Capital Market Outlook (November 12, 2019)


  • Macro Strategy—The swing in the U.S. from a major crude-oil importer to an almost-self-sufficient top producer has crowded out less-reliable exporters and greatly increased the security of supply, helping keep oil prices in check despite heightened geopolitical tensions and various supply curtailments this year. In our view, ample supply should also keep oil prices relatively stable in 2020, supporting our outlook for a global economic rebound.
  • Global Market View—The U.S. current account deficit and federal budget deficit continue to deteriorate as we head into the next decade. Will these "twin deficits" matter in 2020? With the White House among the most protectionist in decades, and obsessed with trade deficits, and with the federal budget deficit now in the neighborhood of $1 trillion annually, we re-visit the twin deficits from a slightly different lens.
  • Thought of the Week—October 29 marked the 50-year anniversary of the creation of the internet, an invention that has helped to shape the global economic and investment landscape ever since. One of the ways we see this has been the shift in composition of business investment over time.
  • Portfolio Considerations—We maintain our preference for U.S. equities, but nonU.S. equities have been placed on our upgrade "watch list" as we head into next year. Within fixed income, we are overall neutral on credit and have a slight preference for short-dated investment-grade corporates.

Oil-market outlook still revolving around excess supply

The oil market has absorbed supply shocks much better than feared this year. In fact, despite sharply lower supply from Iran (exports down from about 2 million barrels per day (mbd) a year ago to about 0.4 mbd in September) and Venezuela (production down from 1.4 mbd on average in 2018 to 0.65 mbd in September) as well as a major attack on Saudi Arabia's oil infrastructure in September, Brent oil prices have declined from $71 per barrel in 2018 to $66 in the first half and a $62 average in the second half, in line with our expectations.

Basically, the big 2018 excess supply extended into this year because of weaker-thanexpected U.S./global oil demand and strong non-OPEC supply growth, especially in the U.S. This has reduced the call on OPEC, causing it to limit production and boost spare capacity. Despite OPEC plus 11 other oil-producing countries' efforts to keep global inventories from increasing, excess supply has boosted Organisation for Economic Co-operation and Development (OECD) inventories to their highest levels since mid-2017, according to the International Energy Agency (IEA). This has reduced the risk of prolonged supply disruptions and the risk premium on oil, keeping prices in check. The greenback's appreciation, typical of global manufacturing and trade slowdowns, also added downside pressures on oil prices.

The combination of downside revisions to demand and another year of robust non-OPEC supply growth shaping up for 2020 suggests moderate oil prices ahead despite a likely upturn in global economic growth. Indeed, major projects coming on line in Norway, Guyana and Brazil at the end of 2019 and in 2020, along with further, if slowing, U.S. production growth, are seen boosting non-OPEC supply next year even more than in 2019 (+2.2 mbd versus +1.9 mbd, according to the IEA). Absent unexpected persistent supply disruptions, this is anticipated to keep the global market well supplied even if annual demand growth strengthens from around +1.0 mbd in 2019 to about +1.3 mbd as generally expected, consistent with a potential global economic growth upturn next year.

The fact that demand has started to turn up in the second half in a number of important oil-consuming countries according to the IEA is encouraging both as an economic growth signal and because it reduces the risk of a potentially destabilizing supply excess next year. Indeed, small, independent U.S. producers have substantially retrenched in response to oil prices getting close to $50 earlier in the year, with the domestic rig count already down 22% year to date. Given cost of production considerations, a better market balance, with a West Texas Intermediate (WTI) price closer to $60 than $50 per barrel in 2020 would help improve the financial health of U.S. shale producers and keep domestic production from weakening excessively. This would not only help U.S. economic growth but would help maintain a higher level of U.S. and global supply security. According to the IEA's Oil Market Report 2019, the U.S. needs Brent prices of around $65/barrel to deliver the disproportionately high share of global supply growth expected through 2024 to meet global demand needs, an important reason why we believe that Brent prices are likely to hover around $65 ahead.

For now, despite the big drop in drilling activity, the outlook for a still-healthy U.S. crudeoil production growth from the current 12.6 mbd record level remains supported by strong well productivity and a decline in drilled-but-uncompleted wells. Given the lagged response of drilling to oil prices, the pickup in WTI oil prices in recent weeks suggests at least a stabilization in drilling activity in coming quarters and additional support for U.S. supply growth in 2020.

Beyond 2020, the non-OPEC project lineup suggests fewer startups and thus a sharp slowdown in the pace of production expansion (estimated at just about +0.7 mbd for 2021 and +0.4 mbd in 2022), which may be when the call on OPEC increases again, putting more meaningful upside pressure on prices. Still, the specter of fading oildemand growth due to environmental concerns appears to have incentivized many oil exporters to ramp up production where and while they can, suggesting upside supply surprises are still quite possible ahead. For example, in spite of serious hurdles, Iraq has boosted its production to almost 5 mbd this year, far exceeding its OPEC-imposed production caps and meaningfully contributing to the global supply abundance of recent years. Despite major instability and security risks, Libyan production has increased about 30% since 2018 to 1.3 mbd, helping offset part of the losses elsewhere. Both countries have vast reserves and ambitious supply expansion plans. The Libyan government has recently allocated about $1 billion for oil-sector investments to help maintain current production rates and increase the productive capacity of the oil and gas sector this year.

Foreign oil companies, most recently from Egypt, appear interested again in fixing its oil fields and infrastructure, which would be critical to the country's oil-sector achievement of a 2.0 mbd production target by 2022 and 2.2 mbd by 2024. Because of high levels of instability, risks around these supplies remain high. In particular, while recent antigovernment protests and instability in Iraq have so far only marginally affected production and exports, an escalation of tensions could deal major blows to the oil market given the country's disproportionate share of global supply.

If Iraqi and Libyan oil exports remain safe, however, oil prices are likely to increase only gradually in response to rising demand and costs of production in the U.S. shale patch as the most prolific fields deplete. A likely flat-to-lower dollar—which is typical when the Federal Reserve (the Fed) boosts liquidity and global growth reaccelerates as we anticipate in 2020—also suggests some upside pressure on prices, in our view. In this context, our base-case scenario is for Brent to remain in a $50-to-$70 range, likely averaging closer to $65 per barrel in 2020. This outlook would remain favorable to consumers and would also be more favorable than in 2019 for most oil producers given that breakeven costs have converged to around $50 per barrel for most oil (with some Russian oil remaining the most expensive). With inventories seen rising next year, the EIA has revised lower its Brent oil price estimate from $62 per barrel to $60 per barrel, while BofA Merrill Lynch Global Research has maintained a $60 price estimate.

Because of massive pipeline capacity coming on line and creating market access for more U.S. oil, the WTI oil price is expected to average about $5 less than Brent compared to a discount of up to about $11 per barrel over the past year. The unprecedented current domestic build-out of pipeline and export capacity is creating a path for greater U.S. production and exports, with positive effects on the security of supply both here and abroad. The U.S. is on track for surplus pipeline distribution capacity through 2024, with the exception of Cushing, OK, to Gulf of Mexico demand centers. Several major Permian long-haul pipelines have already started to operate, with a surfeit of capacity expected as early as at the end of 2019 and further expansions to better link the most prolific U.S. shale oil-basin to export markets in store. According to the IEA, U.S. oil exports have already surged from zero in 2014 to 3.5 mbd, with Gulf Coast export capacity in the process of more than doubling by 2025.

All in all, our base-case oil-market scenario has played out as 2019 progressed, with prices hugging the middle of our $50-to-$70 per barrel estimated range. The 2020 outlook continues to revolve around excess supply, but a flat-to-lower dollar and stronger demand growth suggest slightly higher Brent prices than in 2019, in our view.

Undeniably, the market continues to face crosscurrents that create great uncertainty around the outlook. Importantly, however, the world would be awash in oil absent OPEC restraint and problems in Iran/Venezuela. Ambitious capacity expansion targets in Iraq/Libya/Kuwait and U.S. pipeline and export capacity growth combined with the prospect of an eventual return to market of Iranian and Venezuelan oil suggest massive potential oil supply ahead at relatively moderate prices. OPEC and its allies have plans to keep aside substantial production capacity through March 2020 in order to preclude excessive global inventory build and a prolonged environment of uncomfortably weak oil prices relative to their oil-export-revenue requirements. Supply plans are going to be reevaluated at their early December meeting and will depend on global demand and geopolitical stability.

Will the "Twin Deficits" Matter in 2020?

In the early 1980s, the U.S. experienced a sharp deterioration in the U.S. current account balance along with a sharp rise in the federal budget deficit. The so-called "twin deficits" debate was started, with many in the economic profession arguing that an expanding fiscal deficit, through its effect on national savings and consumption, would lead to a widening of the current account deficit. Like many things in economics, the debate continues to this day.

Will the twin deficits matter in 2020? The short answer is "probably not." But with the White House among the most protectionist in decades, and obsessed with trade deficits, and with the federal budget deficit now in the neighborhood of $1 trillion annually, we thought it an opportune time to revisit the twin deficits from a slightly different lens. Looking forward, an ever-widening trade imbalance could continue to stoke U.S. protectionist measures on both sides of the political aisle. Meanwhile, many investors seem to be questioning (and worry about) the long-term implications of U.S. federal deficits in the stratosphere of a trillion dollars annually.

So yes, the "twin deficits" do matter to the capital markets. The deficits can directly or indirectly influence the cost of capital in the U.S., the value of the U.S. dollar, U.S. corporate earnings and capital investment expenditures, among other variables. Hence, the "twins"—charted in Exhibit 1—are high on our radar screen as we head into a new year and decade. Below we unpack some of these dynamics.

Exhibit 1: U.S. Twin Deficits.

Sources: U.S. Bureau of Economic Analysis; U.S. Department of the Treasury; Haver Analytics. Federal Budget data through Q3 2019. Current Account data through Q2 2019.

The Financial Anatomy of the U.S. Current Account

The U.S. current account—which measures foreign flows of trade and investment income—has been in deficit for almost 30 years and has averaged roughly 2.5% of gross domestic product (GDP) over the past decade (Exhibit 2). In sum, the U.S. runs a large and growing goods deficit with the rest of the world while maintaining a structural surplus in both services trade and foreign income payments. All totaled, the U.S. current account deficit widened by 12% in 2018 to $491 billion. For the first half of 2019, the U.S. posted a total current account deficit of $264 billion, up 19% from the same period a year ago.

Exhibit 2: U.S. Current Account Deficit.

Do deficits matter? Regardless of the answer to this long-standing debate, a lot can be learned about the nature of the U.S. economy by unpacking the balance of payments data. Below we highlight some of the driving forces behind America's current account deficit, which is by far the largest in the world.

  1. Goods Trade Deficit: Since Trump was elected, the trade deficit in goods has widened from $750 billion in 2016 to $887 billion in 2018. Year-to-date through September 2019, the goods deficit is roughly in line with the deficit during the same period a year ago—up less than 1%. Rising U.S. imports of capital goods from abroad has been one of the main drivers of growth. Meanwhile U.S. energy exports have been an important offset to greater deficits in consumer and capital goods. Indeed, trade data released by the Census Bureau last week showed that for the first time in data going back to 1989, the U.S. posted a trade surplus in petroleum products in September. Much of the growth in America's merchandise trade deficit since the start of the decade can be attributed to a widening U.S.-China trade gap, which explains about two-thirds of total U.S. goods deficit growth since 2000.
  2. Services Trade Surplus: Trade in services has become an increasingly important factor in the international trade landscape. With the U.S. a market leader in many key industries, from financial services and insurance to business services and management consulting, the U.S. runs an annual trade surplus in services with the rest of the world. Two other key U.S. services exports are education (students studying in U.S. universities), and intellectual property (charges for foreign use of U.S. industrial processes, computer software, Hollywood movies and other intellectual property). The overall U.S. services trade balance has been somewhat flat in the last five years, as the growth in exports has generally kept pace with imports.
  3. Net Income Receipts and Transfers: The final component of the current account involves U.S. income on foreign investments (less income earned by foreigners in the U.S.). The U.S. currently runs a surplus in primary income, mostly due to large U.S. corporate earnings on foreign direct investment abroad. Direct investment income earned by U.S. business and investors abroad in 2018 was roughly $574 billion, well in excess of the $244 billion that foreign direct investors earned in the U.S. America's large annual surplus in direct investment income is partially offset by deficits in portfolio investment and secondary income (private and government transfer payments).

The Federal Budget Deficit

When it comes to balancing its books, the U.S. government typically fails each year. The U.S. continues to be the world's largest debtor nation, with the federal government in fiscal year (FY) 2019 adding almost $1 trillion to the nation's debt. The U.S. budget deficit in FY2019 rose 26% to $984 billion, representing an estimated 4.6% of GDP. Driven by an aging population and rising healthcare costs, mandatory spending on entitlement programs such as Social Security, Medicare and Medicaid has been the main driver, as well as accelerating net interest payments on an ever-expanding stockpile of debt. Meanwhile, tax cuts and Washington's large spending bills have put additional pressure on the budget at an unusual time in the business cycle—historically deficits tend to fall with unemployment (Exhibit 3).

Exhibit 3: Federal Budget and the Business Cycle.

Sources: Congressional Budget Office; Bureau of Labor Statistics. Data as of November 2019.

Looking ahead, the Congressional Budget Office (CBO) estimates that the deficit will average $1.2 trillion per year over the decade, with the national debt held by the public rising to 95% of GDP by 2029 (from 79% currently). However, there is a wide margin of error with these forecasts. Lower interest rates for longer can help keep interest payments contained.

Do deficits matter? We do not see a fiscal crisis in the U.S. as a major risk. The U.S. government has some fiscal runway—with the dollar as the world's reserve currency, the demand for U.S. assets continues to be strong, which keeps a lid on interest rates. That said, there are long-term consequences. Persistent trillion-dollar budget deficits that contribute to larger and larger debt levels means that spending by the government to service the debt will eventually crowd out more productive uses of capital. Rather than investing for the future in infrastructure, education, and research and development, the U.S. spends a substantial portion of each dollar funding entitlement programs and paying interest on the debt. Together, mandatory spending programs and net interest payments make up 70% of total federal government spending, with the share projected to rise to 75% in ten years. Nondefense discretionary spending makes up just 15% of total government expenditures.

A widening budget deficit also means that America's future financial shortfall will likely need to be filled by foreign creditors. Currently, foreigners hold roughly 40% of total publicly held U.S. government debt, with China and Japan the largest foreign holders of treasuries. This outsized dependence on foreign capital comes as an additional risk for Washington to consider, amid recent protectionist measures.


In the end, we believe current levels of federal debt and deficits are manageable, but policy action from Washington and a more productive and dynamic private sector are needed to change the course of America's financial future. A deterioration in the trade deficit—and the more encompassing current account balance—though not necessarily a huge economic risk, can be an important political risk prompting more protectionist policies from the U.S. Combined, the widening of the twin deficits is a development that warrants close watching in the years ahead.

Happy Birthday to the Worldwide Web

It was 50 years ago, on October 29 1969, that a team of researchers at UCLA transmitted the first ever online message to their colleagues at the Stanford Research Institute. While it may have seemed like a minor achievement at the time, as a simple one-word message caused the system to crash, that day marked what is considered to be the birth of the internet, an invention that has helped to shape the global economic and investment landscape ever since. One of the ways we see this has been the shift in composition of business investment over time.

Business investment in the U.S. has come under significant pressure over the past year, with many companies opting to delay or cancel spending plans due to ongoing macro uncertainty surrounding global growth and trade policy. But within business investment there's been robust growth in spending on so-called "intellectual property products" (for example, software, research & development), which jumped 8.8% in the third quarter, helping to offset weakness in structures and equipment spending (-14.0% and -4.7%, respectively).

Within the S&P 500, capital expenditures (capex) growth has come in at 4% so far for Q3, with guidance from management teams recently falling to a 10-month low, driven by lower spending in traditional capex sectors like Industrials and Materials. In contrast, capex among certain technology companies has been much stronger, with spending at three major companies jumping 27% on a year-over-year basis to a record high. This partly helps explain why semiconductors, which are typically beneficiaries of technology spending, are up 9% in the past month.

These trends underscore the ongoing digital transformation of the U.S. economy, which should remain a key investment theme for years to come. Real value added in the digital economy grew 9.9% annually from 1997 to 2017, versus 2.3% for the broader economy, while spending on intellectual property has risen to 36% of business investment (Exhibit 4), taking share from structures and equipment. The U.S. is home to the most publicly traded technology firms in the world, with over twice as many as second place China.2 Continued investment in advanced technologies should help promote U.S. leadership in cutting-edge industries like artificial intelligence and robotics, allowing companies to be more efficient, enhance productivity and grow earnings more effectively over time.

Exhibit 4: Digitization of the U.S. Economy Continues to Take Hold.