Capital Market Outlook (FEBRUARY 11, 2019)

In This Issue

MACRO STRATEGY

The robust January employment report surprised forecasters with a big increase in the labor force participation rate (LFPR) in response to increased supply-side incentives from lower tax rates and deregulation. Despite accelerating wage growth, inflation remains subdued, forcing the Federal Open Market Committee (FOMC) to halt its aggressive tightening campaign.

THOUGHT OF THE WEEK

Despite a lowered bar for fourth-quarter earnings estimates for the S&P 500, companies have struggled to clear it. However, investors have generally signaled relief. Bolstering optimism has been commentary from health care and consumer firms with operations in China, which have noted resilience, suggesting strength in the country's emerging new economic growth drivers.

GLOBAL MARKET VIEW

Emerging markets (EM) are leading the rally in global equities this year, having troughed ahead of the U.S., Europe and Japan in late October. Several factors have made conditions more favorable over the past few months, and a breakthrough in the U.S.-China trade dispute over the coming weeks would likely give further support to emerging equity valuations, particularly in the Asia-Pacific region.

PORTFOLIO CONSIDERATIONS

We continue to emphasize a higher-quality portfolio positioning overall; in terms of asset allocation this is represented by higher U.S. and large capitalization exposure than our strategic allocations, and higher-quality fixed income relative to high yield and emerging market debt.

Fed Gives Growth A Chance

The FOMC has acknowledged the need for a pause in its tightening campaign given waning momentum in U.S. and global growth and inflation indicators, high financial-market volatility and elevated economic policy uncertainty. The restraining effect of its cumulative rate hikes to date has become increasingly clear and is likely to continue to reverberate throughout the U.S. and global economy, as is typical following a sharp flattening of the yield curve. The economic slowdown appears particularly pronounced overseas. Recent data show a sharp deceleration in global trade volume growth through the end of 2018 and broad-based declines in manufacturing surveys abroad through January, consistent with further softening in global industrial production in the first half. With growth-inhibiting economic policies and political disarray, the euro bloc is again flirting with recession. Weakening leading indicators of growth suggest no improvement in its downward growth momentum this year, making the International Monetary Fund's 1.6% real gross domestic product (GDP) growth forecast for the eurozone this year appear too high. This suggests that its small recent revision to 2019 global growth from 3.7% to 3.5% (the average since 1980) may also prove optimistic.

Its forecast for 2.5% U.S. GDP growth this year appears more realistic. We believe that, while on a decelerating path, U.S. growth is likely to remain a bright spot despite meaningful restraint from the Federal Reserve (Fed) and headwinds coming from overseas. Aside from strong fundamentals and a softening dollar, still-stimulative effects from government spending and tax cuts into 2020 should also help the economy weather the shock from the excessive Fed tightening to date, extending the expansion into its tenth year. Recent data have been mixed, supporting this view. For example, the Conference Board Leading Economic Index significantly declined in the fourth quarter of 2018, pointing to slowing growth in the first half; consumer expectations for January dropped sharply, signaling moderating consumer spending; and housing-related data have remained soft. On the other hand, credit growth is accelerating, employment has continued to surprise to the upside, and leading indicators of employment (Exhibit 1) and wage growth are still robust, while inflation remains subdued. In sharp contrast, with more deterioration in manufacturing surveys overseas, the U.S. Institute for Supply Management (ISM) index regained strength in January, with a jump back into strong growth territory for new orders and production particularly encouraging for the outlook and supporting our view of a softer and quicker downside adjustment in manufacturing activity compared to the previous two ISM minicycles of this expansion (2011–2012 and 2014–2016).

Exhibit 1: Employment Growth Likely to Remain Strong This Year.

In this context, labor demand should remain strong but likely moderate somewhat as the year progresses as a result of slower growth as well as diminishing labor-market slack. Indeed, worries about sufficient available labor remain front and center, and have played an important role in the Fed's decision to tighten as much as it has to date.

The length of the expansion remains critically dependent on attracting more labor from the sidelines. So far, the increase in the LFPR has allowed a robust pickup in GDP growth and employment even as the population continues to age and to grow at a slowing pace. As we had expected, a growing economy, tightening labor market, rising real wages, and tax cuts have reached a critical mass to meaningfully boost participation rates, especially for the prime-age 25 to 54 year-old cohort (Exhibit 2). As a result, the prime-age female participation rate has surged over the past year to a decade high in January. Over the past three years, it has retraced 75% of about a four-point drop from its 2000 peak. This strong performance shows that work incentives matter and boosts the probability of additional gains in male participation as well. While up substantially in January, the participation rate for men 25 to 54 has lagged during this expansion: It has recuperated just about half of its decline from pre-recession levels. We believe closing that gap would allow the economy to keep creating about 200,000 jobs per month through the end of 2020 with the unemployment rate staying around 3.8%. At current participation rates for these cohorts, it would take only about 165,000 jobs per month on average to bring down the unemployment rate to 3.5% by the end of 2020.

Exhibit 2: Led By Women, The LFPR For The Prime-age 24 to 54 Cohort Has Rebounded Significantly Over The Past Two Years.

We continue to believe that there's still meaningful room to boost employment without as big a drop in the unemployment rate as feared by those, including the Fed, who have perceived declining unemployment as a risk to growth due to its presumed impact on inflation (i.e., the Philips curve theory linking low unemployment to high inflation). That said, even if the participation rate for 24 to 54 year old males returns to its 1990s level, the overall participation rate would not likely increase much above 63.5% because of the aging population. While baby boomers are likely to work longer than their parents did, continuing to boost the participation rate of the elderly, their aging is having a large downward effect on the LFPR because people over 65 have much lower participation compared to that of the 55 to 64 and 25 to 54 cohorts: 20% versus 65% and 82%, respectively. This is the main reason why the overall LFPR has declined from 66% to 63.2% over the past decade. With participation for 16 to 24 year olds close to a 50 year low level and unlikely to increase much because of extended education and changing social norms, downside pressure on the overall participation rate should persist, increasing the need to boost productivity to keep economic growth at a healthy pace.

Fortunately, the rising wage pressure to date has been accompanied by faster productivity growth, suppressing upward pressure on inflation. Supply-side reforms seem to be working to boost real wages without the inflationary effects the Fed was expecting. What's more, productivity has substantially more room to accelerate from its "secular-stagnation" lowpoint. In our view, the anemic, stop-go pattern of economic growth during the earlier years of this expansion has played a large role in keeping productivity from reaching potential as labor has been constantly underused in the absence of sustained strong growth. Potential for productivity to increase more as well as for prime-age male participation to recuperate more of its declines of the past twenty years suggest the economy has not reached its limits to growth yet. Subdued recent inflation with low unemployment and still-strong jobs growth are the proof in the pudding. So we salute the Fed's new policy of giving growth a chance.

Emerging Markets' Strong Start to The Year and Potential Upside for Emerging Asia

Emerging markets are leading the rally in global equities this year, having troughed ahead of the U.S., Europe and Japan in late October. Several factors have made conditions more favorable over the past few months, and a breakthrough in the U.S.-China trade dispute over the coming weeks would likely give further support to emerging equity valuations, particularly in the Asia-Pacific region.

So what has changed over recent months? Moderation in the trade-weighted dollar from its December peak has reduced the burden of foreign currency debt for EM corporate and government borrowers. The recent fall in oil prices has improved current accounts for net oil importers, which are now close to 90% of EM equity market capitalization. And perhaps most important has been the shift in expectations for Fed interest rate hikes. Credit spreads in both sovereign and corporate EM debt had continued to widen even after the October equity market bottom. But both have narrowed sharply since the day the Fed indicated that it would be listening to markets, and equities have delivered most of their positive return from the recent lows since this point. Deficit countries that come under the most pressure when rates rise, such as Turkey, South Africa, Pakistan and Argentina, were by far the worst performers of last year according to Bloomberg but have been among the top performers of 2019 so far on expectations for a Fed pause.

The sum total has been a marked improvement in investor appetite for EM assets. October was the last month of net portfolio outflows from the aggregate EM capital account, and total net inflows on a three-month average basis have since risen back to late-2017 levels at close to $30 billion in January. Similar episodes of investor retrenchment during the current cycle have been followed by 1- to 2-year periods of sustained recovery in capital inflows (Exhibit 3).

Exhibit 3: Investor Flows Into Emerging Markets Recovering From Weakness of 2018.

Next to the deficit countries, the second-worst performing group last year were the north Asian markets at the center of the U.S.-China trade conflict, particularly China itself and Korea. As we have shown in the past (see Capital Market Outlook 7.2.2018: Trade Fears Resurface – Is Emerging Asia at Risk?), Korea and Taiwan are the most exposed to China's technology-related exports to the U.S., but the size of their direct economic exposure is relatively low at just 1% to 2% of GDP. There will however be a broader impact on the north Asia region from other sources as a result of the rising trade frictions. Equity market exposure to the technology sector is much larger, particularly for Korea and Taiwan, where information technology hardware-producing industries respectively account for 40% and 58% of market capitalization. Company reports from manufacturers operating in China state that uncertainty over the future tariff regime has dampened their capital expenditure plans. And global multinational exporters have also identified tariffs as a major reason for recent moves to relocate production capacity away from China.

This last trend was, however, already underway before the change of U.S. administration and increase in concern over protectionism. Trade and investment patterns over the course of the current cycle had already shown a downward shift in foreign direct investment (FDI) into China, due in part to rising labor costs and tightening environmental standards. Between 2010 and 2016, net inward FDI for China fell from $244 billion to $175 billion, while the share of U.S. manufacturing imports produced in China slipped from 28.7% to 27.9%. The trade dispute is likely to reinforce this shift, especially if the widely-expected Trump-Xi resolution over the coming weeks leaves room for frictions to re-emerge in future years.

But among the economies that could benefit most from any further supply chain relocation from mainland China will nonetheless be others within the emerging world. Global manufacturers have highlighted a range of markets as preferred destinations, including the lower-income fast-growers in Asia of Vietnam, Philippines, India and Indonesia; middle-income Mexico; and, owing to their well-developed infrastructure and established links to existing Chinese supply chains, even the higher-income north Asian markets of Japan, Taiwan and Korea. Indeed over recent years, non-China emerging Asia and Mexico have seen a rise in both net inward FDI and the share of U.S. manufacturing imports for which they account, even as both measures have declined in China (Exhibit 4).

Exhibit 4: FDI And Manufacturing Exports For China And Other Major Emerging Economies.

Industrial activity in manufacturing, construction and infrastructure was the biggest driver of China's double-digit growth in the pre-crisis cycle, and it has been the biggest contributor to the growth slowdown in China since 2010 (Exhibit 5). This is a trend that is expected to persist over the coming years. Aside from any tariff-related weakness in mainland capital expenditure, China's mature transportation, power and communications networks and built-up stock of commercial and residential real estate mean that investment can no longer be the main driver of economic activity. Indeed the central government is actively restricting funding for property developers and local government infrastructure projects in order to prevent over-investment and to slow the pace of debt growth. This in our view will mean further deceleration in economic activity over the near term, but crucially a more sustainable level of investment that prevents a hard landing in the future. As for trade itself, this was a negative contributor to China's growth in 2018, but has in any case become a minor portion of the overall growth mix.

Exhibit 5: China Real Economic Output Growth By Major Component.

The most important component of Chinese activity today is final consumption of goods and services, which was responsible for 76% of total growth in China last year (up from 45% in 2010). As well as lower investment, higher consumption is also typical for maturing economies with rising levels of per capita income, and this is a further shift for China that we believe should be beneficial for other markets within emerging Asia over the coming years. China remains a net goods exporter to the main emerging economies in southeast Asia (Indonesia, Malaysia, Thailand, Philippines and Vietnam) and India as a group, but its surplus with these countries has begun to turn down over the past few years as consumption and imports have risen. Alongside the nascent shift in manufacturing output capacity into the rest of emerging Asia, a China that is led increasingly by consumption from a larger nominal base should help to sustain improvement in the trade balance and boost potential growth for the rest of the region. And the fourth-quarter policy stimulus from Beijing designed to promote spending (including cuts to personal income taxes and incentives for firms to retain workers) should help provide additional support in the nearer term.

The biggest near-term boost for the regional Asian equity market and therefore EM overall would of course be a U.S.-China deal ahead of the March deadline. Asia has become the dominant region in terms of size within the emerging market equity index, and the 25% of market capitalization held outside the region across 15 countries in Latin America, Europe, Africa and the Middle East is now very much the tail of the asset class. China and Korea, which alone account for 45% of total EM equity market capitalization, were two of the worst-performing markets in 2018 but have so far been among the best performers in all of Asia this year. And with both still below their average multiples across price-to-earnings and price-to-book ratios over the 10-years back to the start of the cycle, the Asia region and the emerging markets index should have room to move higher.

Mid-Season Snapshot: Earnings Struggle to Clear A Lowered Bar

On aggregate, during the S&P 500's tumble from October to December last year, analysts were cutting fourth-quarter earnings forecasts at a rate not seen in more than a yeari. According to FactSet Research Systems, the estimated median earnings-per-share (EPS) for the index shrank nearly 4%, dragging the expected year-over-year (YoY) growth rate from 17.1% to 12.6% by year-end. The bar for companies to beat had been lowered.

Fast forward to the week ending February 1, generally marking the midway point of the fourth-quarter earnings season, with 66% of S&P 500 companies having announced results. According to BofA Merrill Lynch (BofAML) Global Research, implied YoY growth of the consensus median EPS estimate stood at 12.1%, just below year-end expectations and a downshift from third-quarter growth of 28.0% (see Exhibit 6). Beneath the topline result, health care, industrials, and tech companies surpassed estimates on aggregate. Meanwhile sales, also slightly underperforming expectations set at the beginning of the year, were on pace to grow 5.5% YoY.

Exhibit 6: After A Torrid Few Quarters, S&P 500 Earnings Growth Is Expected To Slow, Ending 2018.

Despite struggling to clear a lowered bar, investors have generally signaled relief by the results. Companies that beat estimates generally outperformed the broader index by 2.5 percentage points (ppts) the next day according to BofAML Global Research, which if sustained would mark the biggest reward since the third quarter of 2015. Meanwhile, companies that missed were generally penalized less, lagging by 1.6ppts, versus an average 2.4ppts ding. A factor behind the relief may have been commentary from companies exposed to China, which didn't appear to be all bad. While reports from tech, industrials, and materials firms were generally lackluster, those in the health care and consumer sectors reported resilience, an encouraging sign suggesting China's continued structural economic transition to new-growth drivers of services and consumption remains on track.