Capital Market Outlook (August 26, 2019)

In This Issue

  • Macro Strategy—From Europe to China and India, the repudiation of diesel engines and push for electric vehicles (EV), along with expanding car-sharing availability, are challenging carmakers' business models and disrupting economic activity. Increased stress in these major car markets over the past year has caused global vehicle production to fall at the fastest pace since the financial crisis, an important factor behind weakening global manufacturing output, energy/commodities demand and international trade.
  • Global Market View—Whether global growth firms or softens in the next six to 12 months will hinge on Europe. Will the Continent emerge as a proactive economic stakeholder (pushing through more aggressive monetary and fiscal policies) or a passive bystander? The answer is key to the future of global growth and earnings.
  • Thought of the Week—In July, Ursula von der Leyen and Christine Lagarde were confirmed as presidents of the European Commission and the European Central Bank (ECB), respectively. Lagarde's confirmation has been well received by investors in general. However, investor reaction toward von der Leyen's approval was more mixed.
  • Portfolio Considerations—We remain overweight equities expecting the Federal Reserve (Fed) to get more aggressive in the coming months. We favor U.S. equities over the rest of the world and prefer large-caps to small-caps. We believe long-term investors should wait for the dust to settle in the near term but consider adding to diversified portfolios as the Fed gets more aggressive.

New Environmental Regulations Overseas Jolt Global Economy

While trade-war angst has topped the list of concerns about the economy, clear evidence of a direct link from trade frictions to the global manufacturing-and-trade slowdown of the past year has not been convincing. Business surveys in the U.S. have generally showed a modest actual impact on activity, and a dismal car-industry situation in Germany, China and India compared to the U.S.—second-quarter German car production down 17% year over year and Chinese passenger car sales down 20%; July vehicle sales down 31% year over year in India—suggests that something other than the trade war may also be at play.

A look below the surface reveals negative effects from new emissions regulations in those three major car markets as a real cause behind fading global manufacturing and trade growth. Indeed, the automobile industry has been buffeted by 1) difficulties related to diesel-car production/certification/sales in the aftermath of the German diesel-emissions scandal and 2) tightening emission standards in the eurozone, China and India. These factors are behind the car-making industry's biggest slump since the 2008 Great Recession, with "world car sales expected to fall more than 4 million in 2019," according to a Forbes, June 12, 2019 article. In turn, they have restrained German economic growth for more than a year and have also exacerbated idiosyncratic economic/financial problems in China and India as 2019 progressed.

The importance of car manufacturing to economic growth and the size of the impacted markets explains the potent blow to the global economy coming from this sector, with the cost of the aggressive shift to a world with lower greenhouse emissions likely just starting to be felt. In her speech to the European Parliament on July 16, 2019, Ursula von der Leyen, former German defense minister and new president of the European Commission emphasized her strong commitment to the fight against carbon emissions: "Our current goal of reducing our emissions by 40% by 2030 is not enough. We must go further. We must strive for more… to reduce CO2 emissions by 2030 by 50, if not 55%… The EU will lead international negotiations to increase the level of ambition of other major economies by 2021…This increase of ambition will need investment on a major scale…"

The pressure to change is intense and has taken European producers by surprise. After all, it was government policy that incentivized motorists to choose higher-fuel-efficiency diesel engines over gasoline engines in a push to limit fuel consumption and carbon dioxide (CO2) emissions. Decades later, the dramatic repudiation of diesel engines in the wake of the German emissions scandal, concern over air quality in Europe's largest cities—as diesel engines emit more carcinogenic particulates and nitrogen oxide, which causes smog/acid rain and affects the ozone layer—and increasingly challenging emissions and certification requirements are blowing up established carmakers' business calculations, threatening Europe's already feeble economic growth.

To avoid stiff penalties for exceeding emission limits, manufacturers are forced to boost EV production and sales. However, EVs require less precision engineering, are less labor intensive, and face stiff competition from China, which lacks technological sophistication related to internal-combustion engines but is a leader in EV technology. Because most current mini-cars cannot meet emission schedules without some form of electrification, the higher cost of new emissions and safety standards is particularly seen as putting that segment of European production at risk of becoming uncompetitive.

These challenges have started to take a toll on the German and European economy, exacerbating the negative effects on growth already coming from China's structural economic slowdown, to which Germany has been particularly vulnerable. The introduction of a cumbersome certification process for new car models led to severe disruptions in German and eurozone automotive production/delivery last year. With a number of major European cities launching diesel-car ban programs against pollution and concerns about the resale value of diesel cars, the market share of diesel has plunged. In addition, German companies have been forced to recall millions of vehicles to fix emissions problems. Production and delivery disruptions affected exports as well.

According to the August 16, Wall Street Journal article Rise of Electric Cars Threatens to Drain German Growth, "Europe—especially Germany—is so dependent on the automotive industry for jobs, tax revenue and economic output that even a small shock to the sector can be felt across the entire economy. Late last year, when auto makers had to ramp down production because of difficulties in implementing new greenhouse-gas emission requirements, the loss of revenue was a sizable contributor to a one-quarter contraction in the German economy, by far Europe's largest." Germany's car-industry upheaval has continued this year, again dragging the economy into contraction in the second quarter and raising the specter of an outright domestic recession.

Aside from the prospect of higher competition and a complete industry revamping, including a costly shift to EV, the disappointing pace of car-market expansion in China and India is also adding to the German industry's current gloom. According to a July 31 Reuters article, Chinese industry and government expectations were for 35 to 40 million vehicles by 2020– 2025. Instead, sales are estimated at about 28 million in 2019. With traffic congestion and surging use of ride-hailing services, the Indian car market is also undershooting expectations and dampening expansion hopes despite still very low passenger-car penetration rates.

This year, India's auto industry is experiencing the worst slump in 20 years, causing production cuts and layoffs. The crisis is attributed to a year-long liquidity crisis as well as to back-to-back tax and regulation changes: mandatory safety features; road tax hikes; rising insurance costs; a government push for EV; and the April 2020 implementation of European-type engine-emission norms. The anticipation of big industry discounts for existing models in advance of the new standard has contributed to an eye-popping plunge in car sales, worsening the crisis. The disruptions affecting the industry are significant, with India's biggest car company already announcing an end to the sales of their diesel cars starting next year, for example. Things have not been better in China, where Chinese automakers are spending heavily to meet government quotas for EV, but electric-vehicle subsidies have been drastically reduced and the implementation of "China VI" vehicle emission standards one year before its initial deadline gave manufacturers too little time to prepare. According to the July 1, 2019, Reuters article titled Behind the plunge in China auto sales: chaotic implementation of new emission rules, "While a slowing economy and the trade war with the United States were initially held responsible for slides in sales since April, most of the blame is now being laid on the poorly managed fast-tracking of new rules by the 15 cities and provinces, which account for more than 60% of sales in the world's largest auto market… Now, most expectations are for an annual decline in sales of around 5%, which would follow a 2.8% decline in 2018 when sales contracted for the first time since the 1990s. But … the fall could be closer to 10%....Beijing declared a 'war on pollution' five years ago... To that end, it has aggressively pursued the adoption of the electric cars and its stage-6 emission standards are regarded as the most stringent in the world. The central government ramped up its anti-pollution drive last year, urging local authorities to implement stage-6 standards ahead of time... The process to gain regulatory approval for car models can take six months to a year and vehicle testing agencies…do not have enough labs to meet the sudden surge in demand..."

In sum, a confluence of structural changes has taken the car-making industry by storm. With Germany hurt to the core, its government appears more open to stimulating growth. China's central bank has recently unveiled an interest-rate reform intended to reinvigorate its economy, and calls are growing louder for the Indian government to ease the car-industry crisis. Given collateral damage to U.S. growth, the Fed has also been forced to respond, even if in the name of mitigating headwinds from the trade war.

Europe: Bystander or Stakeholder, and the Stakes for Corporate America

Many question marks hang over the global capital markets, ranging from the next move of the Fed, to the next turn in the U.S.-Sino trade war, to specific, one-off events like Brexit. As a messy summer for the markets comes to a close, there are more questions on the horizon (uncertainty) than answers (clarity), portending more market volatility heading into the final stretch of the year.

Not helping matters is Europe, which we have long flagged as the weakest link in the global economy. True to form, Europe's growth prospects are fading along with summer, with Germany the epicenter of weakness. In all probability, the eurozone's largest trade-dependent economy is slipping into recession, a prospect that not only threatens to drag the rest of Europe down but also create more convulsions in bond markets around the world. The creeping realization that Germany is ailing has placed downward pressure on yields in Germany and around the world, including the United States, where 10-year Treasury yields, albeit briefly, fell below two-year yields on August 14 for the first time in over a decade. For what ails Germany, take a look at Exhibit 1, which outlines various metrics and Germany's relative rank. The picture isn't pretty; the country is vastly overdue for some fiscal pump-priming and structural reform.

Exhibit 1: Beyond the Cyclical Slowdown Are Structural Challenges for Germany to Address.

Information Communications Technology (ICT)

Germany Rank

Overall ICT adoption


Internet download speeds, fixed broadband


Internet download speeds, mobile


Fiber internet subscriptions (per capita)


Cellphone subscriptions (per capita)


Internet users (% of population)


Digital skills of population


Physical Infrastructure

Germany Rank

Overall infrastructure


Quality of roads


Reliability of water supply



Germany Rank

Trade tariffs


Complexity of tariffs


Non-tariff barriers


Services trade openness


Ease of Doing Business

Germany Rank

Overall ease of doing business score


Starting a business


Dealing with construction permits


Getting electricity


Registering property


Getting credit


Protecting minority investors


Paying taxes


Trading across borders


Enforcing contracts


Resolving insolvency



Germany Rank



Labor tax rate


Financial soundness of banks


Domestic credit to private sector


Flexibility of wage determination


Higher number in rank implies weaker global competitiveness. Sources: Speedtest Global Index (June 2019); World Economic Forum Global Competitiveness Report (2018); World Bank Ease of Doing Business (2019).

For U.S. investors fixated on the Fed and fearful of a U.S.-Sino trade war, the inconvenient truth is that Germany in particular and Europe in general matters to the rest of the world, notably the U.S. Whether global growth firms or softens in the next six to 12 months will hinge on Europe. More specifically, the global outlook depends on whether or not the Continent stops being a passive bystander and free-loader on the global stage and instead becomes a proactive stakeholder and standard bearer for global demand by pursuing more aggressive monetary and fiscal policies.

The odds favor more fiscal stimulus, which is constructive for global equities. With that as a backdrop, here are some of the finer (but largely overlooked or forgotten) points on why Europe matters to Corporate America.

  • Large economy. Home to a population of more than 500 million, the EU remains one of the largest economies in the world. In fact, the EU lags only the U.S. when it comes to gross domestic output, measured in nominal U.S. dollars. EU gross domestic product (GDP) in aggregate (including the U.K.) totaled $18.8 trillion in 2018, versus $20.5 trillion in the U.S. and $13.4 trillion in China.
  • Wealthy consumer base. Gaining access to wealthy consumers is among the primary reasons why U.S. firms invest overseas, which explains the continued attractiveness of affluent Europe to American companies. Sixteen of the 25 wealthiest nations in the world are European. GDP per capita in the EU ($36,500 in 2018) is significantly higher than that in China ($9,800) or India ($2,000).
  • Driver of global consumption. Wealth drives consumption, with the EU accounting for roughly 21% of global personal consumption expenditures in 2017. That's a slightly lower share than that of the U.S. but well above that of China (10%), India (3%) and Brazil, Russia, India and China (BRICs) combined (18%). Since 2000, personal consumption expenditures in the EU have almost doubled to reach $9.6 trillion by 2017, representing an increasing market opportunity for global corporations (Exhibit 2).

Exhibit 2: The Spending Power of the European Consumer.

  • Skilled workforce. Wealth in Europe is also correlated with a highly skilled and productive workforce, advanced innovation capabilities, and a world-class research and development (R&D) infrastructure—underpinning the attractiveness of the EU to Corporate America.
  • Europe has been attracting a larger share of U.S. foreign direct investment (FDI) flows. This runs counter to the narrative that multinational firms are increasingly looking to emerging markets for investment opportunities. Europe's share of U.S. investment has actually increased over the decades, from under 50% in the 1970s to almost 60% this decade. In other words, what happens in Europe now matters more than ever for the future of U.S. firms.
  • The total stock of U.S. FDI in Europe was $3.6 trillion as of 2018. That represents 61% of the total U.S. FDI stock abroad and is seven times the combined U.S. investment in Mexico and Canada.
  • Foreign affiliate sales. U.S. companies are bound to the European continent primarily through the activities of their foreign affiliates. In 2018, we estimate that sales delivered through U.S. majority owned affiliates in Europe were roughly $3.0 trillion, well in excess of U.S. exports to Europe ($684 billion). Europe represents almost 50% of U.S. foreign affiliate sales, far more than the 28% share for the AsiaPacific region, which is home to some five billion people.
  • Global R&D activities. The EU also is the number one destination for R&D activities of U.S. multinationals, reflecting U.S. corporations' increasing reliance on Europe as a collaborator for new technology and innovation, as well as a critical source of R&D funding.
  • Foreign affiliate income. U.S. affiliate income earned in Europe ($288 billion in 2018) was almost three times that of Latin America ($101 billion) or the entire Asia-Pacific region ($99 billion). While much attention has been given to the rise of the middle class consumer in China and associated market opportunities, the country remains a difficult place to do business. U.S. affiliates posted just $13 billion in earnings in China in 2018, down 3% from the prior year.
  • Business-friendly policies surrounding property rights, the ability to obtain credit, employment regulations, starting a business and cross-border trade have been a major draw for foreign investors over the years. According to the World Bank's 2019 Ease of Doing Business report, 14 European economies ranked in the top 25 most business-friendly nations. Other factors, such as shared values, respect for the rule of law, credible institutions, advanced infrastructure, a shared language (in some cases), and strong financial markets continue to set Europe apart when it comes to U.S. business investment.

The bottom line

Europe: Economic bystander or stakeholder? The answer is key to the future of global growth and earnings.

Slower growth and/or a recession in Europe is a significant risk to U.S. firms and, in turn, the U.S. economy. Other risks include the growing animosity between the U.S. and Europe and risks of a transatlantic trade war; rising political populism across the Continent; the U.K.'s planned departure from the EU and rising risks of a "hard Brexit;" an escalation of political risk in Italy, the EU's fourth largest economy; and structural challenges to the future of the EU, including the growing divide between the wealthy north and stagnant south on various issues from immigration policy to budget rules. Given the growing challenges facing Europe, more aggressive stimulus from both a fiscal and monetary policy perspective will be needed to limit the profits downside to U.S. firms.

No Honeymoon in Europe

In July, Ursula von der Leyen and Christine Lagarde were confirmed as presidents of the European Commission and the ECB, respectively. Amid a slowdown in global trade, which has hit the EU's economy disproportionally versus the U.S. and China, both are set to begin their mandates on November 1, the day after Prime Minister Boris Johnson has "vowed" to remove the U.K. from the EU. In effect, a honeymoon period is unlikely.

Lagarde's confirmation has been well received by investors in general. As the former head of the International Monetary Fund, she supported aggressive policy measures instituted by the current ECB president, Mario Draghi, implying a continuation of this approach. Her experience as a French finance minister from 2007 to 2011 is also seen as an asset, allowing her to grease the wheels of the EU's political machinery, ultimately inducing a sorely needed fiscal response from reticent national governments. However, some market observers worry that as a former politician and lawyer by trade, she may lead a more reactive central bank and lack Draghi's policy "creativity" in responding to another potential crisis situation.

Meanwhile, some investor's reactions toward von der Leyen's approval were more mixed. Her election did not follow the spitzenkandidat process of prior nominations, defined as the process whereby the European party is able to command a majority governing coalition automatically saw its lead candidate elected. Instead, it entailed a more opaque process blessed by German and French leaders, which did not sit well with EU members of parliament (MPs). The result: Her margin of victory was the narrowest ever received by a commission president since the 2008 Lisbon treaty came in force and depended on support from anti-establishment and nationalist MPs from Italy, Poland and Hungary. Some believe the result compromises her mandate, according to the Financial Times.

Our relative underweight in European equities rests on continued political uncertainty, a dynamic that persists despite these confirmations, in light of the continued array of economic and geopolitical challenges that face the EU.