Capital Market Outlook (May 28, 2019)

In This Issue

  • Macro Strategy—It's shaping up to be a year of historic milestones with the equity bull market having passed ten years, and the economy poised to join it in July, marking the longest economic expansion in U.S. history. Investors might wonder just how long each run-up can continue, and to what degree.
  • Global Market View—Emerging market (EM) equities are now much more heavily exposed to information technology than in past years, particularly in consumer-facing industries, and we view this as a key support for future EM returns.
  • Thought of the Week—Weaker foreign demand for Treasuries is a key risk which, over the long run, could put upward pressure on Treasury yields and cause interest payments on the government's debt to accelerate more rapidly than anticipated.
  • 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.

The Latest from The Chief Investment Officer

The recent uptick in equity volatility and sharp move lower in bond yields based primarily on rising "trade war" concerns is creating new worries over economic and profits growth for the remainder of this year and for full-year 2020.

What type of scenarios could investors think about as the "trade war" rolls on and geopolitical risk remains at high levels?

We believe there are 4 scenarios to analyze and ones that could develop in the next 12 months.

  1. Expansion—Global growth turns higher (lifted by the U.S.) and heads above trend as a "surprise trade deal" develops which helps lift business confidence globally while the Federal Reserve (Fed) stays on hold and financial conditions remain easy.
  2. Moderation—Growth stays on trend in a tight range as geopolitical risk weighs on growth but financial conditions remain attractive, which balances out an aggressive slowdown (the service economy still outweighs a hard manufacturing slowdown). This scenario would likely include an agreement to meet on a trade deal but still no deal.
  3. Contraction—Geopolitical concerns rise thereby pressuring global trade further and business confidence heads south creating a below-trend growth environment. The Contraction scenario would include, in our view, a "no agreement to meet" and another round of tariffs on the remaining $325bn in goods.
  4. Recessionary Episode—Falling business confidence leads to a major decline in consumer confidence as evidence of a job growth slowdown rises aggressively. In addition to a further major decline in trade, consumer spending drops and the Fed acts too slowly to provide liquidity through lower rates. In the Recessionary scenario a "full blown trade war" that includes tariffs on all goods, further boycotts and blacklist items, and an escalation of national security interests, may also lead to a full blown "Tech War." This scenario would also include a Fed that stays on hold and does not cut rates, which hurts confidence further.

These scenarios are not difficult to lay out individually and many market pundits will try to assign probabilities to each individual event. However, we believe combinations of scenarios ultimately develop rather than any one scenario in particular. The reason is due to our belief that the concerns and events that surround them are fluid and evolve over time. They are not static events. Therefore, probability analysis on individual events may not be optimal. It is more important to assess combinations, in our opinion.

We ultimately expect a combination of scenario 1 (Expansion) and 2 (Moderation). Both China and U.S. need a rising "growth story" as the U.S. election cycle gets closer and China's domestic economy needs support. A further drawdown in the equity markets mixed with visible evidence of the "trade war" negatively impacting growth in the U.S. and China could prompt both sides to agree to meet and re-work a trade deal. This should support business and consumer confidence while financial conditions remain easy. However, initially—in the next few months—the combination of scenarios 2 (Moderation) and 3 (Contraction) are more than likely to remain the dominant combination.

In this case, a delay to a trade deal and final Brexit conclusion weigh on sentiment and business confidence. In addition, according to BofA Merrill Lynch Global Research, the "trade war" is not just about economics—it is about technology dominance—which has implications for capital investment, supply chain management, and a significant rise in on-shoring more likely in the years ahead. Non U.S. economies continue to struggle while the U.S. economy is still growing around trend, powered by the consumer and an "easy" Fed. This leads to an environment that oscillates between moderation and contraction, in our view.

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. For the time being, we are waiting this "unclear period" out until the daily or weekly noise begins to subside and more constructive dialogue develops.

Far from the End?

Put the champagne on ice as 2019 is set up to be a year of historic milestones with the equity bull market having reached ten years in March (narrowly escaping the bear in December), and the economy poised to join it by July, eclipsing the 1990s to lay claim as the longest economic expansion in U.S. history. Investors and pundits can be forgiven for wondering just how long each run-up can continue, and to what degree, however, we find reason to suggest that this business cycle may still have more runway after economic activity went through a corrective phase late last year. If the economic expansion does indeed enjoy a renaissance, it should provide additional kindling for the bull market and help power equities further to new heights.

The longevity of the post-Global Financial Crisis (GFC) expansion should not imply that growth has been on a linear upswing in the near-decade since. Rather, it appears that business cycle contractions have been shorter and less pronounced than in years past. The underlying causes of this are varied, from technological improvements in inventory management to more adaptive policy controls, to structural shifts in consumer behavior, and much more. The implications are that slowdowns may occur but do so at a depth more shallow than would traditionally be defined as recessionary by the National Bureau of Economic Research.

Since the GFC, three such slowdowns or "mini-recessions" can be identified. In each case, real gross domestic product (GDP) growth remained positive but slowed to a certain degree, while a composite of coincidental indicators troughed relative to leading indicators (Exhibit 1). The U.S. appears to be emerging from a similar slowdown at the moment, with dampening growth and mixed economic data of concern, but less threat of outright recession looming. We find reason for optimism based on these factors and believe that conditions are in place to jolt output higher and extend the expansion further.

Exhibit 1: Has Momentum Troughed and Coiled for a Rebound?

The pessimistic outlook is set: A global trade contraction, disappointing retail sales, moderating industrial production and inverted portions of the yield curve seem to portend difficulties ahead. To be fair, we acknowledge a slowdown in growth from last year's 2.9% annual year-over-year gain in the U.S. to a pace a bit closer to what is perceived to be the long-term potential growth rate. We do not, however, envision an imminent recession or a more pronounced slowdown. In fact, the alternative case has been made that a confluence of positive factors is actually raising the potential growth rate of the economy and elongating the expansion (Capital Market Outlook "Bring it on Home" May 20, 2019).

Many typical indicators of the late cycle are notably missing or are trending closer to levels more indicative of the earlier cycle including capacity utilization, housing starts, and spending on consumer durables and business goods. In fact, according to Fundstrat Global Advisors, private investment-to-GDP is relatively low at 24%, and a reversion to its historical average of 27% could represent $560 billion upside in capital expenditures (capex). Other measures appear to have made recent bottoms and are once again pointing up, including confidence measures amongst small businesses and consumers. For example, the Conference Board's Survey of Consumer Expectations has recently jumped relative to their Survey of Consumers' Present Situations, indicating a belief of better times ahead. Loan surveys appear to indicate a modest reduction of tightening lending standards and credit spreads have unwound most of the widening experienced in the later portion of 2018.

Importantly, realized inflation and inflation expectations appear well anchored and have helped stop the monetary tightening cycle in its tracks. Supply-side policy reforms supported a boom in capex last year with the effects demonstrating themselves via increased productivity and lower unit labor costs. With pricing pressures well contained, the monetary bias appears to have shifted further away from tightening. In early June, the Fed will convene a "framework" conference in Chicago, headlined by public analysis of the Fed's approach to inflation and full employment. Some discussion amongst members has pointed toward the potential outcome focused on a periodic symmetrical approach to inflation, which would suggest monetary easing as a response to a decade of inflation-undershoot. For its part, the market now prices an approximate 70% chance of a rate cut by the end of the year as illustrated by Fed Fund futures, while an inversion in the shorter end of the yield curve shows a similar reflection.

If the Expansion Continues This Bull Could Run

The current S&P bull market was spared from the voracious jaws of the bear on Christmas Eve, just tenths of a percent away from ending its historic run (bear markets are generally characterized by 20% declines). The pullback coincided with higher credit spreads, deteriorating trade activity and a statement from Fed President Powell indicating that the neutral policy rate was a long way from neutral. In December, the Goldman Sachs Financial Conditions Index hit its tightest level since early 2016, indicating elevated stress.

Since the depths of December, many policymakers have turned decidedly more dovish, prompting rallies and respite for capital markets. High yield credit spreads have tightened (approximately 135 basis points (bps) from December lows), equity multiples have normalized (from 13.6x to 16.4x on a forward twelve-month basis), and financial conditions have moderated a bit (Exhibit 2). What has been absent is notable excesses: Equity multiples are still not overly extended, stock inflows are curiously weak, cyclical sectors are relatively cheap, and we've yet to experience a blow-off top. Not to mention that there remains plenty of room for financial conditions to ease up more, especially if the Fed adopts an explicitly dovish path. The typical signposts of a late-stage bull market simply have not appeared.

Exhibit 2: Looser Financial Conditions have Coincided with Better Leading Indicators

We believe that the backdrop remains conducive and tilted in favor of the Fed attempting to loosen financial conditions further. As detailed earlier, there are some concerning points of data lingering relating to industrial production, retail sales and the yield curve. In addition, concern is mounting that trade tensions with China could move into or even beyond just a short-term simmer as national security points of interest and future technology dominance seem to have become tangled alongside the trade deficit. This will add to fears that growth is slowing, leading policymakers to favor further easing. Subdued inflation removes a barrier toward accommodation, and in fact the stubborn tendency of inflation to remain below its target rate in recent years has actually been cited by some Fed members—such as Neel Kashkari—as reason in and of itself to ease.

Some parallels could be drawn to the rate-hiking cycle of 1994. At the time, Fed Chairman Alan Greenspan tightened policy rates faster and by more than expected to get ahead of inflation that had yet to materialize. Volatility gripped the financial markets, real GDP growth was nearly cut by half, and the Fed ultimately reversed course in July of 1995, which set the stage for a new multi-year rally for markets and growth.


If macro data indeed has troughed and the business cycle gets its second wind, we would expect equities, including those in cyclical sectors such as financials and technology, to benefit. Earnings should be expected to take the lead and power gains ahead, but multiples could also be supported by easier financial conditions, strong relative value, and the return of institutional and retail fund flows into equities.