Capital Market Outlook (JANUARY 28, 2019)

In This Issue


Are investors mistakenly looking past extremely elevated global policy uncertainty? We don't think so. We think monetary policy risks, which have a more persistent effect on business cycle dynamics, trump other policy-related risks at this stage, and a positive shift appears to be underway. Investors can take advantage of better valuations in risk assets during periods of high policy uncertainty and volatility, and this appears to be what they are doing.


Investors breathed a sigh of relief at the start of 2019, as Federal Reserve (Fed) officials finally established a more patient stance on the path for future rate hikes, and markets got some reassurance on the potential for an interim deal between the U.S. and China. Despite an ensuing rally of some 13% as of close on Friday for the S&P 500, many investors seemed to have reduced their risk exposure amid recent downgrades to economic growth projections from the International Monetary Fund and concerns over declining earnings estimates.


The world economy rests on the foundation of consumerism, which means the core holdings of equity portfolios would follow companies that have the wherewithal to tap the larger, wealthier markets of the U.S., Europe and Japan, along with select developing markets. Think large-cap U.S. leaders in such sectors as consumer discretionary and staples, consumer-product leaders in Europe and Japan, and the internet retailers/e-commerce giants of China and local Asian companies.


We are maintaining our overall absolute 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.

Elevated Global Policy Uncertainty Can Be A Good Thing for Long-Term Investors

Global risk assets are pushing forward despite persistent policy related stresses that appear to be gaining momentum. The list of stressors is not short: The U.S.-China trade war, Brexit, talks of a looming fiscal hangover, the government shutdown and tighter U.S. monetary policy are probably cited most often as risks to the outlook for the global economy and risk assets. Climate change/global warming is also a frequent contender, as highlighted recently by the World Economic Forum's Global Risk Report. It is not surprising then that global economic policy uncertainty reached an all-time high in December, as measured by the often-cited Baker, Bloom and Davis index. U.S. policy uncertainty made a large contribution to the rise in the global aggregate and the U.S. Policy Uncertainty Index is also near an all-time high for many of the reasons listed above. Clearly, policymakers have a lot of work to do to relieve the stresses, but just because the policy climate is cloudy right now does not mean the sun isn't shining behind those clouds. In fact, we think there are clearer skies ahead.

Monetary policy is leading the way. There is a clear shift away from tighter global monetary policy. In the U.S., the Fed is likely on hold for the foreseeable future. Yes, the labor market is tight, but core inflation will likely run significantly below the Fed's 2.0% inflation target over the first half of the year, and real gross domestic product (GDP) growth is also expected to slow in the first half. Inflation expectations matter for future inflation and five year-five year forward inflation expectations dropped significantly heading into 2019 and have rebounded only slightly the last few weeks. This is also a yellow flag for Fed officials. In addition, still lofty profit margins are acting as a release valve for wage pressures (higher wages can come out of profits), which should continue to have a dampening effect on inflationary pressures. Productivity has also trended higher and serves to help relieve concerns over future inflation. All of this points to a protracted pause in the rate hike cycle.

In Europe, the European Central Bank (ECB) is likely on hold until 2020 given that inflation is well below its target, and economic growth has slowed. Italy likely fell back into a recession in the second half of 2018. The ECB provided a decidedly more dovish view last week and the premature hike in 2011 likely still haunts policymakers. With the Fed on hold, the last thing Europe needs is a rate hike that strengthens the euro and tightens financial conditions.

The Bank of Japan remains firmly committed to reflation through balance sheet expansion and near-zero rates, and China has already cut the required reserve ratio (RRR) and will likely continue to use this tool if economic data deteriorate. The People's Bank of China (PBOC) has also opened up a medium-term lending operation. While Russia, India, Mexico, Korea and Turkey all hiked rates in 2018, the tone may change as inflation settles in and the Fed pauses, helping keep dollar appreciation at bay. Bottom line: Global short rates are likely to flatten out as the year progresses.

Judging by the media headlines, U.S. fiscal policy is about to fall off a cliff. The reality is much different as fiscal policy stimulus increases in 2019 compared to 2018. The stimulus is a combination of corporate and individual tax cuts and government spending. On the consumer spending side, U.S. taxpayers are likely to get a boost from tax refunds due to the 2017 tax cuts, while lower gasoline prices will also boost disposable income.

Deregulation continues to get far less attention than it deserves, in our view. While it's not "stimulus" in terms of dollars and cents, it is likely a big contributor to the pickup in productivity that is happening and will continue to be a tailwind for the rest of the year. As temporary headwinds fade, deregulation and a friendlier corporate tax environment mean businesses will be more likely to put money to work.

A resolution to the trade dispute would be an additional bonus that would stimulate business investment spending, and both the U.S. and China are feeling the pain the last few months, incentivizing negotiation and resolution. We think investors are able to look past the near-term trade-war pain because it is not solely the president's agenda item (there is consensus among Republicans and Democrats that the system needs to change), and, since the commencement of the trade war, both tariff and nontariff barriers have come down. The trade war adds to policy uncertainty in the near term but more likely than not the end result will be a system that is better for multinational firms.

On the government spending side, some of the estimated fiscal drag for late 2019 and into 2020 is as a result of a drop-off in defense spending that is set to occur as sequestration spending caps come back in fiscal year 2020. We think defense spending cuts are very unlikely in the current environment, and Strategas Research Partners would likely make the same case for nondefense cuts as well (i.e., it is unlikely the sequestration-based fiscal cliff takes place). Obviously, the government shutdown is not helpful for fiscal policy, but the lost spending is typically made up when the government re-opens.

That said, the combination of a government shutdown and a potential inventory drag are two reasons to expect slower growth in the U.S. in the first half of the year. This will add to recession fears, but until we see private sector demand stumble, a recession seems unlikely. The resilience of the U.S. consumer is a key factor to watch here. For now, investors seem to be looking past the potential for a growth pause in the first half as equity markets have broadly moved higher since the shutdown began.

Fiscal stimulus may also kick into higher gear outside the U.S. The U.S. corporate tax cuts are putting pressure on other countries to consider the same, most recently Germany, but given the growth slowdown across Europe, fiscal stimulus seems likely. There is also increasing pressure on China to be more aggressive engineering a soft landing and/or working toward a solution to the trade conflict.

Lastly, climate change and energy policy is gaining traction as a medium-term risk to financial markets. For the second year in a row, the World Economic Forum listed "Failure of climate-change mitigation and adaptation" as a Top 5 Global Risk in terms of both likelihood and impact. At a broader level, environmental risks accounted for four out of the top five risks as climate change contributes to extreme weather, threatening supply chains and pressuring agricultural yields. While the U.S. appears to be on the right track (Exhibit 1), this is likely to be a big campaign issue leading up to the 2020 election, and significant legislation (for example, a carbon tax as proposed in the Baker-Shultz plan) is more likely if Democrats take control of the government.

While the Baker-Shultz plan for a carbon tax/carbon dividend is marketed as a bipartisan plan, we believe there are few voting Republicans who are likely to support it at this stage.

Exhibit 1: Countries with the Largest Reductions/Increases in Carbon Dioxide Emission from 2007 to 2017.

*Other Africa includes Other Northern Africa and Other Southern Africa. Source: BP Statistical Review of World Energy. Data as of 2018.

In short, investors appear to be looking past the spike in global policy uncertainty and taking advantage of better valuations in risk assets. This is rational if the trade negotiations ultimately lead to a more level playing field, monetary policy shifts toward a more appropriate path given the trends in inflation and growth, U.S. policymakers avoid the sequestration-based fiscal cliff, and China engineers a soft landing. Monetary policy remains key, in our view, and appears to be heading in a more appropriate direction. Importantly, empirical evidence shows (for example, Jeff DeGraaf's work at Renaissance Macro) that when global policy uncertainty is low, earnings multiples tend to be high, and when policy uncertainty is elevated, multiples come in. When policy issues are resolved, they tend to move higher. Therefore, investors can take advantage of better valuations during periods of high policy uncertainty and volatility.

Portfolio Positioning Amid Key Global Consumption Trends

We believe that every portfolio should have exposure to one of the most powerful macro-economic trends of the 21st century: the steady march of global personal consumption, both in the developed and developing nations. Because there is nothing more universal than basic human wants and needs, nothing more predictable than more desires and cravings as income levels rise, the largest share of world economic activity is consumption. According to the latest data from International Monetary Fund, global personal consumption expenditures (PCE) account for nearly 60% of world GDP.

In 2017, the latest year of available data, global consumption rose to $47.6 trillion, a 5% jump from the prior year. The annual increase was the strongest since 2011, and reflected a myriad of factors, including steady job growth in various parts of the world; greater labor force participation rates among women; rising wages as labor shortages boost worker incomes in both the developed and developing nations; higher education rates and therefore higher wages; and easy global monetary policies, fueling debt-driven consumption in many nations.

At the apex of global consumption is the United States. On a country-by-country basis, there's the U.S., and then there's the rest of the world. According to data from the United Nations, what U.S. consumers spent on goods and services in 2017 ($13.3 trillion) was greater than the total output of the Chinese economy. Indeed, U.S. consumers outspent the next six nations combined (China, Japan, Germany, U.K., India, France) in 2017.

As the consumer goes, so goes the U.S. economy, with consumption nearly 70% of GDP, one of the highest percentages in the world. That said, with the U.S. labor market basically at full employment, and with wages rising across multiple sectors, it's hard to foresee a U.S. recession in the near term. Yes, the U.S. economy confronts a number of headwinds, including uncertainty over trade, worries over the government partial shutdown, and fears of the aftereffects of Fed tightening. All of these factors have weighed on market sentiment over the past few months. But the U.S. does enjoy one sizable tailwind—the U.S. consumer, who has exhibited only limited signs of pulling back on spending. While lower U.S. equity prices will likely trim spending among the wealthy in the U.S. near term, the offset is the most robust U.S. labor market in decades. In the end, when the U.S. consumer rolls over, so will the economy. Until then, one of the longest economic expansions in U.S. history rumbles on.

Outside of the United States, the next largest consuming cohort is the European Union (EU). Including the United Kingdom, the EU accounts for 21% of global personal consumption. While the EU has half the population of China, the EU still out-consumes China by a factor of 2:1. Consumption expenditures in the EU totaled $9.6 trillion in 2017, double the levels of China's consumption ($4.7 trillion) (Exhibit 2).

Why such a disparity? Because the average European consumer—even in central Europe—is wealthier than the average Chinese, according to the World Bank, and therefore better positioned to spend. To this point, the EU's average per capita income ($32,778) is some 3.5 times larger than China's ($8,690). So while much has been made of the emerging market consumer over the past few years, and the powerful aftershocks to various industries, it's interesting to note that between the U.S. and EU, they (combined) account for half of the world's total consumption. As a footnote, China and India, aggregated, equal 13.6%.

When the rest of the developed nations (Japan, Australia and Canada) are included with the U.S. and EU, the global share of consumption derived from the developed nations rises to 60% (Exhibit 2). That's a much larger share than most investors realize given all the hype and fuss about the emerging market consumer.

Exhibit 2: Personal Consumption Expenditure (PCE).

And what about the developing nations? While they have moved up the consumption curve, they still lag the developed nations. Consumer spending in the developing nations hit a record $18.5 trillion in 2017 and has increased six-fold since the start of the century. As a result, the share of global consumer spending from the developing nations has jumped from 22% in 2000 to just over 40% in 2017. However, subtract China from the total, and things look a little different. Minus China, the developing nations' share of global consumption drops to just 30%, a significant consumption gap between rich (developed) and poor (developing). The gap is narrowing but from a wider-than-realized starting point (Exhibit 3).

Exhibit 3: Percent Share of Global PCE.

What's more, it remains to be seen how fast the gap will close. In terms of annual growth rates, yes, the pace of consumption is faster in the developing nations versus developed markets. But given the outsized gap that exists today, it could take years, if not decades, for the developing nations to reach the consumption potency of the developed nations.

One final note. As Exhibit 4 highlights, global wealth (like global income) is skewed toward the few of those countries listed. Note that the top ten largest consuming nations in the world accounted for over two-thirds of global consumption in 2017. The upshot: When it comes to selling goods or providing services, companies don't necessarily have to be global. Rather, they need to be well represented/positioned in a handful of countries or key regions that have the spending power to drive earnings.

Exhibit 4: Top Ranked Countries in the World by PCE.



Billions of $

Percent of World Total


United States
















United Kingdom























Top 10 Total



It's not necessary for companies to be all things to all people. Africa, for instance, with over a billion people, is not likely going to dictate the earnings of any U.S. company anytime soon. It's too poor yet. Ditto for India. Notwithstanding a large market, above-average global growth rates, an emerging digital class, India's per capital income is just $1,820, a fraction of America's ($58,270). Over the medium term, the nation remains too poor and too wrapped up in a thicket of stifling industry/government regulations to meaningfully drive the future earnings growth of a majority of U.S. firms. The same holds true for most of the Middle East and Latin America, with the possible exceptions of Brazil and Mexico. The one nation that stands out—that may drive earnings growth among the developing nations—is China.

What does all of the above mean in terms of portfolio positioning? The world economy rests on the foundation of consumption, or consumerism, which means the core holdings of equity portfolios should include companies that have the wherewithal to tap the larger, wealthier markets of the U.S., Europe and Japan, in our view. Think large-cap U.S. leaders in such sectors as consumer discretionary and staples, as well as consumer-product leaders in Europe and Japan.

We also continue to favor the internet retailers/e-commerce giants of China and local Asian companies that cater to the emerging consumers across Southeast Asia given the fast-expanding consumption-led economies, supportive of a range of industry groups. Sectors include discretionary goods such as automobiles, consumer electronics and department stores; staples such as health care, household products and packaged foods; and higher-end segments like international travel (airlines, airport operators, tourism agencies) and luxury products.

Investors Stockpiling Cash Amid Persistent Market Risks

Following the fourth quarter market sell-off, investors breathed a sigh of relief at the start of 2019, as Fed officials finally established a more patient stance on the path for future rate hikes, and markets got some reassurance on the potential for an interim deal between the U.S. and China. Despite an ensuing rally of some 13% for the S&P 500 from its Christmas Eve lows, investors have continued to stockpile cash, with assets held in money market funds at their highest levels since 2010 (Exhibit 5). Many investors have reduced their risk exposure amid recent downgrades to economic growth projections from the International Monetary Fund and concerns over declining earnings estimates.

And added to the mix was the longest government shutdown in our nation's history. It's estimated to have shaved 0.1 percentage points (ppt) off GDP growth every two weeks, according to BofA Merrill Lynch (BofAML) Global Research, while limited data releases due to the closure of the Commerce Department has clouded investors' view of the economy. These developments put together have called the durability of this most recent rally into question.

But context is important: Cash allocations are far more than in 2011 when Europe was in a recession, and more than early 2016, which saw a major global growth scare while oil prices plummeted to $26/barrel. In our view, this suggests investors are still positioning for a sharp economic slowdown in 2019. This is consistent with BofAML Global Research's Fund Manager Survey, which notes a collapse in macro expectations among money managers and indicates that allocation to equities is close to a two-year low.

In contrast, we remain positive on equities; still expecting modest earnings growth this year, a pause by the Fed and the potential for a U.S.-China trade deal, helping to support global growth (especially outside the U.S.). Cash should remain competitive, offering a positive real yield for the first time during this cycle, but we believe a solid fundamental backdrop combined with light investor positioning should continue to support the upward trend in equities.

Exhibit 5: Money Market Mutual Fund Assets.

Source: Investment Company Institute. Data as of January 16, 2019.