Capital Market Outlook (June 29, 2020)

In This Issue

  • Macro Strategy—Every recession is similar to and different from previous downturns. The typical economic and financial-market patterns observed when new expansions begin are playing out just as they have in the past. At the same time, the response to the pandemic reveals important societal changes which, in our view, are likely to continue to shape the future investment landscape.
  • Global Market View—We see several factors emerging as foundation for a long-term advance for U.S. equities in the form of low inflation dynamics and accommodative monetary policy, creative destruction leading to productivity improvements, re-shoring and new capital expenditure (capex) growth, and finally cautious investor sentiment and the search for high-quality assets.
  • Thought of the Week—With both sides of the aisle ratcheting up the anti-trade rhetoric and in spite of the growing wave of de-globalization—foreign investors still want a piece of America. As a long-term bullish indicator, foreign demand for U.S. securities remains robust and supportive across multiple asset classes.
  • Portfolio Considerations—The U.S. remains our preferred equity region relative to the rest of the world, and we remain slightly overweight investment-grade credit in fixed income. We expect curves to steepen slightly as the Federal Reserve (Fed) signals forward guidance. Consider staying diversified across growth and value assets and add to cyclical areas, including equities at the asset class level, over time as we still climb that tall "wall of worry."

Something Old and Something New

The business cycle is playing out as it typically does. Economic data bottomed in midApril and have begun to recover. Markets, including the credit and stock markets, have led the economic recovery, as they always do. Because of the well-defined cause of the downturn, namely the shutdowns around the world aimed at flattening the pandemic curve, the timing of the onset and of the end of recession were also well-defined. The damage, disruption and ultimate fallout from the shutdowns could have easily caused a severe depression had policy not intervened to prevent disaster. However, given the policy response, it appears that the disaster scenario is off the table.

In fact, fear of an unstoppable down spiral has caused monetary and fiscal policy to respond in an unprecedentedly aggressive manner that has dramatically changed the economic landscape from what seemed likely before the pandemic. In the U.S., for example, fiscal spending fueled by the biggest deficits since World War II (WWII) combined with the most aggressive monetary expansion in U.S. history showed a political will to err on the side of over-spending as opposed to the relatively stingy policies that followed the Great Financial Crisis of 2008-2009. The failure to generate sufficient growth and inflation to hit central-bank targets during the last expansion is prima facie evidence that policymakers were too timid not only in the U.S., but all around the developed world.

Having learned that lesson the hard way and given the threat that the shutdowns would cause an economic depression, policymakers have instead thrown caution to the wind. Economic and market variables are responding to that fact. It is not a coincidence that the U.S. equity market made its bear-market bottom in the third week of March, when the first Coronavirus Aid, Relief, and Economic Security Act (''CARES Act") package was signed into law, the biggest and fastest fiscal-spending initiative in the history of the United States. The strong recovery in market and economic leading indicators since the economy began to reopen shows that expectations are forming for a very strong and prolonged expansion.

A distinguishing feature of this new cycle is the speed with which it is unfolding: the fastest bear markets in stocks, the fastest and deepest economic plunge followed by the strongest and quickest equity bull market and economic recovery on record. In fact, the timing of the shutdowns pretty much fits the timing of the recession. As usual, the stock market fell in advance of the shutdowns and rose in anticipation of their expiration and the promised fiscal spending. The speed and scope of the U.S. economic recovery are directly proportional to the speed and scope of the policy response. This is true all around the developed world, where the policy response has been similarly gargantuan to that of the U.S. The stimulus in place and the stimulus yet to come imply a period of stronger economic growth not only in the U.S. but all around the world for at least the next couple of years. That's the apparent message in the equity market.

Also as is typical at the end of recessions, pundits look at the cycle low in profits and conclude that the strong gains in equity markets reflect a disconnect between the fundamentals and stock-market valuations. This narrative was as common after the last three recessions as it is now. However, it misses the fact that a brighter future raises the current value of stocks. What's more, the response to the pandemic implies a number of new forces driving the likely evolution of the global economy, with significant implications for investors. In some sense, the pandemic has altered the course of history. In many respects, it has simply sped up trends that were already under way.

One example is Europe. Since WWII, European unification has proceeded in fits and starts. Progress toward a more unified Europe was often the result of a necessary response to crisis. The Great Financial Crisis of 2008-2009 revealed the shortcomings of European institutions for addressing systemic crises. Various baby steps have helped the European Central Bank (ECB), for example, gain the tools it needed to prevent a deflationary collapse and do "whatever it takes" to prevent a breakup of the euro. The need to create a "fiscal bazooka" to address the pandemic's fallout has precipitated a historic "Hamiltonian" moment for Europe. Germany has finally agreed to a European fiscal structure that mutualizes debt across the European Union member states. This allows Europe to match the power of U.S. fiscal spending and eliminates a major source of doubt about the viability of the euro. In addition, the ECB, which has borne the brunt of policy support in the absence of a centralized fiscal authority, has been freed to focus on monetary issues. It has recently revamped its negative interest-rate structure to allow banks to receive positive returns for lending while still paying negative rates to borrow. These important changes to European policy together with an outlook for a solid synchronized global expansion in 2021 and 2022 have caused European stocks to perform more in line with the U.S. after years of underperformance.

Another example is the accelerating move toward the "Singularity," which refers to the eventual merger of human brain power with the speed, capacity and information-sharing ability of advanced technology, and the distinctive potential effects of intelligence becoming predominantly non-biological. The pandemic has clearly accelerated a number of trends that were already under way, such as working from home and e-commerce. The growth of the economy is increasingly in the cloud, where this virtualization resides. Software is eating the world, and artificial intelligence is just increasingly sophisticated software. The momentum in the virtual world is always increasing, and the pandemic caused a step function higher in this already powerful trend. As such, it brings the future and its greater profits forward for the beneficiary companies. In short, it has made tech leaders more valuable. The accelerating momentum implied by the Singularity means their valuations are likely to keep surprising people to the upside. However, given the current positive setup for cyclical stocks, a frequent question is whether the better growth outlook implies a rotation out of tech. In our view, both can do well in a synchronized global expansion with tech bringing the future to us faster and faster.

The pandemic has also accelerated the forces causing the rest of the world to view China in a harsher light. China has chosen to develop its own global sphere of influence rather than abide by the standards that underlie the free world economy. The existential conflict between communism and democracy did not end when the USSR broke apart, and as new technology creates the future, an iron curtain of separation is rapidly descending to divide these alternative worlds, much as happened in the earlier Cold War. This accelerating separation is evident in the redirection of supply chains away from China to more trusted sources. It is driving the dialogue over 5G and Chinese influence. It is the major geopolitical issue markets will have to contend with in the years ahead.

Foundation Building for the Secular Bull Market

Every market cycle is simultaneously different and similar. New bull markets are born from the depths of despair when it seems all hope is lost with economic data at its worst, financial conditions tightest, and market volatility at extremes. In today's context, this was the situation in March and April. Then, seeing the economic and market carnage, policy makers panic and start providing liquidity and fiscal support, which then brings stabilization. We have seen this play out too since April.

We have often said that we are in a secular bull market with the pandemic-driven exogenous bear market an interruption similar to the dynamic in 1987. We see several factors emerging as foundation for a long-term advance for U.S. equities, in the form of low-inflation dynamics and accommodative monetary policy, creative destruction leading to productivity improvements, re-shoring and new capital expenditure (capex) growth, and finally cautious investor sentiment and the search for high-quality assets.

Low inflation and a patient Fed: Investor worries about accelerating inflation given the massive monetary and fiscal expansion are unlikely to be realized in the medium term. Market measures of inflation such as the 5-year and 10-year breakeven rates are grinding higher on economic re-openings, but at 1.1% and 1.3%, respectively, are far below the Fed's target. The Fed may have increased its balance sheet by $3 trillion in a few short months, but that has merely gone to plug the hole between where nominal gross domestic product (GDP) is versus where it could have been absent the pandemic, i.e., not inflationary but trying to prevent deflation. A full economic recovery in the consumer and services sectors is contingent on vaccines and treatments that may be

a year away on the optimistic side, as well as a palpable reversal in job losses, which is likely to be gradual over the course of the next several years. This ongoing labor market slack and rising investment in productivity-enhancing technologies should mitigate any potential upward pressure on wages and inflation.

This will make the Fed err on the side of providing more accommodation. In a recent news conference, when asked how long the Fed would stick with zero interest rates if the economy surprises to the upside, Chair Powell said, "we're not even thinking about thinking about raising rates." The first Summary of Economic Projections (SEP) since December validated his statement. Every voter projected that the fed funds rate will remain at its current near-zero level for all of 2020 and 2021, and only two voters foresaw rate hikes in 2022. Easy financial conditions should nurse the economy and labor market along, providing the strongest foundation to this secular bull.

Creative Destruction: The pandemic has compressed the time frame on trends that were going to unfold over the next several years into a few months, and we believe that innovation will further move into hyperdrive creating new business models and industries. Think more creative destruction ahead as declining business models are replaced with faster growing ones, transforming the stock market in its wake. The average tenure of a company's listing on the S&P 500 will likely shrink to just 12 years by 2027, according to Innosight's work on corporate longevity, declining from 24 years in 2016 and 33 years in 1964.

At this churn rate, a significant number of companies could be replaced in the S&P 500 index in the next decade. Declining business models will either shrink in market value, go out of business, be taken over to be fixed by stronger players or private equity, or be replaced by faster-growing and more digital oriented businesses. For sure, bankruptcies such as the ones being witnessed in the retail sector are messy and create near-term economic headwinds but are natural for a free market economy and ultimately lead to more efficient allocation of capital and greater productivity.

Reshoring and new capex growth: The reshoring trend already in motion prior to the pandemic is expected to further accelerate for reasons ranging from the need for greater supply chain resilience, national security concerns, and lower tax and labor cost arbitrage between the U.S. and China. But it will likely be an increased adoption of technology that should be the tipping point that fully facilitates this trend and ignites a renewed capex cycle. Recessions typically lead to a reduction in business investment, and, given the magnitude of recent job loss, companies could be holding off on any considerable capital spending in the near term. Still, the new economy tainted by necessary pandemic-related behavior adjustments ultimately demands investment—a move toward digital processes, which preserves margins and provides greater speed and efficiency to market. Encouragingly, as Exhibit 1 shows, capex intentions have risen as the worst of the economic data has seemingly passed.

Exhibit 1: Outlook for Technology Spending and Capital Expenditures Has Improved.

Reshoring efforts will also demand investment, with companies leaning on automation and robotics to support these production transitions. While the consumer remains the backbone of the U.S. economy, new economy capex comprising software spending, technology equipment, and research & development (R&D) should be the driving force for economic activity forward. As Exhibit 2 shows, it is notable that traditional capex made up of investment in structures and industrial and transportation equipment has steadily declined as a percentage of total capex, while new economy capex spending has risen from 24% of total capex in 1980 to 47% today and is soon expected to exceed 50% of total capex, according Cornerstone Marco. More technology investment should help increase productivity and boost profit margins, which will allow companies to further invest and support broader job growth.

Exhibit 2: The Share of New Economy Capex Looks to Be On the Rise.

Restrained investor sentiment and the search for high-quality assets will enable a new equity culture: Despite a positive tone to equities with much of the deep March losses recovered at this point, investor sentiment remains restrained. Money market fund assets remain elevated at roughly $4.7 trillion, with cash inflows year-to-date at $1.2 trillion versus $24 billion for government bonds and equity outflows of $30 billion, according to BofA Global Research. And although money market funds have seen outflows in the past five weeks, the levels remain small relative to the overall inflows. The American Association of Individual Investors' well-followed survey similarly shows that bearish sentiment last week moved back up to 48.9 (95th percentile) from the recent low of 38.1. Clearly, investors remain cautious with risks on the horizon from a second outbreak and China tensions to U.S. elections.

As economic conditions improve and uncertainty subsides, the amount of cash on the sidelines will eventually have to be redeployed. Record low interest rates for longer means U.S. equities could remain a major beneficiary, given that the spread between the S&P 500 dividend yield and the 10-year U.S. Treasury yield is now 1.37%, sitting well above the 20-year average at -1.4% and in the 99th percentile. Amid this yield-scarce environment and numerous fragilities on both the domestic and geopolitical fronts as far as the eye can see, investors are likely to lean toward U.S. equities, which provide an appropriate balance of high-quality, secular growth and income opportunities. As Exhibit 3 shows, the composition of the S&P 500, as an example, has notably become more skewed toward Growth, Stability and Defensive industries in the last 10 years.

Exhibit 3: The Premium on Quality, Yield and Growth Has the Potential To Drive the Market Composition.

Millennials are likely to drive this new equity culture that could prove resilient in the decade ahead. This cohort has now faced two major shocks in their prime wealthbuilding years—the pandemic and the 2008/09 crash. Based on the Fed's latest survey of consumer finances, millennials had the lowest median net worth for adults younger than 35 in every pre-crisis period dating back to 1989 and only 10% held stocks, the second lowest in 30 years. Now amid the COVID-19 shock, younger investors will likely need to increase their allocation to equities as they play "catch-up" in accumulating wealth, further supporting the secular bull market.


The foundation is coming together for the ongoing secular bull market. As such, pullbacks during this consolidation phase would present an opportunity for investors to rebalance up in equities and put cash to work in high-quality investments. Also, a gradual economic recovery to prior GDP highs with accelerated creative destruction means that investors will have to be disciplined, nimble and focused on risk management to capture these opportunities.

Bullish Indicator: U.S. Capital Inflows Remain Robust

With both sides of the aisle ratcheting up the anti-trade rhetoric and In spite of the growing wave of de-globalization—foreign investors still want a piece of America.

According to the latest Flow of Funds data from the Fed, foreign ownership of U.S. securities (specifically: Treasuries, government agency bonds, corporate bonds and U.S. equities) remained robust in the first quarter of 2020, totaling $18.6 trillion. As denoted by Exhibit 4, foreign ownership of U.S. securities has surged over the past two decades, underpinned by a number of variables ranging from the depth and sophistication of the U.S. capital markets to ever-expanding global demand for U.S. dollars, the world's reserve currency and to the fact that the U.S. economy remains among the strongest and most competitive in the world, backstopped by an innovative economy housing corporate champions in a number of key sectors, ranging from agriculture to aerospace to e-commerce.

Exhibit 4: Foreign Ownership of all U.S. Securities.

According to the latest figures, foreign investors owned some $6.8 trillion in U.S. Treasuries at the end of the first quarter of 2020, up 4.6% from the prior year. Notably, foreign investors, like U.S. investors, lowered their equity exposure in the first quarter, with foreign investors owning $6.8 trillion in U.S. equities versus $7.2 trillion in Q1 2019. As a critical component of the U.S. capital markets, foreigners owned roughly 35% of outstanding tradable U.S. Treasuries in Q1, 34.3% of U.S. corporate bonds, 13% of U.S. government agencies, and 19.2% of outstanding U.S. equities. These are market-moving levels of ownership.

And speaking of ownership, despite the spike in U.S.-Sino trade tensions, Chinese holdings of U.S. Treasuries have held relatively steady over the past few years, totaling $1.1 trillion in April 2020 (Exhibit 5). Japan's Treasury ownership, the largest foreign owner, was $1.2 trillion in the same month.

Exhibit 5: Holdings of U.S. Treasury Securities.

The bottom line: politics and diplomacy aside, and as a long-term bullish indicator, foreign demand for U.S. securities remains robust and supportive across multiple asset classes.