Capital Market Outlook (FEBRUARY 4, 2019)

In This Issue

MACRO STRATEGY

We believe 2019 should see no shortage of market-moving events, amid U.S.-China trade negotiations, Fed meetings, debt ceiling debates, and deliberations over Brexit. Below we outline a few catalysts for investors to monitor in upcoming months.

THOUGHT OF THE WEEK

Top of mind among investors is the deteriorating fiscal position of the U.S. government, with a recent report from the Congressional Budget Office (CBO) not offering investors much solace about the fiscal future of America, making portfolio risk management all the more critical in the years ahead.

GLOBAL MARKET VIEW

Fiber may be the future, but fiber optic connectivity in the

U.S. is in its infancy and we are a pygmy relative to Japan, South Korea and China. That said, however, investors should consider gradually building out positions in and around leading fiber optic players/networks. With or without the U.S., the fiber revolution is coming.

PORTFOLIO CONSIDERATIONS

We are maintaining our overall equity allocation across all risk profiles. However, we are lowering our non-U.S. developed equity allocation and adding to U.S. largecap equities. We maintain our risk exposure in emerging market equities.

Four Upcoming Market Catalysts

Following a sanguine 2017, concerns last year ranging from Federal Reserve (Fed) actions to trade disputes, to slowing growth and geopolitical tensions contributed to higher volatility across financial markets. We believe 2019 should see no shortage of market-moving events either, amid U.S.-China trade negotiations, Fed meetings, debt ceiling debates, and deliberations over Brexit. Here we outline a few catalysts for investors to monitor in upcoming months.

I. China Tariff Deadline: March 1

Following the G20, markets were granted some relief as the U.S. and China agreed to a temporary truce and 90-day negotiation period on trade. And with the 2020 presidential election and the 100-year anniversary of the Chinese Communist Party approaching, we remain cautiously optimistic on the potential for an interim deal. As China's economy slows down, investors have received assurances from officials that they are dedicated to supporting growth via infrastructure investment and tax cuts, in addition to significant monetary easing from the People's Bank of China. We believe agreeing to a deal with the U.S. would further support an economy facing clear structural headwinds. Domestically, softness in manufacturing data and weakening company guidance for earnings and capital spending seem to have created an impetus for cooperation as well. For instance, the December Institute for Supply Management report included commentary from companies across the technology, transportation and machinery industries outlining the tariffs' negative impacts on their businesses.

It can't be overstated that China is a crucial market for the U.S.; a major holder of U.S. government debt ($1.1T), market for U.S. multinationals ($13.4B of income for U.S. affiliates in China in 2017), and trading partner (Exhibit 1). Negotiators must parse a number of key issues, including intellectual property theft and unfair advantages for state-owned enterprises, with key officials underscoring the progress that is yet to be made and emphasizing that their ultimate priorities are structural reforms rather than short-term concessions. If a meaningful deal is struck, we expect a boost to global growth and business sentiment, improved visibility on earnings, and a softer dollar—a clear risk-on for equities, with emerging markets as the main beneficiary. But if not, the U.S. plans to raise tariffs on $200B of Chinese goods to 25%, signaling a bumpier path ahead.

Exhibit 1: U.S. Trade Deficit in Goods by Country.

Ii. Fed Meetings: March 19–20

Against a backdrop of slowing growth in the U.S., over-tightening by the Fed is one of the most prominent risks to our otherwise positive economic outlook. The Fed was a major catalyst of the fourth quarter market sell-off, as inflation data and the yield curve signaled that policy was tightening too quickly, leading to concern of a sharp economic downturn in 2019. But after more dovish language in the December minutes and commentary from key Fed officials, investors got some assurance that the Fed was attuned to these signals from the market, which contributed to the rebound in equities and inflation expectations.

Investors will be watching closely for guidance regarding the path for future rate hikes and balance sheet roll-off. Signals from the Fed of a more gradual tightening pace would assuage concerns on the outlook for the economy and markets, improving risk sentiment, steepening the yield curve and softening the dollar. Domestically, lower rates would also support business spending and provide some relief to rate sensitive sectors like housing, which remains near the lower end of its historical range as a percent of gross domestic product (GDP). But if not, expect to see renewed weakness in equities, tighter credit conditions, a potential yield curve inversion, and continued deterioration in economic data. The Fed took a meaningful step in the right direction at their January meeting, emphasizing patience and flexibility in raising rates and rolling off its balance sheet: a "wait-and-see" approach that was well-received by the markets.

Iii. Debt Ceiling Deadline: March 1

The current political gridlock faces a crucial deadline in March, as new analysis indicates that the federal debt limit is expected to be re-instated at a record-high $22T. But despite the ominous tone associated with the debt ceiling, breaching this deadline is not necessarily disastrous, in our view. If Congress cannot compromise on the terms of the debt ceiling prior to March, the Treasury will likely use so-called "extraordinary measures" to temporarily finance government operations through early summer of 2019. But if no action is taken by then, the government may face default on its debt, which would be detrimental to global financial stability.

This is not our base case however. Reports have indicated that Democratic leaders don't want to "weaponize the debt ceiling," stating it should not be used to extract policy concessions from the opposing party. In fact, during the 2013 debt-ceiling debate between the House Republicans and former President Obama, House Speaker Nancy Pelosi stated she would not use the debt ceiling to try to force policy concessions from Republicans if she ever gained the majority again. In our view, the U.S. government has more fiscal runway, as demand for U.S. assets remains strong, the tax base large, and the sovereign debt market liquid. Regardless of party association, we believe congressional leaders understand raising the debt ceiling is a necessity.

Iv. Brexit: March 29

Nearly three years after the United Kingdom (U.K.) voted to leave the European Union (EU), much remains up in the air as to what the terms of the U.K.'s exit will be. Faced with immense opposition from Parliament, Prime Minister Theresa May's preliminary deal with the EU got a resounding "No" vote by the House of Commons on January 15, casting doubt on the prospects for an agreement by March 29. Current expectations are for a possible extension of the two-year Brexit process, a second referendum, or perhaps the most detrimental— a nodeal Brexit. Extending Article 50 appears unlikely as it requires unanimous approval among all EU member states, and currently there is no majority in Parliament for a second referendum. A no-deal Brexit has several implications, ranging from the imposition of a hard border between the Republic of Ireland and the U.K. to the reversion to World Trade Organization trading rules to operational inefficiencies within supply chains.

The state of the boundary between the Republic of Ireland and Northern Ireland remains a key issue. Critics of May's "backstop," the pledge of no hard border, fear it risks binding the U.K. in a customs union with the EU, weakening future trade negotiations. But reintroducing customs controls would impose costs on cross-border trade exceeding $3.5B a year, according to Bloomberg, potentially jeopardizing the supply of everything from food to drugs to manufacturing components. Considering previous efforts to alter the backstop have been rejected by the EU, we see a growing prospect of a no-deal Brexit. The next major vote, following nearly two full days of debate, comes on February 14.

Brexit has already led numerous companies to relocate or close facilities, stockpile extra supplies, delay investment plans, alter their workforce, or further lower earnings guidance. Against this backdrop, the European Parliamentary elections in May will mark the first since a member country decided to leave the bloc, and the potential of various populist parties increasing their influence presents significant political risk. Filled with immense uncertainty and extended volatility, our outlook for Europe remains negative, given the weak growth backdrop and continuous political disruption.

Fiber and The Future of The U.S.

It's a common but important question often asked by clients and investors: What keeps you awake at night? Answer: incessant time zone changes, for sure, in addition to the Fed, China, and the rise of populism-cum-political polarization. Also on the list: the secular decline in federally funded research and development, juxtaposed against the government's consistent track record in driving innovation and competitiveness at precisely the moment the U.S. stands on the cusp of potentially missing out on the 5G technology revolution due to an underdeveloped fiber optics network.

Innovation Dividends

Federally funded research has paid significant innovation dividends, helping to drive economic growth and investment returns. Case in point: the U.S. healthcare sector's outperformance vs. the S&P 500 over the past decades stems in part from the introduction of 19 new FDA-approved anti-cancer drugs; this wave of new products has helped boost the earnings of many U.S. companies. However, keep in mind that many of these new drugs were incubated by federally funded research back in the 1970s or when public sector outlays against the "War on Cancer" were ramped up in the Nixon administration.

Another case in point: While the energy revolution in the U.S. has been led by the private sector, the roots of the fracking revolution stem from federally funded research in the wake of the first OPEC oil embargo in the 1970s. It was federal outlays that helped spawn directional drilling technologies, as well as the development of diamond drill bits tough enough to cut shale. In addition, many of the first attempts of hydraulic fracturing were public-sector-led and -financed.

And one final example: Unbeknownst to many consumers, Apple's innovative products are the results of decades of federal support for innovation. While the company's products are beautifully designed and packaged, nearly every state-of-the-art technology found in the iPod, iPhone, and iPad is courtesy of the research efforts and funding from the U.S. government and military.

As Mariana Mazzucato notes in her book, The Entrepreneurial State: Debunking Public vs. Private Sector Myths: From the development of aviation, nuclear energy, computers, the Internet, biotechnology, and today's development in green technology, it is, and has been, the State—not the private sector—that has kick-started and developed the engine of growth, because of its willingness to take risks in areas where the private sector may have been too risk averse.

Backing up this statement, the author notes that "between 1971 and 2006, 77 out of the most important 88 innovations— or 88 percent—have been fully dependent on federal research support, especially, but not only, in their early phases."

Fiber Optics—The Electricity of The 21st Century

Forget copper and cable, the future is in fiber optics. Think of the latter as the electricity of the 21st century, since it is fiber optics that can enable faster and cleaner high-speed internet, cable television, telephone services, and related activities. In addition, the future of Big Data and the Internet of Things will be largely driven by access to a fiber optic infrastructure. Fiber optics uses light instead of electricity to transmit data, which means higher frequencies, longer distances, less interference, and greater capacity to move data, among other things.

"If the information–carrying capacity of copper wire is like a two-inch-wide pipe, fiber optic is like a river fifteen miles wide."

That said, America lives on copper, not fiber. Presently, fewer than 10% of U.S. households are connected to last-mile fiber optics and at very high costs. The comparable adoption rate is 100% in Japan, South Korea, Hong Kong and Singapore. In China, meanwhile, the nation is installing twenty thousand last-mile fiber optic connections every single day and seems to be on course to build one of the largest 5G mobile networks in the world.

Among the Organization for Economic Co-operation and Development (OECD) nations, the U.S. is woefully behind in terms of fiber adoption rates, with the U.S. ranked 25th out of 36 countries measured by the OECD (Exhibit 2). Fiber optical subscriptions make up just 13% of total broadband internet connections in the U.S., while the average among OECD countries is 23%. In other words, the U.S. is a fiber pygmy, which, in turn, means its Information and Communications Technology (ICT) infrastructure is nothing to brag about. In the latest Global Competitive Ranking from the World Economic Forum, the U.S. ranked 27th in terms of ICT infrastructure (Exhibit 3).

Exhibit 2: U.S. Lags in Fiber Optic Penetration.

Exhibit 3: World Economic Forum, Global Competitiveness Report 2018.

ICT Adoption (Infrastructure)

Rank

Country

Score

1

Korea, Rep.

91.3

2

Hong Kong SAR

87.9

3

Japan

87.4

4

Singapore

85.2

5

Sweden

85.2

6

United Arab Emirates

83.7

7

Iceland

82.7

8

Denmark

82.3

9

Qatar

81.9

10

Norway

81.6

 

...

 

27

United States

71.2

What does all of this mean for the real economy? Think of it this way—lacking a widely diffused and low-cost fiber optics network equates to diminished growth prospects for nearly every U.S. economic sector and the U.S. economy in general. Smart cities won't be as smart; Big Data will/may not move as fast; the lack of growth in e-health and e-related activities will lag; and the launch of the 5G revolution (fifth-generation mobile networks) in the U.S. could be delayed or undermined by an incomplete fiber optics network. As a report from Deloitte put it, "building 5G without fiber optic infrastructure would be like building all the exit ramps without having the highway to connect it, which is what fiber provides."

Fiber may be the future but fiber optic connectivity in the U.S. is in its infancy. What's more, it's going to be expensive to build and install, with Deloitte estimating that the U.S. needs $130–$150 billion to develop its fiber optic networks over the next five to seven years. Other nations, however, are pushing ahead in this space, notably China, and could gain first-user advantages in various sectors leveraged to the next generation of speed and latency of the internet.

Meanwhile, back in Washington, the U.S. public sector, long the driver of American ingenuity, remains effectively MIA as the champion of fiber optics. A few cities—San Francisco and Chattanooga—have been proactive in promoting fiber optic connectivity, but they remain the exception not the rule. Given the current state of the federal government's finances (and most states for that matter), public funding for a fiber optics network doesn't appear to be a priority. Indeed, as Exhibit 4 highlights, federally funded R&D has been sliding as a percentage of GDP since the mid-1980s, with the latest percentage (0.66% in 2016) about half the percentage in 1986. Compounding matters, amid all the noise about a bipartisan infrastructure plan emerging from Washington, rarely is the need for a national fiber optics network seriously mentioned.

Exhibit 4: Decline in Federal Government Sourced R&D Offset By Rise in Business Funding.

*Other non-federally funded sources include nonfederal government, academic institutions and other non-profit organizations. Source: National Science Foundation. Data as of May 2018.

What about the private sector? While R&D outlays from Corporate America are among the largest in the world, funding for fiber has been lacking. The private sector, notably the communications/wireless industry, currently lacks the capital and incentives for a massive build out of the fiber network, preferring instead to invest in other areas like content, satellite TV, and advanced business services. Regulatory hurdles, legacy costs, high operating expenses, corporate interests, the need for short payback periods—these variables, and others, represent key barriers to scaling up investment in America's fiber networks.

The global 5G race may contribute to more structural diversity in wireless connectivity markets around the world, i.e telecom investment stories may start differing more fundamentally. The 5G race is not so much about timing of the first network launches, but about share and influence in the supply chain as well as availability of economy-boosting innovative services. The U.S. is considered a natural leader with its hardware/software tech credentials, but China appears to be a strong contender with its fast-grown tech industry, scale economies and strong government focus on 5G. With such rivalry and differing interests of different countries around the world, this could lead to a rise of structural diversity in wireless connectivity markets, in areas such as open access networks, net neutrality, privacy, security etc. Therefore this could differentiate telecom investment stories and make them more fragmented than before.

Between short-term shareholder pressures on publicly traded companies to generate profits and a public sector less inclined and financially unable to partner with the private sector, funding for the nation's fiber optics network remains inadequate. Under these circumstances, will the lack of lastmile fiber optic networks slow economic growth in the U.S. this year? We think not. But there are a myriad of potential long-term opportunity costs associated with America's lagging internet and bandwidth capabilities.

The future is fiber—with or without the United States' fullblown participation. Belatedly, sometime in the next decade is our guess, America will likely come around to this fact. Our hunch is that once the U.S. understands and sees how fiber optics and 5G are going to radically transform the competitiveness of China, then Washington will get serious about fiber optics and lead the charge to bring America's internet into the 21st century. Meanwhile, investors should consider gradually building out positions in and around leading fiber optic players/networks. The fiber revolution is coming.

America's Annual Fiscal Physical

Last week's checkup with the CBO resulted in a seemingly chronic, incurable diagnosis worsening at the expense of the U.S. fiscal position. Top of mind among investors is the deteriorating fiscal position of the U.S. government, with the recent reportv from the CBO not offering investors much solace about the fiscal future of America.

Although a 35-day government shutdown cost the economy $3 billion in foregone economic activity, more concerning is the headline number of $383 billion in annual interest payments the U.S. will pay this year on the national debt. Yes, America's debt-servicing obligations are running at about $1 billion a day owing to the fiscal profligacy of the U.S. government over the past decade. The CBO predicts the budget deficit is set to reach nearly $1 trillion this year, up from $585 billion in 2016 and more than 4% of GDP. The U.S. national debt is projected to balloon from its current level of 78% of GDP to 93% in 2029, the highest level since World War II.

Thought of The Week

As Exhibit 5 shows, as the fastest growing part of the U.S. budget (America's net interest payments triple over the coming decade), interest costs for federal spending could crimp the funds that our national government has available for discretionary spending—thus surpassing Medicaid as early as this year and outpacing military expenditures by 2025. In other words, the U.S. government appears to be on track to pay more to its creditors than for its defenses, Medicaid, nondefense discretionary expenses or myriad of other programs, all the while leading to a higher deficit.

Exhibit 5: When Interest Takes Over.

True, these projections should be taken with a large grain of salt, in our view, and are, of course, subject to change given the variability of U.S. spending, revenue growth, economic activity, etc. However, the current state of Uncle Sam's financial temperature is running red-hot, which makes portfolio risk management all the more critical in the years ahead.