Capital Market Outlook (June 24, 2019)

In This Issue

  • Macro Strategy—U.S. growth remains strong, yet inflation and inflation expectations are falling rapidly. Global growth is shifting away from the rest of the world and back to the U.S. The Federal Reserve (the Fed) needs to focus on hitting its inflation target by easing as soon as possible. Once it does, we expect the fourth upswing in the global economic expansion since 2009.
  • Global Market View—With global growth momentum clearly slowing, many investors fear that margins have reached a cyclical peak and that rising wages and input costs may start to erode corporate profitability, with the trade war making things even worse. We outline some of the secular forces that have driven changes in corporate profitability over the years, as well as some of the cyclical drivers to watch as the profitability cycle matures.
  • Thought of the Week—As the fiscal year for state governments comes to a close, governors and state legislators have been updating their revenue and spending plans. Recently strong revenues, prudent spending plans and rising reserve balances suggest generally stable credit fundamentals for U.S. states.
  • Portfolio Considerations—We still believe equities are more attractive relative to bonds at current valuations and prospects. We maintain our constructive view on U.S. equities versus non-U.S. equities in the medium term on the basis of stronger real economic growth and corporate profits.

Mixed data reflect shifting global-growth pattern

The populist-driven remixing of global growth currently underway from increased globalization toward more focus on national interests is increasingly evident in incoming economic data showing big trade-surplus countries, like China and Germany, slowing more than expected while big trade-deficit countries, like the U.S., have performed relatively better as trade-war concerns dampen the growth of international commerce. This relative outperformance of domestic versus international growth is apparent in the latest U.S. business survey data. The National Federation of Independent Business (NFIB) survey of small U.S. businesses has been rebounding since its December low point thanks to the Fed's pivot away from additional tightening. As interest rates have come down, small-business confidence has risen to a new high for the year, with rising plans for capital spending and more optimism that "now is a good time to expand."

In contrast, while still elevated, CEO confidence at big multinational corporations has continued to come off last year's highs as trade concerns weigh on views about international trade and global supply chains are increasingly reevaluated and shifted in response to actual and threatened increases in tariffs. As the trade war increasingly focuses on China, it has seen significant slowing and growing interest in moving production elsewhere.

Prior to 2016, confidence at large multinational firms was consistently higher than that of small business owners, which never recovered to typical expansion levels until 2016. Since then, the gap between big company CEO confidence and small business confidence has closed, and this year is moving in favor of the small-business sector, presumably reflecting the differential impact of tariffs on domestic versus foreign sales.

Thus, there are two distinct dynamics at play: a strengthening U.S. domestic economy and a weakening global economy, especially pronounced in countries with the biggest trade surpluses, which are most vulnerable to this reset in the global economic order. The resulting mixed messages in the global data are well encapsulated in the BofA Merrill Lynch global wave index. After declining through the second half of 2018 into early 2019, the global wave indicator has flattened out, with some leading indicators currently improving, including the recent earnings revisions ratios, consumer confidence and employment indicators. At the same time, slowing global trade is offsetting some of these gains by restraining production data. The wave will likely begin to rise once the Fed eases policy and the yield curve starts to steepen. Similarly, the index of U.S. leading indicators has been restrained by the inverted yield curve while other subcomponents related to housing, employment, equity prices and consumer spending have turned up and should get additional impetus when the Fed takes the brakes off.

Indeed, favorable consumer spending data have spurred upside revisions to forecasts for second-quarter gross domestic product (GDP) growth from about 1.5% to over 2%, and the sharp drop in interest rates this year is helping prolong the expansion. The Atlanta Fed GDPNow forecast for real personal consumption expenditures was lifted from about 3% to about 4% as it makes up for soft growth in the first quarter. Since consumption is about 70% of GDP, this raises the possibility that GDP growth could surprise to the upside again and remain close to the 3% trend of the past year.

While the weaker-than-expected May employment report fed fears of a significant slowing underway, other labor market indicators such as the Job Openings and Labor Turnover Survey (JOLTS), initial claims for unemployment compensation, and the latest Manpower survey all show a still red-hot jobs market. The employment component of the manufacturing Institute for Supply Management index stabilized over the past three months, while the May non-manufacturing ISM survey showed a surge in employment. Also positive, vehicle sales remain solid, and housing is now getting a significant boost from the plunge in mortgage rates. As a result, after subtracting from GDP growth the past two years, housing is beginning to add to growth again.

This consumer and housing support is welcome for the outlook for business investment given softening corporate revenue growth as a result of the tight Fed policy (due to weakening business pricing power, strong dollar, slowing global growth). Overall, leading indicators suggest mid-single-digit growth in business fixed-investment into 2020, helped by an improvement in the nonfinancial corporate financing gap, relatively steady growth in non-investment GDP, and lower interest rates.

With leading indicators consistent with 3% real GDP growth into 2020, the plunge in interest rates and inversion of the yield curve is perplexing the consensus as they typically precede significant U.S. economic slowdowns or even recessions. Mainly, economists are puzzled by the combination of strong growth and falling inflation because this is inconsistent with the long-held consensus view that strong growth causes inflation. This view has led the Fed to believe that the fall in inflation is temporary, and policy rates are not a problem for the economy.

However, in our view, and increasingly clear in the signals coming from the financial markets, the drop in inflation and inflation expectations has been caused by the excessive tightening in 2018, which engendered much stronger deflationary pressures than the Fed realizes. This became evident last summer when leading indicators of inflation rolled over sharply. Since then, "core" Personal Consumption Expenditures (PCE) inflation has dropped from 2% to about 1.5%, and the signs that inflation expectations are becoming unanchored are spreading. The latest University of Michigan survey shows household inflation expectations dropped to the lowest level in the 40-year history of the survey. Also, ever since late 2018, the NFIB survey shows declining actual and planned price increases despite the more optimistic outlook for activity. This plunge in the inflation outlook is global. Inflation in Europe and Japan is even further below centralbank targets and falling, as Fed policy tightening hit the rest of the world even harder than the U.S. Fortunately, the Fed pivot this year is allowing other central banks to ease and help ignite a new round of reflation.

Basically, the Fed overtightened in the second half of 2018, imparting a deflationary shock that the markets are screaming to have reversed by urgent rate cuts this year. The Fed has remained sanguine about the appropriateness of Fed policy and only slowly shifted to a dovish stance. Its credibility has become an issue given the failure to meet the 2% "core" inflation mandate again this year and leading inflation indicators softening.

In the short term, falling inflation is good for U.S. consumers, making the U.S. economy stronger. Longer term, however, it raises the risk that the U.S. economy relapses back to the zero-bound for interest rates. While real growth remains solid, falling inflation depresses nominal magnitudes like corporate revenues, retail sales and personal income. Importantly, the growth in the aggregate payrolls index (which takes into account the growth in the number of jobs, average hourly earnings and hours worked) has softened significantly and suggests waning pricing power for businesses ahead and eventual brakes on hiring and investment (Exhibit 1). Indeed, in a highly leveraged economy like the U.S., softening revenue growth makes it harder to service debt and grow at a level sufficient to sustain full employment. In other words, despite the Fed's sanguine view about growth and its policy stance, strong growth is unlikely to persist unless the central bank gets serious about achieving its inflation goal. Absent a rate cut soon, the U.S. is headed in the direction of Europe and Japan, where nominal growth is persistently below 2%, and interest rates are negative.

Exhibit 1: Sharp Reversal in Consumer Spending Power Growth to an Estimated 4% or Less as the Year Progresses Suggests Fed has Overtightened.

Corporate Margins: Durable Under Pressure

The profitability of U.S. corporations has trended higher over the last three decades and shown remarkable resilience throughout this cycle. However, coming out of a banner year for corporate profits in 2018, recently we have seen mounting concerns over economic growth in many regions of the world, as well as headwinds from trade, leading investors to brace for a potential "earnings recession" in the U.S. With global growth momentum clearly slowing, the prevailing view is that profit margins have peaked and that rising wages and input costs may start to erode corporate profitability, with the trade war making things even worse. We outline some of the secular forces that have driven changes in corporate profitability over the years, as well as some of the cyclical drivers to watch as the profitability cycle matures (Exhibit 2).

Exhibit 2: Cyclical and Structural Forces Shape the Outlook for Margins.

Note: dotted line represents the trend. Grey bars are recessions. Sources: FactSet; Chief Investment Office. Data as of June 20, 2019.

Structural Drivers of Corporate Profitability

Over the past three decades, globalization has reshaped the way multinational companies operate, where they produce and where they sell their products, benefitting firms immensely in the form of a larger customer base and higher profitability as they source production from lower cost regions. But over the past couple of years, we've witnessed a number of geopolitical and economic trends that are leading many companies to rethink how to structure their global supply chains. For example, manufacturing wages in China rose at an annualized rate of 15% from 2010 to 2017, according to the National Bureau of Statistics (now about 1.5x as high as India, Vietnam and the Philippines), which, combined with weakening demographic trends, is leading many companies to consider diversifying their production, with tariffs acting as a catalyst for change. A number of companies in the telecom equipment, auto and apparel/footwear industries are revamping their supply chains, with "reshoring" being a key trend. While offshoring/globalization are not going away any time soon, we believe the scope for further margin improvements from lower wages and manufacturing costs may be limited going forward.

The substitution of capital in place of labor, most recently including trends in robotics and automation, represents another key structural force that has helped to drive stronger corporate profitability. Over the past sixty years, the labor share of income has been on a clear downward trajectory and has accelerated lower since the turn of the century, as longer-term technological and demographic forces have driven companies to take advantage of more advanced technologies to address labor shortages and cut expenses. This trend is especially prevalent in developed economies, for instance U.S. manufacturing firms now add one robot for every three human workers, while Japan adds around as many robots as people, according to Empirical Research Partners. Globally, sales of industrial robots rose to an all-time high of 381,335 units in 2017, driven by increased adoption in the metals industry (+55%), electronics (+33%) and autos (+22%), according to the International Federation of Robotics.

Declining union membership over the past few decades has also awarded less bargaining power for workers to negotiate higher pay and push back against companies' efforts to cut costs. The percent of private workers in labor unions has dropped from 16.8% in 1983 to just 6.4% last year, partially as a result of companies moving operations to less-union-friendly states, with employment growth since the 1980s having been much stronger in states with low union participation rates versus those with high union participation rates (Exhibit 3). Two major Supreme Court rulings have acted as catalysts as well: one that prohibited unions from collecting fees from non-union employees and another that allowed companies to require employees to handle disputes via arbitration rather than a class-action lawsuit.

Exhibit 3: State Employment Growth versus Union Participation.



Union Participation Rate (%, 2018)

Employment Growth (%, 1983–2019)

Top 5 Union Participation




New York









Rhode Island



Bottom 5 Union Participation










North Carolina



South Carolina





Average Among Top 5


Average Among Bottom 5


Total U.S.


Note: Employment data range from January 1983 – May 2019. Source: Bureau of Labor Statistics. Data as of June 22, 2019.

Finally, secular tailwinds for the technology sector has been a longer-term driver for S&P 500 margins from an index composition perspective. The Technology sector's share in the S&P 500 has risen roughly 15 percentage points since 1990, taking share away from lower margin sectors like Consumer Discretionary/Staples, Industrials and Energy. Profit margins for technology companies are around twice those of the broader S&P 500 (24% vs. 13% operating margins last year), since tech firms often have more scalable business models.

Cyclical Crosscurrents Driving Margins

Profit margins have remained unusually high in this cycle, supported by rising revenues and low input cost gains, namely wages, but risks are growing. Going forward, nominal global GDP growth will need to stabilize and pick up for revenues to be supportive of margins, underscoring the need for global manufacturing and trade to get back on track. Trends in global manufacturing have been lackluster over the past year, with the Global Manufacturing Purchasing Managers Index (PMI) reaching its lowest level since October 2012 last month. Trade flows have weakened, emanating across Europe, parts of Developing Asia, as well as Canada, Mexico and Japan, while slowing Chinese demand has bled into its major trading partners like Europe, Japan and Korea, reflected in the recently lowered expectations for growth in Germany and Italy. The rebound in Chinese growth earlier in the year is becoming less promising, with industrial production starting to show signs of weakening, but we expect Beijing to provide more support by reducing banks' required reserve ratio and boosting infrastructure investment. Data suggests U.S. economy is doing well on a relative basis, but certain forward-looking indicators like the PMI are hinting at a moderation in growth, while lower inflation expectations and an inverted yield curve signal a heightened risk of a slowdown. A rate cut by the Fed before the end of the year is becoming increasingly likely and should help buffer the economy from slower growth abroad and soften the dollar.

Upward pressure on wages, given that the U.S. unemployment rate is below 4%, is a key risk to profit margins. Higher employment costs will pressure profitability to slip lower over the coming quarters, but not collapse, in our view. One underappreciated benefit of tax reform and deregulation has been an acceleration in productivity growth in recent quarters. In particular, the growth rate of spending on intellectual property products has nearly doubled since tax reform was passed, helping to support the pickup in productivity growth over the past couple of years. This is especially important in a tight labor market as higher productivity helps offset the detrimental impact of wage pressure on margins and suggests margins could hold up if productivity continues to accelerate as we expect (Exhibit 4).

Exhibit 4: Higher Productivity Growth Helps to Support Margins.

Note: EBITDA = Earnings before interest, taxes, depreciation and amortization. Sources: Bureau of Labor Statistics; Haver Analytics; Bloomberg. Data as of June 18, 2019.

Finally the U.S. dollar and tariffs will influence profitability trends. The dollar has been firm in the last year, acting as a headwind for exporters and multinationals that translate foreign earnings into dollars; as a rule of thumb, a 10% appreciation in the dollar versus the euro represents around a 3% to 4% headwind for S&P 500 earnings per share (EPS), according to BofAML Global Research. In our view, the dollar can soften and act as a tailwind to revenues if growth outside the U.S. stabilizes and the Fed cuts rates. The impact of tariffs on profitability varies by industry and products and depends on the ability of companies to either absorb the higher input prices into their cost structure and/or pass them onto consumers. Generally speaking, the longer the current tariffs stay in place, the more downward pressure they will exert on margins. BofAML Global Research estimates the incremental direct impact to S&P 500 EPS from 25% tariffs on all remaining Chinese imports to be 1%, with additional downside in the form of weaker capex and slower global growth overall.


The bottom line is that margins will be a key determinant of future corporate profits and equity market performance. Some secular drivers of profitability, like globalization and free trade, have likely peaked whereas others, like increasing penetration of productivityenhancing technology, are in the early innings. Cyclically, persistent gains in productivity are helping to insulate earnings from rising wages. Top-line growth will track global nominal GDP growth, which, while slowing in the near term, would be bolstered by easing from the Fed supporting inflation expectations and easier financial conditions. On balance, we expect profit margins to move slightly lower but not collapse. Ultimately, in an environment with no shortage of risks, ranging from slower global growth to a renewed sense of uncertainty over trade, we believe that only a slight pro-risk tilt in portfolios is warranted as investors await more clarity on the macro outlook.

The State of U.S. States: Strong Finances Underpinning Economic Growth

While much attention has been devoted to the budget policies of the federal government, many market participants often fail to recognize another key driver of the U.S. economy and fiscal policy: state and local governments. Combined, the annual spending of this cohort of states, counties, municipalities and townships is nearly $3.0 trillion—more than the GDP of most nations.

As the fiscal year (FY) for state governments comes to a close, governors and state legislators have been updating their revenue/spending plans.1 Many states have been working with budget surpluses, thanks to stronger-than-expected revenue collections, with tax receipts being boosted by strong economic growth, favorable stock market returns and certain tax law changes. States are deploying this additional capital in two ways: by increasing savings and boosting spending.

Exhibit 5 shows that as revenue collections rise, states have been building up their reserves. Following exceptionally strong revenue growth in FY 2018 (+7%), states grew their so-called rainy-day funds to a combined $68.2 billion in FY 2019, with the median state setting aside enough funds to cover 7.5% of annual expenses, a record high. These rainy-day funds can provide some protection from declining state revenues in a potential recession.

Exhibit 5: Strong Revenue Growth Helping States Boost Savings.

*FY 2019 is estimate. FY 2020 is based on governor's recommended budgets. Source: National Association of State Budget Officers, Fiscal Survey of the States 2019. Data as of June 13, 2019.

Meanwhile, states are also increasing their expenditures. General fund spending is estimated to rise by 5.8% in FY 2019, the strongest rate of growth since before the financial crisis. Proposed budgets for next year indicate expenditure growth of 3.7%, with most of the additional spend being allocated toward education.

This combination of strong revenues, prudent spending plans and rising reserves suggests generally stable credit fundamentals for U.S. states and supports our slight preference for municipal securities within fixed income for high-income investors. That said, the aggregate figures mask important discrepancies among states, and pockets of weakness exist in some states with large unfunded pension and other post-employment benefit liabilities. These differences in financial and economic conditions among states provide opportunities for municipal bond investors to add value through bond selection, as well as diversify within the asset class.