Capital Market Outlook (November 18, 2019)


  • Macro Strategy—With the U.S.-China trade and technology conflict top of mind for many investors, it is prudent to assess the state of U.S. innovation leadership: Is the U.S. still leading China in technological innovation? We think so. China is closing the gap, but catching up in the world of innovation, economics and productivity is easier than taking the lead, and the U.S. has a number of well-entrenched advantages. National security is a powerful motivator for both countries and is likely accelerating the pace of innovation globally.
  • Global Market View—Information technology last week surpassed consumer discretionary to become the top performing sector in the S&P 500 during the postcrisis period. But gains in the sector do not appear overextended, and we maintain our preference for information technology in the current environment.
  • Thought of the Week—China's "Singles' Day" was a blowout, with the 24-hour online retailing shopping bonanza tallying $38.3 billion this year, a 25% lift on sales a year ago. A critical test of Chinese consumer confidence and a positive omen for future global growth and earnings, the bar was handily cleared.
  • Portfolio Considerations—We maintain our preference for U.S. equities, but non-U.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.

Dueling Innovation Ecosystems

Investors are always looking for the best new idea. From a top-down perspective that means finding the countries with the most supportive innovation ecosystems and then digging deeper into sectors, industries and individual companies. The U.S.-China technology and trade conflict has brought two contrasting innovation ecosystems front and center as the countries race for economic supremacy. The stakes are high because both regimes believe whoever wins the innovation/technology war will win the economic war and will be in a stronger national security position. While national security priorities and the U.S. defense sector have long been on the leading edge of innovation in the U.S. (both directly and indirectly), China's expanding geoeconomic presence makes this time different. For investors, it is prudent to understand the competing innovation ecosystems to have a better chance of identifying attractive investment. Key questions include: Does the U.S. currently maintain a lead in innovation versus China? How likely are they to maintain that lead? And, is it even a race? If global innovation accelerates as a result of the rivalry, we believe the global economy could benefit.

Who's Ahead at this time?

There is no straightforward answer to the question of which innovation ecosystem (the U.S. or China) is more effective, and there is no shortage of analysis. In addition to the fact that there is a stark difference in the broad approach (market-oriented in the U.S. versus commanddriven in China), the interconnectedness of the U.S. and China economies and innovation systems muddies the analysis. It is also difficult to capture the effect of technology being stolen outright. That said, there are several institutions that attempt to provide cross-country analysis of innovation systems. The Global Innovation Index (GII), co-produced by Cornell, SC Johnson College of Business, INSEAD and the World Intellectual Property Organization, is one source. According to this measure, the U.S. remains on top, but the gap has narrowed significantly over the last six years (Exhibit 1). Importantly, the U.S. improved its score in 2019 and has clear areas of weakness to improve for making further progress.

Exhibit 1: Global Innovation Index.

Note: The GII relies on two sub-indices—the Innovation Input Sub-Index and the Innovation Output Sub-Index—each built around key pillars. Five input pillars capture elements of the national economy that enable innovative activities:
(1) Institutions,
(2) Human capital and research,
(3) Infrastructure,
(4) Market sophistication and
(5) Business sophistication.
Two output pillars capture actual evidence of innovation outputs:
(6) Knowledge and technology outputs and
(7) Creative outputs. Each pillar is divided into sub-pillars and each sub-pillar is composed of individual indicators (80 in total in 2019).
Source: Cornell University; INSEAD; World Intellectual Property Organization. Data as of 9/30/2019.
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.

The World Economic Forum also ranks "Innovation Ecosystems" through its Global Competitiveness Report, and the U.S. is ranked at the top. According to the report, the U.S. scores an 84 in Business Dynamism (first in the world) and 84 in Innovation Capability (second in the world to Germany), versus scores of 66 and 65 for China, respectively. As further evidence, the Bloomberg Innovation Index also shows an advantage for the U.S., albeit a much narrower one (Exhibit 2).

Exhibit 2: Summary of Key Innovation-Related Index Rankings.




Global Innovation Index*







Human Capital & Research






Market Sophistication



Business Sophistication



Knowledge & Tech Outputs



Creative Outputs



Ease of Doing Business Index**



Corruption Perceptions Index (2018)***



Bloomberg Innovations Index****



Sources: Center for Strategic and International Studies.
* Cornell University; INSEAD; World Intellectual Property. 2019. /
** World Bank 2019 /
*** Transparency International 2018 /
**** Bloomberg as of 2019. Blue shaded area represents highest rankings of each index between the U.S. and China.
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.

What can we learn from the subcomponents of these various indexes, including those from the GII seen in Exhibit 2? For one, the U.S. has an advantage in scores related to "institutions" across the surveys. This includes the overall stability of the political environment relative to the Chinese system. In contrast, China scores relatively poorly in categories related to the "rule of law." This is also evident in the "Ease of Doing Business Rank" and "Corruption Perceptions" indexes shown in Exhibit 2. These scores are important to innovation because a lack of protection for intellectual property leaves less incentive for innovation.

Universities are also a key pillar of support for U.S. innovation, particularly graduate institutions, which provide global talent and ideas that feed the innovation cycle. In Exhibit 2, the strength of U.S. universities shows up under the subcategory of "Human Capital and

Research." The U.S. received the top score versus all countries in the GII. According to the Times Higher Education World University Rankings 2020 (Oxford and Cambridge), China only has three graduate institutions in the top 100. The U.S. has seven schools in the top 10. University funding and collaboration will likely remain a top priority for U.S. policymakers.

Partnerships are a key input to innovation in both countries. The U.S. has a robust ecosystem of innovation related to university partnerships with the private sector and military branches, incubators, accelerators and defense-related university-affiliated research centers (UARC). Examples include the Air Force and Massachusetts Institute of Technology (MIT) partnership, the Army and Northeastern University partnership, Johns Hopkins University Applied Physics Laboratory, a UARC. Perhaps not surprisingly, universities account for a smaller percentage of research and development (R&D) in China.

The "Business sophistication" advantage for the U.S. is partially being driven by this university and industry research collaboration. It is a subcomponent of this index in the GII scoring. This is a good example of an area where China is catching up, however, through its civilian-military fusion.

The U.S. is a leader in Market Sophistication, excelling in ease of getting credit and venture capital, for example. The U.S. also scores well in the intensity of local competition, which is based on survey data in the GII index. While China uses its command economy to get credit to government-linked companies (Stated Owned Enterprises (SOEs) get preferential access to bank loans), it scores poorly in microfinance. This likely hurts entrepreneurship.

China excels in infrastructure and has nearly closed the gap completely with the U.S., as suggested in the GII in Exhibit 2. China is not as strong in this department as it relates to ecological sustainability of infrastructure development, however, and there is a strong push underway to address this weakness. China's general infrastructure score in the GII is consistent with the common narrative that command economies have the advantage of being able to more efficiently catalyze technological development by dictating direction and providing funding, in this case to infrastructure. In the Chinese model, this is enhanced by the role of SOEs. The most obvious example is the speed and scale of China's infrastructure development both domestically and abroad. This is challenged by the idea that government investment can be inefficient and misguided.

Both countries score high in Knowledge and Tech Outputs and China has surpassed the U.S. in Creative Outputs (Exhibit 2). This is a function of the number of trademark applications filed in China. China is the world leader in patent applications, but this says nothing about the quality of the patents. This is also a function of having a larger population. While the U.S. is smaller in numbers, we still have decent population growth and an open economy that allows us to access the global talent pool. The key lesson here is where the U.S. cannot compete on population size, it should compete on diversity of thought and openness/global talent pool.

The National Security Card

The rivalry is being intensified by the increasing interconnectedness of economic security and national security. Both countries have cited national security as a reason to use policy to protect innovation. On the U.S. side, the White House and the U.S. Intelligence Community (IC) have made it clear that national security and economic security are increasingly intertwined. For example, the Director of National Intelligence's Worldwide Threat Assessment released in January 2019 included "Emerging and Disruptive Technologies and Threats To Economic Competitiveness" as a key threat. China also clearly recognizes the link between economic power and national security.

Greg Levesque's testimony before the U.S.-China Economic and Security Review Commission earlier this year summarized China's approach as follows: "Responding to both the technological moment and strategic moment, Beijing has introduced an industrial policy focused on mastering core technologies and constructing requisite policies, incentives, and mechanisms to develop 'original source innovation' ecosystems that serve economic, social, and military development priorities." While often viewed as evidence that globalization is ending, the national security card could serve to accelerate the already rapid pace of innovation in the U.S. and China.

Finally, it's worth considering the role of economic freedom in this context. The U.S. ranks high in measures of this key variable while China ranks in the bottom tier of the world's countries. Is it a coincidence that economic freedom correlates strongly with economic prosperity and innovation over long periods of time?

Technology Sector Leading Market Advance, But Gains Not Extended

Information technology last week surpassed consumer discretionary to become the top performing sector in the S&P 500 during the post-crisis period. From the market lows of March 2009, technology has now registered a price return of 659%, well in excess of the near 357% price gains for the broad equity index (Exhibit 3).

Exhibit 3: Information Technology Has Surpassed Consumer Discretionary as Top-performing Sector for the Cycle So Far.

Source: Bloomberg. Data as of November 12, 2019. Past performance does not guarantee future results.

As we continued to emphasize, the technology sector benefits from a range of trends around our "Innovation" investment theme such as robotics, cloud computing, artificial intelligence, digital media and rising global internet penetration. But throughout the current cycle, the price advance has nonetheless been an intermittent source of concern for investors that the sector may have risen too far too quickly. The S&P 500 Information Technology index moved past its dot-com price peak in mid-2017 and now stands over 50% above its highs of 2000. And according to the BofA Merrill Lynch Global Fund Manager Survey, long U.S. technology this month became the most crowded trade across asset classes for global investors. As the tech sector broke to new highs last week and we expect to continue to lead the equity market uptrend, we would not be surprised to see more market participants make comparisons with the 1990s. But for at least three key reasons, we view the current runup in technology stocks as a long way from the dot-com boom and subsequent bust, and we would therefore see any such concerns as unwarranted at this stage.

Technology sector returns in the 1990s far exceeded those of the current cycle

The near-660% price return for the technology sector in the 128 months since the financial crisis low has been well ahead of (almost twice) the broad market, but it remains far behind the gains of the 1990s. Over a shorter time period of 113 months between the start of the 1990s bull market and the 2000 price peak, the tech sector rose by 1,697%—more than four times the 417% for the S&P 500 over the same period. During that time, the sector delivered seven consecutive years of 20%-plus annual price returns between 1993 and 1999, including gains of 78% in both 1998 and 1999. But should the market finish 2019 at current levels or higher, this would be only the fourth year of 20%-plus price gains after 2009, 2013 and 2017 (Exhibit 4), and the sector would still have to more than double from its current level to match the cumulative return heights of early 2000. In short, the magnitude of the current tech rally bears little resemblance to the huge gains of the 1990s. And while the sector has been the biggest outperformer of the current cycle so far, it has not diverged from the broad market to anywhere near the extent that it did in the past, in our view.

Exhibit 4: Technology Sector Returns in the Current Cycle Still Well Behind Gains of the 1990s.

Source: Bloomberg. Data as of November 12, 2019. Past performance does not guarantee future results.

Valuations for the technology sector today are not stretched relative to past

As they have for the broad market, valuations for the technology sector have risen over the course of the current expansion. On a trailing price-earnings basis, tech multiples have risen from a cycle low of 10.5x in 2009 to 24.3x today. At just under $7.5 trillion, the S&P 500 holdings traditionally included in the technology sector now account for 28.1% of the total index market value. This is up from 17.7% at the 2009 cycle trough, though still far below the 34.5% at the dot-com peak. Most important, the relative increase in market value over the past decade has essentially been matched by the relative rise in earnings generated by the sector. As a result, the relative valuation of the technology sector has not departed materially from that of the S&P 500. Indeed at 1.2 times the broad market, the relative trailing P/E ratio for technology is essentially unchanged from its level of March 2009 and only moderately higher than its cycle trough of 0.9 times. By contrast, the tech sector began the 1990s cycle on a valuation multiple in line with the S&P 500, but reached a relative high of 2.7 times at the market peak. On a median basis, the average valuation across the same 72 technology stocks stands close to the market cap-weighted average at 25.7x. At the upper end of the range, the top quartile valuation level today stands at 38.5x and the top decile at 53.4x. At the 2000 peak by contrast, the median index valuation was 63.1x (above today's top decile level), with the top quartile at 122.0x and the top decile at 163.0x (Exhibit 5). The technology sector valuation increase of recent years has therefore not been excessive relative to the rest of the market, and it is dwarfed by the multiple expansion of the 1990s.

Exhibit 5: Technology Sector Valuations Remain Moderate Compared with the 1990s.

There are fewer signs of excess from new entrants coming into the public market

In addition to being a period of booming prices and valuations for the technology sector, the 1990s also saw a surge in initial public offerings (IPOs). In 1999 for example, a total of 370 technology IPOs were floated—more than one a day on average for the year. Over recent years by contrast, the IPO pipeline has been much smaller. Just 38 tech firms were listed in 2018, slightly higher than the annual average of 35 since 2009. Moreover, the profile of the companies launching IPOs today has been much more mature than in the 1990s. The average company age and annual revenue of new issues in the second half of the '90s was low and falling, whereas over the past five years both have been higher and rising (Exhibit 6).

Exhibit 6: Technology Sector Initial Public Offerings: Fewer and More Mature in the Current Cycle. Information Technology IPOs by Year


Number of technology IPOs

Median sales ($2014 million)

Median age of company (years)









































Revenues for new entrants into the public market averaged $27.9 million (in 2014 dollars) between 1995 and 1999. But since 2014, the average has been $136.2 million. Similarly the median age of issuing companies averaged just 6.4 years in the second half of the 1990s—well below the average age of 11.4 years between 2014 and 2018. Despite the media focus on the elevated valuations assigned to a small number of highprofile private firms, and the underperformance of a handful of new public listings over recent years in growing categories such as social media, financial technology and the sharing economy, this points to fewer signs of excess in the current cycle.

We therefore maintain our preference for information technology in the current environment. The sector has now become the top performer over the course of the post-crisis bull market so far, but does not appear over-extended. In both price and valuation terms, the gains of the current cycle have not been excessive compared to the broad market and remain well short of the boom years of the 1990s. And activity in the IPO market has been restrained. At the same time, the sector has benefited from the fundamental tailwinds of an expanding digital economy, new products and services that are experiencing widespread commercial application and strong growth in corporate profits. We think highly valued single stocks could yet be vulnerable to disappointments in earnings results or company guidance, but the favorable outlook for the sector as a whole remains intact.

Global Bull Indicator: The Chinese Consumer Is Currently Doing Just Fine

Score one—a big one—for global growth: China's "Singles' Day" was a blowout, with the 24-hour online retailing shopping bonanza tallying $38.3 billion this year. By boosting sales 25% from year-ago levels, the Chinese consumer—undaunted by slowing economic growth, rising unemployment in some trade-hit provinces and protests in Hong Kong— proved it is one of the most powerful and important economic forces in the world, second, in our opinion, to only the American consumer.

Fortunately for the global economy, neither the U.S. consumer nor Chinese households have been negatively affected by simmering U.S.-Sino trade tensions. The much feared global recession of 2019 never materialized thanks to strong consumer spending in the world's two largest economies, offsetting the downdraft in global trade. As a point of reference, combined, the U.S. and Chinese consumer account for almost 40% of total personal consumption expenditures.

As for Singles' Day, the accompanying exhibit underscores the spending might of the Chinese consumer. Of the $38 billion raked in over the 24-hour period, $13 billion was spent within the first hour. According to Daniel Zhang, the chairman and CEO of Alibaba, the company handled 480,000 orders per second at the peak of Singles' Day. International brands wanted a piece of the action (major apparel, cosmetic, electronics and food brands participated), with the U.S. ranking as the second-biggest source of products followed by Japan. The bottom line: More goods are sold online over the full 24-hour period in China than during the U.S. five-day holiday spree that begins on Thanksgiving and stretches to Cyber Monday.

Exhibit 7: Breaking the Internet: Alibaba's Singles' Day Sales.

In the end, Singles' Day was a critical test of Chinese consumer confidence. As a positive omen for future global growth and earnings, the bar was handily cleared.