Capital Market Outlook (August 5, 2019)

In This Issue

  • Macro Strategy—Recent fears that the record longevity of the U.S. economic expansion makes a recession more likely have caused many investors to move into cash and other defensive assets. A look at the factors that generally warn of impending recession suggests that these fears may be overblown. The main exception is Federal Reserve (Fed) policy, which remains restrictive by our time-tested gauges despite the first rate cut in over a decade.
  • Global Market View—Against the backdrop of an aging population, a positive prospect for the U.S. economy is the Millennial generation—the largest living adult generation on the cusp of their prime working and consumption years. Poised to reshape the growth and earnings dynamics of multiple sectors in the years ahead, a stark reality stands— it seems there is no alternative to the Millennials.
  • Thought of the Week—Against a backdrop of rising labor costs and increasing concerns over U.S.-China trade tensions, manufacturing companies have begun to diversify their supply chains away from China. Vietnam and other countries have benefited from these shifts, but certain constraints may limit them from fully taking China's place as "The World's Factory."
  • Portfolio Considerations—We remain overweight equities relative to fixed income and continue to emphasize the U.S. over the rest of the world. We also prefer shorter dated yields in fixed income, investment-grade credit relative to high yield, and we believe that the overall level of yields has bottomed in the short term.

Current Market Volatility

One hand gave (Fed rate cuts), while the other hand took away (new tariffs on Chinese goods), triggering down-side pressure and volatility across all asset classes last week. The trade truce between the U.S. and China came to an abrupt end with the August 1 communication from President Trump that the U.S. was planning a 10% tariff on some $300 billion of Chinese imports beginning September 1. The tariffs, if implemented, will target consumer goods for the first time, and has the possibility to open a whole new front on the U.S.-China trade war. One of China's policy responses was to allow the yuan to drop below CNY7.00 to the U.S. dollar for the first time in over a decade, a move that could precipitate more tit-for-tat currency devaluations and harden the negotiating positions of the two parties. The government has also ordered state-owned companies to suspend the importing of U.S. agricultural goods.

The near-term collateral damage from the spike in trade volatility could potentially include declining global sovereign yields; diminished inflation expectations; softening commodity prices; waning business confidence and investment levels; lower corporate guidance; and a general "risk-off" mentality among investors. Escalating U.S.-China trade tensions have been accompanied by sharp market selloffs in the past, followed by market resets/recoveries due to countercyclical forces (e.g., easy monetary policies) and a de-escalation of trade tensions as the negative effects become more apparent and painful to both parties. The more the market pain, the more the urgency to find an exit ramp— although each escalating round of trade tensions has seen eroding mutual trust and makes it more onerous to cobble together even a truce let alone a trade deal. Investors need to brace for episodic bouts of trade volatility but not lose sight of current favorable market fundamentals: better-than-expected U.S earnings; stronger-than-expected U.S. gross domestic product growth, led by the consumer; global central bank easing; productivity-led capital expenditures (capex) levels; and fairly priced U.S. equities.

Checking for Recession Warnings

In July, the U.S. economic expansion surpassed the record duration of 120 months set in the 1990s. This month, the expansion becomes 122 months old. Naturally, recent fears of recession have grown with the age of the expansion. Still, while the current expansion looks old in the context of two centuries of U.S. experience, it looks young compared to Australia's almost three-decade long current expansion, for example, as well as when judged by a number of other indicators, as discussed below.

Indeed, one has to examine the factors that cause recessions to ascertain whether it's sensible to expect one anytime soon. On this score, the factors that cause recessions can generally be divided into two categories: financial and economic imbalances that create excessive inflation and force the Fed to restrain economic growth to restore balance; and, alternatively, Fed policy mistakes that unduly hamper growth and cause recession through excessive monetary tightening. Looking across these dimensions, we find the greatest risk remains an unnecessary Fed restraint. There is little evidence in the economic indicators to suggest a recession caused by economic imbalances or inflationary pressures. There is, however, strong evidence that Fed policy is slowing down U.S. and global growth, raising the risks of recession and a deflationary relapse.

Signs of Imbalance Missing

Generally speaking, signs of imbalance often manifest in overheating that creates financial bubbles and/or inflationary pressures. On the first score of financial excesses, Fed Chairman Powell summarized the results of the Federal Open Market Committee's (FOMC's) latest quarterly update on financial stability at his July 31 press conference. The Fed sees few signs of financial excess across asset valuations and within balance sheets. Consumer balance sheets have recently been fortified, and debt-service ratios are currently the lowest in over three decades. The latest benchmark revisions to the national income accounts substantially boosted the savings rate and incomes of households, raising the prospects for continuing strength in consumer spending and helping to explain why confidence remains near 50-year highs.

Those same revisions did, however, reduce the financial health assessment of the nonfinancial corporate sector, which has offloaded a lot of its debt from banks to nonbank lenders. This is where the Fed has focused its attention for systemic problems given that banks, like consumers, have substantially deleveraged and are currently in the strongest financial shape in decades.

One reason there are few signs of inflationary overheating in the U.S. economy is the choppy and subdued nature of this expansion. In essence, there have been three global minicycles since 2009, when the expansion began. Each involved about two years of accelerating growth followed by a year of slowing before the next upswing. The excesses that normally accumulate over a cycle have been corrected in these minicycles, helping to prolong this cycle and postpone a recession.

Late-cycle problems often arise when economic growth becomes more and more dependent on borrowing. Exhibit 1 shows a normalized composite indicator of how much borrowing is funding the incremental unit of economic growth. As can be seen, just prior to the financial crisis in 2008 this leverage ratio reached more than 2.5 standard deviations above normal as housing and housing finance got deep into bubble territory. After deleveraging for an extended period after the crisis, borrowing has slowly returned closer to normal and fizzled out since the Fed began "normalizing" interest rates. Bottom line: leverage is in a midcycle position, not a late-cycle position, suggesting this expansion likely has plenty of room to run before financial overheating is a constraint.

Exhibit 1: Midcycle Levels of Leverage.

Sources: Federal Reserve Bank of Chicago/Haver Analytics. Data through July 29, 2019.

Other standard symptoms of overheating are missing as well. The capacity utilization rate, which typically surpasses 80% when the economy is running full speed and inflation pressures are building, rolled over well shy of that mark and has been declining as the manufacturing slowdown has gathered steam in recent months.

A low unemployment rate is another precursor to recession as a tight labor market forces higher wages, which in turn can raise inflation. Unlike previous cycles, however, higher wages have not translated into higher inflation this time around. Instead, higher productivity in recent quarters has allowed workers to enjoy higher wages with more purchasing power. In fact, the benchmark revisions to the national income accounts boosted 2018 real disposable income growth by more than a percentage point, helping to explain why real goods consumption grew at the fastest rate in 15 years in the first half of 2018.

All told, signs of inflationary overheating and financial imbalances are missing despite the currently strong labor market. Unfortunately, the Fed misinterpreted the implications of the tight labor market and overtightened policy over the course of 2015–2018, when the funds rate rose by 225 basis points. In recent testimony, Chairman Powell has acknowledged as much, admitting that the Fed misjudged the need for higher rates because it overestimated both the neutral rate of interest and the inflationary impact of low unemployment. The result is Fed policy went past neutral into restrictive territory. This, in our view, has created the biggest recessionary risk for the economy. Fortunately, the Fed has begun "a midcycle" adjustment to correct this policy mistake.

Fed the Big Unknown

With few signs of late-cycle excesses, inflation falling further below target and fading economic momentum, the recession question basically boils down to whether the Fed can end its restrictive policy before it's too late. The good news is weak inflation makes a tight policy unnecessary. The bad news is the Fed does not see policy as restrictive.

The Fed has acknowledged its framework for gauging policy is broken. In our view, the one indicator of policy that has stood the test of time is the yield-curve spread between the overnight federal funds rate and the 10-year Treasury note yield. When this spread is above normal, policy is typically more accommodative and helping growth to increase. Unfortunately, when the spread is lower than average, as it has been for the past year, the economy tends to slow down as monetary policy has moved into restrictive territory. When the spread is inverted, the risk of recession is generally high.

For example, the New York Federal Reserve Bank's recession probability model, which is based on the yield-curve spread, rose from less than 10% during the first nine years of this expansion to over 30% in July. Since 1959, this (rising above 30%) has happened eight times. In all but one case (1967) recessions occurred.

The Fed's ease of a quarter-point on July 31 was a step in the right direction. It still leaves the yield curve inverted, however. The longer this persists, the more likely a recession will occur. To restore a normal yield-curve slope assuming the 10-year yield remains around 2% would require about three or four quarter-point cuts. Alternatively, the 10-year yield could rise back to 3% if growth and inflation remain healthy with the current funds rate just over 2%, and the yield curve would normalize, signaling policy was back to neutral. Given spreading global disinflationary pressures and a still-strengthening dollar, risk management considerations suggest it would be a mistake for the Fed to bet on that outcome while global growth is slowing.

TINA and the Case for the Millennials

According to Wall Street speak, TINA (There is No Alternative) helps explain the underlying preference among investors for historically higher-yielding equities versus lower-yielding bonds. When it comes to market returns, it seems there are no real alternatives to equities.

The same relationship neatly describes the role of the U.S. consumer in driving U.S. economic growth—with consumer spending accounting for two-thirds of the economy, there is no alternative engine. The same TINA-like theme is evolving in U.S. demographics.

We've seen it before, demographically, as the post-war Baby Boomer generation propelled economic activity as they moved en masse into their prime working, earning and spending years. Now, with 10,000 65-year old birthdays a day, Baby Boomers are reaching retirement age in droves, passing the baton to younger generations. A dynamic that reaches an important inflection in 2019 but plays out for decades to come: the Millennials, numbering 73 million, are the largest living adult generation,2 and are on the cusp of their prime working years, household formation years, and heightened consumption years. All of this is a positive prospect for the U.S. economy and a stark reality—when it comes to future spending, it seems there is no alternative to the Millennials.

So, rather than assume the popular rhetoric that Millennials are anti-marriage, sharing economy-enthusiasts—including but not limited to--cars, clothing, living spaces, working spaces-- are synthetic meat-eating, bitcoin buffs--we take a look at three dynamics concerning the Millennials that matter to the markets and economy.

By the Numbers

Changes in economic fortunes around the globe can be due to demographics such as plunging birth rates across the rich world, net negative migration, Europe's fertility rate now comfortably below replacement level and the U.S. fertility rate recently hitting a new low.2 And while the working-age population (defined by the United Nations as all people aged 16 to 64) and total populations are shrinking in nations such as Japan, Germany and France, in contrast, the U.S. is expected to continue to grow—representing a huge tailwind to U.S. productivity and a comparatively brighter long-term outlook for the U.S. (Exhibit 2). The U.S. working-age population is set to expand with the gap further deviating in the coming decades as other G10 countries, on average, turn negative.

Exhibit 2: Prospective Future Work Forces.

G10 ex-U.S.: Belgium, Canada, France, Germany, Italy, Japan, Netherlands, Sweden, Switzerland, UK. Source: United Nations. Data as of 2018. UN projections out to 2040.

Forty nations now have shrinking working-age populations. In the late 1980s, the number was nine—think economic headwind as the number of elderly soar and the number of workers decline. While Millennials are currently 35% of the U.S. labor force today, by 2030 that percentage is expected to increase to 75% of the workforce.

Homebase Matters

Homeownership rates in the U.S. for young people are near their lowest levels in more than three decades, with about 40% of young adults (ages 25 to 34) distinguished as homeowners in 2018, according to federal data. That is down from about 48% in 2001, when the generation before them, Generation X, were young adults. Household formation tends to pick up noticeably in the 25-34 age range, so whether rented or owned, this cohort typically drives demand for shelter. Some estimates suggest that over a 10-year horizon, Millennials and Generation Z are expected to fuel a 7% increase in housing demand—unlikely to counterbalance the 43% increase in supply to the market from Baby Boomers returning existing stock.

Also trending higher, Millennials are moving back in with their parents and, with that, for longer stretches. In 2018, 15% of the older-aged Millennials (25-37 years old) were living in their parents' homes. That percentage is nearly double the share of Boomers and Silents and 6 percentage points higher than Generation X when they were the same age. Also generous, nearly 80% of parents give some financial support to their adult children, running a bill of $500 billion a year, which is twice the amount parents parked into a retirement account the same year.

Forever Young and Forever Indebted

To get the full picture of Millennials' financial well-being, debt levels accumulated by Millennials eclipse those of the previous generation with a different mix in the type of debt. According to the St. Louis Federal Reserve Bank, given their unique housing choices, mortgage debt is about 15% lower for Millennials and credit card debt was about two-thirds that of the generation before them (Generation X). Student debt, inescapable by a much broader age segment with over 44 million borrowers across age segments, burdens this generation most heavily. Although they are generally better-educated and have the diplomas to prove it, total student loan debt was over 300% greater than for the generation before them. Shown in Exhibit 3, all in, the youngest segment's debt totals around $1 trillion.

Exhibit 3: A Look at the Debt Mix Across Age Groups.

Totals are rounded for illustrative purposes. Source: Federal Reserve Bank of New York. Data as of May 16, 2019.

To top it off, Millennials are just now hitting stride—entering the key debt accumulation phase and expected to represent 70% of loan growth over the decade amounting to $600 billion.

Investment Implications

When considering what consumption will look like in the future, a key structural dynamic is this: Household consumption generally rises through the prime working years, peaking around 45–54 years old. From there, annual expenditures generally decline such that those over the age of 75 spend just slightly more than those under 25. Thus, the natural progress of consumption should accelerate as Millennials age into their prime working and spending years.

Given their potential effects on both productivity and growth, we view the demographic trends before the U.S. as a net positive for equities relative to the demographic fortunes of the rest of the world. Ultimately, the shift toward the Millennial generation in the labor force should support several tailwinds to growth and is supportive of our longer-term secular bull market stance.

We look to invest in consumption categories that benefit from demographic shifts such as the retiree spending cohort, as 36% of all healthcare spending is by the 65+ population, according to the U.S. Department of Health and Human Services, as the cost of healthcare rises with age. Conversely, spending on housing tends to decline with age, excluding the oldest age group representative of the cost of senior living facilities, assisted living and other costly elder care options.

The Millennials account for $1.8 trillion in income and represent a $1.3 trillion opportunity in annual consumer spending according to BofA Merrill Lynch (BofAML) Global Research, driving dramatic shifts in consumption patterns across the digital world with the rise of the sharing economy, which has already impacted housing, autos and apparel, to name a few categories. There are strong tailwinds for growth in a number of consumer-related sectors like e-commerce, travel and leisure, technology, fitness and cosmetics. In the end, Millennials are considered poised to reshape the growth and earnings dynamics of multiple sectors in the years ahead. For many companies, there will be no alternative to this massive cohort.

Shifting Gears: China to Vietnam

Against a backdrop of rising labor costs and increasing concerns over U.S.-China trade tensions, manufacturing companies, especially in industries like global electronics and apparel/ footwear, have begun to diversify their supply chains away from China. As this trend plays out, we believe key winners like Vietnam, Taiwan, Malaysia, Chile and India will likely emerge. Vietnam, in particular, in the last 12 months accounted for two-thirds of the growing trade deficit between Southeast Asian countries and the U.S., according to BofAML Global Research.

Why Vietnam? Its favorable demographics make it potentially attractive for labor-intensive exporters. Similar to China, 70% of Vietnam's population is of working age, but the country faces less of a risk of a rapidly declining population compared to China. Vietnam's existing strength in export industries such as phones, electronics and machinery also makes it competitive. Other benefits include proximity to China, excellence in assembly and low labor costs. Vietnam's production workers get paid an average of $216 a month, roughly half of China's rate. Given these advantages, Vietnam has become a center for supply chain shifts, more recently accelerated by U.S.-China trade tensions.

While these trends appear promising, Vietnam's recent increase in exports to the U.S. has coincided with a pickup in Chinese imports (Exhibit 4). This surge, therefore, may perhaps be boosted by transshipment, a loophole through which companies reroute goods to avoid tariffs. In reality, the country still has a long way to go before it challenges China's status as "The World's Factory." For starters, Vietnam exports make up only a tenth of China's $2.5 trillion level, and China's manufacturing capacity may be too large for Vietnam to absorb alone.13 Moreover, long-standing relationships between Chinese suppliers and U.S. businesses may be difficult to recreate. And Vietnam's infrastructure still needs substantial development, ranking significantly lower than China's in quality, according to the World Bank.

While a deal between the U.S. and China could ease trade uncertainty in the short term, supply chain shifts out of China may continue to happen as businesses reduce dependency on Chinese production. Vietnam could be a viable option, but it is not immune to trade tensions. Ultimately, multinationals may look to move production closer to the consumer with the help of automation.

Exhibit 4: Vietnam Has Benefited from U.S.-China Trade Tensions.

Sources: U.S. Census Bureau; China General Administration of Customs and Nomura. Data as of June 2019.