Capital Market Outlook (June 3, 2019)

In This Issue

  • Macro Strategy—The deflationary shock from last year's tightening has extended the long-run trend of inflation falling short of the Federal Reserve's (Fed) target and depressed nominal gross domestic product (GDP) growth despite still-solid real growth. The inverted yield curve reflects the reduced outlook for nominal growth in a tighter monetary policy environment.
  • Global Market View—Settle into a world of non-American All-Americans, because some of the best, fastest and most accomplished athletes are now in many other parts of the world. Led by Asia, Western sports have gone global, a bullish prospect for many global brand leaders in the world of sports.
  • Thought of the Week—Europe emerged from the polls having avoided a populist takeover, but the results could suggest more gridlock, uncertainty and challenging times ahead for a region longing for structural reforms.
  • Portfolio Considerations—We believe that opportunities to re-balance portfolios should unfold in the coming weeks and as equity markets re-set, we would view weakness as buying opportunities, particularly for investors that are below their target equity policy percentages.

Yield Curve Signals Policy Too Tight

Trade tensions have combined with excessive Fed tightening to further invert the yield curve in recent weeks. While inversions are often a signal of impending recession, they can also be a sign of disinflationary pressure. Either way, in current circumstances, the inverted yield curve implies the Fed has passed neutral and begun to slow down the economy and reduce inflation. This is causing inflation to fall further below the target.

If we look at the long-run trend of the Fed's preferred inflation measure, the "core" personal consumption expenditure deflator (core PCE) as measured by ten-year averages, the Fed has fallen short of its target for the past two decades. The last time this long-term average was 2%, or higher, was in 2001 (Exhibit 1). Through the 1990s the "core" PCE was falling rapidly from the much higher levels of the early 1980s, thanks to the successful inflation-beating policies initiated by Paul Volcker and continued by his successors.

Exhibit 1: Core Inflation Trend Remains Well Below Target.





































Sources: Bureau of Economic Analysis/Haver Analytics. Data as of May 30, 2019.

Over the latest 10-year period through 2018, inflation averaged its lowest pace in the modern era. This downtrend in "core" inflation has happened at a time when the Fed has moved more explicitly to target a 2% rate. Why has inflation moved in the opposite direction from the Fed's stated objective?

One reason the Fed has failed to reach its objective is a wavering over the commitment. Other objectives are often cited to justify current Fed policies. Recently, for example, some Fed officials have used the risk of financial bubbles to rationalize a tighter policy. Often the state of the real economy is invoked to explain policy. The strong growth of the past year has caused many policymakers to state that this tighter policy is "about right." In the meantime, inflation is falling again, and the yield curve is inverting.

While these other objectives sound plausible, they cause the Fed to take its eye off of the ball and undershoot its only long-term objective: creating an average of 2% inflation over the long term. Since this objective has not been met for two decades, it may be hard to take the Fed Chairman's recent assertion that the latest undershoot is transitory very seriously unless he believes policy is about to finally become serious about achieving the objective. This will require cutting rates, steepening the yield curve and letting inflation run over 2% for an extended period to reverse the disinflationary trend evident in Exhibit 1.

Another reason for the Fed's half-hearted commitment to the inflation objective is a lack of belief in the necessity of a two-percent target. If unemployment is low and growth strong, many economists are happy to see lower inflation. This short-term satisfaction with economic conditions is likely the main reason the Fed has fallen persistently short of its longer-term goal. The unfortunate side effect is the descent into a low-nominal-growth world with increasing strains from excessive leverage whenever interest rates rise.

Economic experience over the past two decades illustrates the dangers from low inflation and the consequent low growth of nominal GDP. Exhibit 2 shows the long-run trend of nominal GDP growth (Exhibit 2, blue line 20-quarter average) together with the shorter-term year-over-year rate (red line).

Exhibit 2: Nominal GDP Trying to Break Out of Deflationary Trap.

The financial crisis caused the weakest five-year period of nominal growth since the 1930s. The Fed's aggressive actions prevented this from becoming even worse. As can be seen, the U.S. economy is struggling to maintain a nominal growth pace above 4%, which had been the minimum, usually in recessions, since World War II until 2008–2009. Last year's nominal growth topped 5% for the first time since the crisis.

Unfortunately, the Fed's rate hikes have sharply reduced inflation and begun to slow growth, raising the risk that the economy's brief flirtation with escape velocity will relapse back into the sub-4% region where debt-deflation risks persist.

Nominal GDP growth governs the growth in cash flows through the economy: consumer incomes, corporate revenues, retail sales and earnings to name a few. The drop in nominal GDP is crimping these cash flows and threatens to cause a recessionary credit crisis. This is the direct result of too tight monetary policy. Despite protestation to the contrary because of the solid real economy, the inverted yield curve is signaling future nominal growth will likely be slower whether through lower inflation or lower real growth, or some combination of both.

There is no good reason for this to happen. Inflation is already too low. There is no reason to want slower real growth. The obvious policy implication is to cut interest rates, steepen the yield curve and let the economy do as well as it can until the Fed has finally achieved its long-term inflation objective. Given the facts in Exhibit 1, this will require several years of above-trend inflation. A few years of inflation over 2% combined with real growth of 3%, or more, given the new higher rate of productivity growth, implies nominal growth should run in the five to six percent range for a few years. As Exhibit 2 illustrates, that would be more in line with the norm since World War II.

We anticipate a major Fed policy change before year-end.

East Meets West: The Globalization of Sports

Naomi Osaka, Jin-Young Ko, Sung Kang, Han Xu—none of these folks are household names in America, although they are superstars in their home countries, more importantly, at the cutting edge of one of the most powerful trends in the world: the global convergence of sports, with Asia at the forefront.

Naomi Osaka of Japan is the top-ranked female tennis player in the world. Korea's Jin-Young Ko is the top female golfer on tour, while her fellow countryman, Sung Kang recently secured a career-first PGA Tournament victory at the AT&T Byron Nelson. Han Xu, a 6-foot-9 Chinese basketball player and a second-round pick in the WNBA (Women's National Basketball Association), is being compared to Yao Ming, the first Chinese male to make a significant mark on the NBA. These names share the common thread of not only being elite athletes in their respective sport but also representative of the rise of sports globally. As a number of coveted trophies and accolades are awarded to foreigners from various pockets of the world, it's clear sports fanaticism has gone global.

Stretching from Japan to India, Asia is home to over 3 billion people who enjoy sports

(watching and participating) as much as baseball fans in Boston or football fanatics in Manchester. For decades, however, there wasn't much overlap between East and West when it came to sports. For instance, cricket, one of the most popular sports in Asia, doesn't have much of a following in the U.S. Ditto for either badminton, a fan favorite across Southeast Asia, or archery, the national sport of Bhutan. Meanwhile, more westernized sports like golf and tennis were typically for the very well-to-do in Asia for decades, although since the start of the century, participation in golf and tennis, in addition to basketball and even soccer—the most popular sport in the world—have gone mainstream across Asia.

In short, the sport silos between East and West are crumbling. Soccer has become immensely popular in Indonesia, China, Thailand and Vietnam, and even India. Basketball and baseball are blossoming in China. Even marathons are becoming increasingly popular in many Asian nations.

Countries that a few decades ago served as little more than sporting goods manufacturing bases now are the elite pool of sporting event participants and event hosts. In 2019, China will be the venue for the FIBA World Cup (basketball), Formula 1 Grand Prix (motor racing), Rolex Shanghai Masters (tennis), plus a host of EPL (football), NBA (basketball), NFL (American football), NHL (ice hockey) and PGA (golf) events.1 At the same time, Beijing is preparing for the 2022 Winter Olympics and is set to become the first city in the world to host both the summer and winter editions of the Olympic Games. Japan, meanwhile, is gearing up for the 2020 Summer Olympics.

Sports popularity = fitness craze

The growing popularity of sports in Asia reflects many variables, including rising per capita incomes and discretionary lifestyles, growing concerns for health, budding accessibility to athletic events and competitions, and enhanced sports facilities and infrastructure. This enthusiasm is pumping up a multibillion dollar sportswear industry in athletic performance sports apparel and branded footwear and driving growth for brands like Nike, which saw a 26% year-over-year revenue increase in China for 2018 and triple its expansion in any other market. However, as an aside, over the medium term we see apparel price deflation and pressure for producers to increase automation because of rising labor costs.

Asia is the second largest sportswear market in the world accounting for $83 billion of sales in 2018 (Exhibit 3). Nevertheless, the region remains dwarfed by the largest sportswear market in the world—the U.S., with an estimated $120 billion in 2018 fueled by higher per capita spending. Asia is expected to account for 33% of the global sportswear market by 2020, becoming a crucial market for sportswear sales fueled by shifting health and wellness trends as sportswear evolves as a constant within consumers' wardrobes. Asia's sales are heavily dictated by China which accounts for over 40% of the region's overall sportswear sales.

Exhibit 3: The Rise of Sportswear in Asia.

New approaches to health, fitness and wellbeing offer a multibillion dollar fitness industry and nicely barbell a backdrop of over-indulgence and growing obesity rates in the developing (and developed) world. For instance, throughout Asia, two out of every five adults are considered overweight or obese, with 230 million individuals burdened by diabetes. Given the increasing prevalence of obesity and rapid adoption of a westernized lifestyle in Asia, that figure is expected to exceed 355 million by 2040.

In the end, the world of sports has evolved as the industry globalized—and for the better. The Emerging Market (EM) consumer remains one of the most powerful economic forces in the world and a largely untapped market for sportswear and related gear and activities. These consumers take their sports seriously and have exhibited a voracious appetite for premium-priced, upscale goods and services in various sports-related sectors, ranging from demand for up-scale trainers to eSports.

With various government promotion and support, new construction around fitness facilities and infrastructure in the developing world, demand for gyms and other such services will undoubtedly increase in the coming years, especially surrounding key athletic events attracting international attention. And with that, the rising tendency for consumers to share on social media platforms has contributed to the rise of numerous sports- and exercise-related smartphone applications.

And the sports craze goes beyond sportswear. We remain long-term bulls on agricultural goods due to shifting/improving diets among the EM middle class; the demand for protein, fruits and vegetables should remain quite robust over the medium term. Hence, our continued long position in farm land, timber and related hard assets. We see continued upside pressure for energy, water and other natural resources as well.

The bottom line: Get ready to settle into a world of non-American All-Americans, because some of the best, fastest and most accomplished athletes are now in many other parts of the world. Led by Asia, the Western sports have gone global, a bullish prospect for many global brand leaders in the world of sports.

Results are in. Now what?

Immediately following the results of the European Parliamentary elections last week, negotiations began for the leading jobs at the European Union's (EU) top institutions, including president of the European Commission, the EU's executive body, and president of the European Central Bank. Following the rise of nontraditional political parties like the Greens, coupled with the dissolution of the combined majority between the two largest centrist blocs, the path to consensus on who will fill these roles seems uncertain and may likely lead to more volatility or even delays in appointments. France and Germany have already come to a clash over who will take the top job at the European Commission, with France not recognizing Germany's proposed candidate. And now that the traditional parties have lost seats, their weaker claim to these top jobs may dictate the need for new alliances. The political disagreements already surfacing have set the stage for the uncertainty to come when Mario Draghi's term ends this fall.

For Italy, the EU elections led to a victory for the county's nationalist, far-right League Party, solidifying Matteo Salvini's claim to leadership. His influence and ability to forge a populist group in the European Parliament, however, comes with some limits as euroskeptic parties gained some ground in the election but ultimately did not capture as many seats as projected and remain ideologically fragmented. Emboldened, Salvini is now girding to confront Brussels as it relates to Italy's budget deficit and funding mechanisms.

Across the English Channel, the Brexit implications appear to portend a more binary outcome between a harder Brexit and a second referendum, as voting reflected polarization. Nigel Farage's Brexit Party received the largest share of votes while "remain" parties also gained substantial share, both siphoning support from the traditional Conservative and Labour Parties. This may open the door for a more euroskeptic replacement for Prime Minister Theresa May. Early general elections also cannot be ruled out, punting the Brexit issue back to voters in an effort to shake out a new parliamentary backdrop. Complicating matters is a looming October 31 deadline and reluctance of some EU leaders to provide more time or leeway to help unlock the impasse. Brexit uncertainty seems destined to persist well into 2020.

Ultimately, Europe emerged from the polls having avoided a populist takeover (Exhibit 4), but the results could suggest more gridlock, uncertainty and challenging times ahead for a region longing for structural reforms.

Exhibit 4: The 2019 elections loosened the grip of the pro-EU center.

Source: Current parliament seats based on data reported by the Financial Times. Results of the 2019 election as reported by the European Parliament in collaboration with Kantar.