Capital Market Outlook (July 8, 2019)

In This Issue

  • Macro Strategy—While markets continue to be distracted by trade tensions, the deflationary shock the Federal Reserve (Fed) inflicted on the global economy in 2018 continues to work its way through global cash flows. Inflation and inflation expectations are falling around the world, while businesses report declining pricing power and revenue growth. Signs of weakening consumer-income growth are the last step on the road to recession. These are all signs of overly-tight monetary policy.
  • Global Market View—As we move into the second half of 2019, healthcare has so far been the trailing sector across the major equity benchmarks. But for small drug makers in particular, we see an emerging range of new therapeutic approaches that are likely to support market share and pricing power over the years ahead.
  • Thought of the Week—Since the passage of tax reform, U.S. multinationals have repatriated almost $900 billion of their global earnings, which has helped increase shareholder returns and boost capital investment in the U.S. Although repatriations are likely to come in much weaker this year versus 2018, they should remain above historical averages and continue to support equity returns over the balance of the year.
  • 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 shorter dated 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.

Flirting with Disaster

Economic data have generally disappointed since our May 2019 Capital Market Outlook, The Case for a Fed Rate Cut. These include U.S. and global manufacturing surveys, uncertainty, the Conference Board index of leading indicators, international trade, Eurozone sentiment indicators, as well as base- metal prices. The loss of U.S. and global growth momentum this year is not surprising given the sharp deceleration in money supply since early 2018, the strong dollar, and drop in business pricing power and consumer inflation expectations, all symptoms of a tight Fed monetary policy.

This disappointing mix of softening growth and inflation pressures has started to reduce revenue and profit growth estimates and to stifle business investment, labor income and consumer spending growth. Not surprisingly in this context, the yield curve has become increasingly inverted, consistent with a weaker-than-expected nominal gross domestic product (GDP) growth environment in 2019—likely averaging below the 5% threshold we believe is necessary to service the debt in the economy and allow for growth at potential—and heightened risk of a premature recession.

As a result, the case for the Fed cutting interest rates has strengthened over the past two months and has become widely recognized. Expectations for Fed action are greater now than was apparent earlier this year, when policymakers missed the opportunity for a prudent and preemptive minor policy adjustment. While self-correcting forces signal that a stabilization in global manufacturing is underway, further Fed equivocation creates downside risks to the U.S. and global economy.

Indeed, U.S. employment growth indicators are still strong, but they are lagging indicators, not leading indicators: They respond to past strength in the economy rather than reflecting a positive growth outlook. The large drop in mortgage rates since the Fed's recent dovish turn has spurred refinancing activity and a jump in the University of Michigan's home-buying sentiment index to a one-year high, but housing activity remains soft and appears poised to only grind higher given still-depressed home-buying sentiment (Exhibit 1) and signals for softening labor-income growth in coming months, as discussed below. For now, building permits, which are a leading indicator, hardly point to a construction boom, with an ongoing shortage of skilled workers and building lots as well as high construction costs also pointing to sustained constraints on housing activity ahead, in our view.

Exhibit 1: Housing Likely to Restrain Consumer Spending.

* z-score: is the number of standard deviations from the mean a data point is.

While we still expect the Institute for Supply Management (ISM) manufacturing index to bottom soon and at a higher level than in the 2011–2012 and 2014–2015 manufacturing slowdowns because of pro-growth U.S. fiscal policies, we now don't see it exceeding its long-term average in the second half, consistent with only modest manufacturing activity expansion. The downward revision to our manufacturing outlook is due to soft housing and the current dollar strength, as well as to ongoing weakness in global manufacturing conditions. This is especially true in Europe, where Germany has surprised to the downside this year. While Eurozone manufacturing activity has undershot domestic-demand growth, which is typically a signal for a strengthening manufacturing outlook, leading indicators now point to slowing domestic demand ahead. For example, German manufacturing orders signal further, albeit smaller, declines in manufacturing production into the Fall, and other incoming Eurozone data suggest a significant weakening of business equipment investment growth to about 0% this year, residential investment growth slowing to just about 2.5% and consumer spending growth likely stable at about 1.0%. As a result, only a protracted stabilization period and gradual/weak pickup in the Eurozone Purchasing Managers Index (PMI) to 52 or 53 by mid-2020 is now expected, consistent with tepid manufacturing growth and a soft global capital expenditures (capex) outlook.

The U.S. consumer sector has remained the bright spot in the economy, helping mitigate headwinds from the trade war and the global manufacturing and trade slump. With jobs plentiful and incomes rising, consumer confidence has remained high, and incoming data suggest a strong second-quarter real spending rebound to an almost 4% annualized quarterly gain from the disappointing 0.9% pace of the first quarter, when the government shutdown, the stock-market rout in December, fears of a monetary-policy mistake, and growing concerns about a trade war all hurt spending.

Still, we believe that even in this sector, there are reasons to be concerned because of signs that the lagged effects of a tight Fed are starting to dampen the consumer income and spending growth outlook as well. First, absent a big upside housing-sector surprise, modest home sales activity is likely to rein in consumer spending. Second, in our view, high uncertainty, weak business pricing power, low single-digit corporate-revenue growth this year, and the big June drop in the Conference Board consumer expectations survey suggest that labor income and real consumer spending are poised to soften in coming months. Essentially, the Fed's deflationary shock has been spreading through all the cash flows in the economy: spending, revenues and incomes included. For example, leading indicators of labor-income growth suggest that year-over-year aggregate payroll index growth may drop from over 6% in January 2019 and 4.4% in June to about 3.70% by October, which would take more steam out of the economy and keep inflation pressures to the downside. Leading indicators of consumer-spending growth point to a deceleration from 2.7% year-over-year growth in May to just around 2% by October.

Monetary policy affects the economy with a lag, so the Fed should cut rates soon to prevent a deepening economic problem, possibly even a recession. Because of the damage already done, financial markets are now pricing in up to three rate cuts by the end of January 2020. Notwithstanding growing negative risks to the outlook and the perceived need for significant Fed rate cuts (as reflected in the inverted yield curve), markets have remained calm. In our view, financial markets appear to believe that the Fed won't kill the expansion in the absence of an inflation problem and that there's still time to save the expansion with rate cuts. Well-behaved credit spreads and resilient equities may also reflect the strong productivity gains over the past year, which have kept unit labor costs contained despite the tight labor market. This has helped keep margins high, which tends to correspond with low credit spreads. While margin pressures are unlikely to increase substantially given our positive productivity growth and contained wage growth outlook, weaker corporate revenue growth than our 4.5% estimate for 2019 would undermine margins, possibly causing credit spreads to turn up on a dime, as they typically do when margins come under pressure, usually in recessions.

The symptoms of a tight Fed policy are thus clear: decelerating money-supply growth, depressed housing activity, and a softening nominal-growth environment. Import prices and base-metal prices have declined, and inflation expectations and interest rates around the globe are notably surprising to the downside. The economic expansion doesn't have to end just because it is now the longest in U.S. history. However, interest rates clearly need to be lowered at the front end to steepen the yield curve consistent with a healthier nominal GDP growth outlook. Early signs of self-adjustment—including positive signals from Organisation for Economic Co-Operation and Development (OECD) leading indicators for a softening dollar and a stabilization in manufacturing sentiment surveys both in the U.S. and globally—are welcome but insufficient. The yield curve suggests that the expansion cannot sustain current money-market interest rates.

Biotechnology Innovation: A Growth Driver for the Healthcare Sector

As we move into the second half of 2019, healthcare has so far been the trailing sector across the major equity benchmarks. Within the healthcare sector, large-cap pharmaceuticals and biotechnology have lagged most other industries, weighing on aggregate returns. But their small-cap counterparts have by contrast been outperformers, leading all but information technology among the Global Industry Classification Standard level 1 groups. For small drug makers in particular, we see an emerging range of new therapeutic approaches that are likely to support market share and pricing power over the years ahead. Disease treatment techniques have traditionally been limited to prescribed medication, surgery and changes in behavioral habits. But advances in genomics and the falling cost of DNA sequencing are enabling new, more targeted approaches that potentially offer more effective means of treatment.

The cost of genomic sequencing has collapsed over the past decade. Between the start of 2010 and the first quarter of this year, the sequencing cost for a human-sized genome fell by 97%, from $47,000 to just $1,300. But perhaps less widely appreciated has been the accompanying surge in sequencing activity. Over the same period, the total number of sequencing projects catalogued by the National Institutes of Health Center for Biotechnology Information has multiplied from 57 million to 945 million (Exhibit 2). However with many fewer human genomes estimated to have been sequenced, primarily in laboratories as part of scientific research projects rather than in hospitals, we are yet to see the full economic impact of next-generation genomics on the healthcare sector and others, which McKinsey has estimated could be worth as much as $0.7-$1.6 trillion annually by 2025.

Exhibit 2: The Falling Cost of Gene Sequencing Is Enabling New Treatment Techniques.

* Cost of sequencing a human-sized genome.

**Total number of genome sequencing projects catalogued in the National Center for Biotechnology Information (National Institutes of Health) WGS database.

The biggest implications are likely to be for drug discovery, particularly in areas such as cancer treatment where genetic variation plays a major role. A lower cost of sequencing should allow research scientists to produce larger sets of data on specific genetic mutations which can then be matched against observable symptoms to develop targeted treatments.

This represents a far more efficient approach to drug development than the traditional trial and error testing widely practiced now, and a much firmer basis for diagnosis than simply which part of the body is affected and how far the disease has spread.

The drug approval process should receive a further tailwind from elements of the regulatory environment. In particular, the U.S. Food and Drug Administration (FDA) "breakthrough therapy" designation was established in 2012 to accelerate approvals for new drugs designed to treat severe clinical conditions, and a rising number of drug treatments has been approved under this designation since its inception. As of last year, a total of 132 drugs awarded the breakthrough therapy designation had been approved by the FDA, of which 76 (58% of the total) were cancer treatments. The rest were targeting infectious disease, inherited disorders and other chronic conditions (Exhibit 3).

Exhibit 3: Drug Treatments Approved by FDA Under Breakthrough Therapy Designation.

At the same time, biotechnology firms are developing a new range of gene-linked biopharmaceutical techniques that also aim to reverse or reduce the risk of chronic, infectious and inherited disease.

Immunotherapy describes a class of treatments primarily aimed at cancers that act through enhancements to the patient's immune system. In the past, these have been limited to drugs known as checkpoint inhibitors, which improve the capacity of the immune system to recognize and eliminate cancer cells. But more recently, the ability to sequence tumor and immune cells at lower cost has assisted the development of a new group of better-performing immunotherapy approaches that rely on the infusion of immune system cells into the patient. In particular, so called CAR-T therapies extract the patient's own immune system T-cells, re-engineer them to more effectively attack the tumor, and then re-introduce them by injection. The FDA delivered its first ever CAR-T approval in 2017, and though this technique has so far proved most capable in tackling blood and bone marrow cancers, ongoing research may allow similar techniques to deliver comparable results for solid tumors in the future.

Gene therapies by comparison target a wider range of conditions, aimed primarily at correcting inherited disorders but also at reducing the risk of other chronic illnesses. They typically act in one of two ways. Gene augmentation therapy adds DNA to mutated cells in order to restore lost genetic function, while gene inhibition therapy introduces DNA that aims to suppress the growth of disease-related cells. In the case of inherited diseases, a single genetic mutation may be the primary cause of the disorder. While in the case of other chronic diseases, patient risk can be influenced by multiple genes as well as environmental factors that can have varying effects across individuals. A gene therapy for the treatment of spinal muscular atrophy was approved by the FDA this past May, with the agency stating earlier in the year that it expects to be approving 10 to 20 annually by 2025.

At an even earlier stage of development are gene editing techniques—treatment methods which aim to correct gene-related disorders more precisely than augmentation or inhibition therapies. Three main methods have been developed, each of which acts by directing enzymes to target specific DNA sequences in order to delete diseasecausing mutations. The latest technique, known as CRISPR/Cas9, currently shows the most promise and is the least expensive and easiest to apply. Gene editing has already been used in the modification of plant and animal genomes, with future applications of the technique potentially including the improvement in crop yields and the development of more efficient biofuels. In healthcare, researchers in China have conducted several human trials to treat a range of conditions including HIV and lung cancer. While in the U.S., the National Institutes of Health has given its approval to a group of doctors at the University of Pennsylvania to test CRISPR in the editing of human T-cells for use in immunotherapy. The first trial took place earlier this year.

In each of these cases, the key to more widespread clinical adoption will be reducing cost, improving efficacy and limiting side effects, and we expect these new areas of innovation to be a source of growth for the healthcare sector over the coming years. This comes on top of the underlying tailwind of a broadening global patient pool as an additional 170 million people reach retirement age by 2025, a further 315 million by 2030 and close to 900 million by 2050 on United Nations demographic projections. For investors, downward pricing pressure remains a risk as more treatments come to the market, and as payers and politicians express concern over high reimbursement rates. But small and mid-cap firms at the leading edge of innovations in gene therapy, gene editing and immunotherapy should likely stand to gain from new FDA approvals and as potential targets for acquisitions. Larger pharmaceuticals and biotech firms that can expand their pipelines through takeovers or licensing agreements with developers of differentiated treatments may also stand to be beneficiaries. Indeed over recent years a number of major funding deals and acquisitions have taken place between large-cap biotech leaders and smaller-cap biotechnology firms specializing in gene therapy and immunotherapy. And with the pharmaceuticals and biotechnology industry groups within the S&P 500 accounting for close to 50% of total healthcare sector market capitalization, ongoing advances in disease treatment and continuing interest from major drug makers that can bring these new treatments to market should act as a tailwind for the sector as a whole.

Repatriation Update: $900 Billion of Foreign Earnings Returns to U.S.

Last year, U.S. firms made a record amount of profits overseas, raking in some $531 billion, a 13% jump from the prior year. U.S. companies can either reinvest these earnings into their foreign affiliates or repatriate profits to the parent company back in the U.S. Prior to the 2017 Tax Cuts and Jobs Act, it was unfavorable for companies to do the latter—repatriate profits—as they would be forced to pay a high U.S. corporate tax rate on all earnings brought back to U.S. soil. As a result, companies opted to shelter profits abroad, leaving roughly $3 trillion of funds stockpiled overseas by 2017.

After the 2017 tax act reduced the rate corporations had to pay to repatriate prior earnings, U.S. multinationals began to send a large share of profits back to the U.S., giving them access to capital which could be utilized to increase shareholder returns and boost productivity in the U.S. Last year, a record $777 billion was repatriated, roughly in line with our forecasts, and leaving equity investors wondering just how much fuel is left for 2019.

Recently released balance-of-payments data gives us some clue into the pace of repatriations for 2019. In the first quarter, foreign affiliates repatriated an additional $100 billion, more than double the amount that was reinvested abroad (Exhibit 4). While this is a slower pace than what we saw last year, it still represents a significant amount of cash, well in excess of the ~$40 billion quarterly average in the years leading up to tax reform. It is also bullish for equity markets, with corporate buybacks and dividends rising to a record $1.26 trillion in 2018. So far this year, S&P 500 buybacks and dividends are tracking at a slightly faster pace than last year. Some other cited uses for the newly repatriated cash include reducing corporate debt, mergers and acquisitions (M&A), investing in capex, among others. Although repatriations are likely to come in much weaker this year versus 2018, they should remain above historical averages and continue to support equity returns over the balance of the year.

Exhibit 4: Homecoming for U.S. Corporate Profits.

Negative reinvested earnings can occur when the amount of funds repatriated exceeds current-period earnings.