Q4 2012 » Putnam Perspectives

Capital Markets OutlookJeffrey 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 Small overweight Overweight

EQUITY l

U.S. large cap l

U.S. small cap l

U.S. value l

U.S. growth l

Europe l

Japan l

Emerging markets l

FIXED INCOME 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

COMMODITIES l

CASH l

CURRENCY

Dollar/yen Favor dollar

Dollar/euro Neutral from favor dollar

Dollar/pound Neutral

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

2

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 under-

gone 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.

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 condi-

tions 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 signif-

icantly, 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.

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

1.75%

2.00%

2.25%

2.50%

2.75%

12/31/11 10/5/121/31/12 3/31/12 5/31/12 7/31/12

Source: Bloomberg.

9/12 market close, before QE3 announcement

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3

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 legis-

lation 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 inves-

tors should begin to build exposures to assets that provide

some inflation protection. These assets include inflation-

indexed 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 trepida-

tion. 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.

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

-40%

-20%

0%

20%

40%

60%

80%

12/31/04 8/31/1212/31/06 12/31/08 12/31/10-50%

-25%

0%

25%

50%

Source: Bloomberg.

Exports to U.S. (—) and E.U. (—) — MSCI World Index

4

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 viewsEquityU.S. equity Investors looked past a multitude of macro-

economic 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, util-

ities, 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 finan-

cials, consumer cyclicals, and industrials. Within financials,

global money center banks, which are vulnerable in a still-

fragile 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 euro-

zone 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 coin-

cides 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 funda-

mental research should offer a distinct advantage.

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5

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 resur-

gence 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 perfor-

mance 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 nego-

tiate 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 long-

term 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 prepay-

ment 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 tech-

nicals, 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 expe-

rience 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 partic-

ipants look to Washington for clues about a short-term

6

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 avail-

ability 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.

CommoditiesCommodities have lagged other risk assets on a year-to-

date 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 year-

to-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

markets. However, inflation could be a catalyst for poten-

tial 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.

Currency 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 Transac-

tions 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 underper-

form 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.

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7

MARKET TRENDS Index name (returns in USD) 3Q 12

12 months ended

9/30/12

EQUITY INDEXESDow Jones Industrial Average 5.02% 26.52%

S&P 500 6.35 30.20

Nasdaq Composite 6.17 29.01

MSCI World (ND) 6.71 21.59

MSCI EAFE (ND) 6.92 13.75

MSCI Europe (ND) 8.70 17.31

MSCI Emerging Markets (ND) 7.74 16.93

Tokyo Topix -3.16 -3.27

Russell 1000 6.31 30.06

Russell 2000 5.25 31.91

Russell 3000 Growth 6.01 29.35

Russell 3000 Value 6.44 31.05

FIXED INCOME INDEXES Barclays U.S. Aggregate Bond 1.59% 5.16%

Barclays 10-Year Bellwether 0.93 5.65

Barclays Government Bond 0.60 2.95

Barclays MBS 1.13 3.71

Barclays Municipal Bond 2.31 8.32

BofA ML 3-Month T-bill 0.03 0.07

CG World Government Bond ex-U.S. 3.98 3.46

JPMorgan Developed High Yield 4.56 19.31

JPMorgan Global High Yield 4.71 19.71

JPMorgan Emerging Markets Global Diversified 6.64 19.55

S&P LSTA Loan 3.43 11.27

COMMODITIES S&P GSCI 11.54% 12.74%

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 bil lion. The DJIA has been price-weighted since its inception on May 26, 1896, reflects large-cap companies representative of U.S. industry, and historically has moved in tandem with other major market indexes such as the S&P 500.

The 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 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 fixed- income 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-capitalization-weighted 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 broad-market Russell 3000 Index chosen for their growth orientation.

Russell 3000 Value Index is an unmanaged index of those companies in the broad-market 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

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