Capital Market Outlook (March 2, 2020)

In This Issue

  • The Market Selloff in Perspective—Last week's market selloff pushed the S&P 500 into correction territory. This latest pullback has followed a strong runup for equities since the start of 2020 and comes amid high levels of uncertainty over the global economic fallout from the Covid-19 (Coronavirus) outbreak.
  • Macro Strategy—Economists do not agree on what caused the dismal U.S. productivity performance between 2010-2016, and have been particularly baffled since it occurred during a period of rapid technological progress. They have also been surprised by its recent improving trend. Prior assumptions for persistent productivity weakness caused them to underestimate potential gross domestic product (GDP) growth and overestimate both inflation and interest rates.
  • Global Market View—Given growing Covid-19 risks, the global backdrop for U.S. foreign earnings appears to be deteriorating once again. Not yet fully discounted are the growing likelihood of headwinds to foreign profits, notably weaker demand from China, shocks to multinationals' global supply chains and a stronger U.S. dollar.
  • Thought of the Week—As the "unknown unknowns" of the Covid-19 outbreak rattled markets, volatility measures are surging. The Chicago Board Options Exchange Volatility Index (VIX) has spiked nearly 230% in just seven trading days, and many investors are shunning risk or may be hedging positions. However, at these elevated levels of measured risk, the hurdle for market conditions to worsen is also higher, and the slope of volatility forward curves suggests lower expectations for uncertainty down the line.
  • Portfolio Considerations—We maintain our preference for equities relative to fixed income and still prefer the U.S. relative to the rest of the world. The Covid19 outbreak has imparted a deflationary shock to the global economy that may delay the full benefit of the underlying recovery that we believe is setting up a fourth mini-wave expansion.

The Market Selloff in Perspective

Last week's market selloff pushed the S&P 500 into correction territory, down by more than 10% from its February 19 peak over the course of just six trading days. This latest pullback has followed a strong runup for equities since the start of 2020 (the market had been up 5.1% on a year-to-date basis before the correction) and comes amid high levels of uncertainty over the global economic fallout from this virus outbreak. Though the speed of the market selloff has been rapid, 10% pullbacks during economic expansions have not been uncommon over recent decades or even during the current cycle. In 12 expansions since World War II, the S&P 500 has fallen by 10% or more on 27 previous occasions, including six such episodes since 2009. On average, the market has dropped by 15.7% from peak to trough over a period of 84 trading days (Exhibit 1), with the fastest (10.2%) correction taking place over nine days in early 2018. A total of 18 of the 27 corrections have been smaller than the 15.7% average, with a handful of 20%-plus pullbacks (most recently in the fourth quarter of 2018) pulling the average magnitude higher. The average time taken for the market to regain its previous high across these 27 episodes has been 122 trading days (Exhibit 2), and the largest corrections have required the most time to reverse. Excluding the drawdowns of 20% or more, the average time taken for the market to regain its prior peak has been a much lower 71 days. Market corrections of the type we have witnessed over recent sessions have also historically offered attractive entry points for investors. In these 27 post-war expansion episodes, the average price gain for the S&P 500 six months on from the correction has been 18.9%; and the average advance 12 months after the correction has been 23.5%. We continue to monitor the unique challenges posed by the current circumstances, but the lesson from past periods has been that equity market corrections that occur during economic expansions tend to be relatively short-lived and are typically followed by outsized returns.

Exhibit 1: Equity Market Corrections During Post-War Expansions.

Source: Bloomberg, Chief Investment Office. Data from 1945 through December 2019.

Exhibit 2: Recoveries from Post-War Equity Market Corrections.

Source: Bloomberg, Chief Investment Office. Data as of February 2020.

Productivity Trend Up

Productivity growth is the source of rising real wages and standards of living. Without rising productivity, real GDP per capita, as a measure of standard of living, would only increase if a larger share of the population worked, or if population declined. Over the past two decades, the U.S. experienced both declining labor-force participation and weakening productivity. As a result, the 20-year growth in output per capita collapsed to its slowest pace in 70 years.

Persistently poor U.S. productivity growth between 2010–2016 in particular raised significant questions about its trend and reduced expectations for potential GDP growth. Numerous reasons have been offered for this underperformance, including: 1) recent digital technology is not as impactful as the steam engine or electrification were; 2) mismeasurement issues related to the rising share of services in the economy, which suffer from productivity measurement challenges; 3) slowing business dynamism; 4) increased business concentration; and 5) slow adoption of new technology. Indeed, according to a June 2018 McKinsey article, Is the Solow Paradox Back?, adoption barriers, lag effects and transition costs are delaying the impact of digital technologies, with only a small fraction of activities and processes digitized so far and many companies still trying to understand how they can benefit from the new technology.

Interestingly, the list of reasons why productivity growth during the past decade was about half its 2.2% post-World War II (WWII) average omits the most obvious reason, which, in our view, is the economic, financial, confidence, regulatory and tax backdrop. For example, years of deficient demand after an incomplete policy response to the Great Recession and its aftermath kept housing, small-business sentiment and consumer spending extremely depressed. The stop-go pattern of the current expansion has precluded businesses from fully using their operating leverage, constraining productivity growth to a below-average pace. The hollowing out of the U.S. industrial base over the past 20 years, which coincides with China's accession to the World Trade Organization (WTO) and the growing share of the less productive and slower-productivity-growth service sector, also played a role, as did the lagged effect of the dollar depreciation and eventual undervaluation from 2002 to 2014.

Encouragingly, these overlooked factors, which tend to lead productivity growth trends, have reversed in favor of a productivity reacceleration. As a result, despite widespread expectations for a persistently weak productivity performance, nonfarm-productivity growth has doubled from a 0.7% average between 2011-2016 to 1.5% between 2016-2019. With a gain of 1.7% in 2019, it approached its past 40 year average pace of 1.84% even with no productivity growth in the manufacturing sector, which was in recession (Exhibit 3).

Exhibit 3: Favorable Turn in Factors Affecting the Productivity-growth Trend Suggests "Secular Stagnation" is Likely Over.

Source: Bureau of Economic Analysis/Haver Analytics. Data as of February 27, 2020.

First, history shows that tax and regulatory policy can shape the structural backdrop for economic growth. Since WWII, there has only been one other protracted period of growth and productivity as weak as during 2006-2016 in the United States: the late 1970s and early 1980s period of "stagflation." After that, a major pro-business policy shift helped spur a two-decade economic revival of solid growth with falling inflation. The same appears to be the case now, with both labor-force and productivity growth surprising to the upside following the implementation of pro-growth policies over the past three years.

Indeed, with strengthening domestic demand, low inflation, and the strongest labor market in 50 years, real wages have accelerated, attracting more workers off the sidelines. Primeage female labor-force participation rate (LFPR) hit its highest level in 20 years, helping drive the overall participation rate higher despite an aging population and still-depressed participation for men. The fact that male participation still has room to expand to help meet future demand for labor is favorable for the sustainability of the expansion.

We believe that demand conditions are a major, yet underappreciated, driver of productivity growth. A poor consumer demand and investment backdrop with lots of underutilized labor and capital, as that between 2008-2016 is not conducive to strong productivity growth even with rapid technological progress. Only when demand growth strengthens on a sustained basis are capital and labor more fully utilized, and pressure to find ways to produce more with the available resources increases. However, the 2007-2013 period saw the weakest 6-year average real consumer spending growth of the post-WWII period (less than 1% compared to 3.6% over the previous 50 years). At the same time, and related, residential investment was stuck in a depression. Hurt by offshoring and the Great Recession and its aftermath, U.S. manufacturing production pretty much flatlined after 2001, with the capacity utilization rate stuck far below average ever since. In turn, this has constrained business capital spending.

The trend in consumer and business confidence generally affects trends in both demand and productivity growth. As consumer confidence surged to a two-decade high, consumer-spending growth has materially improved. Given increasing labor scarcity, this creates pressure to boost output through faster productivity growth. Also, small-business confidence was extremely depressed until 2016, hurting investment and new business formations, which according to the Bureau of Labor Statistics rose just 10% over the 10 years to 2016. Confidence has surged since 2016, and new business formations have spiked 20%, according to the same source. This bodes well because new businesses tend to be more productive. Faster business creation tends to be associated with increased business dynamism and faster productivity growth.

More favorable tax and regulatory policies also halted the exodus of U.S. industry to lower tax and regulation countries, helping to reverse the shock to productivity from a shrinking U.S. manufacturing base. Concerns about intellectual property protection and supply-chain disruptions are also bringing back investment and production. Also important, the drop in the domestic manufacturing base has reduced the number of U.S. patent applications, restraining technological progress and U.S. productivity growth. According to a July 9, 2019 Financial Times article, China has ramped up investing in technology, leading to a six-fold jump in the numbers of patents filed to 1,300,000 between 2008 and 2017, while in the U.S. the number only increased from about 430,000 to around 600,000.

Second, pressure for higher productivity also comes from labor-force growth limitations due to population aging. Unfilled job openings are close to record levels in the U.S., and the percentage of businesses reporting difficulty filling positions is the highest in about two decades. This scarcity of labor creates incentives to boost output per workers by adding capital, improving production techniques, and training workers to be more productive. Productivity growth is the solution to labor scarcity as demand expands.

Third, the trade-weighted dollar affects productivity trends. The stronger the dollar, the more it pressures U.S. companies to find ways to become more efficient and productive to remain competitive. The dollar's shift to one standard deviation overvaluation since late 2014 has increasingly put pressure on companies to find ways to cut costs in order to remain competitive. Given the lags involved, this process is likely to keep supporting the productivity-growth trend ahead.

Fourth, the age composition of the population should also work in favor of faster productivity growth over the next decade. Millennials (born between 1980 and 1998) represent the biggest age cohort in U.S. history and are dominating U.S. job growth as they come of age and enter the labor market. As higher-paid older workers have retired and have been replaced by lower-paid, less productive millennials, labor-productivity growth has been dampened, similar to when baby boomers were entering the workforce in the 1970s and early 1980s, when productivity was also weak. However, millennials' depressing impact on productivity will ease over the next decade as they move from their low-productivity 20s to their higher-productivity 30s and 40s. The median-aged millennial was born in 1989 and turned 28 in 2017, implying a positive demographic impact on productivity growth over the next 20 years.

Most of these forces tend to lead productivity growth, and over the past few years, they have moved in favor of a rebound in the productivity trend, which has already been borne out in the data, and, in our view, should continue. The productivity growth pickup and strongerthan-expected prime-age LFPR have helped potential GDP growth surprise to the upside, refuting the "secular-stagnation" view and keeping inflation contained and the Federal Reserve (Fed) at bay. Their improving trends bode well for rising U.S. standards of living.

Supply, Demand and Dollar Shock: The Triple Threat to U.S. Companies' Foreign Earnings

After decelerating sharply last year, U.S. foreign profits are at risk of further weakness in 2020. Last year, growth in gross corporate profits from the rest of the world slowed to just 2.8% year-over-year in Q3 2019 after posting double-digit growth rates in 2018. Meanwhile, foreign affiliate income, a narrower metric of U.S. global earnings, rose just 0.2% in the first three quarters of 2019 versus 13% the prior year.

Given growing Covid-19 risks, the global backdrop for U.S. foreign earnings appears to be deteriorating once again and could amount to a noticeable headwind to first-quarter earnings and beyond. According to FactSet, earnings expectations for the year remain relatively strong at 7.4%. Not yet fully discounted are the growing headwinds to foreign profits, notably weaker demand from China, shocks to multinationals' global supply chains and a stronger U.S. dollar. Depending on the spread and severity of this virus in the months ahead, these risks could portend continued volatility for large-cap U.S. companies with above-average global revenue exposures.

The Perfect Storm for U.S. Multinationals

1. Demand Shock

The most noticeable and immediate economic impact of this virus has been the loss of demand from Chinese consumers. Corporate warnings on this virus have been accumulating in recent weeks, as U.S. companies with large foreign trade or sales exposures attempt to assess the potential economic damage. Thousands of stores in China have been shuttered, with consumer goods outlets, global restaurant brands, automakers and tourism providers taking a large hit from the lack of demand. At risk are U.S. foreign affiliates operating in China, where over 80% of their sales of goods and services are for the local consumer.

Going forward, the spread of this virus in Europe will be key to watch, since the region represents a major hub for U.S. multinationals' earnings. American foreign affiliates generate about 50% of total U.S. overseas earnings in Europe, more than double the amount earned in the entire Asia-Pacific region.

Meanwhile, the services industry in the U.S., which had for the most part been sheltered from the economic damage of the trade war, may also start to feel the pain. U.S. exports of "travel" (i.e., foreign visitors and students spending money in the U.S.) are the second largest export category, greater than the total U.S. exports of computers and electronic products.

The financial markets are starting to discount foreign-exposed companies, but there may be more underperformance in store, depending on the progression of the virus. Since the market peak on 2/19/2020, U.S. companies with greater than 50% international revenue exposure have seen greater price declines than the overall S&P 500, on average. More negative news around this virus could exacerbate this trend, while positive developments and an easing of market fears could lead to a rebound/outperformance of foreign-exposed companies. Information technology and energy stocks have the greatest revenue exposure to China, and have thus far seen the largest declines during this virus stock market rout (Exhibit 4b).

Exhibit 4: Global Revenue Exposure and Market Returns.

Sources: FactSet, Bloomberg. Data reported as of February 19, 2020. Past performance does not guarantee future results. Performance would differ if a different time period was displayed. Short-term performance shown to illustrate more recent trend.

2. China Supply Shock

The economic hit from this virus is as much a supply issue as it is a demand issue. Many global companies that depend on China as the world's factory have seen a major disruption to supply chains as the country takes longer to return to work. Note that of the 290 million migrant workers in China, only about a third had returned to their jobs by mid-February. A longer-than-expected return to work, extended factory closings, and bottlenecks and backlogs at major Chinese ports are just some of the potential downside risks to the recovery.

Industries most at risk include consumer electronics and autos. Global trade in the computers and electronics industry is composed of trade in parts and components (from semiconductors to microprocessors), with multinationals slicing up various tasks across companies and countries. In many cases, China is typically the last stop for final assembly of electronic goods.

Additionally, some auto factories outside of China have paused production as they deal with a shortage of components from China. Other companies with a large dependence on intermediate imports are pharmaceutical companies, capital equipment and machinery producers, and other transportation equipment manufacturers. China is the second largest source of U.S. imports of intermediate goods, after Canada.

Consumer goods are also a large component of China's total exports to the U.S., with large retailers dependent on cheap imports from China in categories such as toys, apparel, electronics and furniture. The adoption of "just-in-time" inventory methods has made supply chains especially fragile and more susceptible to exogenous supply shocks.

3. Dollar Shock

On top of demand and supply issues, U.S. multinational companies must also cope with an unexpected strengthening of the U.S. dollar. Despite giving up some gains last week, the currency is up over 1.7% year-to-date.

As shown in Exhibit 5, when strength in the dollar accelerates, foreign profit growth slows. A strong dollar makes U.S. goods relatively more expensive in international markets, harming profits for U.S. exporters. It also weighs on foreign earnings, since U.S. profits earned abroad must be converted back into USD on earnings reports. Companies can hedge this exposure in the financial markets, but not all do, and even companies that do are sometimes not fully hedged. That said, the dollar has failed to break out to the upside, with the Bloomberg Dollar Index declining 0.4% last week.

Exhibit 5: Foreign Corporate Profits at Risk from Dollar Acceleration.

Corporate profits before tax with inventory valuation and capital consumption adjustments, seasonally adjusted annualized rate. Sources: Bureau of Economic Analysis; Federal Reserve; Haver Analytics. Profits data is quarterly through Q3 2019. Trade-weighted dollar data is monthly as of February 2020. February 2020 data is estimated using data from first 14 trading days of the month.

A strong dollar may not be a problem for all companies. Businesses that import intermediate products from abroad could see a lower import bill as a result of a stronger dollar. However, the significant supply shock from China could outweigh the benefits of cheaper imports.

Portfolio Strategy

Investors should carefully monitor the risks of investing in U.S. companies with strong foreign exposure, especially in the case of dollar strengthening and a protracted demand and supply shock from abroad. The good news, however, is that U.S. equities (in aggregate) are relatively less exposed to the rest of the world than some other developed markets. Over 60% of U.S. companies' revenues are generated domestically, while that figure is less than 25% in Germany, France and the U.K. Of Europe's largest companies, represented by the EuroStoxx 50, just 44% of total revenues comes from Europe, 30% from the Americas and 20% from Asia-Pacific. Chinese companies are largely leveraged to their local market (over 90% of revenues by Chinese companies are earned in China).

The shock to global markets in recent weeks from this virus is a reminder to investors that diversification should remain a key pillar of any asset allocation strategy. Traditional diversification methods—whereby investors allocate funds according to company domicile—can be misleading. Companies' revenue exposure to different consumers around the world is more telling and important. Understanding these exposures is critical for portfolio positioning and diversification.

How Do You Price the Unknown? A Volatility Spike Illustrates the Challenge

As the "unknown unknowns" of the COVID-19 outbreak rattle markets, volatility measures are surging. The VIX has spiked nearly 230% in just seven trading days while the ICE BofA MOVE Index has surged over 61%. Many investors acknowledge that they cannot project the distribution of potential outcomes with confidence, so they aren't keen on assuming risk or may be hedging positions. However, at these elevated levels of measured risk, the hurdle for market conditions to worsen is also more difficult, and the slope of volatility forward curves suggests lower expectations for uncertainty down the line.

Immediate volatility measures are approaching magnitudes last seen during prior market shocks, including the Financial Crisis and the volatility squeeze of early 2018. But it's also important to note that volatility forward curves have tended to invert during these events, with current values substantially elevated relative to later-dated settlements. The intuition underpinning the inversion being that today's conditions are abnormally more uncertain but that calm might emerge over time and/or that a potential policy response may help quell market consternation. Fed funds futures are currently pricing in nearly three rate cuts in 2020.

Levels of uncertainty are abnormally elevated, and sentiment has moved more bearish, weighing on riskier assets in the process, yet the bar for volatility to sustain itself or even move higher becomes increasingly more difficult. In the last three episodes during which the VIX breached 30, it only sustained that level for a period of 2-3 days before settling below. That doesn't mean that it's not possible to sustain higher levels of volatility if uncertainty continues, as the VIX averaged over 28 across the entire second half of 2011. At the present time, we acknowledge that there is much that remains unknown, and we expect markets to continue to be influenced by this uncertainty and sentiment until the fog is lifted and fundamentals regain prominence.

Exhibit 6: VIX Forward Curve Resembles Inversions of Prior Periods of Episodic Volatility.

Source: Chief Investment Office, Bloomberg. Data as of February 27. 2020.