Q4 2012 » Putnam Perspectives

Capital Markets Outlook
Jeffrey L. Knight, CFA Head of Global Asset Allocation

Key takeaways

•Government policy has become the dominant force in financial markets. •World trade patterns will continue to influence relative performance across markets, and matter to the durability of a global expansion.
Putnam’s outlook
Asset class Underweight Small underweight Neutral l l l l l l l l l l l l l l l l l l l Small overweight Overweight


U.S. large cap U.S. small cap U.S. value U.S. growth Europe Japan Emerging markets

U.S. government U.S. tax exempt U.S. investment-grade corporates U.S. mortgage-backed U.S. floating-rate bank loans U.S. high yield Non-U.S. developed country Emerging markets

Dollar/yen Dollar/euro Dollar/pound

Favor dollar Neutral Neutral from favor dollar

Arrows in the table indicate the change from the previous quarter.

Q4 2012 |  Capital Markets Outlook

Investment themes
Government policy has become the dominant force in financial markets.
Ronald Reagan famously quipped that, “the nine most terrifying words in the English language are ‘I’m from the government, and I’m here to help’.” The humor of this remark, derives, of course, from the kernel of truth in it. We find it ironic, then, that investors have come to depend on government help for their good fortune in 2012. Both the good fortune and the help have been significant so far this year. The impact of policy will remain significant to markets in the months ahead, but we caution investors that the spirit behind President Reagan’s remark is worth heeding. Consider monetary policy. Let there be no doubt that the conduct of monetary policy around the world has undergone a fundamental philosophical shift in recent months. Since Paul Volcker served as Fed Chairman from 1979 to 1987, monetary policy has focused first and foremost on constraining episodic inflation pressures. Today, in contrast, central bankers around the world steer policy decisions with an eye toward growth and financial market stability instead. In the third quarter, we witnessed new easing measures by the Fed and the European Central Bank (ECB), not to mention the Bank of Japan and Bank of England.
Figure 1. Inflation expectations jumped following the Fed’s QE3 announcement Difference in yields between 10-year Treasuries and comparable TIPS 12/31/11–10/5/12

In September, the Fed launched QE3 — a program that will increase purchases of agency mortgage bonds by $40 billion per month, to $85 billion, with the express intention of maintaining the policy until there is clear improvement in job creation. In Europe, the ECB acted to protect the euro by instituting a new bond-buying program, Outright Monetary Transactions (OMT), to purchase unlimited amounts of sovereign bonds of nations that meet its conditions for reforming government finances. This facility eases short-term funding pressure on Spain and Italy. In turn, this moderates the risk that banks would take capital losses on their sovereign bond holdings, which threatened major European banks with insolvency. Financial markets roared with approval, and risk assets rose to new highs for the year in many markets around the world. This is all well and good in the short term, and the rallies make sense given the decline of the tail-risk scenarios that were priced into markets. Sovereign debt defaults, bank failures, and recessions have a drastically lower probability of occurring anytime soon. That said, we have deep concern for the longer term. The central banks’ plans for printing money to buy bonds from national governments running huge deficits cannot be considered a long-term solution to debt problems. Investors should focus on two alternative scenarios that central banks invite over time. The first is that the policy overstays its welcome. In this case, we should expect a sharp decline in the purchasing power of all this newly printed fiat money, with inflation mounting, perhaps significantly, in due time. In fact, one of the more noteworthy market reactions to QE3 has been a distinct rise in inflation expectations as measured by break-even inflation rates implied by TIPS (Treasury Inflation-Protected Securities) (Figure 1). The other scenario (and strangely, the more optimistic one) is that monetary policy reverses before inflation surges. Consider this. Will there be demand for the bonds that central banks will need to sell, or the ones that central banks will no longer be buying? If the impact of this quantitative easing is so helpful to markets now, won’t its reversal be equally hurtful? We are wary in the long term of both the unintended consequences of these policies as well as the prospect of their ultimate reversals.

9/12 market close, before QE3 announcement




1.75% 12/31/11 1/31/12 Source: Bloomberg.







Figure 2. China’s export trade has influenced global equity performance in recent years Year-over-year percentage change in exports from China to the United States and the European Union, and in the MSCI World Index, 12/31/04–8/31/12
80% 60% 25% 40% 20% 0% -20%
Exports to U.S. (—) and E.U. (—) — MSCI World Index




-40% 12/31/04
Source: Bloomberg.




-50% 8/31/12

Looking at a shorter horizon, we believe that during the next six months, fiscal policy will overtake monetary policy as the central focus for investors. In the United States, attention will soon turn to the issue of the so-called “fiscal cliff.” Current law imposes a substantial fiscal contraction in the U.S. federal budget beginning in January 2013. The slated $0.5 trillion combination of tax increases and spending cuts would represent nearly 4% of U.S. real gross domestic product (GDP) of $13.5 trillion. For an economy whose recent growth trajectory has barely eclipsed 2%, this government sector contraction would likely cause a recession in 2013. Yet investors, who have observed countless examples of last-minute actions to forestall such fiscal contraction, are assigning almost no probability to this scenario, expecting Congress to deftly sidestep the consequences once more. Frankly, investors are probably correct in expecting legislation late in the year that addresses the fiscal cliff. We believe there is almost zero probability that current law will remain unchanged and that the fiscal contraction on the books today will hit with full force. However, we disagree with the market’s complacency on this issue. We believe some fiscal contraction in 2013 is likely even if the parties reach a new agreement. While it is impossible to forecast the ultimate details, given the variables of the November elections and subsequent political negotiations, almost every scenario involves spending cuts, and some scenarios

involve tax increases. More to the point, the impact will hit an already sluggish economy, and even a small fiscal contraction could cause the economy to stall, worsen unemployment, and deal a setback to stocks. We draw two conclusions from this policy analysis for fourth-quarter investment strategy. The first is that investors should begin to build exposures to assets that provide some inflation protection. These assets include inflationindexed bonds, commodities and stocks of commodity producers, and leveraged companies. Just as important, investors should reduce holdings that are vulnerable to inflation, chiefly longer-duration government bonds. The second conclusion is that we expect today’s monetary policy euphoria to soon give way to fiscal policy trepidation. When this shift occurs, we expect that actions taken to reduce portfolio volatility will be valuable.

World trade patterns will continue to influence relative performance across markets, and matter to the durability of a global expansion.
With policymakers focused primarily on domestic issues during the 2012 slowdown, investors may be temporarily distracted from global issues. However, we believe it is important to recognize that global trade has had a long-term beneficial impact on market performance, and we regard the current deceleration in trade as a source of concern.

Q4 2012 |  Capital Markets Outlook

Europe’s debt crisis has led to austerity and recession, undercutting the region’s demand for China’s exports by more than 10% this year, and reducing China’s economic growth to its lowest level in three years (Source: Reuters). China’s slump has, in turn, reduced that nation’s demand for exports from its suppliers around the world, including Australia, Brazil, Russia, and Africa. These patterns are consistent with relative equity market performance this year, with Australia, China, and Brazil noteworthy as market laggards. We find this problematic. For the rally in risk assets to gain fundamental traction, we would need to see expansion in the real economy. Such an improvement would be reflected in more vigorous trade and in renewed outperformance of developing markets versus developed markets. We find it unlikely that European import demand recovers meaningfully in the midst of ongoing austerity. China, in turn, has slowed significantly, leaving the trajectory of growth there very much in doubt. Only the United States is in the position to drive the recovery in world trade. However, we believe the Fed’s monetary policy may have the unintended consequence of constraining the United States from filling this role. One of the potential outcomes of QE3 is a weaker dollar, which would restrain U.S. import demand and slow down a trade revival. In other words, signs of dollar strength are important in the next few months. For us to become more fundamentally bullish on equities in general, and emerging-market equities in particular, we would want to see a positive correlation between the U.S. dollar and risk assets. This correlation would indicate that an improving U.S. economy is powering a revival in global trade. To assess this trend, we are closely monitoring U.S. foreign exchange rates; the performance of companies that export to the United States, particularly in closely linked economies like Mexico; and the performance of developing market equities more broadly.

Asset class views
U.S. equity Investors looked past a multitude of macroeconomic worries and took U.S. equities to multi-year highs in the third quarter. The market’s summer rally was uncharacteristic not only given the context of weakening economies in several world regions, but also because it started with defensive sectors. High-dividend-yielding equities in areas such as telecommunications services, utilities, and pharmaceuticals outpaced cyclicals in the early weeks. By the quarter’s midpoint, the market reverted to a more traditional pattern, in which controversial and higher-growth stocks took the lead. Despite the period’s strong results, we believe opportunities remain in sectors with exposure to global economic growth, such as financials, consumer cyclicals, and industrials. Within financials, global money center banks, which are vulnerable in a stillfragile global financial system, may hold particular appeal for long-term investors. The market’s ability to climb a wall of worry was certainly put to the test, as many issues remained unresolved across global markets. Equity investors must be vigilant about developments — and setbacks — in the ongoing eurozone debt crisis, the cooling economy in China, and the potential for a destabilizing fiscal cliff in the United States. While these are complex challenges, it could be argued that they are adequately discounted in the market, and it is worth considering the compelling valuation opportunities offered by equities in this environment. Corporate earnings continue to be a powerful dynamic for the U.S. equity market, although this may be changing. While most companies again exceeded expectations for bottom-line growth, early signs of revenue pressure emerged in the quarter as fewer companies beat estimates for top-line growth. This trend merits watching, as it coincides with an expected gradual deceleration in earnings growth. For 2012, we are likely to see a decline from last year’s 15% growth rate, and we expect further slowing in 2013. This will create a more challenging backdrop for equity investing — one in which a focus on rigorous fundamental research should offer a distinct advantage.



Non-U.S. equity ECB policy moves offset the impact of sovereign debt problems in the third quarter, leading to European stock market strength. In the wake of this broad market advance, European stocks are trading at roughly 10x forward earnings — close to their all-time lows — while U.S. stocks are trading in the vicinity of their long-term average price-to-earnings ratio of 15.5. Despite the recent rally in Europe, which raised stock prices across a range of sectors with cyclical exposure, the European market is still suggesting that there will be downward earnings revisions. While we believe this is likely, we also think there are cases where value in the region remains to be found. For good or ill, growth in the rest of the world plays a big role in the health of European companies, of which many capture about a third of their revenue from other countries, including the United States. A U.S. recovery, for example, would carry benefits for German exports, while a resurgence in China’s growth — or at least a leveling off in that country’s slowdown — would have important implications for a host of Europe-based industries. External factors, in other words, will likely go a long way toward determining European companies’ earnings — and the growth outlook in the United States and China is anything but clearly positive. In the emerging markets, prospects for equity performance could be hindered by potential setbacks to global growth, as well as the impact of uncertainty stemming from China’s political transition, Europe’s struggle to negotiate a fiscal union, and the United States’ approach to its November election and looming “fiscal cliff.” In China, it is unclear whether policymakers have been effective in engineering a “soft landing” for the country’s overheated economy. The risk, it would seem, is that policymakers may inadvertently be engineering a hard landing, particularly in infrastructure, where companies focused on heavy machinery and excavation, for example, are suffering badly. This could have far-reaching implications for companies in emerging and developed markets alike that have benefited for the past 10 years from China’s massive infrastructure build-out.

Fixed income
U.S. fixed income Slowly but surely, the markets seem to be returning to a more “normal” investment environment in which fundamentals rather than large macroeconomic events are the main drivers of performance. That’s not to say the large-scale issues worrying investors have been resolved; rather, they seem less potentially catastrophic than they once appeared. While the opportunities for implementing yield curve strategies within developed markets and adding value through country selection in sovereign credit have increased in recent months, we continue to find the most attractive opportunities in certain segments of the U.S. bond markets. While the “spreads,” or yield advantage, in many sectors of the market have tightened in recent months relative to their historical norms prior to the 2008 dislocations, they still appear very attractive. Investors seem to be slowly returning to the idea of employing longterm strategies rather than timing the next risk trade, and we believe that makes for a more constructive investment environment in general. In terms of positioning, we continue to prefer both credit risk, gained through exposure to corporate bonds and non-agency mortgage-backed securities, and prepayment risk, which is associated with certain types of collateralized mortgage obligations, over interest-rate risk. While the potential for short-term price volatility still remains high, we believe that our actively managed, risk-conscious approach remains a prudent strategy for investing in today’s bond markets. U.S. tax exempt We continue to be optimistic on the outlook for municipal bonds, given strong market technicals, and continue to favor essential service revenue bonds. While yield spreads are well off their widest levels, they remain attractive, in our view. Supply is likely to experience a seasonal increase in October and November, but demand for bonds remains strong given cash flows into the asset class, and December and January will once again bring the potential for increased reinvestment demand. Like most asset classes, the municipal bond market will likely be more heavily influenced by the fiscal cliff the closer we get to the election, and beyond, as market participants look to Washington for clues about a short-term


Q4 2012 |  Capital Markets Outlook

extension of tax rates, the sequester, the debt ceiling, and the potential for broader tax reform in 2013. All of these factors could affect the value of the exemption, the availability of bonds, and the transfer of federal dollars to state and local municipalities and, therefore, credit quality. Non-U.S. fixed income The European sovereign debt situation, which has dominated headlines for much of the past 12 months, appears to have stabilized. Europe’s fiscal problems have by no means been solved, but it now appears rather unlikely that the Continent is facing an imminent financial meltdown, or that the European Union is on the verge of disintegration. The recent introduction of a new and potentially unlimited bond-buying program is an improvement over previous iterations, and investors have tended to view it as such. We’re not overly optimistic on the situation in Europe, and few investors are. But the expectations are generally so low that if policymakers can avoid disaster, we believe the markets will interpret that as a positive signal going forward. A potential slowdown in China was another big concern for investors in recent months. We believe we’re in the early stages of China transitioning from an export-driven economy to a more domestic-focused one, and while that may mean China’s economy won’t continue expanding at 10% per year, we don’t anticipate that the slowdown will be so severe as to usher in another global recession. The takeaway for investors is that many segments of the bond markets, by our analysis, were priced for disaster, and absent any shocks to the financial system, so-called “risk assets” appear attractively valued.

markets. However, inflation could be a catalyst for potential commodity divergence. If the impact of worldwide quantitative easing ultimately turns inflationary, then commodities could decouple from other risk assets, we think, and appreciate in part as a consequence of falling purchasing power. This is likely to be especially true for precious metals, but could encompass all commodities to some degree. We would favor increasing commodity exposure at the first sign of nascent inflationary pressures.

Our view on the U.S. dollar has shifted from significantly favorable to slightly neutral as risk aversion has abated following the Fed’s aggressive policy stimulus. Over the coming quarter, this relatively easy monetary policy should keep the dollar weaker against more volatile currencies. However, the Presidential election has large ramifications for the U.S. fiscal cliff, the U.S. dollar, and risk assets. Amid poor global growth, the U.S. economy is the one bastion of stability. Signs of gridlock from Washington are likely to increase market risk, but strengthen the dollar as a safe haven. While we are less negative on the euro because the ECB’s announcement of the Outright Monetary Transactions facility significantly reduced the risk premium of a eurozone demise, we still do not favor it. We believe the euro-U.S. dollar exchange rate is likely to remain in a narrow range, as both the euro and U.S. dollar are used to fund carry trade strategies. We have turned negative on the British pound sterling over the quarter. National accounts remain weak and survey data has been volatile, keeping the Bank of England in easing mode. The currency will likely follow the direction of the euro relative to the U.S. dollar, but should underperform higher-yielding and higher-credit-quality currencies like the Canadian dollar. We are modestly negative toward the Japanese yen as risk aversion remains low. At recent exchange rate levels, Japanese officials are voicing concerns about yen strength and the threat of intervention remains.

Commodities have lagged other risk assets on a year-todate basis. While price spikes in commodities often make headlines, investors should not lose sight that this volatility works in both directions. After all, second-quarter losses in commodities are the reason behind the lackluster yearto-date performance even after a strong third quarter. As long as commodities stay highly correlated with other risk assets, we are likely to favor smaller allocations, as risk is more efficiently deployed elsewhere across capital



Index name (returns in USD) 3Q 12

12 months ended 9/30/12


Dow Jones Industrial Average S&P 500 Nasdaq Composite MSCI World (ND) MSCI EAFE (ND) MSCI Europe (ND) MSCI Emerging Markets (ND) Tokyo Topix Russell 1000 Russell 2000 Russell 3000 Growth Russell 3000 Value

5.02% 6.35 6.17 6.71 6.92 8.70 7.74 -3.16 6.31 5.25 6.01 6.44 1.59% 0.93 0.60 1.13 2.31 0.03 3.98 4.56 4.71 6.64 3.43 11.54%

26.52% 30.20 29.01 21.59 13.75 17.31 16.93 -3.27 30.06 31.91 29.35 31.05 5.16% 5.65 2.95 3.71 8.32 0.07 3.46 19.31 19.71 19.55 11.27 12.74%

Barclays U.S. Aggregate Bond Barclays 10-Year Bellwether Barclays Government Bond Barclays MBS 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 Global Diversified S&P LSTA Loan


It is not possible to invest directly in an index. Past performance is not indicative of future results.

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 United States. 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 S&P 500. 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 JPMorgan Developed High Yield Index is an unmanaged index of high-yield fixedincome 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 fixedincome securities. 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 emerging markets. 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/LSTA Leveraged Loan Index (LLI) is an unmanaged index of U.S. leveraged loans. 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.


NOTES This material is provided for limited purposes. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Putnam product or strategy. References to specific securities, asset classes, and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice. The opinions expressed in this article represent the current, goodfaith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. The views and strategies described herein may not be suitable for all investors. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the article. Predictions, opinions, and other information contained in this article are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss. This presentation or any portion hereof may not be reprinted, sold, or redistributed in whole or in part without the express written consent of Putnam Investments. The information provided relates to Putnam Investments and its affiliates, which include The Putnam Advisory Company, LLC and Putnam Investments Limited®. Prepared for use in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (o/a Putnam Management in Manitoba). Where permitted, advisory services are provided in Canada by Putnam Investments Inc. [Investissements Putnam Inc.] (o/a Putnam Management in Manitoba) and its affiliate, The Putnam Advisory Company, LLC. Diversification does not assure a profit or protect against loss. It is possible to lose money in a diversified portfolio.

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. If you are a U.S. retail investor, please request a prospectus, or a summary prospectus if available, from your financial representative or by calling Putnam at 1-800-225-1581. The prospectus includes investment objectives, risks, fees, expenses, and other information that you should read and consider carefully before investing.
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CM0100 276776 10/12

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