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April 17, 2014
Global Economic Review & Outlook

Seeking Equilibrium

We believe:

The global economy can maintain its slow recovery trajectory, supported by accommodative monetary policy and low inflation.

The U.S. is in the middle innings of recovery, China is positioned for a soft landing, and conditions in the euro zone and U.K. are increasingly favorable.

Economic reforms provide a compelling backdrop for many emerging markets, but selectivity is key.

The current climate calls for a balance of secular and cyclical growth, as well as adherence to valuation disciplines.

Convertibles may prove especially beneficial in a volatile equity market, against the backdrop of rising interest rates.

JOHN P. CALAMOS, SR.
CEO AND GLOBAL CO-CIO



GARY D. BLACK
EVP AND GLOBAL CO-CIO

Seeking Equilibrium

Volatility returned with a vengeance as we entered the second quarter, fueled by dueling concerns that the economy was growing either too fast or too slow and by the perception that valuations in some sectors had become stretched. The sell-off that began in March with momentum-oriented names extended across a broader swath of the global market, with defensive names holding up best. We then saw a shift back to momentum when Federal Reserve meeting minutes were released on April 9, followed by another sell-off and then another rally.

Fed communications have been a significant factor in these vacillating global markets, especially as they triggered widespread de-risking by hedge funds. However, beyond that, there haven't been many clear catalysts to explain the volatility. Depending on who you ask, the shift away from higher-valuation stocks reflects either increasing or evaporating conviction in the global recovery. Those who think the recovery is getting stronger believe cyclicals can provide growth at more attractive valuations. The nonbelievers would say the recovery is losing steam and it's time to de-risk and head to more defensive areas.

Our view is that a balance of secular and cyclical growth makes the most sense, as economic growth looks to be on a measured pace, neither too hot nor too cold. Valuations remain attractive around the world. The high level of volatility in the markets and froth in certain sectors call for a high vigilance to valuations, however. We're cautious about securities with the highest valuations, and therefore, the greatest vulnerability to changing sentiment and a rising U.S. interest-rate environment.

First Quarter Review

The U.S. continued to lead the global recovery, with steady GDP expansion, including an upward revision of fourth quarter GDP to 2.6%. The euro zone climbed further out of recession, supported by favorable trends in both the core and periphery, as well as the European Central Bank's (ECB's) stated commitment to further accommodative policy.

Despite greater conviction that global economic growth was improving and overwhelmingly accommodative global monetary policy, markets were choppy and rotational during the quarter, with increasing volatility. Investor anxiety initially centered on emerging markets, notably Turkey, Argentina, Russia and South Africa, as the tapering in the U.S. caused foreign exchange reserves to dwindle, forcing a number of central banks to raise rates to support their currencies even as their fragile economies were coming under pressure. Concerns about the health of the Chinese economy were exacerbated by unknowns in China's monolithic shadow banking system, as the government broke with precedence and allowed for defaults. Later in the quarter, political risk took center stage as mounting tensions in Ukraine further spooked investors and reduced the appetite for emerging market risk.

Uncertainties were not confined to the emerging markets, however. In the U.S., the economic impact of severe cold weather on consumer activity sent shivers through the markets. Weather woes paled in comparison to the market's reaction when Federal Reserve Chair Janet Yellen raised the prospect of U.S. interest rates increasing in mid-2015, earlier than many investors expected. As we noted, the specter of higher U.S. rates sparked a swift rotation in the global equity markets in late March (Figure 1). Growth had led throughout much of the quarter, as secular growth names were well supported by underlying fundamentals. But in the waning days of March, investors shunned long-duration equities with higher multiples and growth rates in favor of more defensive names. (Long-duration equities are those where the vast majority of earnings and cash flows are many years out.)

The rotation was particularly brutal because stocks with high estimated growth and high multiples had became expensive relative to the market (2.2x versus a longterm average of 1.8x, as shown in Figure 2), although these "big grower" relative multiples were well below peaks reached before the Nifty Fifty meltdown of 1973 and the tech bubble implosion of 2000. Also, correlations of high-growth names had increased sharply, causing momentum stocks across sectors to behave singularly(Figure 3).

When all was said and done during the first quarter, the MSCI World Index eked out a return of 1.4% and the S&P 500 Index rose just 1.8% (Figure 4). The 10-year Treasury gained 3.4%, as concerns about equity markets ultimately overshadowed fears of rising interest rates.

Convertible securities outpaced equities globally, and U.S. convertibles also gained more than 10-year Treasurys. This performance is what we would expect as the equity market advanced but vacillated and spreads narrowed in the bond market. That is, we saw a high level of participation in equity upside, with good downside protection due to fixed-income characteristics, notably rising bond values. Increased appetite for less interestrate sensitive securities likely stoked investor appetite for convertibles as well.

Global Outlook

Our global outlook remains positive as we enter the second quarter. We continue to estimate 2014 global economic growth of 2.5% to 3.0%. Inflation remains very low in the developed markets and looks to be on the decline in the emerging markets (Figure 5). Global monetary policy remains accommodative and provides a tailwind for recovery, even with the taper in U.S. As we discussed in our January commentary, we believe as the global economy heals, governments will focus less on aligning policies with one another, instead pursuing more country-specific policies to address their domestic issues. In most cases, however, this will likely lead to the same result of accommodative policy.

United States. Compared with the start of the year, the economy hasn't gotten much better, but it hasn't gotten much worse, either. We think we're in the middle innings of the recovery and believe GDP growth will be in the range of 2.0% to 2.5% for 2014. The Fed taper and the prospect of tighter monetary policy by late 2015 affirm the steady growth in the economy, as do consumer spending and improvements in industrial sectors. Job growth remains fairly sluggish at 150,000 to 200,000 a month (Figure 6). These levels aren't slow enough to cause the Federal Reserve to stall or delay the taper, but they fall far short of the 250,000 to 300,000 monthly jobs we believe would be needed for the U.S. economy to achieve escape velocity.

We believe severe weather was the primary cause for dampened economic activity, including slowdowns in the housing market and auto sales. Economic expansion is likely to accelerate in the second quarter as weather reverts to normal, which we believe will help retail, housing, autos, and other key sectors. We already saw a promising turn in auto sales in March (Figure 7). Even though the housing recovery may be hindered somewhat by rising rates and higher prices, we expect a pick up there as well (Figure 8). However, the long-anticipated recovery in capital spending has not occurred yet (Figure 9).

At less than 2%, inflation looks well contained. Although the Federal Reserve's balance sheet has expanded by close to 400% since 2008, the velocity of money has not kicked in and remains at a historic low. This backdrop should be supportive to continued economic expansion. While the March new jobs report fell a bit short of the 200,000 mark, jobless claims in early April declined to pre-financial crisis levels, pointing to a much-improved labor market.

There's little reason to believe we're anywhere near an economic peak. Economic declines generally begin when we see one or more of the following: Fed monetary policy shifts from neutral to tight (not from accommodative to neutral); corporate earnings growth turns negative; or an exogenous shock disrupts consumer or business confidence (e.g., energy crisis, 9/11, financial crisis).

Euro zone and United Kingdom. Recovery is gaining meaningful traction in the euro zone, with fourth quarter GDP growth of 0.5%(Figure 10), and we believe the ECB will continue to maintain its accommodative policy, which provides a floor for the equity market. In Germany, unemployment reached a record low of 6.7% and GDP grew by 1.4% in the fourth quarter; the country's economic health and strengthening demand trends can provide a tailwind to the rest of the euro zone, as well as to the global economy. The United Kingdom has been a source of consistently better news, including declining unemployment, a strengthening housing market, as well as above-forecast rises in retail sales and industrial production. Conditions in France are improving as well.

Austerity measures, as well as the support of the ECB and member nations, have led many of the once most-fragile euro zone economies to fundamentally brighter prospects (Figure 11), which we believe will continue. Italy, Ireland, Greece and Spain have reined in borrowing costs significantly, with 10-year bond yields that are lower than or closing in on levels at the start of 2009. Additionally, the high interest we saw last week for Greece's $4.2 billion five-year bond issue points to how far that country has come in its painful recovery, as well as to the market's view of the country's prospects.

Nonetheless, our outlook reflects some caveats: It remains to be seen if the ECB can stave off deflation without embarking on actual quantitative easing, which it has so far just talked about. Also, the chasm between Northern Europe and Southern Europe remains wide in many regards, including unemployment, government debt, manufacturing data, and GDP growth.

Japan. Abenomics has sown green shoots, but it is too soon to gauge how fast they can grow. Over recent months, many of the positive headlines have been tempered with negatives. While nominal GDP increased 2.2% year over year (Figure 12), government support drove most of the rise and private nominal GDP rose just over 1%. There have been upticks in construction and segments of the housing market, but gains may well have been the result of a pull-forward in activity in advance of the 3-percentage point sales tax increase. As we were going to print, there was widespread speculation that the government would reduce its economic forecast for the first time in 18 months as a result of the sales tax increase that went into effect in April, which could result in more quantitative easing.

The Tankan manufacturing survey rose in the first quarter but is projected to move lower in the second quarter and beyond, again due to the impact of the tax hike, as well as a China slowdown. Finally, employment data has improved, but wage growth remains discouraging.

The structural hurdles (wage growth, labor force participation) remain stubborn and we believe the sales tax will be a hurdle to consumer activity. With 19% of its exports going to China, Japan may be quite vulnerable to even a soft landing for its trade partner. However, we believe the Bank of Japan is in a "whatever it takes" mode, and will continue to inject stimulus into the economy. On the back of this stimulus, we believe Japan may see 2% to 3% GDP growth for 2014.

Emerging Markets. The emerging markets are the most significant wild card in our global outlook. The good news is that as the emerging markets have matured, they are moving less in lockstep. Debts denominated in local currency (versus the high level of U.S. dollardenominated debts in the 1990s), greater levels of economic diversification, and different reform trajectories all reduce the risk of event-driven contagion. We are also seeing promising economic development trends in smaller economies, such as Mexico and the Philippines.

Among the major economies, China appears to be charting a course toward a soft landing, as evidenced by first quarter GDP growth of 7.4%. The dominance of state-owned infrastructure projects within the economy is shifting to more consumer and export -driven activity, and the government seems to be taking very deliberate steps to slowly deflate, rather than pop, the country's credit bubble. The decision to allow a handful of trusts to default has allowed for market liquidity, while telegraphing risks to investors. Targeted stimulus measures may also help keep growth on keel. We're also encouraged by regulatory changes that allow state-owned insurance companies to increase their participation in the credit markets, providing another source of liquidity.

In regard to the rest of the BRICs, India seems to be in far better shape than Brazil or Russia. Members of our team recently visited India, and their meetings affirmed their conviction that the country may be poised for a turnaround story over the next few years. So far, it has benefited by successfully engineering a weakening of its currency and by cutting government spending. Elections are underway, with predictions that the incoming government will be pro-growth and anti-corruption. The problems in Brazil are more intractable, including a highly levered consumer, inflation that has failed to respond to nine interest rate increases, and declining GDP growth. Meanwhile, the sanctions and conflict resulting from Russia's move into Crimea may well push Russia into recession.

The Case for Equities

We believe the global recovery can sustain its slow upward growth trajectory. This would benefit both stocks that we consider traditional secular names, as well as stocks with a higher degree of economic cyclicality. We are maintaining a strict valuation discipline as we focus on proactively addressing the potential impact of volatility, sentiment shifts, and the changing interest rate environment in the U.S.

We believe a clearer direction could emerge within the equity markets as the U.S. enters earnings season. Investor concerns should be eased if earnings are good, particularly in the higher-growth sectors that have suffered significant price declines of late. On the bright side, first-quarter earnings expectations are low due to weather, and low first-quarter U.S. GDP. If earnings deliver and the market still fails to hold, then we could be in for a rockier ride.

U.S. equities. We are likely to see a return of "bad news is good news," where weak economic data reduces the odds of tighter monetary policy, and allows companies with strong secular growth to be revalued higher.

Equity earnings yields continue to compare favorably to inflation and long-term Treasury yields. Based on a P/E for the S&P 500 Index of 16.2x 2014 earnings—or a 6.1% earnings yield—and a 10-year Treasury yield of 2.7%, the equity risk premia (the difference between the 10-year Treasury yield and the equity earnings yield) is currently +340 basis points. This level is within the cheapest quartile over the past 60 years. Valuations typically look stretched when equity premia drop below zero. If we use real earnings yields (reflecting an inflation rate of 1.7%), the current +440 basis point differential is in the cheapest 30th percentile over the past 60 years. Valuations typically look stretched when real earnings yields drop below +200 basis points.

As we noted, we believe the U.S. looks to be in the mid-cycle phase (Figure 13).Our focus on balancing secular and cyclical growth has led us to favor companies in technology, financials, consumer discretionary and industrials. Historically, companies in these sectors have performed well as economic activity accelerates with minimal inflation and an upward sloping yield curve.

We believe the opportunities for growth equities remain significant. Figure 14, from Empirical Research Partners, shows that growth stocks tend to outperform during the middle and later stages of the business cycle, as euphoria spreads and investors are willing to pay more for future growth. Importantly, growth stocks significantly outperformed value stocks before every business cycle ended (i.e., before every downturn) over the past 30 years: 1981–1982, 1990–1991, 2000–2001, and 2008–2009. While growth did outperform value in 2013, it was not by much. This lack of growth outperformance and the other "tepid" macro data we've discussed (sluggish job growth, limited inflation, the absense of a capital spending recovery, and GDP growth in the 2% to 3% range) suggest we are still in the mid cycle with an extended period ahead of us, during which growth stocks can outperform.

European equities. As in the U.S., we are adding cyclical exposure to balance out more secular positions. For example, we have identified companies positioned to benefit from improvements in the U.K. housing recovery. While we continue to focus on the core economies within Europe that are showing strength (U.K., Germany and France, for example), the economic recovery has prompted us to also look more closely at select opportunities with the periphery.

Japanese equities. We haven't seen the stimulus create real wealth yet, as we discussed. Therefore, we are adding at the margin to areas are we believe can benefit most directly from stimulus measures, such as financials (easy money) and industrials (building projects).

Emerging markets equities. As in the developed markets, we are emphasizing a blend of cyclical and secular growth opportunities. As the markets have rotated, we continue to find a breadth of choices at good valuations (Figure 15), including among lower-beta industries. Many countries have made meaningful progress in reforms. Others have pivotal elections this year, potentially opening the door to better economic and investment prospects. Against this backdrop, we've found opportunities in Mexico, the Philippines, Taiwan, Indonesia and South Korea. In countries where key reforms are in more nascent stages, such as India, Indonesia, and Thailand, we are taking a more selective approach to our exposures, while also seeking to take advantage of market pullbacks.

We've found a range of Chinese companies that meet our criteria, including "New China" companies (those that benefit from the opening of the country's economy and markets). In Brazil, we have added more defensive positions, including consumer staples. We also have identified pockets of secular growth potential, such as companies positioned to benefit from government efforts to incent people to pursue higher education. In India, we've found opportunities in financials, consumer goods, and health care—again reflecting the dual focus on cyclical and secular attributes.

Convertibles Shine in Volatile Markets

Equity market volatility, combined with the likelihood of moderately higher rates in the U.S., provides a favorable backdrop for convertible securities—both for investors who are concerned about the risks of bonds and those who are apprehensive about fluctuating equity markets. With a blend of equity and fixed-income characteristics, convertibles have historically demonstrated less interest-rate sensitivity versus traditional investment-grade bonds. Moreover, convertibles can provide equity upside participation with potential downside protection should equities decline. Convertibles have tended to perform well during periods of volatile but upwardly moving equity markets (as the convertible's embedded option increases in value), as well as during periods of rising interest rates.

In the current environment, we believe convertibles are well positioned to take advantage of the positive moves that may occur in the equity market. The characteristics of convertibles vary over time, with differing degrees of equity and fixed-income sensitivities. For example, during the aftermath of the 2000 and 2008 recessions, convertibles' fixed-income characteristics were more pronounced, and they tended to trade more like bonds. Now, the performance of convertibles is generally tied to their underlying equities. As Figure 16 shows, the equity sensitivity of the U.S. convertible universe, as measured by delta, is at a relatively high level of its historical range. This equity sensitivity is beneficial in a rising equity market and should help offset the impact of rising rates on convertible's fixed-income characteristics. Given the higher current correlations between equities and convertibles, we believe that our equity research work can serve us in good stead.

We expect that investors' interest in convertibles will continue to rise as equity prices continue their rebound and interest rates move up. We are closely monitoring supply and demand issues. Among the positives, global issuance is on pace with that of 2013. New issues reflect a level of geographic and industry diversification that we believe speaks to the health of the convertible market.

The high level of issuer diversification by industry and country has not been mirrored in credit quality, and lower-grade credits continue to dominate global issuance. We view this as less of an impediment in a recovering economy because we are comfortable considering a wider range of credit tiers.

Still Bearish on Bonds

Treasury bonds enjoyed a surge of market interest at the end of the first quarter, and the 10-year Treasury yield has continued to move downward in the first half of April. This move may be the result of equity market turmoil (i.e., flight to safety) or the bond market sensing a weakening economy. Either way, until volatility settles down or we get more evidence that the U.S. economic recovery is continuing, bonds and cash equivalents will likely benefit. To be clear, our outlook on investment- grade bonds hasn't changed. We believe bonds remain highly vulnerable to interest-rate risk, making them a far less attractive choice than convertible securities or alternative income-oriented strategies.

Conclusion

We believe we are somewhere in the mid-cycle of a global economic expansion and accompanying bull market, which recently passed its five-year anniversary. We continue to view U.S. equities as the best way to play this economic recovery, given low inflation, continued accommodative monetary policy and attractive valuations. We expect the recent volatility in secular and cyclical growth equities will stabilize as solid revenue and earnings results reinforce valuations. We are adding selectively in Europe and Asia. We remain cautious about bonds and find convertibles attractive as economic activity picks up and interest rates begin their global rise.