Global Investment Outlook - Prudential Financial

PRUDENTIAL INTERNATIONAL INVESTMENTS ADVISERS, LLC.

Global Investment Outlook January 2015

2015 Year Ahead - Global Investment Outlook Stocks likely to Post Solid Gains in 2015 Fuelled by Fresh QE Stimulus in Eurozone & Japan, Rate Cuts & Stimulus in China & Other Emerging Markets & Modest Rate Hikes by Fed & BoE. Stocks also Supported by Improved Global GDP Growth, Solid Earnings & Fair Valuations Bond Yields likely to Drift Higher in 2015 with Strengthening GDP Growth, Fed & BoE begin Rate Hikes

John Praveen’s Global Investment Outlook expects global stock markets to post solid gains in 2015 driven by continued liquidity & interest rate support from the European Central Bank (ECB), Bank of Japan (BoJ), China & other Emerging Markets, improved global growth, solid earnings growth, and stocks cheap relative to bonds.

John Praveen, PhD Chief Investment Strategist

Stocks: Global Stock Markets were mixed in 2014 with strong gains in the U.S., China and India, while Europe, Japan and several Emerging markets, including Brazil and Russia struggled. Looking ahead to 2015, we expect global stock markets to post solid gains fuelled by: 1) Liquidity & interest rate support as fresh QE liquidity from the ECB and BoJ, further rate cuts & stimulus by China and other Emerging Markets should offset the modest rate hikes by the Fed and the BoE; 2) Improved GDP growth with the U.S. & U.K. remaining solid, Japan and Eurozone Core recover, the Periphery strengthens, China’s growth stable and growth strengthens in Emerging Asia; 3) Solid earnings growth & 4) Reasonable valuations with P/E Multiples below long-term average and stocks cheap relative to bonds.

We look for double digit gains by global stock markets in 2015. Our target for the U.S. stock market is for the S&P 500 to reach 2250 by 2015 year-end and the Dow to reach 19,500.

Bonds: Bonds yields fell sharply in 2014 with weak GDP growth in Eurozone and Japan, low inflation, and safe haven demand with heightened geopolitical tensions. Looking ahead, bond yields are likely to drift higher in 2015. Yields are likely to come under upward pressure from: 1) Solid GDP growth in the U.S. and U.K., Japan rebounding, Eurozone Core stabilizing and the Periphery strengthening; 2) The U.S. Fed and the BoE on track to start raising rates in 2015; While the Fed has indicated that it can afford to be “patient” in raising rates, there is likely to be increased uncertainty about Fed exit strategy and the pace of rate hikes in 2015; 3) Bond valuations are very expensive relative to stocks with the sharp decline in yields during 2014.

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However, the rise in bond yields is likely to be limited by: 1) Inflation remaining low in the developed economies and the recent collapse in oil prices increasing the risk of Eurozone sliding into deflation; 2) The ECB set to undertake full-fledged QE in early 2015 while the BoJ is likely to further expand QE; 3) Safe haven demand from lingering geopolitical tensions.

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*Prudential International Investments Advisers, LLC. (PIIA) is a business of Prudential Financial, Inc., (PFI), which is not affiliated in any manner with Prudential plc, a company headquartered in the United Kingdom. For informational use only. Not intended as investment advice. See “Disclosures” on the last page for important information.

Global Investment Outlook

Market Outlook: After Mixed Returns in 2014, Global Equity Market likely to Post Solid Gains in 2015. Stocks lifted by Fresh QE Stimulus in Eurozone & Japan, Further Rate Cuts & Stimulus in China & Other Emerging Economies and Modest Rate Hikes by Fed & BoE. Stocks also Supported by Improved GDP Growth, Solid Earnings & Stocks Cheap Relative to Bonds After Solid Bond Market Gains in 2014, Bond Yields Likely to Rise in 2015 with Improved GDP Growth & Rate Hikes by Fed & BoE. Low Inflation, QE Stimulus by ECB & BoJ likely to Limit Rise in Yields Stock Market Outlook (2015): Global stock markets were mixed in 2014 and posted modest gains. Stocks were supported in 2014 by central bank liquidity, low interest rates & rate cuts by both developed and emerging central banks, solid earnings growth and fair valuations. However, stocks also struggled with elevated geopolitical tensions in Ukraine and the Middle East, Ebola pandemic scare and GDP disappointments in Europe, Japan, Brazil and Russia. Developed Stock Markets were mixed in 2014 with solid gains in the U.S., while Europe and Japan struggled. U.S. stocks had another solid year of double digit gains (~13%) on healthy GDP growth, solid earnings, Fed QE liquidity and low interest rates. U.S. stocks are now within a whisker of our 2014 year-end target of 2100 (for S&P 500) and 18,100 (for the Dow). Eurozone stocks rose 2% in Euros but declined -9% in US$ with weak GDP growth, Ukraine tensions and uncertainty about the ECB QE policy. Japanese stocks rose 9% in yen but declined -5% in US$ with weak GDP growth (sharp GDP contraction in Q2 & Q3) and the BoJ slow to expand QE. However, Japanese stocks rose in Q4 after the BoJ provided fresh stimulus and on expectation of fresh Abe reforms after the December elections. U.K. stocks declined -2% in sterling, -9% in US$ on expectations of rate hikes by the BoE. Emerging Markets were also mixed in 2014, with gains and losses driven largely by political dynamics. Emerging Asian stocks posted solid gains led by China (+48% on PBoC stimulus), India (+31% on expectations of market reforms after the May elections), Indonesia and Taiwan. Emerging Europe was dragged lower by a plunge in Russian stocks (down -45% in US$) with Putin’s Ukraine adventures and in late 2014 with the collapse in oil prices. However Turkey gained on easing of political uncertainties. Latin America also struggled as Brazil (-13%) plunged after the election disappointment with the re-election of President Dilma Rouseff and the widening Petrobras scandal. Looking ahead to 2015, we expect global stock markets to post solid gains fuelled by: 1) Liquidity & interest rate support as the ECB and BoJ take over the QE baton from the Fed; 2) Improved global GDP growth; 3) Solid earnings growth, & 4) Reasonable valuations with P/E multiples below long-term average, and stocks cheap relative to bonds.

1) Liquidity & Interest Rate Support despite Cross Currents: After enjoying synchronized monetary policy support from developed central banks since 2008, global stock markets are expected to face interest rate cross currents in 2015 with the ECB and BoJ set to expand QE stimulus, China and other Emerging central banks continue to cut rates and provide stimulus, while the Fed & the BoE are on track to start rate hikes. The ECB is on track to undertake full-fledged QE with broad-based buying of sovereign debt and corporate bonds. The ECB has overcome internal opposition to QE, especially from Germany, and has laid the ground work to undertake full-fledged QE in early 2015. The ECB has indicated that it will expand its balance sheet by €1trn to around €3trn. The ECB has already started purchase of Asset Backed Securities and covered bonds in Q4 2014. The Bank of Japan (BoJ) has increased the pace of its balance sheet expansion, accelerating the purchases of Japanese government bonds to ¥80 trillion from ¥50 trillion, and triple its purchases of ETFs and REITs to ¥3tr and ¥90 billion, respectively. The BoJ is likely to further expand QE buying in 2015. The U.S. Federal Reserve ended its Quantitative Easing program in November 2014. At its December meeting the Fed dropped the language that it will keep the Fed funds rate at current near-zero level for a “considerable time” but reassured that it “can be patient in beginning to normalize the stance of monetary policy.” This suggests that the Fed rate policy is data-dependent, implying that the first rate hike could occur in early or late 2015, depending on the

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For informational use only. Not intended as investment advice.


evolution of economic data. Current expectations are for the Fed to begin raising rates in mid 2015. However, with inflation already low (around 1.3% in November) and the collapse in oil prices likely to put further downward pressure on headline inflation, the Fed could push rate hikes into late 2015. The Bank of England (BoE) is likely to be the first developed central bank to start raising interest rates. The BoE is on track to start raising U.K. rates in Q2 2015 given the strength of the U.K. economy. However, low inflation could also prompt the BoE to delay the start of rate hikes. Several emerging central banks are on track to cut rates or undertake other easing measures in 2015. The People’s Bank of China (PBoC) is likely to cut rates again and undertake targeted easing in 2015 with low inflation giving the PBoC room to undertake further easing measures. Among other emerging central banks, India, Taiwan and Korea are likely to cut rates with easing inflation. In Eastern Europe, deflation risk is likely to prompt rate cuts in Hungary, Poland, and Czech Republic in 2015. The exceptions are likely to be Brazil and Russia whose central banks are forced to raise interest rates to counter rising inflation and defend weakening currencies.

2) Improved Global GDP Growth: After the growth disappointment in 2014, Global GDP growth is expected to strengthen in 2015 with growth in the U.S. & U.K. remaining solid, the recovery in Eurozone Core economies gaining traction, while the Periphery continues to strengthen with ECB QE stimulus, weaker Euro and lower oil prices. Japan’s GDP growth is on track to strengthen with another fiscal stimulus package, postponement of the 2015 tax hike, lower energy prices, fresh BoJ stimulus, and the weak yen supporting exports. China GDP growth is expected to remain stable around 7% while GDP growth is expected to strengthen in India, Taiwan, Korea and Indonesia. However, Brazil and Russia are expected to continue to struggle leading to modest growth in Latin America and Emerging Europe.

3) Solid Earnings Growth with improved GDP growth, margins remain healthy: Corporate earnings were solid in 2014 despite disappointing GDP growth. After 8% earnings growth in 2014, global earnings growth is expected to strengthen to 12% in 2015 with double-digit earnings growth in the U.S. (12%), Eurozone (17%), Japan (12%) and Emerging Markets (12%). Earnings growth in 2015 is likely to be driven by solid GDP growth in the U.S. & U.K., growth improving in Japan and Core Eurozone, the Periphery strengthening, and improving growth in the emerging economies. Profit margins had widened during 2014 and expected to remain solid in 2015, boosting earnings growth. U.S. corporate earnings are expected to strengthen further to around 12% in 2015 after earnings growth of 8% in 2014, with U.S. GDP growth strengthening to over 3% from around 2% in 2014. Margins are expected to remain wide with low labor cost and lower oil prices. Eurozone & U.K. earnings are expected to improve in 2015 to around 17% and 8% respectively with Eurozone GDP growth recovering in 2015 while the U.K. growth remains solid. Japanese earnings are expected to grow a solid 12% with GDP rebound. Further the weak yen should support earnings growth. Emerging Markets earnings are expected to be around 12% in 2015 after just 7% growth in 2014. Emerging Asia earnings are supported by improved GDP growth and rate cuts. Latin America & Emerging Europe earnings are likely to be under pressure from modest GDP growth and rate hikes in Brazil and Russia.

4) Reasonable valuations with P/E Multiples below long-term average, stocks cheap relative to bonds: P/E multiples continued to rise during 2014 with stock price gains especially in the U.S. The rise in P/E multiples was modest as stock price gains were offset by earnings growth. The P/E multiple for Developed Markets rose modestly to 18.2X at the end of 2014 from 17.9X at the beginning of 2014. In the U.S., the P/E multiple (for S&P 500) rose to 18.5X (December 29) from 17.2X at the start of 2014. The multiple for the Japanese stocks is currently at 16.3X from 16.2X at the beginning of 2014, while the multiple for Eurozone stocks rose to 21X from 19.5X during 2014. Emerging Market valuations rose sharply to 13.2X from 12.1X at the beginning of 2014 mainly due to a decline in earnings growth. Over the last two years, P/E multiples expanded in the U.S. while Europe, Japan and emerging markets had a smaller P/E expansion or even multiple contraction. Hence there is scope for the P/E expansion in 2015 in Eurozone, Japan and Asian emerging markets, especially with QE stimulus and rate cuts. In the U.S., stock market gains in 2015 are likely to be largely driven by earnings growth with limited scope for P/E expansion, especially with the Fed starting to hike U.S. rates.

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Stock valuations have become cheaper relative to bonds. The earnings yield on U.S. stocks eased to 5.5% from 5.8% at the end of 2013, while the 10-year Treasury yield fell sharply to 2.2% from 3%. The yield gap between U.S. stocks and bonds widened to 3.3% from 2.7% during 2014. The long-term average yield gap is 1.1% (20 year average). Eurozone stocks have become cheaper relative to bonds. The earnings yield on Eurozone stocks is 4.6% and the 10-year Bund yield is at 0.70% resulting in a yield gap of 3.9%, well above a long-term (10-year) average of 3.4%. Japanese stock yield is at 6.2% and JGB bond yield at 0.40% with a yield gap of 5.8%, well above the 10-year average of 3.9%. However, stocks face several risks which could keep markets volatile. These include: 1) Oil price uncertainty; 2) Geo-political tensions; 3) Uncertainty about Fed’s exit strategy & timing/pace of rate hikes; 4) Eurozone uncertainty with fresh Greek drama with elections and risk of exit from Euro; 5) Potential GDP growth & earnings disappointments.

Bottom-line: Despite the uncertainties, we expect further gains by global stock markets as fresh QE liquidity from the ECB and BoJ, further rate cuts and stimulus by China and other Emerging Markets should offset the modest rate hikes by the Fed and the BoE. Further, improving GDP growth, continued solid earnings growth, reasonable P/E multiples and stocks cheap relative to bonds, are likely to lift stock markets higher during 2015. We look for double digit gains by global stock markets in 2015. Our target for the U.S. stock market is for the S&P 500 index to reach 2250 by year-end 2015 and the Dow index to reach 19,500. Bond Market Outlook: Bond Yields Likely to Rise with Stronger GDP Growth & Rate Hikes by Fed & BoE. Low Inflation, QE Stimulus by ECB & BoJ & Geo-political tensions likely to Limit Rise in Yields Bond yields fell sharply in 2014 with weak GDP growth in Eurozone & Japan, low Inflation with Eurozone sliding close to deflation, and safe haven demand with geopolitical tensions in Ukraine and the Middle East. Bonds yields are likely to drift higher in 2015. Yields are likely to be under upward pressure from: 1) Solid GDP growth in the U.S. and U.K., Core Eurozone stabilizing, the Periphery strengthening, and Japanese GDP rebounding after the growth collapse in mid2014; 2) The U.S. Fed and the BoE on track to start raising rates in 2015; While the Fed has indicated that it can afford to be “patient” in raising rates, there is likely to be increased uncertainty about Fed exit strategy and the pace of rate hikes in 2015; 3) Bond valuations are very expensive relative to stocks with the sharp decline in yields during 2014. However, the rise in bond yields is likely to be limited by: 1) Inflation remaining low in the developed economies and the recent collapse in oil prices increasing the risk of Eurozone sliding into deflation; 2) The ECB set to undertake full-fledged QE in early 2015 while the BoJ is likely to expand QE; 3) Safe haven demand with lingering geopolitical tensions.

Investment Strategy: Asset Allocation: Stocks vs. Bonds - Overweight Stocks, Modest Underweight Bonds Stocks – Overweight as stocks likely to post solid gains in 2015 with fresh QE liquidity from the ECB and BoJ, further rate cuts & stimulus by China and other Emerging Markets, improved global GDP growth, solid earnings growth, stocks cheap relative to bonds and P/E multiples below long-term averages. We look for double digit gains by global stock markets in 2015. Bonds – Modest underweight as yields are likely to drift higher with improved global GDP growth led by the U.S. and U.K., recovery in Eurozone & Japan, the start of rates hikes by the Fed & BoE, and bonds expensive relative to stocks.

Global Equity Strategy: Overweight in Japan, Emerging Asia & Eurozone. Underweight in U.S., U.K., Latin America & Emerging Europe Japan: Overweight as we expect solid gains in 2015 with GDP growth rebound, further BoJ QE stimulus, GPIF asset allocation shift to stocks, and the Abe administration undertaking reforms.

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Emerging Asia: Overweight with further gains in China and India on rate cuts and easing measures, improving GDP growth & solid earnings outlook. Eurozone: Modest Overweight with the ECB set to launch full-fledged QE, improving GDP growth and solid earnings growth. Eurozone stocks are also likely to benefit from P/E expansion as ECB launches QE and Ukraine tensions ease. Latin America & EM Europe: Underweight with weak growth outlook in Brazil and Russia and central bank rate hikes to fight high inflation and defend weakening currency. U.S.: Underweight as U.S. stocks are expected to post more modest gains in 2015 compared to Japan & Eurozone. The 2015 gains are likely to be driven by solid GDP and earnings growth and Fed rate hikes likely to be modest. Our target for the U.S. stock market is for the S&P 500 to reach 2250 by year-end 2015 and the Dow index to reach 19,500.

Global Bond Market Strategy: Eurozone Bonds & Emerging Market Debt Likely to Outperform U.S. Treasuries, U.K. Gilts & Japanese JGBs Eurozone bonds: Overweight with the ECB set to launch full-fledged QE in 2015, low inflation and modest GDP growth. Emerging Markets Debt: Overweight EM Asia debt with improving growth and further rate cuts; Underweight in Latin America & EM Europe with weak growth and further rate hikes likely in Brazil & Russia. Japan JGBs: Neutral as the outlook is mixed. Bonds are supported by the BoJ expanding QE stimulus, but offset by improving GDP growth and GPIF asset allocation shift from bonds into stocks. US Treasuries: Underweight as yields likely to rise in 2015 with solid U.S. GDP growth and the Fed starts rate hikes. U.K. Gilts: Underweight as the outlook for Gilts is negative with solid GDP growth and the BoE set to hikes U.K. rates.

Global Sector Strategy: 

Overweight: Industrials, Info. Technology; Modest Overweight: Healthcare, Financials

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Neutral: Consumer Discretionary, Materials & Energy

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Underweight: Consumer Staples, Telecommunication Services & Utilities

Currency Strategy: 

Overweight: U.S. Dollar with further gains likely on solid U.S. GDP growth and Fed starts rate hikes.

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Underweight: Euro & Japanese Yen as they are likely to weaken further with full-fledged QE by ECB, additional BoJ QE stimulus & modest GDP growth relative to solid U.S. growth.

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