays Municipal Bond -2.97 0.24
BofA ML 3-Month T-bill 0.02 0.11
CG World Government Bond ex-U.S. -3.44 -5.72
JPMorgan Developed High Yield -1.26 9.74
JPMorgan Global High Yield -1.76 9.47
JPMorgan Emerging Markets Global
Diversified -5.64 1.11
S&P LSTA Loan 0.19 7.32
S&P GSCI -5.93 2.04
It is not possible to invest directly in an index. Past performance is not
indicative of future results.
new products are having an enormous impact on compa-
nies’ future growth potential, and where new consumer
packaging ideas can revitalize mundane and well-worn
consumer products by changing how they are delivered to
Two zones of risk to watch are Japan and China, which
will rely on the sustainability of the weak yen and avoiding
an excessively damaging slowdown. We are also attentive
to risks in Europe, which we expect may experience flat
growth but could generate a positive economic surprise.
In short, despite potential bumps in the road to Europe’s
recovery, we believe there is an opportunity in the making
among European stocks.
U.S. fixed income The Fed’s comments about reducing
its asset purchase program generated significant
interest-rate volatility in the United States, changing
the opportunity set for fixed-income investors. Spread
sectors — meaning sectors that trade at a yield premium
to U.S. Treasuries — which had been buoyed by the
massive liquidity created by the Fed’s purchases, sold off,
with emerging-market bonds getting hit particularly hard.
Global government bonds also fell, although not to the
same degree as sectors with greater risk.
Despite the rapid increase in yields, we believe the
broader U.S. economic recovery remains on track and
should continue at a moderate pace, as recent data have
been a bit better than expected. We also believe that
the U.S. housing recovery will continue apace, although
mortgage rates moved higher during May and June. In
our view, home sales are improving because of stronger
economic activity and better consumer confidence, not
because of mortgage rates. In mortgage credit, following
the liquidity-driven sell-off, we have found opportunities
attractive enough in non-agency residential mortgage-
backed securities to begin rebuilding positions during
June, seeking to benefit from their improved relative value
supported by solid fundamentals.
As investors adjust their expectations about when
the Fed will actually begin tapering its asset purchases,
we expect continued volatility in interest rates and yield
spreads. However, we think it’s unlikely that they are going
to suddenly spike dramatically higher. As a result, we believe
the environment for corporate credit and other risk-based
fixed-income categories may continue to be favorable.
In term structure, we think the better opportunities
exist among short- to intermediate-maturity securities, as
opposed to long-term bonds. Within investment-grade
corporate credit, we like bonds issued by banks and other
financial institutions, as well as utilities. High-yield spreads,
after backing up during the second quarter, offer more
attractive value, we believe.
Q3 2013 | Capital Markets Outlook
Non-U.S. fixed income The global macroeconomic
environment, though less solid than the United States,
appears to be stable, with the exception of China, where
weaker growth and high consumer debt levels have
created challenges for a government that is trying to stim-
ulate domestic demand. We continue to see challenges
more broadly for developing economies, hampered by
both the strength of the U.S. dollar and the anticipation for
less stimulus from the Fed. In Europe, peripheral eurozone
economies have performed better than we anticipated,
thanks to sharply lower interest rates in those countries.
Core European economies were somewhat weaker
than we expected, but data near the end of the quarter
from Germany, the Netherlands, and Switzerland were
While we think the degree of increase in global rates
during the quarter was more than the current economic
environment warrants, leaving less impetus for near-term
increases, we continue to believe global rates are likely to
move higher over the medium- to longer-term horizon.
Tax exempt Although the municipal market experi-
enced a notable sell-off along with most fixed-income
asset classes from May into June, we continue to have
a constructive outlook and believe munis still offer a
good option for investors seeking tax-exempt income.
Although significant outflows have compounded the
sell-off in municipal bonds, typically in July and August
reinvestment demand becomes more favorable; and total
supply is down 11.5% year-over-year through the end of
June. This could bolster the supply/demand picture. Aside
from isolated credits such as Detroit and Puerto Rico,
fundamentals within the municipal market are generally
improving. It is likely that factors such as interest rates and
the direction of the economy could continue to influence
A degree of uncertainty over tax policy has been
clarified, as income tax rates for 2013 are now certain.
However, other policy issues that can affect the value of
municipal bonds remain unresolved, including federal
budget sequestration, the debt ceiling, and the potential
for broader tax reform. We are monitoring developments
in these areas.
As has been our strategy for some time, we continued
to favor essential service revenue bonds over local
general obligation bonds. From a credit-quality perspec-
tive, overall default rates remain low. In our analysis, the
A-rated and BBB-rated segments of the market continue
to offer attractive relative value opportunities. We
generally favor higher-yielding sectors and issues with
below-average sensitivity to interest rates.
Our commodity outlook has turned pessimistic. The
asset class generally behaves with more momentum than
reversion, and we are coming off a very weak second
quarter. Beyond the negative momentum, the weakness
in emerging markets represents a very problematic signal
While the outlook might be negative, there are two
major sources of upside risk. Geopolitical concerns are
at a high point in the Middle East, with political tensions
in Egypt and continued strife in Syria. Egypt represents a
risk above and beyond the general area instability, as any
disruption to the Suez Canal has the potential to cause
a supply shock for energy markets. The other source of
upside risk for commodities is the continued correlation
with equity markets. While they have fallen from recent
highs, the strong correlations suggest that commodities
will outperform as an asset class in the event of a risk rally.
To reconcile the two countering views, we advocate a
more modest underweight to the asset class.
We favor long positions in the U.S. dollar. Over the
medium term, the U.S. dollar should be supported by a
relatively better growth outlook, a gradual reduction in
the pace of accommodation by the Federal Open Market
Committee, and the effect of forward guidance about the
first rate hike in 2015.
For the euro, as well, we favor a slight long position, but
not against the U.S. dollar. The single currency remains
supported by healthy trade flows — the eurozone is set to
run a current account surplus exceeding 2% of GDP this
year. We are moderately pessimistic on the British pound
sterling given prospects for a continued easing policy. In
the Japanese yen, we expect renewed weakness. Over the
medium term, the Bank of Japan is expected to increase
easing, and this should provide further impetus for the
U.S. dollar to rally versus the yen.
Emerging-market currencies remain over-owned in
a world where the U.S. term structure is likely to grind
higher, we believe. Amid lower levels of global growth and
lower commodity prices and inflation, emerging-market
central banks have shifted into easing mode. With weaker
current account surpluses in emerging markets, large
capital outflows are a major risk for emerging-market
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greater price fluctuations. Bond investments are subject to interest-rate risk, which means the prices of the fund’s bond
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