Capital Market Outlook (FEBRUARY 19, 2019)

In This Issue


Government debt and deficits are the topic of much discussion, often raising concerns about the economic consequences of too much deficit spending. Updates by the Congressional Budget Office (CBO) since the passing of the Tax Cut and Jobs Act in 2017 have raised the outlook for U.S. nominal gross domestic product (GDP) growth by $7 trillion over the coming decade substantially reducing projected deficits and raising tax revenues well above the levels estimated when the law was passed.


As growth slows in the eurozone and political populism gains traction across the continent, at risk are large-cap U.S. corporate earnings. Although cyclical reflationary policies seem to be falling into place that should limit the profits downside to U.S. firms, given the region's uninspiring growth record, we are warily watching Europe.


After a strong recovery in January, we expect global equities to consolidate for the time being. Further gains in the near term will likely be driven by slightly higher valuations as uncertainty around U.S./China trade levels off.


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 longer-term strategic allocations and higher-quality fixed income relative to high yield and emerging market debt.

The Fiscal Bogeyman

Fears of government deficits and debt have been a ubiquitous feature of the American political discourse since the days of the founding fathers. Indeed, the idea of a perpetual central government debt was a significant bone of contention between Alexander Hamilton, the first secretary of treasury, and Thomas Jefferson, the first secretary of state, that contributed to the creation of political parties and the bipartisan nature of the U.S. political system. Chronicles of the debates in the early days of the republic make it clear that the bitter animosities of today's political scene are nothing new.

Hamilton's views were heavily influenced by the British experience, which served as his model for a large marketable pool of government debt and a private central bank like the Bank of England, already a century old and established to help finance the government's wars with France. In his quest to build a strong central government, Hamilton recognized the importance of access to finance. He is regarded as the creator of the Federalist Party, which generally supported more centralized government power.

On the other side was the Jeffersonian Republican party, which was deeply suspicious of finance and government power, argued against a central bank like the Bank of England, and believed government debt was an evil to be avoided, if possible. The debate over a U.S. central bank continued until 1913, when the Federal Reserve System was finally established.

Without a central bank, and with a low tax base largely based on tariffs, government debt generally mushroomed only in wartime and languished afterward until the Great Depression and Second World War. The creation of entitlement programs, like Social Security, and massive defense expenditures in the 1940s solidified dependence on income taxes and heavy government borrowing. Since then, entitlements like health care and Social Security have been growing much faster than the overall economy, bringing debt and deficit concerns to the fore (Exhibit 1).

Interestingly, the only time the government debt seriously threatened economic stability was in the immediate aftermath of the Revolutionary War, when the institutions were still yet to be created to pay it back. Also, the "continentals" printed as money during the war generally became worthless. Aside from that experience, the U.S. has enjoyed the longest period of domestic monetary stability without hyperinflation of any major economy on the planet, well over two centuries. This relative monetary stability helps explain how the U.S. became the highest productivity economy in the world, as well as the wealthiest.

Exhibit 1: U.S. Debt and Deficits Were Highest During World War II.

While the U.S. success to date provides a solid base for continued growth in government debt, it is still important to ponder what the limits are before government debt might become unsustainable and create economic stagnation or high inflation. Certain considerations help in this sense. First, the size of government deficits and debt relative to the size of the economy reached their highest levels of the past 120 years during World War II. Deficits more than six times as big as the deficits of recent years (25% of GDP compared to 4%) were routine during World War II. By the end of the war, the cumulative debt was over 100% of GDP. The Federal Reserve (the Fed) purchased the debt as needed to keep interest rates at very low levels. These actions illustrate how government debt, central banks and the money supply are intertwined just as they were back in Alexander Hamilton's day. Hamilton understood these relations and wanted a modern financial apparatus to help finance the newly evolving merchant and industrial economy in the early days of the republic. In contrast, Jefferson's and Madison's views were rooted more in the rural, agrarian culture they favored. There was also a creditor-debtor tension in their competing views.

In any event, the mechanics of interaction between a changing supply of government debt, central-bank policy and the balance of payments between the U.S. and the rest of the world helps to understand when there might be too much debt and why we have not really seen any symptoms of a serious debt problem since the Revolutionary War. Importantly, U.S. government debt forms the basis for the U.S. money supply. The Fed buys Treasury securities when it wants to expand the money supply. Over the course of the past 70 years, aside from the recent period of quantitative easing (QE), the normal growth in this central-bank demand for government debt has been around 6% a year, roughly in line with the growth rate in the cash flows through the economy and nominal GDP. This implies that once the Fed normalizes its balance sheet, the natural growth in Treasury debt demand for money-supply purposes is expected to be in the $120 to $180 billion range. Let's call it about $150 billion of new debt demand each year for the Fed's balance sheet. This is "monetized" debt that is never paid off and is essentially interest-free since the Fed refunds most of the interest payments to the Treasury.

Assuming nominal GDP growth of about 5% to 6% per year and a fixed ratio of government debt to GDP over time implies a fiscal deficit of 5% or 6% of GDP in addition to the Fed's monetary requirement. Since the level of nominal GDP is roughly equal to the level of government debt outstanding, just over $20 trillion, 5% of GDP is about $1 trillion. A deficit of $1 trillion plus the monetary-base requirement of about $150 billion implies that a deficit of $1,150 billion would keep the ratio of outstanding non-Fed-held government debt to GDP constant around current levels, which currently show no signs of strain on the economy. Furthermore, CBO projections for the fiscal deficit for the next ten years are mostly well below 5% of GDP.

Finally, the level of interest rates also influences the sustainability of government debt, as we often see in emerging markets. Rates far higher than GDP growth are usually a sign of serious debt problems. Fortunately, U.S. rates are usually in the ballpark of nominal GDP growth, and in recent decades have been even lower, allowing for higher levels of sustainable debt.

Another aspect for gauging the sustainable level of government debt is who owns it, domestic or foreign investors. People often express concern, for example, that large Chinese or Japanese holdings of Treasury securities make the U.S. vulnerable to sudden selling by these foreign holders. Like concern about the size of the debt, concern about foreign holding falls in the class of chronic worries that never turn into real world problems. Several factors explain why.

First, the flipside of the U.S. trade-deficit fueled outflow of dollars is foreign use of those dollars to invest in the U.S. The premier reserve currency status of the U.S. dollar causes external demand for greenbacks to grow several percentage points a year, matching the size of the trade imbalance. This demand for dollars from foreign countries and investors helps explain why the U.S. can run trade deficits on a perpetual basis without ever facing a day of reckoning. In total, foreigners have accumulated about $3 trillion more of assets in the U.S. than

U.S. investors have accrued abroad. That is, the U.S. balance sheet with the rest of the world is insolvent to the tune of just over $3 trillion. However, like other exaggerations of impending debt problems, this factor is often hyped in scary stories about the U.S. being the world's biggest debtor.

What these stories never mention is the astounding fact that the income flows from U.S. assets held abroad exceed the income flows from the U.S. to foreign investors despite their larger holdings.1 This phenomenon highlights a major reason why the big U.S. deficits and debt don't cause the kind of negative consequences alarmists are constantly warning about: A substantial share of foreign investment in the U.S. takes the form of U.S. Treasury holdings.

As mentioned above, the U.S. economy has the longest, most stable economic, political and monetary track record of any major economy in the world. As a result, foreign investors living in less stable environments seek U.S. Treasuries as a lower-risk investment compared to those in their own countries, where there is often a history of less political and monetary stability. Thus, foreign investors generally buy more low-yielding, higher-quality investments, while U.S. investors tend to go abroad for higher yielding, riskier investments. The higher yield on a smaller amount of riskier investments abroad typically generates more income for U.S. investors than the larger amount of lower yielding U.S. assets held by foreigners.

Part of the U.S. "exorbitant privilege" is a positive net-income flow despite its net-debtor status. The U.S. essentially gets paid to be the world's largest debtor nation.

In addition, U.S. Treasury debt is issued in dollars, and the U.S. central bank can print as many dollars as it needs to balance economic forces like interest rates and inflation. Other countries, as we saw in Turkey and Argentina in 2018, for example, often borrow dollars but don't enjoy the "exorbitant privilege" of being able to print greenbacks to pay back their debt. As a result, they sometimes don't have enough dollars to repay their debt, precipitating financial crises.

Putting it all together, the U.S. has avoided the negative consequences of excessive government borrowing for some basic fundamental reasons. The growth of government debt has largely been within the parameters set by the size and growth rate of the economy that generates the tax revenues to finance the government. In addition, the U.S. enjoys wider latitude to borrow beyond the limits constraining most other countries. Thanks to its more stable monetary history and premier reserve currency status, there is a substantial external demand for U.S. government debt that adds to the fiscal capacity of our economy. Comparing the limits set by these factors with CBO projections for future fiscal deficits suggests the U.S. government will be able to finance future deficits without the severe side effects seen in many other countries with big deficits.

The Drivers of Future Stock Returns

Global equities have enjoyed a nice bounce off the lows in late December. Whereas the latter part of 2018 saw risk after risk being piled on, finally breaking investor sentiment, in January investors were comforted by the Fed pivoting to a more dovish stance than they had earlier indicated. The most oversold segments of the market, such as small caps and cyclicals sectors like energy and industrials, have led the recovery this year as fears of a U.S. recession have partially receded. With the S&P 500 higher by 10% for the year but still 6% below the highs in September, the likely trajectory for equities is one of consolidation while waiting for confirmation that the business and profit cycle has legs.

The Yin and Yang of Profits And Multiples

Corporate profits are expected to be less supportive for the markets in the near term, if consensus numbers are to be believed. For the S&P 500, profit forecasts for Q1 have been steadily cut, with analysts now expecting a decline of 2% year over year (YoY), which if it comes to pass would be the first YoY decline since Q2 2016. For 2019, the consensus forecast for earnings implied a YoY growth rate of just 5%, down from roughly 10% on September 30 (Exhibit 2).

Exhibit 2: S&P 500: Sales and Earnings Estimates for 2019.

The primary culprit for these downgrades is that analysts are yet to be convinced that growth is on a stable track, especially outside the U.S. While China's slowdown in its manufacturing sector and consumer spending is being cautiously watched, the European Commission reduced the region's growth estimates last week to 1.3% for this year from their prior forecast of 1.9%, with sizeable cuts for larger member states like Germany and Italy. This economic uncertainty is filtering through to lower profit expectations for international stocks, with analysts now cutting their European earnings per share (EPS) growth estimate from 10% in October to 7%.

Meanwhile, valuations for U.S. equities, which had cratered to less than 14x in December on a forward price to earnings (PE) basis, have recovered to 16x, in line with their historic average. For global equities, the forward PE has also risen from 12.4x to 14x. This recent recovery in stock prices and valuation multiples can be attributed to more dovish central banks and lower bond yields globally. Given the headwinds from earnings, for the markets to move higher, valuations may need to continue to do the heavy lifting, at least in the near term.

Near Term: Stock Returns Contingent on Multiple Expansion

The escalating trade war between the U.S. and China has had a larger than originally anticipated impact on the global economy. Trade, industrial data, business sentiment and spending, and lately consumer confidence have progressively deteriorated as the White House imposed tariffs on Chinese imports. We are cautiously optimistic on the prospect for a deal or at least a ceasefire with promise to keep negotiating, as both President Trump and President Xi are likely averse to further damage to the economy and asset prices. The market is beginning to sniff out some good news as well, as evidenced by the 13% bounce in Chinese stocks this year and the near 3% rise in its currency since the end of November, according to Bloomberg.

To be sure, a deal can mean everything or nothing when it comes to the substance of what is agreed upon. The most likely outcome in our view is that China agrees to lower tariffs on key American exports such as cars and agricultural products first while thornier issues like intellectual property protection and forced technology transfer are likely to be moved to an extended timeline for further discussions.

With global central banks again standing on the side of the markets, a scenario of renewed trade growth should create the space for multiples to expand. In the near term, emerging markets are likely to see the biggest potential benefit from this as may stocks in Europe, where countries are more dependent on global trade and where we have seen persistent weakness in export data from Germany, as an example.

Medium Term: The Fog Needs to Clear on The Economy And Profits

It is interesting to note that earnings growth forecasts for the S&P 500 for the first three quarters of this year are now below the corresponding revenue growth estimates. This negative growth gap between earnings and revenues is unusual in an economic expansion and suggests that analysts may have over-corrected earnings estimates and believe that margins may drop.

Given this low bar for earnings, for the next three quarters, we think positive surprises are more likely now. This could bring some support for equities, but for a sustained rally, investors will need confirmation that the economic expansion and profit cycle is durable at least through early 2020. The Fed remaining patient and positive developments on the U.S./China trade relationship are prerequisites for this to happen, and still remain our base case. Overall, we expect S&P 500 earnings to grow 5% in 2019, supported by top line growth, moderating unit labor costs and share buybacks. However, given that almost 40% of S&P 500 revenues are outside the U.S., the possibility of a recession in Europe and further material weakness in China are key risks to our estimates.

Emerging market equities have been outperforming global equities since last fall, but in the medium term their fortunes will depend on how effective China's monetary and fiscal accommodation are in keeping GDP growth above the 6% levels. Meanwhile, a sustainable rally in European equities will only come when growth metrics revive in major economies like Germany, in our view. Improving trade will help, but significant expansion of fiscal stimulus across the region may be needed to begin to stop the downward spiral. This may seem impossible given that Brussels has just forced Italy to adhere to strict budgetary limits, but there are early signs that some countries are either itching to or beginning to loosen the fiscal purse strings. For example, in Germany, Annegret Kramp-Karrenbauer, Angela Merkel's successor as the new leader of the party has called for tax cuts to head off the economic slowdown.

Exhibit 3: Future Drivers of Stock Returns.

Global Equities

Near Team (3–6 months) Valuation expected drivers

Medium Term (6–12 months) Growth and profit expected drivers


US-China trade outcome (=)

Dovish central banks (+)

Washington budget standoff (-)

Global trade revives (-)

Consumer spending (+)

Manufacturing improves (-)

Business confidence & capex (=)

Productivity and labor force participation rises to keep inflation tame (+)


Brexit (-)

US-China trade outcome (=)

Political risk – France, Parliamentary elections (-)

Dovish central banks (+)

Global trade revives (-)

Germany, Italy, France economic activity stabilizes (-)

Fiscal stimulus (+)

Easing of political risk (-)

Emerging Markets

US-China trade outcome (=)

Dovish central banks (+)

Dollar weakness (+)

China manages to keep growth above 6% i.e. no hard landing (=)

Global trade revives (-)

U.S. dollar weakens (+)


After a strong recovery in January, we expect global equities to consolidate for the time being. Further gains in the near term will likely be driven by slightly higher valuations as uncertainty around U.S./China trade levels off. Thereafter, a sustained rally in the medium term will depend on improving economic activity and stabilization of profit growth.

We recommend investors consider remaining within their strategic asset allocations. We believe this is not the environment to be too aggressive given the cloudy backdrop for growth and profits, or too defensive given the newfound dovish stance by the major central banks. A slight pro-risk tilt in our view is appropriate favoring the U.S. and emerging market equities, which are more likely to sustain further upside if the U.S. economy can grow in the 2% to 2.5% levels, and Chinese growth stabilizes, which is our base case. It is too early to get optimistic on European equities, until signs of growth stabilization come through, likely as a result of fiscal stimulus and structural reforms.

Warily Watching Europe

U.S.-China trade tensions have become increasingly problematic for U.S. corporations, but a larger threat to U.S. earnings could be building across the Atlantic.

We are warily watching Europe because:

  • No commercial artery in the world is as large as the investment artery forged between the United States and Europe. Total transatlantic foreign affiliate sales were estimated at $5.5 trillion in 2017, easily ranking as the top artery in the world (Exhibit 4).
  • According to the latest figures from the Bureau of Economic Analysis, U.S. foreign assets in Europe totaled $15.6 trillion in 2016, representing roughly 62% of the global total.
  • U.S. majority-owned foreign affiliate sales on a global basis (goods and services) totaled an estimated $6.2 trillion in 2017, according to our estimates, with U.S. foreign affiliate sales in Europe accounting for roughly half of the global total. Sales of U.S. affiliates in Europe were roughly 75% larger than the comparable figures for the entire Asian region.
  • In 2017, U.S. affiliate income in Europe rose to a record $265 billion, and by another 6% in 2018 by our estimate, to a record $281 billion. Putting that number into perspective, U.S. affiliate income in Europe—$211 billion in the first nine months of 2018—was about three times more than the affiliate income of Latin America ($71 billion) and Asia ($69 billion), respectively. U.S. income in Europe accounts for 55% of the global total.

Exhibit 4: America's Major Commercial Arteries.

Europe matters, in other words. As growth slows in the eurozone, as the U.K. bumbles towards Brexit, and political populism gains traction across the continent, at risk are large-cap U.S. corporate earnings. The good news: the European Central Bank (ECB) is on hold; and fiscal austerity has given way to spending across most of Europe. Although cyclical reflationary policies seem to be falling into place that should limit the profits downside to U.S. firms. That said, however, given the region's uninspiring growth record, we are warily watching Europe.