Capital Market Outlook (July 22, 2019)

In This Issue

  • Macro Strategy—The story for Japanese equities over the past 12 to 18 months has been one of tailwinds at the micro level (improved corporate governance and shareholder payouts) being stymied by recent headwinds at the macro level (slowing global growth and trade). Here we argue that maintaining a strategic allocation to Japanese equities is still prudent for investors to consider.
  • Global Market View—Long term, we believe the perfect storm of de-globalization, de-industrialization and de-population represents a significant and structural headwind to the emerging markets. Over the long run, these three forces should likely cause countries to invest in more productivity-enhancing capital expenditure (capex), potentially benefitting the world's technology leaders.
  • Thought of the Week—Second-quarter earnings season is underway and primed to pick up momentum. The results thus far have been encouraging, but, as more companies report, investors will be keenly attuned to trends in revenues, margins and forward guidance.
  • 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 shorterdated 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.

Catalysts Needed for Stronger Japanese Equity Performance

Japanese equities have long been a macro play on global growth, which has led many investors to shy away from a tactical overweight allocation to Japan given the numerous headwinds to the global economy. The story for Japanese equities over the past 12 to 18 months has been one of tailwinds at the micro level (improved corporate governance and shareholder payouts) being stymied by recent headwinds at the macro level (slowing global growth and trade). But while U.S. equities have been persistent outperformers over the past few years, Japanese equities have been the "best of the rest" of non U.S. equities, beating Emerging Markets (EMs) and Europe since Shinzo Abe re-took office in 2012 (Exhibit 1), so here we also argue that maintaining a strategic allocation to Japanese equities is still prudent for investors to consider.

Exhibit 1: Japan Has Trounced Non-U.S. Equities Since Shinzo Abe Re-Took Office.

Note: Returns are price return in U.S. Dollars. Source: Bloomberg. Data as of July 17, 2019. Past performance does not guarantee future results. Performance would differ if a different time period was displayed. Short-term performance shown to illustrate more recent trend.

Improved Capital Stewardship

Improving corporate governance at Japanese companies has been a top priority for the Abe administration for years, and, despite moving too slowly for many investors, it has gained traction in recent years with activist investors and private equity firms being major catalysts. The number of Japanese companies targeted by activist investors jumped by 40% last year, making Japan a leader in investor activism in Asia, according to Nikkei Asian Review, helped by more foreign participation, with foreigners now owning 25% of outstanding shares versus just 13% in 2000. The median percent of independent directors on Japanese boards has reached almost 30%, which is an improvement over recent years but still remains below the 50% that foreign investors typically prefer (the U.S. is close to 90%). Mergers & Acquisitions (M&A) activity could get a long-awaited boost from fewer takeover defense measures, with the number of "poison pill" plans at Japanese companies down from around 400 in fiscal year 2012 to roughly 260 in fiscal year 2018, while stricter disclosure requirements under the 2018 Revision of the Corporate Governance Code have led many companies to begin unwinding crossholding positions in other firms.

Shareholders have been major beneficiaries of improved capital stewardship, with buybacks rising by an impressive 119% year-over-year from January-May, already surpassing last year's total by 6%, according to CLSA. Japanese corporations have historically paid out much less than the S&P 500 but could potentially have more upside, holding cash/short-term investments at 127% of equity book value (versus 50% in the U.S., 57% in Germany, 96% in France), and maintaining margins at close to record levels.

Headwinds from Trade and Global Growth

Against a backdrop of weaker global growth, evidence of a pronounced economic slowdown in Japan seems to be rising. Machine tool orders are now down around 42% from their peak, while the manufacturing sector more broadly is beginning to crack, especially new export orders, which have been contracting since late last year. The second quarter Tankan survey of businesses indicates that despite years of ultra-aggressive monetary easing, there are still little signs of inflationary pressure, with capacity shortages and output prices beginning to ease. Interestingly, a similar dynamic to the U.S. is emerging where the more domestically oriented services sector is holding up relatively well even as the export-oriented manufacturing sector appears to be faltering.

Consumer confidence has fallen to the lowest level since 2015, while weakness in wage growth, the average work week and employment growth suggest labor income is down around 4% year-over-year, just as the government gets ready to raise the sales tax to chip away at their massive debt load. Japan's economy did poorly after previous valueadded tax (VAT) hikes in 1989, 1997 and 2014, and there isn't much evidence that "this time is different." The earnings outlook will likely be challenged by weaker external demand as well; 63% of TOPIX earnings come from abroad (25% from the U.S. and 15% from China), and goods exports have continued to drop (Exhibit 2), especially to the European Union (EU) and China, which are down 7% and 10%, respectively. One potential catalyst could be the Federal Reserve and other central banks shifting from tightening policy to recent easing, contributing to a "fourth wave" for global macro momentum, which would be a significant tailwind.

Exhibit 2: Currently Faltering External Demand Risks Pulling Earnings Lower.

Sources: Bloomberg; Ministry of Finance. Data as of July 18, 2019. Past performance does not guarantee future results. Performance would differ if a different time period was displayed. Short-term performance shown to illustrate more recent trend.

While Japan has generally steered clear of a major trade dispute with the U.S., it's not without trade-related problems of its own. Japan recently tightened export controls on semiconductor material shipments to Korea, which is expected to have a negative impact on both Korea, for which memory chips are around a fifth of exports, and the global smartphone market more broadly. Japan also plans on removing Korea from its "white list" of trading partners that are exempt from trade restrictions, which could lead to tighter controls on machine tools and equipment, creating further disruption to industrial supply chains in the region. Korea has threatened retaliation, including boycotts of Japanese products, but we believe that tensions are unlikely to rise to the specter of the U.S.-China dispute. Japanese officials have recently indicated that they will provide licenses for non-military exports, and the two sides are expected to meet in coming weeks to work toward a resolution.

Another catalyst for improved performance could be fiscal stimulus to help offset the October tax hike. The budget that was passed in March includes 2T yen ($19B) in stimulus measures aimed at supporting domestic demand. The government is exempting food from the hike to reduce the cost-of-living impact for households, providing rebates to small/mid-size retailers, providing free pre-school education, as well as tax cuts for home/auto purchases to help buffer the impact.

The risk of U.S. tariffs is also higher for Europe than Japan. If a deal between the U.S. and China gets done, the U.S. is more likely to move to Europe. The administration is focused on countries with which the U.S. has large goods-trading deficits, and Japan is the fourth largest after China, the EU and Mexico, while Japan already has low tariffs as measured by World Trade Organization average tariff rates. Japan is also an important geostrategic partner helping to balance power versus China in Asia, so the risk of a protracted trade conflict between the U.S. and Japan is relatively low, in our opinion.

Data suggests worst may also be priced in for Japanese equities, trading near the bottom of their historical valuation ranges, and after a disappointing fiscal year 2018 for earnings, company guidance for 2019 has started to stabilize. This is especially true for autos, financials, construction and materials, so we could see a situation similar to the U.S. where the bad news is priced in and companies have a low hurdle to surpass. This is consistent with steadier earnings revisions in recent months. Other reasons for optimism include steady capital spending as companies mitigate labor shortages (especially robotics where Japan is considered a global leader) and an impetus for the government to support the economy ahead of the 2020 Olympics. Monetary policy should remain a tailwind as well, in our view, with Bank of Japan demand for exchange traded funds currently near record levels and government bond yields expected to remain close to zero for the foreseeable future.

Bottom Line

As a major driver of international developed equity performance (24% of the MSCI EAFE index), we believe there are reasons to reinforce strategic allocations to Japan. Japanese corporations have a close tie to the U.S. consumer, which looks relatively strong, and bad news may be mostly baked into earnings expectations, while light positioning among fund managers and low valuations could set up the region for a potential rebound. These factors, along with positive trends in corporate governance and generally lower political risk, make us slightly more optimistic on Japan compared to Europe. But ultimately, until global growth conditions start to stabilize, especially trade flows and business sentiment, the scale should continue to tilt toward a more negative view on international developed equities, including Japan, from a tactical asset allocation perspective relative to the United States.

The Emerging Market Perfect Storm: De-Globalization, DeIndustrialization, De-Population

Central bank easing, the U.S.-Sino trade truce and China reflationary efforts have given some ballast to EM assets, with the MSCI EM index up almost 10% year-to-date, in price returns through July 19. Near term, however, we remain underweight the EMs out of concerns about the current underlying fragile health of global trade, uncertainty over global growth, and ever-lingering trade tensions between the U.S. and its major trading partners.

We are cautious long term as well, believing the perfect storm of de-globalization, deindustrialization and de-population represents a significant and structural headwind to the EMs. We discuss each dynamic below and have summarized key points in the accompanying table.

Exhibit 3: The Perfect Storm in Emerging Markets Long-Term




Potential Investment Implications


  • Rise in global populism
  • U.S.-China trade war
  • Rising nationalism
  • Balkanized global economy
  • Reconfiguration of global supply chains
  • Slow growth in global trade/investment
  • Technology leaders: robotics/Artificial Intelligence (AI)/3D printing
  • Defense/cybersecurity
  • Large Cap China/U.S.


  • Aging global labor force; full employment; rising wages
  • Reconfiguration of global supply chains
  • Advancement in robotic capabilities
  • Rise in global tech/automation capex
  • Rise of the high-tech, global service economy
  • Slower growth in labor-surplus EMs
  • Leading robotics/automation companies
  • Tech-intensive industries and/or high valueadded goods/services
  • Leading global services providers


  • Internal political strife
  • Reduced economic opportunities
  • Climate change (droughts/famines) triggering human migration
  • Anti-immigrant backlash in developed markets
  • Reinforce anti-globalization; political populism
  • Rise in intra- and inter-state conflict
  • Downside risks to frontier markets
  • Sector focus: bullish EM consumer discretionary and tech
  • Tech that supports state-surveillance capabilities

Source: Chief Investment Office. As of July 2019. Chartered Financial Analyst® and CFA® are registered trademarks owned by CFA Institute.

De-Globalization: The Great Unwinding

Globalization—or the unfettered cross-border movement of goods, people, services, capital and data—isn't dead, in our opinion, but it has probably peaked, with the risks to the downside. This represents an inauspicious backdrop for developing nations requiring external linkages to the capital markets of the developed nations; dependent on the trade and investment ties with multinationals for job and income growth; and wanting to leverage the post-war multilateral system to their economic advantage.

Times have changed. Cross-border financial flows (total assets + liabilities as a share of gross domestic product (GDP)) peaked at almost 50% in 2007 and have since come down to average roughly 10% in recent years. Global trade intensity (exports + imports as a share of global GDP) has also stalled—at 60% of world GDP—after surging over most of the post-war era. The last completed multilateral trade round of talks was completed in 1995; today, tariffs on global trade are escalating, led by the United States. Foreign direct investment barriers are also rising. According to the United Nations, the number of new foreign investment restrictions rose to a near-record high last year, with a total of 31 restrictive policies introduced globally. Given rising technology protectionism, the global diffusion of the internet is no longer a given.

The world, in sum, is no longer flat—it's twisted, curved and coiled. We have moved from a world of liberal and open borders (i.e., flat) to one where protectionism and nationalism have gained the upper hand, making it much harder for EMs, China included, to become more integrated and interdependent on global growth.

De-Industrialization: No More "Flying Geese"

In the past, the path to industrialization for many developing nations was through the "flying geese" model, whereby industrial production would continuously shift from more mature/developed economies to lower-cost EMs, helping the latter to leverage their comparative advantages and "catch up" with the West. The paradigm was perfected in Asia, where the extraordinary industrial development of the region was kick-started by Japan, then passed on to the NICs (or newly industrialized nations of South Korea, Taiwan, Hong Kong and Singapore), before filtering down to Southeast Asia (Indonesia, Thailand, the Philippines and Malaysia) and ultimately China.

Among other things, this model helped boost the manufacturing base of host nations, as well as growth in cross-border trade and investment. In addition, technology was transferred, human capital improved, while the level of international reserves rose in many host nations. Intricate global supply chains were created as more and more multinationals incorporated various nations into their global production networks, boosting industrial capabilities of the host nation.

Times, yet again, have changed. Labor-intensive manufacturing is in retreat around the world, with employment in manufacturing as a share of total employment declining not only in the U.S., Europe and Japan but more recently in many EMs like South Korea and Taiwan. As a share of employment and output, service activities have become paramount. Meanwhile, owing to advances in automation, artificial intelligence and the proliferation of industrial robots, many firms are producing more output with less labor, and producing it closer to home, obviating the need to push additional capital spending overseas. Global supply chains are contracting; 3-D printing and the potential for mass customization is one more force for de-industrialization.

In the end, we believe a more automated workforce will not only be disruptive to developed economies like the U.S. (where much media attention appears to be) but will also be just as challenging to many EMs barely on the curve of industrialization.

De-Population: The Great Migration

The third structural headwind to the EMs pivots on the current record number of forcibly displaced people in the world, with the bulk, unsurprisingly, from the developing nations. As both a source and/or host of displaced people, it's the EMs that are bearing the brunt of the record number of individuals on the move. Here are the salient numbers: According to the United Nations, almost 71 million individuals were forcibly displaced as a result of persecution, conflict, violence or human right violations in 2018. Climate change—think droughts and floods—has also contributed to this tidal wave of human movement. Last year's figure (70.8 million) contrasts with 43.3 million displaced individuals in 2009. Children under the age of 18 years old constituted roughly half the global refugee population last year. Since 2012, the refugee population under the mandate of the United Nations has nearly doubled, robbing the home country of future supply (workers) and demand (consumers), while placing undue burdens on host countries straining to accommodate surging populations.

While Syria, Afghanistan, South Sudan, Myanmar and Somalia constitute 67% of the world's refugees, more than 3 million people had left their homes in Venezuela by the end of 2018, depleting one of Latin America's largest economies of its economic vitality. Population growth is a key ingredient/determinant of future economic growth, so the more nations like Syria and Venezuela bleed people, or de-populate, the lower their growth prospects.

By the same token, the more host countries like Turkey and Pakistan are challenged by record numbers of displaced individuals, the more resources are diverted from the economy, crimping growth and development prospects. As a footnote: Of the major host nations of refugees, Colombia, Pakistan and Turkey are included in the MSCI EM index, while other large host nations—Jordan, Bangladesh and Lebanon are included in the MSCI index of frontier nations.

Finally, the world's record number of displaced workers has not only negatively affected home and host nations, but also the world at large. Remember, the populist, antiimmigration surge across Europe in the past few years—triggering even more division and discord among member states—was triggered by the Syrian civil war and attendant refugee crisis. Meanwhile, the fierce immigration debate in the U.S. stems in part from the failed and flailing economies of Central America, driving record numbers of individuals north, creating political fissions in the United States.

Investment Summary

Looking ahead, investors need to understand and monitor the powerful forces pushing against the growth and earnings potential of the EMs, and in turn, become more discerning about the true definition of what constitutes an EM asset. Not all EMs are created equal—with some tech- and consumption-led markets (China, South Korea and Taiwan, for instance) appearing to be better positioned to confront the unfolding perfect storm versus others (Turkey and Mexico). In addition, we believe the EM perfect storm will potentially benefit the world's technology leaders, with de-globalization de-industrialization, and de-population all lending themselves to more productivity enhancing capital expenditures. In this bucket fall leading defense and cybersecurity firms, service leaders and large-cap market leaders in China and the U.S.

S&P 500 Earnings Preview: It's a low bar but will companies hurdle it?

Second-quarter earnings season is underway and is primed to pick up momentum as more than 70% of S&P 500 companies are still to report. The results thus far have been encouraging, however, there is a historical tendency for companies to beat consensus. Since 2002, more than 82% of S&P 500 constituents surpassed EPS expectations more than half of the time. Earnings count but context often matters for markets, and investors will be keenly attuned to trends in revenues, margins and forward guidance.

In the first quarter, analysts expected a 2% year-over-year (YoY) earnings decline amid global growth and trade concerns, but EPS actually grew more than 3%. In fact, over the past twelve reporting seasons, earnings have surpassed initial consensus by an average of 4.2%, according to FactSet Research Systems. But estimates remain pessimistic, with consensus once again calling for a 2% fall in earnings for the second quarter along with significant margin compression. If recent history is a guide, more upside surprises could be in store. BofA Merrill Lynch (BofAML) Global Research expects flat growth, or 2% upside relative to consensus. Healthcare, Communication Services and Utilities are projected to enjoy the greatest earnings and sales growth. Through July 19, 63% of reported companies have beaten EPS estimates with 41% also exceeding sales projections for the quarter.

Looking further out, BofAML Global Research is a bit less optimistic, projecting full-year EPS growth of 1.9% in 2019 and 6.7% in 2020, which falls below consensus (Exhibit 4). Importantly, earnings revisions trends appear to be looking better for domestically oriented sectors relative to multinationals, with the 3-month earnings revision ratio for pure domestics in the S&P 500 indicating more upgrades than downgrades in estimates, while multinationals have experienced the opposite.

Headline earnings may grab attention, but investors will also be looking to parse information pertaining to sales, cost pressures and guidance to inform forward-looking views. Revenue growth typically tracks nominal GDP but is expected to slow considerably, while stable margins could indicate productivity in the wake of stronger wages but lower unit labor costs. Management guidance will be critical to forward expectations as investors will key in on the expected impact of macro events, including trade and central bank policy.

Exhibit 4: EPS Growth Is Expected to Recover by Year End.

Note: E=Estimate, Consensus=First Call consensus of bottom-up analysts estimates. Sources: BofAML Global Research US Equity & Quant Strategy, Factset/First Call. Data as of July 12, 2019.