Capital Market Outlook (April 22, 2019)

  • Macro Strategy—A regulatory-led German manufacturing recession and panic over Chinese growth prospects given trade-war concerns exacerbated the adverse impact of the Federal Reserve (Fed)-led liquidity tightening on global growth and international trade as 2018 progressed. This year, in contrast, there are signs that the global manufacturing and trade cycle is starting to improve anew.
  • Global Market View—A high level of market irregularities is creating a confusing backdrop for investors, who would be well served to separate near-term uncertainties, such as growth and profits, from longer-term trends which are expected to persist beyond this cycle.
  • Thought of the Week—State-owned enterprises serve a purpose for governments. Yet, markets on balance have assigned a higher value on private companies, which focus more on maximizing productivity.
  • Portfolio Considerations—We remain overweight equities and would be buyers on weakness—particularly in between earnings seasons. Within fixed income, we are overall neutral on credit and have a slight preference for short-dated investment-grade corporates and municipals across the curve.

More signs of a global manufacturing and trade rebound

The global economy was buffeted by powerful negative forces through the end of 2018, including mounting concerns about an overly aggressive Fed policy, growth-inhibiting policies and political disarray in the eurozone, a rapid Chinese slowdown, and an unexpected German manufacturing recession. The plunge in international trade volume between October and December seemed to only validate expectations that an escalating trade war would end the global expansion.

Yet, as we had expected, the Fed's about-face on monetary policy in light of slowing growth and inflation pressures breathed new life into U.S. and global growth prospects, as reflected in declining financial-market volatility, narrowing credit spreads, and the outperformance of cyclical stocks and emerging markets so far this year. As discussed in our March 7, 2019, Capital Market Outlook, "Soft patch should be short lived," economic data have also been increasingly supportive of this view, with accumulating green shoots of a fourth cyclical manufacturing upturn since the expansion started in 2009.

With the Fed out of the way and lower uncertainty, the underlying positive U.S. growth trend has started to reemerge. Initial claims for unemployment compensation, a leading indicator, have dropped to a fifty-year low, and March nonfarm payrolls rebounded strongly from a weak February reading. Payrolls are up 1.7% from a year ago, in line with our 2019 average growth estimate based on leading indicators of employment and our expectations for a slight further increase in the participation rate, especially for prime-age men, which remains about one percentage point below its average of the previous expansion.

With lower mortgage rates, home sales recovered their 2018 declines by February, and motor-vehicle sales remained strong through March, led by new record highs for light truck sales. Strong big-ticket spending is consistent with the reported 15-year-high level of household expectations for real income a year ahead and surging expectations for personal finances five years ahead, according to the University of Michigan consumer sentiment survey for April.

Thus, as we had expected, strong consumer fundamentals, a stable dollar, and stillstimulative effects from government spending and tax cuts into 2020 appear to have helped the U.S. economy weather the shock from the excessive Fed tightening to date, extending the expansion into its tenth year. Efforts to stimulate growth overseas in the face of a loss of momentum in the U.S. and trade tensions have also started to bear fruit. For example, following massive fiscal stimulus, credit infusion, and other growth promoting government policies, Chinese data have started to turn up, helping improve global growth prospects and boosting risk-taking sentiment.

Given its large exposure to the global manufacturing and trade cycle and an almost yearlong manufacturing recession, a brightening of the economic outlook in China and other emerging markets (EMs) couldn't be more welcome than in Germany. Major supply-chain disruptions related to the implementation of Worldwide Harmonized Light Vehicles Test Procedure (WLTP) emissions regulations on September 1, 2018, caused German manufacturing to fall into recession in the second half of 2018. Because of certification delays for numerous car models, passenger-car output and registrations dropped about 40% from March to December 2018 and March to September 2018, respectively. This heightened worries about the prospects for growth in an already feeble eurozone and added substantial drag on global manufacturing and trade. Supply disruptions no doubt affected shipments to overseas buyers as well, further weighing on global trade.

This setback is temporary, however, and its unwinding is no doubt stimulating trade, helping ease risk aversion and boost relative performance of EM equities, which is typical in an upcycle phase of economic activity. German and eurozone passenger-car registrations have already recovered their eye-popping declines. Consumer confidence remains elevated, retail sales growth has strengthened, and expectations for retail sales over the next three months have stayed firm. Also, German service Purchasing Managers Index (PMI) is still significantly stronger than manufacturing PMI and in expansion territory, inconsistent with a broad-based domestic-demand deterioration. Moreover, research shows that gaps between service PMIs and manufacturing PMIs tend to be resolved by the manufacturing PMIs reverting to the service PMIs, rather than the other way around, as inventories are restocked. Also, the backlog of German manufacturing orders has increased sharply for various categories of goods, including motor vehicles, and the increase in the Ifo Business Climate Index for retail points to an improvement in German manufacturing conditions ahead (Exhibit 1). A similar message comes from the upturn in the ZEW index of macroeconomic conditions for Germany and the eurozone six months ahead. A eurozone fiscal-policy boost of about 0.25% of gross domestic product (GDP) expected this year should further bolster this trend.

Exhibit 1: Improving Growth Trend for German Manufacturing Activity in Sight.

Accumulating green shoots of a manufacturing upturn in China and other EMs also suggest a rebound in German manufacturing and international trade. After a year of deterioration, the Markit manufacturing PMI for EMs reversed its downtrend and returned to growth territory this year, service PMIs remain expansionary, and many central banks are in a better position to ease now that the Fed has paused. A dovish Fed has taken some wind out of the dollar, allowing more room for EMs to ease monetary policy to boost growth. In addition, more countries, including Australia, have announced meaningful fiscal-stimulus packages to remain competitive with the U.S. and to sustain growth while China shifts to a slower, less commodity, manufacturing, and export-led growth model.

In this context, we expect global trade growth to reaccelerate following a disconcerting dive between October and December. In our view, year-over-year growth should turn up from -1.8% in December 2018 to around 3% during the second half of 2019, closer to global real GDP growth. This improving trade-growth pattern is typically associated with EM equities and currencies outperforming, which is consistent with the sharp EM equity rally so far this year. A successful trade agreement between the U.S. and China would further enhance this outlook.

Cutting Through a Dense Fog

Market anomalies are quite common, but it's rare to experience the level of irregularities we are now, creating a confusing backdrop for investors. Consider the following: A brutal end to 2018 has been followed by a historic surge in global equities to begin 2019, shrugging off a weakened corporate profit outlook. Meanwhile, bond yields seemingly capitulated and a portion of the yield curve inverted, while inflation still can't seem to sustain a run toward the Fed's 2% target eleven years into the economic expansion. And the traditional liberal world order, having been established to promote free trade and democratic values, is under increasing threat from multiple angles—from populism and inequality, to growing tensions between China and the United States. This begs the question—are equities flying blind here?

To navigate this confounding environment, investors would be well served to separate near-term uncertainties pertaining to growth and profits, and the manner of their expected resolutions, from the secular long-term trends that will simmer in the background and are expected to persist beyond this business cycle.

An understandable concern for equity investors is an inversion of the yield curve, particularly the much followed 3-month-to-10-year segment of the curve. While we resist any temptation to claim, "This time is different," the primary cause of the inversion has been a decline in longer maturity bond yields, indicating a slowdown in the global economy coupled with expectations for low levels and low volatility of inflation. These have helped to attract safe haven inflows along with producing a low term premium. In addition, treasuries have gained in relative attractiveness as the German 10-year bund yield has dipped into negative territory, reflecting growth concerns abroad. We would expect inflation to remain subdued as wage growth is restrained by increased labor force participation, a shift in labor force composition, and disruptive technology dampening pricing pressures across the economy.

We don't take curve inversions lightly, but we don't expect it to be the death knell for this equity bull market. For one, given lower bond yields, investors tend to reallocate to equities, and equity multiples tend to re-rate higher, which is currently happening. Also, inversions typically coincide with the Fed pausing rate hikes or beginning to cut, which can also help boost equity valuations. As a result, equity performance after an inversion occurs historically tends to be strong. Furthermore, since 1950 the lead time from inversion to recession has averaged between nine months to 4.5 years, and in each of the seven instances stocks continued to build gains before peaking, according to Fundstrat Research. Finally, the most recent inversion may best be characterized as "touch-and-go," with the curve having steepened to positive territory since. Economic data may be mixed, but investors should not throw in the towel on the U.S. business cycle. As of now, we believe that the Fed has paused and pivoted to a much more dovish stance, just in time to enable it to continue.

This dovish tilt has helped to stabilize the dollar and ease financial conditions, alleviating pressure on rate-sensitive sectors such as housing. Mortgage rates have fallen nearly 20% since November 2018, the fastest decrease since 2008 according to BofA Merrill Lynch Global Research. Realtor and buyer confidence has improved, as has their negotiating leverage, while the National Association of Home Builders Index has also rebounded. Housing activity should pick up in the near term and provide a tailwind for growth.

Investors may also be underestimating the growth effects of corporate capital deployment following tax reform. While buybacks did exceed capital expenditures in 2018, capital expenditures (capex) per share for the S&P 500 also jumped to record levels, according to Bloomberg. Companies have not foregone accretive investment to buy back stock and the productive effects of this investment may help extend the cycle moving forward.

Overseas, the German ZEW Index for expectations of economic growth has firmly picked up, providing hope for the eurozone's largest economy that a turn may be near. Citi's Economic Surprise Index has improved for most regions and appears to be forming a bottom in others, the Baltic Dry Index has ground higher, and industrial metal prices are firm (Exhibit 2).

Exhibit 2: Momentum is Beginning to Slow or Shift in Many Regions

The V-shaped recovery in stocks has transpired as global central banks have backed off from their tightening bias. This renewed easy money (liquidity) backdrop has supported increased valuations with the forward price/earning (P/E) multiple for the S&P 500 having risen from 13.9x during the December lows to 16.8x today. However, for a more sustained rally, it will be essential for corporate profits to resume their pace higher. Current estimates point to negative 4% year-over-year profit growth for the S&P 500 in Q1 and no growth in Q2. Surprise results to the upside could power stocks higher, however, profit recessions within broader economic expansions have historically been followed by outsized equity returns over the following year. If the U.S. continues to stave off a recession, we believe equities should be insulated.

For earnings to march higher, we believe it essential to see a recovery in global manufacturing and trade. To this end, we continue to monitor the outcomes of China's stimulus measures in supporting weakening consumer and labor market trends. These efforts appear to be producing early returns with manufacturing PMIs picking up (Exhibit 3), money supply increasing, and Chinese equities surging. An amicable and structurally positive outcome for U.S./China trade negotiations would also be an encouraging sign for global corporate profits.

Exhibit 3: Manufacturing Activity Has Picked Up in the U.S. and China

Amidst a sea of earnings downgrades, a possible green shoot has emerged in that the three-month global earnings estimate revision ratio has ticked up in March for the first time in 14 months, close to the trough levels reached in 2011 and 2015, respectively. The ratio still indicates more cuts than raises to estimates, but at a slowing pace. It also remains below its historical average, which has historically suggested weaker near-term returns, leading us to believe that equities will likely be in a choppy consolidation phase across the next couple of quarters.

So are all of the equity returns already behind us? It's possible, but history would suggest otherwise. The S&P 500 has climbed 13% in the first quarter, which would mark just the 14th time the broad index has gained +10% in the first quarter since 1926, according to Strategas Securities (Exhibit 4). Of these previous occasions, there were only four years in which the S&P 500 did not tally +20% over the entire year—and the last time the index fell after posting at least 10% in the first quarter was in 1987, the year of the stockmarket crash known as Black Monday. While we acknowledge the reasonable likelihood for the market to consolidate, we would suggest using pullbacks as opportunities to reposition appropriately, especially in the absence of shifting fundamentals.

Exhibit 4: Stocks Typically Add on to Historically Strong Starts

S&P 500 Performance After Q1 Exceeds 10% (Since 1926*)

Average (%)

Median (%)

1st Quarter Performance



2nd Quarter Performance



2nd Half of Year Performance



Full Year Performance



The Pros and Cons of SOEs

State-owned enterprises, or SOEs, are seen by many governments as useful tools. They can assist in supplying public goods, such as transportation services, in segments that cannot be addressed efficiently by the private sector. They also can address markets where regulatory solutions are deemed unworkable or ineffective. They also address national economic and strategic interests. Among these may be maintaining social stability or paving the way for the creation of new industries. In part, because of these benefits, the global presence of SOEs has grown. According to the World Bank, from 2005 to 2015, SOEs increased as a share of the Fortune Global 500 from roughly 9% to 23%.

Despite their usefulness, SOEs can also weigh on an economy. Unlike private enterprise, profit maximization may not be a primary objective. Governments may instead be keener on reducing job loss during times of economic turmoil. Furthermore, while subsidy programs may provide greater financial resources for research and development in new industries, they may also reduce incentives for efficiency, leading to the potential for corruption and waste. The impact of these dynamics usually manifests itself in lower productivity.

Balancing the benefits and costs, markets seem warier of the latter. A sub-index of all SOEs within the MSCI EM Index, on an annualized basis as of March 31, 2019, returned 2.5% over a 10-year period, compared to a return of 8.4% for a sub-index exclusively of EM private companies (Exhibit 5). The underperformance of EM SOEs is also applicable to broader measures of financial performance. The MSCI Emerging Markets and All Country World Indices, returned 6.3% and 12.6% respectively, on an annualized basis over the same time frame.

Exhibit 5: SOEs Have Weighed on Financial Market Performance in EMs