Capital Market Outlook (May 13, 2019)

In This Issue

  • Macro Strategy—Paradoxically, favorable growth and inflation developments have raised doubts about the wisdom of the Federal Reserve (Fed) pause. In fact, leading indicators suggest that a rate cut is more likely than a rate hike this year as inflation has continued to surprise to the downside.
  • Global Market View—In one of the world's largest democratic events, European Union (EU) citizens head to the polls next week to elect a new European Parliament. In a seven question Q&A, we address some of the key investor questions regarding the EU elections.
  • Thought of the Week—The negotiations between the U.S. and China are over trade, but remember, Corporate America's global reach extends well beyond the traditional sense of imports/exports. A finer point of U.S.-China trade talks are the annual sales of U.S. foreign affiliates derived from China totaling $13.3 billion in 2018.
  • Portfolio Considerations—We continue to prefer equities relative to fixed income and favor the U.S. and emerging markets (EMs) over other regions. We continue to prefer large caps relative to small caps as well.

The Case for a Fed Rate Cut

From real gross domestic product (GDP) trend growth to productivity, employment, consumer confidence and inflation, incoming U.S. economic data have continued to track our expectations for a "Goldilocks" economic environment of robust growth and contained inflation. Still, while real GDP growth posted a strong 3.2% annualized pace in the first quarter and consumer spending rose back close to its 3% growth trend by March, for example, a number of forward-looking cyclical indicators, including manufacturing and nonmanufacturing surveys, have softened, suggesting moderating pressures on growth as the year progresses. In addition, inflation expectations have continued to weaken, and the yield curve is flirting with inversion, suggesting downside risks to inflation and heightened risk of a premature recession in 2020.

As we have discussed over the past year, the Institute for Supply Management (ISM) surveys were poised to continue their downtrend that started in the fall of 2018. A strong dollar, soft housing sector and the series' self-correcting historical pattern have long suggested that a likely period of softer readings was in store for the manufacturing ISM index following its strongest 18-month streak since 1984. Still, contrary to fears of much deeper declines ahead, which would portend substantial loss of momentum in the U.S. economy in the second half, we continue to expect it to trough by mid-year and trend up thereafter. This is important because the ISM manufacturing index tracks U.S. manufacturing activity strength, corporate revenue growth and profit expectations.

While we believe the ISM is likely to trough higher and quicker than in its previous two minicycles of this expansion because of pro-growth regulatory and tax policy, its outlook also depends on the dollar. Any moderation in the dollar would help sharpen its upturn, while continued dollar strength would dampen its prospects. So far, the Fed's equivocation on the policy stance has kept the dollar relatively stable thus far but with an appreciation bias, which, if sustained, would become problematic not only for growth and profits but also for the inflation outlook. Indeed, while there's much consternation about the Fed's pause in the face of recent upside growth surprises, downside risks to inflation appear underappreciated. As discussed below, for a number of reasons, the Fed pause this year was likely just the first step in correcting course.

First, growth has never gotten a chance to overheat, and leading indicators of growth/ inflation have softened, consistent with a restrictive Fed policy. Second, it's the Fed's pause itself that allowed incoming data to remain favorable by stemming the deterioration in consumer and business confidence, consumer spending and financialmarket conditions as well as by keeping the dollar from appreciating more. Continued tightening would have caused much more damage to sentiment and economic activity than observed in the immediate aftermath of the December Fed rate hike.

Third, we believe that just because the unemployment rate is at a 50-year low, the Fed shouldn't be expected to keep raising rates in a soft inflation environment. Inflation is a lagging indicator, so the inflation outlook through mid-2020 appears "baked in the cake" in response to past Fed tightening, with around 2% "core" consumer price index (CPI) inflation and 1.5% to 1.7% "core" personal consumption expenditures (PCE) inflation, in our view. This implies that inflation is on course to undershoot the Fed's 2% target for the "core" PCE measure in 2020 for the 12th consecutive year.

How much it undershoots will depend on Fed actions in the coming months. Continued dollar strength, a symptom of a restrictive Fed, would dampen the ISM manufacturing index, wage growth and import prices more than we assume, with negative effects on an already soft inflation outlook. Given the lags involved between Fed policy changes and inflation, the Fed should act soon to prevent inflation from excessively falling short of target next year. We believe this is the signal from the yield-curve flattening and its flirting with inversion.

That conditions don't justify more Fed tightening is also reflected in wage growth and productivity trends. Despite puzzlement about the fact that average hourly earnings (AHE) growth has not been much stronger given a 50-year-low unemployment rate, this measure appears to follow, with the typical lag, the historical pattern determined by improvement in business sentiment, labor-force participation rates, increased quits rates, as well as uncertainty levels. Overall, the leads and lags involved suggest that AHE growth is likely to average about 3.5% this year, with a probable shift up to an average of close to 4% in 2020, largely depending on Fed policy, labor-market dynamics, uncertainty levels and inflation expectations. Rising policy uncertainty would suppress wage growth in 2020 and would exacerbate the wage-tempering effects likely coming from the rollover in ISM leading indicators for employment.

Depressed inflation expectations are an effect of the Fed's interest-rate hikes to date that continue to influence wages and inflation. As reported in the University of Michigan's Consumer Sentiment Survey, five-year ahead inflation expectations have dropped to the lowest level in the 40-year history of the survey, and pricing pressures reported in the ISM and other manufacturing surveys have plunged over the past year. Softening growth overseas and dollar appreciation have no doubt contributed to this decline.

The contained wage-growth outlook combined with the fact that productivity growth is likely to keep surprising to the upside, in our view, suggests that fears of runaway inflation remain premature, with risks to inflation rather to the downside. Indeed, although the meaningful productivity gains of the past year have been dismissed as transitory, productivity tends to accelerate following a decisive upturn in wage growth as well as following dollar appreciation trends (companies make extra efforts to boost productivity when dollar strength makes their exports too expensive). This suggests that productivity growth is likely to continue to accelerate, keeping inflation under control even as wage growth moderately strengthens further.

All in all, the risks to the inflation outlook appear to remain to the downside. In order for the "core" inflation outlook to not deteriorate much more, we believe that consumer spending must remain strong, around 3%, and the dollar must stop appreciating on a year-over-year basis to boost U.S. manufacturing activity and relieve downside pressure from import prices, an important factor driving inflation lower. The dollar strength has been associated with the softening in the Conference Board Index of Leading Indicators, weakening Organisation for Economic Co-operation and Development growth trends of the past year, and the drop in inflation expectations, all related to the 10-year Treasury note yield decline over the past six months. With the Fed hiking 200 basis points, the yield-curve spread collapsed, signaling heightened recession risks a year ahead.

Although there are early signs that global growth momentum is starting to improve, the 10-year Treasury note yield is under sustained downside pressure (Exhibit 1), keeping the yield curve on the verge of inversion. In our view, an "insurance" rate cut would be wise to soften the dollar and steepen the yield curve to avoid an unnecessary economic slowdown and inflation undershoot.

Exhibit 1: Strong Dollar Transmits Deflationary Pressure, Depressing 10-year Treasury Yields.

Why Europe's Parliamentary Elections Matter: Some Q&A

In one of the world's largest democratic events, EU citizens head to the polls next week to elect a new European Parliament. In the past, the elections have rarely been cause for front-page news, but given recent political and economic challenges facing the EU, and the fact that over half of U.S. global earnings come from the region, we believe investors should be paying closer attention this election cycle.

Here are some of the key questions and answers regarding the EU elections.

What is Parliament's role in the EU?

The European Parliament is one of the main governing bodies of the EU and represents the interests of the EU's more than 500 million citizens. It is the only directly elected EU institution, comprised of 751 members (or "MEPs"—Members of European Parliament).

Parliament's powers include deciding the EU's budget, supervising other EU institutions, and electing the European Commission and Commission President. In terms of legislation, while the European Commission (the EU's executive arm) proposes laws, Parliament has the power to adopt, amend or reject legislation. Through this veto power, Parliament wields significant influence over many EU policy priorities—from immigration to energy, trade and climate change.

How do the elections work?

Every five years, EU citizens cast votes for who they want to represent their country in the European Parliament. Each country is given a certain number of seats in parliament that is roughly proportionate to that member state's population—ranging from 96 seats for Germany to just six spots for Malta.

Most candidates run under the names of their national political parties, yet are associated with broader European political parties, made up of different MEPs that share political affinity. After the election, if no majority is reached by a single European party, government coalitions are formed. Most recently, in 2014, the largest two political groups, the European People's Party (EPP) and the Progressive Alliance of Socialists & Democrats (S&D), aligned to form a "grand coalition" to reach majority.

What is the expected 2019 outcome?

According to recent polls, the "grand coalition" is expected to lose its majority, with the EPP and S&D parties each expected to lose around 40-50 seats (Exhibit 2). This would mark the first time in history that these two parties alone do not command a majority after elections and suggests that a broader alliance must be negotiated in order to form the necessary majority to pass legislation. Political analysts have suggested that the pro-EU/centrist Alliance of Liberals and Democrats for Europe (ALDE) party (currently aligned with Emmanuel Macron's La Republique en Marche party) will gain political influence as it picks up seats (+30 expected) and become a potential coalition partner.

Also widely anticipated in next week's elections is the rise of Euroskeptic MEPs and populist influence in Brussels. Recently, Matteo Salvini, leader of the anti-migrant League party in Italy, has united with other populist forces across the continent to build a Euroskeptic alliance. His party is predicted to take 71 seats. All totaled, Euroskeptic MEPs could make up about one-third of the seats in Parliament, according to comprehensive polling analysis by Politico as of May 8.

Exhibit 2: Ruling Coalition to Lose Majority.

What about Brexit?

The show must go on. The U.K. missed its deadline of March 29 to depart the EU and has delayed its departure date until October 31. However, because Britain has not officially left the EU, it is required to participate in next week's elections. Britain currently has 73 seats in Parliament. If the U.K. were to leave the EU before the vote, 46 of those spots would be abolished, and the rest would be redistributed to under-represented countries.

Why do these elections matter?

Voter turnout in recent EU elections has been low and on a downward trend, declining from 62% in 1979 to less than 43% in 2014. However, as Europe's challenges have intensified—from its Brexit woes, to its refugee crisis, a resurgent Russia and escalating U.S.-EU tensions—awareness of the elections among Europe's electorate has increased. And it's not just voters—investors should also be paying more attention to these election results, for several reasons.

First, the rise of Euroskeptic parties could reverse or delay progress on European integration. Less support for structural reforms in the eurozone could diminish longterm growth and result in an EU architecture less capable of handling the next economic downturn. That said, the populist presence in Parliament is unlikely to be felt overnight. Euroskeptic parties are not anticipated to win a parliamentary majority, and even if they gain a substantial share of seats, significant ideological differences exist among different populist parties, making it difficult for these MEPs to form a united front.

Second, the election results may provide important insights into the state of national politics across Europe. Importantly, it could provide some insight into where U.K. citizens stand on Brexit. The newly minted "Brexit" party is currently leading in some polls, similar to the 2014 election when the Euroskeptic U.K. Independence Party won the largest share of votes. In addition, a strong win for Italy's League party could embolden the party to call for fresh national elections.

Third, the Parliamentary election sets up key leadership appointments to be filled in the coming year (Exhibit 3). One of the first acts of the new parliament will be to elect a new Commission president to replace Jean-Claude Juncker. Most of the European Parliamentary groups have put forth their lead candidates for the role; the European Council then proposes a candidate (most likely from the party with majority), and parliament votes on the nominee. Perhaps even more important for financial markets is the election of Mario Draghi's replacement as European Central Bank (ECB) president. Parliament plays a minor role in ECB appointments: The European Council makes the decision after consulting with Parliament. These appointments last eight years, and thus are important in shaping the future of the EU economy.

Exhibit 3: Changing of the Guard: Top European Positions Opening Up this Year.


Currently Held By (Nationality)

Term Ends

Potential Successors

ECB Chief Economist

Peter Praet (Belgium)

May 2019

Philip Lane (Ireland) Already approved.

European Parliament President

Antonio Tajani (Italy)

July 2019

Mairead McGuiness (Ireland) Guy Verhofstadt (Belgium) Antonio Tajani (Incumbent) Source: Politico as of April 28.

ECB President

Mario Draghi (Italy)

Oct 2019

Francois Villeroy de Galhau (France, moderately dovish) Erkki Liikanen (Finland, hawkish) Benoit Coeure (France, moderately dovish) Olli Rehn (Finland, moderately hawkish) Jens Weidmann (Germany, hawkish) Source: Bloomberg poll of economists as of April 2019.

European Commission President

Jean-Claude Juncker (Luxembourg)

Oct 2019

Manfred Weber (Germany, EPP) Frans Timmermans (Netherlands, S&D) Guy Verhofstadt, Margrethe Vestager, etc. (ALDE)* Source: lead candidates put forth by top 3 polling parties.

European Council President

Donald Tusk (Poland)

Nov 2019

Mark Rutte (Netherlands) Dalia Grybauskaite (Lithuania) Source: Financial Times as of May 2019.

ECB Executive Board Member

Benoit Coeure (France)

Dec 2019


What effect will elections have on U.S.-EU relations? Trade policy?

In terms of trade policy, Parliament plays an indirect, but important, role. While the power to initiate and negotiate trade deals is held by the European Commission, Parliament can make recommendations to the Commission throughout the negotiating process and, along with the Council, must approve the final text of the agreement before it is implemented.

The current impasse in U.S.-EU trade discussions is a result of the two parties' conflicting objectives—one of the biggest points of conflict being whether to include agriculture in the negotiations. Meanwhile, tensions remain over steel and aluminum tariffs and the threat of U.S. auto tariffs. If the latest polls are correct, the new European Parliament will be more protectionist and more fragmented than before—a result likely to prolong the trade stalemate between the U.S. and EU.

What is the importance of the election result to Corporate America?

Rising investment uncertainty and structural issues throughout Europe could lead to a more challenging operating environment for U.S. multinationals, which have long counted on Europe to drive the bulk of their non-U.S. earnings growth. At 55% of foreign profits, Europe remains, by far, the most important market for U.S. multinational companies.

In the end, the future of the EU remains critical to the health of Corporate America. As political populism gains traction across the continent, as structural eurozone reforms fail to gain support, and as the transatlantic commercial arteries slowly begin to close, U.S. multinational companies are at risk of losing a key source of future earnings. Investors should be paying close attention.

A Finer Point of U.S.-China Trade Talks

Market fears of a U.S.-Sino trade war are not unwarranted considering that U.S. foreign affiliate income derived from China totaled $13.3 billion in 2018, more than what U.S. affiliates booked in Germany and France combined ($10.1 billion) (see Exhibit 4). Yes, the negotiations between the U.S. and China are over trade but remember: Corporate America's global reach extends well beyond the traditional sense of imports/exports. The U.S. is one of the largest exporters in the world, but exports pale in comparison to the annual sales of U.S. foreign affiliates, the global foot soldiers of U.S. multinationals. As the primary means of delivering products overseas, both U.S. investment in China and therefore attendant U.S. foreign affiliate income, have soared over the past few decades. Per the latter, affiliate income totaled just $1.2 billion in 2000 but was more than 10 times that level last year.

Exhibit 4: U.S. Affiliate Income Earned Abroad.

China has been a key source of global earnings for U.S. companies, underscoring both the breadth of U.S. global engagement and the related risks associated with any policies that threaten to disrupt U.S.-China trade/investment flows. It is little wonder, then, that U.S.-Sino trade tensions have upended the global capital markets, notably the boost in U.S. tariffs and the expected retaliatory measures from China. Our base case remains that Trump and Xi will remain motivated to strike a deal, and any kind of long-term impasse is unlikely. But we are at a trade stalemate, which means heightened market volatility and acute emphasis on quality assets in portfolios.