Capital Market Outlook (May 20, 2019)

In This Issue

  • Macro Strategy—As the U.S. economy nears an unprecedented 41st quarter of consecutive expansion, a very unusual thing is happening. Weakening inflation and a budding small-business, investment and productivity renaissance is raising the potential growth rate and extending the expansion, making U.S. equities more attractive.
  • Global Market View—Yet another reason for investors to be bullish, notably with a long-term horizon: America is considered the first when it comes to greenfield foreign direct investment. Nothing speaks better to the underlying resilience and dynamic DNA of the U.S. economy, and the future for potential economic and earnings growth, in our opinion.
  • Thought of the Week—Market expectations on trade have gone through a sharp recalibration in these past two weeks. While tariffs are a headwind to equities in general, a focus on higher quality can help investors position for market turbulence as the negotiations unfold.
  • Portfolio Considerations—We continue to prefer equities relative to fixed income and favor the U.S. and Emgering Markets (EMs) over other regions. We continue to prefer large caps relative to small caps as well.

Bring It on Home

Like Benjamin Button, the U.S. economic expansion seems to be getting younger as time passes. Normally, late in a cycle, rising wages, tight capacity utilization rates, and an unsustainable proportion of spending on big-ticket consumer and business goods, like housing, autos, structures and capital equipment cause inflation to rise and the Federal Reserve (Fed) to tighten policy and cause a recession. Despite this expansion's old age, the capacity utilization rate is still well below average, and spending on big-ticket items is closer to typical early-cycle, rather than late-cycle, shares of gross domestic product (GDP). There are scant signs of economic overheating despite an economy that is running substantially above the growth rate that the consensus believes is its long-run potential rate.

Recent data show a dramatic decline in pricing pressures (Exhibit 1) together with a rebound in confidence among businesses and consumers about the U.S. outlook. The Fed is starting to realize it's too tight. This is why inflation is below target for the eleventh straight year. In comments to CNBC on May 16, Minnesota Fed President Neel Kashkari said "With inflation somewhat too low, and the job market still showing capacity after 10 years, the only reasonable conclusion I can draw is that monetary policy has been too tight in this recovery." That's the result of consistently mistaken estimates of key macro variables like the neutral interest rate, full employment and the potential growth rate. As the yield curve continues to invert with rates falling to new lows, the message from the market is clear as well: The Fed needs to ease before deflationary forces intensify.

Exhibit 1: 2018 Tightening Caused Big Deflationary Shock.

Fortunately, the Fed's excessive tightening has mainly slowed inflation rather than growth. That's because a pro-growth supply-side policy mix of deregulation and tax cuts has bolstered business confidence in the future, unleashing a small-business investment boom and drawing jobs and investment back to the U.S. from other countries. Tariffs on imports are also incentivizing domestic production over outsourcing.

This supply-side restructuring is especially benefiting the small-business sector, which employs most of the people in the U.S. economy. Here's what the National Federation of Independent Business (NFIB) president and CEO said when the results of their latest survey were released on May 14: "America's small and independent businesses are rebounding from the first quarter 'shut down, slow down' and don't appear to be looking back. April's index is further evidence that when certainty and stability increase, so do optimism and action. The continued economic boom is thanks, in a major way, to strong growth in the small business half of the economy." From 2007 until the 2016 election, small-business confidence was stuck at low levels previously only seen in recessions. This pessimism dissipated on hopes for pro-business policies, like deregulation and tax reform. While small-business confidence took a hit in late December, when the Fed was threatening to cause a recession, it only fell to levels that were still higher than any time between 2007 and the 2016 election. The latest reading continues to show a recovery within this high range associated with strong growth.

One of the important consequences of the return of small-business confidence is a growing willingness to invest and expand. Indeed, since 2016, the percentage of NFIB respondents reporting "now is a good time to expand" has been fluctuating in the highest range since the 1980s. A recent study by Cornerstone Macro, "Improving capital expenditures (CAPEX) Breadth and What It Means for Productivity," notes that "Small/mid cap CAPEX growth (10.5% year over year) is more than twice that of large caps (4.7%)." In addition, it finds that the share of firms with double-digit CAPEX growth is the highest in about seven years.

Basically, a new CAPEX spending cycle began in 2018. Growing investment reflects an improved U.S. outlook and the need to raise productivity in the tightest labor market in 50 years. Strong evidence of rising productivity growth means U.S. workers can potentially get higher wages without causing inflation or depressing profit margins, which remain historically high, spurring business expansion.

Improving domestic growth is starting to help those at the lower end of the income and education spectrum. Indeed, wage gains have been faster for lower-income workers, and confidence has risen more for consumers without college degrees, who were hurt most by the outsourcing of jobs when U.S. investment increasingly shifted overseas.

Incentives to invest and hire in the U.S. are evident in the small-business renaissance depicted in the latest NFIB survey and other economic data like faster growth, stronger productivity and low inflation. On the downside, the effects of tariffs and a better U.S. business environment have caused a relative shift in global growth toward the U.S. and away from the rest of the world. In sum, assuming monetary policy is sufficiently accommodative, we believe the U.S. economy will remain on a positive track. Bringing jobs and production back to the U.S. helps explain the relative outperformance of the U.S. stock market, which we expect to continue, and we therefore remain overweight the U.S. relative to non-U.S. developed markets.

Global Greenfield Investment: America is First

Foreign direct investment (FDI) comes in varies guises and can have varying effects on an economy. Definitions of FDI range from intra-company loans, reinvested earnings, mergers and acquisitions, and, most importantly, "greenfield" investment. The latter refers to a type of investment where a company establishes/constructs a new operation (manufacturing plants, warehouses, data centers) where no facilities currently exist. This investment is new and is associated with rising capital expenditures and the creation of jobs.

The opposite of "greenfield" is "brownfield"—which is an investment in a pre-existing facility through an acquisition or merger. This investment does not usually produce much bang for the buck and in many cases can possibly come with job cuts and reduced capital expenditures. That said, the most desired form of FDI is job-creating, investing boosting greenfield investment.

2018 was a good year for global greenfield investment projects, which totaled 14,845, up 7% from the prior year, according to the latest data from fDi Markets Intelligence. These projects totaled $917 billion, up 42% year on year, generating over 2 million new jobs.

It was also a good year for the United States, which easily emerged as the number one location for new greenfield investment based on announced projects. Some 1,581 projects were announced in the U.S. in 2018, more than double the level of projects in China (796), and nearly 25% greater than second place United Kingdom (1,278). As Exhibit 2 highlights, America easily outranks the rest of the world when it comes to attracting the most desired form of FDI. This top billing underscores one of our long running themes: that when it comes to attracting the capital of the world's top global companies, no one does it better than the United States.

Exhibit 2: Greenfield FDI in 2018: America First. (based on number of projects)





















America is first when it comes to greenfield investment projects for a number of reasons. Consider a large and wealthy population, top-notch universities, a transparent rule of law, an ease of doing business that compares favorably to other nations, worldclass innovative capabilities, a relatively young population and deep capital markets. We do not believe there is any country that has such favorable economic DNA for FDI as the U.S., with corporate tax reform and yes, rising threats of U.S. protectionism, contributing to rising FDI projects in 2018.

Another allure of the U.S.: the diversification of the economy, which is second to none on a global scale. Foreign investment can be found across a large swathe of U.S. industries, ranging from automobiles to agricultural, chemicals to construction, logistics to life sciences, energy to entertainment, and more.

And the benefits of this dynamic flow both ways: The more foreign companies that set up shop in the United States and build out their presence in the U.S., the closer these companies are to their U.S. customers and the greater their U.S.-based earnings potential. Meanwhile, the greater the number of FDI greenfield projects in the U.S., the greater the U.S. economic output and the higher the number of jobs, trade and R&D outlays are likely generated in the United States.

In our opinion, it is a win-win proposition and one worth highlighting given all the market angst around U.S.-China trade tensions. Regarding the latter, yes, a trade deal/truce will be concluded at some point in the future. But the longer this particular battle brews, the greater the downside pressure on corporate earnings, as well as corporate guidance and earnings revisions. That said, we remain constructive on U.S. equities relative to fixed income, with a home bias toward large caps, and such sectors as technology, financials and industrials.

As the Chief Investment Office has enumerated a number of times, there are a halfdozen reasons why the bull market will likely rumble on once a trade truce is hatched. In brief, we believe 1) we are at the start of a new growth cycle in the U.S; 2) the Fed is on hold; 3) China is in the process of reflating demand; 4) current financial conditions (low rates, low inflation, narrow credit spread, stable U.S. dollar) are supportive of growth and earnings; 5) investor sentiment is fragile, limiting prospects of equities becoming overvalued; and 6) the U.S. and the world stand on the cusp of a productivity-led boom in growth (see "Resumption of Bull Market Once Brinkmanship Subsides", May 13, 2019). These dynamics are tailwinds to the gusty headwinds of trade.

Yet another reason to be bullish, notably with a long-term horizon: America is considered the first when it comes to greenfield foreign direct investment. Nothing speaks better to the underlying resilience and dynamic DNA of the U.S. economy, and the future for potential economic and earnings growth, in our opinion.

Weathering Market Turbulence with Higher Quality

Market expectations on trade have gone through a sharp re-calibration in these past two weeks. Heading into May, the prevailing view was that it was only a matter of time before the U.S. and China reach a deal on trade, only to be upended when the administration hiked tariffs on Chinese imports, and Beijing retaliated with tariffs of its own. Now with no end in sight for negotiations, investors are left to contend with an extended period of heightened volatility and uncertainty as they await clarity on the path forward.

While tariffs are a headwind to equities in general, a focus on higher quality can help investors position for market turbulence as the negotiations unfold (i.e. large-cap over small, U.S. over international, and emphasis on companies with strong balance sheets and pricing power). Tariffs should create winners and losers over time, as companies with the pricing power to pass along higher costs to customers could potentially fare well versus those with weak pricing power, like we've seen since the steel and aluminum tariffs were announced last year (Exhibit 3).

Markets began pricing in the chance that a deal could fall through after Robert Lighthizer's testimony to the House Ways and Means Committee, where he emphasized the uncertainty still facing the negotiations, reflected in the performance of a basket of companies tracked by Strategas that are heavily exposed to China. With these latest developments, cyclical momentum may continue to wane, including weaker trade flows, manufacturing and earnings estimates, which could compound the longer we go without a deal. A weaker yuan may also pressure capital flows out of China and have knock-on effects to other EM currencies and commodities like we saw last summer.

We still maintain our tactical asset allocation in light of our confidence in the current fundamentals of the U.S. economy, especially the consumer and productivity. But in an environment with no shortage of risks, ranging from slower global growth to renewed uncertainty over trade, we believe only a slight pro-risk tilt in portfolios is warranted as investors await clarity on U.S.-China negotiations.

Exhibit 3: Pricing Power Will be Key as Trade Tensions Continue On.

Note: Strong Pricing Power is defined as companies with high and stable gross margins while Weak Pricing Power is defined as companies with low and variable gross margins. These indexes are subsets of the Russell 1000 Index. Past performance is no guarantee of future results. Performance would differ if a different time period was displayed. Shortterm performance shown to illustrate more recent trend. Sources: Goldman Sachs; Bloomberg. Data as of May 15, 2019.