Capital Market Outlook (July 29, 2019)

In This Issue

  • Macro Strategy—Decelerating global economic growth thus far combined with restraining effects on oil demand and upside U.S. supply surprises in response to the 30% average oil-price increase of 2018 have generally kept oil prices at moderate levels within the $50 to $70 per barrel range, as we had anticipated. In our view, prices are likely to continue to gravitate toward the high end of the range over the next eighteen months if the global economy reaccelerates in response to easier central-bank policies.
  • Global Market View—After decades of explosive growth in production and use, the world has reached a tipping point when it comes to plastic. Plastic now permeates every corner of the world economy—creating environmental hazards no longer ignored by countries, companies and consumers. A movement has begun to reduce the global footprint of plastic, creating potential investment opportunities in a number of areas/sectors.
  • Thought of the Week—Whether the Federal Reserve (Fed) cuts 25 or 50 basis points (bps) in July seems nearly immaterial to the long-term investor. What is critical, in our view, is the Fed's policy stance: accommodative, ready to ease monetary policy when necessary, with the ultimate goal of extending the U.S. economic expansion.
  • 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 have bottomed in the short term.

Abundant Oil Supply Exerts its Pull

Following strong global oil-demand growth and an OPEC-engineered inventory decline in 2017, fears of persistently tight oil-market conditions in anticipation of the November 2018 U.S. sanctions on Iran caused Brent oil prices to increasingly exceed our expectations as 2018 progressed, reaching $86 per barrel by early October 2018. As we had expected, however, the price surge proved temporary. Higher-than-expected U.S. supply and a surprise six-month waiver program for eight Iranian oil importing countries caused prices to collapse to $50 per barrel by December and to gravitate around $65 per barrel since. In our view, prices are likely to remain moderate despite the expiration of the Iran-oil waivers in May and escalating geopolitical tensions related to the Iran sanctions.

First, revised data show that instead of a feared supply shortfall, 2018 saw a large oilinventory accumulation. Moreover, according to the International Energy Agency (IEA), the inventory build extended into the first half of this year due to much weaker-thanexpected U.S. and global oil demand. This, along with large upside revisions to 2019 U.S. supply and downside revisions to 2020 demand forecasts have set up the market for more stable prices around $65 expected for the foreseeable future. In fact, our supply and demand estimates suggest that Brent is unlikely to average much above $70 per barrel even assuming reaccelerating global growth and a steady-to-softer dollar in 2020.

Aside from bigger-than-expected increases in non-OPEC oil-production capacity in 2018 and 2019 (80% to 90% coming from the U.S.), Nigerian and Libyan production have also exceeded expectations given beleaguered oil-related infrastructure and operations. This has helped prevent a bigger shock from the collapse of supply from Iran and Venezuela under the pressure of U.S. sanctions. Iraq has also continued to surprise to the upside with production just below 5 million barrels per day (mbd). What's more, Iraq and Libya are seeking to advance ambitious production and export expansion plans. Iraq has a production target of about 6 mbd by end-2020 and 9 mbd by end-2023, while the Libyan government aims to double the country's production to about 2.1 mbd by 2021. Advanced talks between Kuwait and Saudi Arabia related to the restart of production in the Neutral Zone (where disputes shut down about 0.5 mbd of supply in 2015), add to the massive potential supply increase in these oil-rich countries and suggest limited upside risks to prices ahead.

Current upside supply surprises, along with diminished expectations for global economic growth, have forced OPEC and its allies to continue to set aside substantial oil-production capacity through March 2020 in order to preclude an additional global inventory build and a prolonged environment of uncomfortably weak oil prices relative to their oil-export-revenue requirements. The substantial global inventory and spare capacity accumulation over the past year and a half, combined with the rapidly expanding share of moderately-priced U.S. oil, have reduced the risks of undersupply and have lowered the risk premium on oil prices. Data suggests that supply looks to generally remain quite benign, even assuming an almost complete elimination of Iranian and Venezuelan exports in coming months.

Basically, abundant U.S. supply has crowded out less reliable producers, helping to improve the security of supply and keep oil prices in check, temporary dislocations notwithstanding. What's more, given U.S. shale producers cost structures and the unprecedented build-out of pipeline and export capacity underway, we believe the U.S. has great potential to step in with even larger supplies than currently assumed, if Brent prices sustainably average over $65 per barrel. For example, according to the IEA, billions of dollars of investment are projected to boost Permian pipeline capacity from 3 mbd to 8 mbd by the end of 2024, with a surfeit of capacity expected to be in place by the end of 2019.

This includes 2 mbd pipeline capacity out of the Permian basin to the Gulf Coast coming on line by the end of 2019, when the main potential constraint to expanding Permian oil supply becomes related to overwhelming volumes of associated natural gas, which oil producers may not find a way to economically deal due to a glut of U.S. natural gas, insufficient gas pipelines out of the Permian basin, unfavorable costs of accessing gas pipelines by oil producers, and potential caps on flaring/venting because of environmental concerns. For now, however, the U.S. is seen on its way, based on the IEA data, to more than double its crude oil exports to 8 mbd by 2025 from less than 1 mbd in 2017, with major positive effects on global oil-market conditions expected.

While these supply trends and conditions suggest limited upside pressure on prices, downside pressures are also limited because of cost increases, the stimulative effects of lower prices on demand and geopolitical tensions. For example, much lower prices would likely not only disadvantage OPEC and its allies, including Russia, which has declared as acceptable a $60 – $65-per-barrel Brent-price range and has cooperated with OPEC to defend it. They could also hurt many small, independent producers in the U.S., some of which may not survive a prolonged period of destocking and weak pricing. In turn, this could hinder U.S. oil supply growth and tighten the market, pushing Brent prices up to their apparent $60 – $65-per-barrel equilibrium level, where enough production can come on line and demand is neither hampered nor excessively stimulated. According to the IEA's Oil Market Report 2019, the U.S. needs Brent prices of around $65/barrel to deliver the disproportionately-high share of global supply growth expected through 2024 to meet global demand needs.

Indeed, strong U.S. production gains cannot be taken for granted. Lower international oil prices since late 2018 and a high discount of West Texas Intermediate (WTI) to Brent have resulted in a 10% drop in U.S. drilling activity year to date. Given the lagged response of drilling to oil prices, current prices suggest small further declines in the rig count through year-end. With less drilling and moderating well productivity, U.S. production has plateaued in recent weeks and year-over-year production growth has decelerated sharply from +20% to about +10% year to date. If prices were to weaken much more in coming months, production would likely surprise to the downside. Also important, with the Permian basin's most prolific fields depleting first and fast, the productivity of its wells is expected to slow, creating upside cost and price pressures over time.

One other factor likely to support prices is that "effective" global supply is currently smaller than reported because Iran still produces about 0.7 mbd more oil than it can export. While this oil is added to inventories, seemingly boosting the global oil glut, the Iranian stockpiles are not accessible to the market until sanctions eventually get removed. For the same reason, the 1.5 mbd of shuttered Iranian production is not considered part of "spare capacity." This suggests that the market will likely be less oversupplied this year than current Iranian production implies, though still comfortable absent major new disruptions elsewhere. Along with intensifying tensions in the Strait of Hormuz, we believe this is likely to keep a premium on Brent and support prices for the foreseeable future.

All in all, the oil market is currently facing crosscurrents that make it hard to discern the direction of oil prices. Fundamentally, however, the risk of supply disruptions has diminished as a result of surging U.S. production. In fact, because of the U.S. resurgence, the world would be awash in oil absent OPEC restraint and problems in Iran/Venezuela. Recent ambitious plans to expand capacity in Iraq/Libya/Kuwait, unprecedented U.S. production, pipeline and export capacity expansion, combined with the prospect of an eventual return to market of Iranian and Venezuelan oil suggest massive potential oil supply, with a "lower for longer" oil-price environment more likely than a tight market and high, growth-inhibiting prices, notwithstanding temporary head fakes, in our view.

Given inherent uncertainty and typical variations in supply and demand, we continue to believe that oil prices will fluctuate in a $50 – $70-per-barrel range, with a global growth upturn expected in 2020 and a steady-to-lower dollar likely to keep Brent closer to the high end of the range. The IEA is currently forecasting $67 per barrel for Brent in 2020, while BofA Merrill Lynch (BofAML) Global Research expects an average of $60 per barrel.

A Primer on Plastics: What Investors Need to Know

There is probably nothing more ubiquitous and mundane as plastic. Light, durable and cheap, plastic emerged as a substitute for concrete, glass, metals and a host of other materials starting in the 1950s. Today, it can be found in virtually every product imaginable; every region of the world; every ocean, including the Artic and Antarctica; numerous wildlife species like birds, fish and whales; and yes, even humans. Researchers recently found a variety of microplastics in stool samples of people—such is the explosive use and proliferation of plastic over the past few decades. Presently, some 350 million tons of plastic are produced each year.

Single-use plastic (for example, using a plastic bag, straw or bottle once and then discarding it) has become so prevalent that Collins, the dictionary publisher, chose "single-use" (as in "singleuse" plastics) as their word of the year in 2018. In short, the world is at a tipping point when it comes to plastic, with plastic rapidly becoming as culturally stigmatizing as tobacco due to its damaging effect on the environment and a host of species. As the Financial Times recently noted, "plastic, an emblem of postwar consumerism, is triggering a spasm of disgust."

As the global backlash to plastic builds, it's important to understand the size and scale of the challenge. So some salient numbers to consider from data as of 2018 – 2019:

  • A single-use plastic bag from a typical store has a useful life of 15 minutes but takes a staggering 500 to 1,000 years to degrade.3
  • The U.S. goes through 100 billion plastic shopping bags annually.
  • Plastic diapers and sanitary pads take between 500 and 800 years to biodegrade. Styrofoam takes 5,000 years. Glass takes 1 million years.
  • In the U.S. alone, some 2.5 million plastic bottles are thrown out per hour. Each one takes 500 years to decompose, according to Recycle Across America.
  • Americans throw out 40 billion soft drink cans and bottles each year—placed end to end, they would reach to the moon and back 20 times, according to Eco-Statistics.
  • Production has grown at such a breakneck pace that virtually half the plastic ever manufactured has been made in the past 15 years.3
  • Only 9% of all plastics in the U.S. are recycled. Roughly 12% of all plastic use in the U.S. is incinerated, while 79% of plastic ends up in landfills basically forever.3
  • Some 8 million tons of plastic seep into our oceans each year, which is the equivalent of dumping one garbage truck in the ocean per minute.3
  • There are about 46,000 pieces of plastic floating in every square mile of our oceans. In the Great Pacific Garbage patch, for every 2.2 pounds of plankton, there is 13.2 pounds of garbage.2
  • According to the World Bank, there could be more plastic than fish (by tonnage) in the ocean by 2050, based on current rates of usage and recycling.
  • Worldwide, people use an estimated 1 trillion plastic bags, which equates to 100 million barrels of oil.2
  • Speaking of oil, by 2030, one-third of all oil demand will emanate from the petrochemical industry to produce more plastic, according to the IEA.

The Great Awakening

The bad news is that the great plastic crisis is upon us. The good news: Countries, companies and consumers are slowly waking up to the crisis and future challenges. A global backlash against disposable plastic is gaining traction, creating potential investment opportunities.

A growing list of nations, for instance, has banned plastic bags, imposing steep fines and jail time on violators, with Kenya leading the charge. By 2020, France is committed to banning plastic plates and cups. Bans on plastic microbeads in cosmetics as exfoliants are planned to take effect this year in the U.S., Canada and the U.K. Prime Minister Justin Trudeau of Canada is expected to ban "harmful" single-use plastics as early as 2021. Similar legislation has passed through the European Parliament, which voted to ban single-use plastic items including straws, food containers and cotton bud sticks to encourage sustainable alternatives.

A recently proposed law in New York City would ban the sale of single-serve bottles at parks, golf courses and other public venues. In Mumbai, India, the government has banned water being sold in small bottles; Berlin and London have adopted similar measures. At this year's Wimbledon tennis tournament, plastic racket wrappers were banned. In Indonesia, the sprawling city of Surabaya, residents can pay their bus fare by recycling 10 plastic cups or up to 5 plastic bottles. In Estonia, citizens can now exchange plastic, glass and cans for cash or charity donations. Recycling vending machines populate Tallian, the nation's capital, making it easier and more convenient for consumers to kick-start a consumer-driven plastic recycling process.

In Washington D.C., yet another city to ban the use of plastic straws, "straw cops" now patrol public areas like Union Station looking for fast food outlets dispensing plastic straws; violators could face fines of up to $800.

Companies are also getting into the act. H&M, the British retailer, has halted use of plastic bags in Japan. Evian, the French bottling company, hopes to use only plastic bottles from recycled plastic by 2025, up from 30% today. Nestlé and PepsiCo are working hard in similar efforts, with the goal of making all plastic bottles recyclable by the next decade. Coca-Cola, through the company's World Without Waste Initiative, hopes to collect and recycle the equivalent of every bottle or can the company sells globally by 2030.

Among the world's largest consumer product groups, firms like Procter & Gamble, Pepsi and Unilever plan to start selling some of their products in glass, steel and other containers designed to be returned, cleaned and refilled. Unilever estimates that a refillable steel container for its Dove stick deodorants will last eight years, which is long enough to prevent the disposal of as many as 100 traditional deodorant packages. The Danish brewery Carlsberg recently unveiled a wood fiber bottle.

China says "no thank you"

Then there is China. Long the largest importer of the world's waste, China has decided not to be the world's dumpster anymore. After accepting and importing nearly half of the world's scrap/waste over the past few decades, China suddenly put a ban on imported plastic waste and other materials in 2018. Why? Because the country wasn't making any money recycling low-quality, contaminated and toxic items like garbage bags, bubble wrap, bottles, and was only adding to its own pollution problems in the process.

The upshot: As a result of China's garbage import ban, waste is piling up in places like Japan, which produces the largest amount of plastic waste per capita, according to the United Nations Environment Program, after the U.S. Scrambling, the Japanese government has mandated that retailers charge for shopping bags and slash the use of microplastics in facial scrubs and toothpaste. In the United States, which has traditionally exported one-third of all its trash, notably to China, numerous cities are struggling to cope with the mounting levels of municipal trash. For decades, wealthier countries shipped their plastic waste to developing nations, notably China, but today, even the world's underdeveloped nations don't want other people's waste.

The bottom line

There is a mounting premium on reducing the global footprint of plastic. Countries, companies and consumers are increasingly aware of the plastic plague, putting into motion various efforts on multiple fronts. At the forefront are the following: 1) finding alternative materials to plastics; 2) greater spending on the global recycling infrastructure; 3) increased investment in potential bio-degradable plastic materials; 4) new consumer packaging/wrapping technologies; and 5) a laser-like focus on the creation of the circular economy, where the world of "take, use and dispose" is upended for one that is "reduce, reuse, recycle." Finally, from the point of view of impact investing, we believe investors could likely reward firms that are at the forefront of finding solutions to the great global plastics crisis.

Fed Communication and Negation Causes Consternation

The Fed has made two abrupt about-faces recently. After facilitating a 20% drop in equities late last year, the Fed communicated "patience" with further rate increases, pausing the hiking cycle. Inflation expectations continued to fall, however, and the Fed abandoned its pause just a few months later, telegraphing a rate cut seems likely.

This market now questions the size of July's cut: 25 or 50 bps. The chance of 50 bps rose to about 1-in-3 following June's Federal Open Market Committee (FOMC) meeting, when Fed Chairman Powell emphasized that it was "well understood to be correct" that when close to zero rates, "an ounce of prevention is worth a pound of cure."

Subsequently, the Fed Board (FRB) St. Louis President James Bullard—who dissented last meeting, preferring a rate cut—said "50 bps would be overdone." This statement dropped expectations for 50 bps to 0%.

Just two days before the Fed's "blackout period," though, FRB New York President John Williams echoed precisely what Powell alluded to; "swift action" is warranted when rates are near zero. This message—consistent with Powell's—drove chances of a 50 bps hike to 64% intraday. This abrupt market move led a very rare clarification from the NY Fed: "This was an academic speech … not about potential policy actions." The chances for a 50 bps hike dropped immediately to about 20%, where they stand now.

This unpredictability is endemic in an era of hyper-transparency, where the Fed micromanages market expectations, attempting not to deliver any FOMC meeting surprises. It can be disconcerting for anyone focused on the short-term, leading to potential rate market whiplash. While good to understand the drivers of this volatility, investors should keep fresh in their minds that markets are a voting machine near term but a weighing machine long-term. The main point should not be lost: Whether the Fed cuts 25 or 50 bps in July seems nearly immaterial to the long-term investor. The Fed's policy stance is what is critical, in our view: accommodative, ready to ease monetary policy when necessary, with the ultimate goal of extending the U.S. economic expansion. We believe errors made in the interim—particularly communications gaffes, which may be plentiful—should be course-corrected and quickly fade into the rear-view.

Exhibit 1: Chance of a 50 bps cut at July FOMC meeting.