No bubble trouble; stocks are still reasonably priced. This credit cycle has unique characteristics that continue to make high-yield bonds attractive. Interest-rate volatility poses greater risk than higher rates themselves.
Putnam Perspectives: Capital Market Outlook Q1 2014
Q1 2014 » Putnam Perspectives
Capital Markets Outlook
Jason R. Vaillancourt, CFA®
Co-Head of Global Asset Allocation
No bubble trouble; stocks are still
• No bubble trouble; stocks are still reasonably priced.
As the S&P 500 closed 2013 at a record
high — after setting more than 20 previous
record highs during the past year — many
investors pondered whether stock valuations
might be getting excessive. Some pundits
have gone so far as to utter aloud the dreaded
B-word — bubble.
• This credit cycle has unique characteristics that continue
to make high-yield bonds attractive.
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: Neutral (from favor euro last quarter)
Dollar vs. pound: Neutral
Dollar vs. yen: Dollar (from neutral last quarter)
Arrows in the table indicate the change
from the previous quarter.
• Interest-rate volatility poses greater risk than higher
At Putnam our analysis indicates no cause
for alarm, but rather, we believe stocks may
continue to advance. The current valuation
of the market is just about normal relative
to long-term history, based on one of our
preferred valuation metrics: FCF yield (free
cash flow to price).
We believe it is also important to recognize
that in the broader context of capital markets
today, valuation is not the only thing that
matters. It certainly matters at extremes, but
even if stocks were moderately overvalued,
the market could still continue on an upward
trajectory for some time, as stocks tend to
overshoot in one direction or the other without
One of our chief reasons for optimism comes
from our monitoring of pent-up corporate
demand. As we described in recent quarters,
we have been studying the level of capital
investment by businesses, which has lagged
considerably during this recovery compared
with past cycles. During 2013, we noticed
some firming of capital investment, and more
recently we have started to see indications of
an improving trend in the data, particularly
with respect to non-defense ex-aircraft capital
goods orders. This uptick is corroborated by
the ISM survey’s new-orders component.
Q1 2014 | Capital Markets Outlook
Figure 1. Stock valuations are near the
average of the past quarter century.
valuation of the
market is just about
normal relative to
— Free cash flow yield
— Average yield 1990–2013
It appears businesses have finally gained adequate
confidence to sustain an increase in spending, which
can help GDP growth accelerate. The situation is similar
in other developed markets, particularly in Europe and
Japan, and we believe both regions have the capacity to
help drive global growth.
Source: Bloomberg. The graph shows
valuations of stocks in the SP 500
as measured by their free cash flow
yield. This is the amount of a company’s
operating cash flow minus the amount
of its capital expenditures, divided by
its stock’s price.
In Japan, the question continues to be the need for
material progress on Prime Minister Shinzō Abe’s “Third
Arrow” policies targeting structural reform. One of these
policies, a large sales tax increase, will take effect in April
and threatens to be a new drag on growth.
However, we continue to hold out hope for many of
Abe’s structural reforms to start to take shape in 2014. We
are closely monitoring the multilateral talks surrounding
the Trans-Pacific Partnership free trade agreement, which
is a key barometer of Abe’s ability to accomplish his policy
agenda. Abe was elected on a platform of returning Japan
to regional prominence, as a counterbalance to China, and
internal economic policy is one part of this larger political
project. At the same time, we recognize that policy
change follows different timelines in Japan than in the
United States, and a temporary setback for Abe might not
While we have a constructive outlook for Europe and
Japan, neither one is free of risks. In Europe, the underlying causes of poor credit conditions remain a major
question and still require greater clarity before we favor
an overweight to the region. Europe is recovering, but the
pace is anemic. Signs of insufficient credit demand mean
that we cannot yet assign this sluggish pace solely to a
lack of credit availability in the private sector. It could also
be caused by a tepid pace of new business creation and
Remember that the United States showed similar
ambiguity in the early days of the recovery starting in mid
2009. Ultimately, credit availability improved once sufficient evidence emerged that demand was growing. We
are now looking for similar evidence for Europe. Our analysis is taking into account one of the important differences
between Europe and the United States: European credit
flows through banks, while U.S. credit flows primarily
through capital markets.
Outside of developed-market economies, the marginal
tightening (or in Fed-speak, “less accommodation”)
of U.S. monetary policy as the Fed begins reducing
its purchases of bonds in January will likely weigh on
growth in emerging markets, but without dragging down
developed markets. Countries with high current account
deficits and those reliant on external financing will be
PUTNAM I NVESTM ENTS | putnam.com
This credit cycle has unique characteristics
that continue to make high-yield bonds
In the current cycle, we have seen only a partial
narrowing of valuations and credit spreads, and
corporations still sensitive to the pain of the 2008 financial
crisis have been somewhat slower to turn to merger and
acquisition activity. Also, the current cycle stands out from
most predecessors by virtue of its extremely low interest
rates and a dearth of nominal yields available to investors
around the world. The hunt for yield that has been a
hallmark of capital markets for several years is likely to be
another factor extending the length of this credit cycle.
The current economic recovery started in June 2009
according to the National Bureau of Economic Research.
Today, more than four years into the recovery, capital
market opportunities are shifting, with conditions in credit
sectors such as high-yield corporate debt becoming less
attractive. However, the current cycle has different characteristics that suggest investors should not abandon
credit strategies just yet.
Interest-rate volatility poses greater risk
than higher rates themselves.
First, let’s consider a typical cycle. By this point, the
valuations of high-yield credit relative to investmentgrade bonds, which were separated by a wide chasm in
2008 and 2009, have narrowed considerably. At the same
time, credit spreads have tightened, leaving credit sectors
with a less impressive yield advantage over higher-quality
issues. Third, we have begun to see a change in corporate
behavior that often emerges to diminish the attractiveness of credit, as companies begin to issue debt in order to
finance mergers and acquisitions. Greater debt issuance
tends to weaken balance sheets, even as buying pressure
supports equity prices.
The yield of the 10-year Treasury rose above 3% in the last
week of December, in the wake of the Fed’s announcement that it would reduce bond purchases beginning in
January. While rising yields are consistent with a strengthening economic recovery, they also prompt the concern
among businesses and investors that higher interest
expenses could become a drag on continued expansion.
We take a relatively positive view of rising rates, which,
on their own, should not be a cause for worry. Rather they
should be seen as a symptom of better growth prospects.
Indeed, longer-term real interest rates — as measured by
the difference between bond yields and inflation — have
Figure 2. Rising new manufacturing orders indicate
stronger corporate demand.
It appears businesses have
finally gained adequate
confidence to sustain
an increase in spending,
which can help GDP
Source: ISM Manufacturing Report on Business:
New Orders Component.
Q1 2014 | Capital Markets Outlook
Figure 3. Treasury volatility increased sharply
in 2013 and could continue in 2014.
We see real risks ahead
as the Fed grapples with
— MOVE Index of Treasury Option Volatility Index
Source: Merrill Options Volatility Index
reports the average implied volatility
across a wide range of outstanding
options on the two-year, five-year,
10-year, and 30-year U.S. Treasury
securities (with a total weight of 40
percent on the 10-year Treasury and
total weights of 20 percent each on the
Asset class views
been moving higher for almost two years. During the past
six months, long-term real rates even moved from negative levels to positive territory, yet economic growth and
employment gains have remained steady.
U.S. equity A strong fourth quarter and continued
economic growth helped U.S. equities extend their rally
and deliver their best annual performance since the
1990s. The market advance had a brief pause in October
when investors were distracted by the U.S. congressional budget debate and the 16-day partial shutdown of
the federal government. While ongoing concerns about
Federal Reserve policy weighed on equities somewhat,
the market responded favorably in late December when
the Fed announced its first modest reduction in asset
purchases. Throughout 2013, U.S. equity indexes achieved
and surpassed their all-time highs several times, with relatively low volatility.
While a continued glacial pace of rate increases does
not alarm us, we nevertheless see real risks ahead for the
Fed as it grapples with communication challenges. We
highlighted last quarter that the Fed is employing forward
guidance in an attempt to smoothly exit its extraordinary
policy initiatives: A mix of bond purchases and holding
short-term rates near 0%.
The Fed owns over $4 trillion in fixed-income securities, and how its policy goals influence its actions with this
portfolio has major consequences for the market. Investors may come to doubt the Fed’s forward guidance given
the central bank’s spotty record in economic forecasting.
These doubts could contribute to rate volatility across
the yield curve. Investors should be prepared to navigate
more interest-rate volatility as the Fed seeks to chart a
difficult course ahead.
U.S. equity performance in 2013 was top quartile by
historic measures, and our outlook is more tempered
heading into 2014. At the close of the year, equity valuations were in the middle of their historic range; with stocks
at average valuations, our expectation should be for
average returns. Also worth noting is the fact that most
stocks are trading at a price–earnings ratio of around 15x
earnings, meaning that valuations are essentially the same
across all market sectors. With considerably less disparity
in multiples, we believe U.S. equity investors should pay
closer attention to growth potential than to valuation.
PUTNAM I NVESTM ENTS | putnam.com
MSCI EAFE (ND)
MSCI Emerging Markets (ND)
MSCI Europe (ND)
MSCI World (ND)
Barclays Government Bond
For example, as European countries gradually reduce
the intensity of their fiscal-austerity programs, there will
be less fiscal drag. This could result in better GDP growth,
improved revenue growth for corporations, and better
margins for companies that streamlined their operations
through the austere fiscal regimes instituted by European
Index name (returns in US$)
Dow Jones Industrial Average
Russell 3000 Growth
Russell 3000 Value
FIXED INCOME INDEXES
Barclays Municipal Bond
Barclays U.S. Aggregate Bond
BofA ML 91-day T-bill
CG World Government Bond ex-U.S.
JPMorgan Emerging Markets
JPMorgan Global High Yield
SP LSTA Loan
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. Having said that,
the multi-year underperformance of emerging markets
does open the door to certain investment 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.
JPMorgan Developed High Yield
In Japan, we think government policy will continue
to put downward pressure on the yen; consequently,
we think earnings growth will continue to accelerate
among Japanese companies. There is also the potential
upside from Japanese structural reform, which includes
a list of politically challenging 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 significant progress on these issues, so based on the
extent to which the administration of Prime Minister Abe
delivers on its ambitions, we think markets are likely to
U.S. fixed income The fourth quarter of 2013 continued
to be a favorable environment for taking credit risk and
liquidity risk. In addition, strategies oriented toward
prepayment risk — such as investments in interest-only
collateralized mortgage obligations — generally performed
well. The fourth major risk we analyze — interest rates —
offered less attractive investment opportunities, in our
view, particularly against the backdrop of rising rates.
In the years following the 2008 financial crisis,
equity correlations rose to record highs. More recently,
correlations 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 more
focused, bottom-up approach to portfolio construction.
The U.S. macroeconomic picture continued to show
signs of health, which contributed to a rising rate environment, but also pointed the way toward a more robust
economic recovery in the United States. In particular, the
Federal Reserve’s December decision to modestly reduce
its bond-buying program offered a degree of confirmation
that the economy continues to heal. Bond yields spiked
on the news, with the yield on the benchmark 10-year U.S.
Treasury breaching the 3% level by year-end.
Non-U.S. equity In our view, international stocks
offer broad opportunities to investors at the present time.
Earnings recoveries, restructuring opportunities, and
emerging-market rebound potential are all brightening
the horizon for international stocks.
Q1 2014 | Capital Markets Outlook
As 2014 begins, we are focused on several key policyrelated and macroeconomic risks. First, the Fed is faced
with a delicate balancing act as it seeks to communicate
about further reductions in its bond-buying program
without destabilizing the financial markets or the U.S.
economy. This will bear watching as economic data
emerge in the months ahead. The second risk is the potential for wage inflation. As the unemployment rate moves
downward, we believe wage inflation could develop earlier
than the Fed is anticipating, in which case we could see
the central bank reducing its stimulus efforts much earlier
than the markets are currently forecasting.
isolated credit situations have diverted investor attention
from the overall health of the municipal bond market.
However, we believe that the underlying fundamentals
in the market are quite strong. And while the backdrop in
2014 may create some headwinds, we continue to think
that the attractive tax-free yields of municipal bonds
remain a valuable part of a diversified portfolio for longterm investors seeking income.
In our view, technical factors in the market are the big
wild card. Tax-exempt municipal fund outflows for 2013
topped $60 billion (Source: JPMorgan) — the most in
20 years — and have put downward pressure on prices.
Although we have seen some value-conscious retail and
institutional 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, many issues
remain unresolved, including the debt ceiling and the
potential for broader tax reform — both of which could
affect the value of municipal bonds.
Lastly, it is possible that economic growth in 2014
could be stronger than forecast, particularly during the
second half of the year. If that occurs, real interest rates —
prevailing interest rates minus the rate of inflation — which
have been negative since 2008, could significantly rise.
That said, we don’t believe rates are likely to rise so quickly
that the shift will undermine the markets.
Non-U.S. fixed income In concert with improving
economic data in the United States, Japan’s economy
strongly rebounded through the end of 2013, while core
European economies performed better than we expected.
All told, a supportive global economic backdrop encouraged investors to put capital to work in the credit markets.
We continue to have a negative outlook for commodities.
Most of our signals remain unchanged from the beginning
of the previous quarter, with momentum, emergingmarket weakness, and the performance of currencies of
commodity-exporting countries continuing to contribute
to our pessimism. There have been significant outflows
from commodity markets over the course of 2013, and this
remains an unfavorable environment. Geopolitical risk also
remains diminished. While there are increasing tensions
in important oil producers Libya and Iraq right now, we
continue to feel that the potential softening of sanctions in
Iran represents more of a downside risk for oil prices.
By contrast, the rise in U.S. rates led many investors
to move money out of emerging-market sovereign and
corporate debt (EMD), which were perceived to be too
risky relative to “safer” developed-market debt securities offering higher-trending yields. Also, many investors
moved out of emerging-market equities, which put
downward pressure on emerging-market currencies and
amplified the decline in EMD.
Looking forward, we see potential opportunities in
select areas of higher-yielding sovereign debt. While these
positions may be perceived as riskier in terms of credit
risk, they are generally short-term bonds, implying a lower
exposure to the negative effects of rising interest rates.
Assuming the market is not caught up in a risk-aversion
trend that leads to another widespread sell-off of EMD,
we believe this approach to sovereign debt can potentially
provide EMD portfolios with a yield advantage.
Within the asset class, energy has performed stronger
than non-energy commodities and the futures curve is
more supportive. Where we have policy-driven investments
in commodities, we would continue to favor energy-heavy
indices such as the SP/GSCI Index. But where there is no
policy position, we do not favor long positions.
As the year progresses, we will continue to evaluate the
extent to which the global economy has recovered and
potential support from emerging markets. But at least for
the first quarter, we do not believe that these factors will
support commodity markets.
Tax exempt The past quarter, and most of 2013 for that
matter, proved to be a volatile time for municipal bonds,
and market conditions remain less than robust. Uncertainty about interest rates and the headline risk from a few
PUTNAM I NVESTM 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 billion. 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 SP 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 SP GSCI is a composite index of commodity sector returns that represents a
broadly diversified, unleveraged, long-only position in commodity futures.
The SP/LSTA Leveraged Loan Index (LLI) is an unmanaged index of U.S. leveraged
The SP 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.
We favor the U.S. dollar. Labor market data has been
consistent with the Fed’s intention to taper asset
purchases beginning in January. The Federal Open Market
Committee (FOMC) under Janet Yellen has altered its
forward guidance to be more qualitative to help ensure
that front-end rates remain anchored. However, the front
end is likely to come under pressure as the U.S. economy
continues to outperform and the market begins to challenge the FOMC forward guidance These trends should be
supportive of the U.S. dollar.
We modestly favor the euro as the surprise rate cut
by the European Central Bank (ECB) was not the beginning of a more aggressive policy, but rather a statement
that the council has done enough given its expectations
for growth and inflation. The risk of the euro weakening
remains somewhat limited as the eurozone is set to run a
current account surplus exceeding 2% of GDP this year,
eurozone banks continue to shed and repatriate overseas
assets, and economic data slowly improve.
We have a neutral view of the British pound sterling.
U.K. growth data remain strong and are challenging the
forward guidance as laid out by the Bank of England, but
the pound has been the strongest currency over the past
several months, reflecting this strength. The pound should
be supported over the medium term, but positioning
could be a challenge in the short term.
The Japanese yen remains vulnerable to weakening.
Over the medium term, it is expected that the Bank of
Japan will have to do much more than currently slated
and should provide further impetus for the dollar to rally
versus the yen.
The Fed’s tapering expectations continue to have an
impact on the Australian dollar and other current account
deficit countries that had been supported by safe-haven
fixed-income flows. This should keep the Australian dollar
biased to the downside. We also favor an underweight to
the Canadian dollar. As Canada suffers from a widening in
its current account and balance of payments, the Canadian dollar will likely continue to lose ground against the
U.S. dollar over the medium term.
In emerging markets, the environment has changed
substantially and our views are much more neutral. Those
currencies with weak external balances, such as those
of Indonesia, India, Turkey, and South Africa, remain
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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
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