Capital Market Outlook (November 4, 2019)


  • Macro Strategy—Excessive pessimism set the market up for a favorable reaction to better-than-expected third-quarter earnings results. In our view, the stage is now set for a turn to the upside for 2020 corporate profits as the global economy begins the fourth mini-cycle rise of this record-long expansion.
  • Global Market View—We disagree with the notion that demographics are boring, glacial and irrelevant to today's investment climate. Shaped by three powerful forces—unprecedented waves of (M)igration; record-breaking levels of global (A)geing; and accelerating rates of population (D)ecline in a number of key nations—the world is M.A.D.
  • Thought of the Week—As a common input into building, machinery and consumer equipment, copper is historically cited as a leading indicator used by analysts to help project economic activity. The red metal has performed well as of late, rising from end-of-summer lows. Its recent ascent also coincides with a recent pickup in other leading indicators, potentially foretelling a fourth mini-wave of global expansion.
  • Portfolio Considerations—A more highly diversified overall portfolio across and within asset classes makes sense, in our view, given the high level of macro uncertainty still overhanging the capital markets.

Earnings Stall Likely Over

The hallmark of this record-long economic expansion has been recurrent fears of a relapse into the debt-deflation abyss of the 2008 financial crisis. This has played out in three stages of panic-driven downturns: the first precipitated by the European Central Bank's (ECB's) premature tightening in 2011, the second driven by a China-Emerging Market (EM) recession and commodity-oil-price collapse, and the most recent by the Federal Reserve's (Fed's) miscalculation of the impact of quantitative tightening and rate "normalization."

The common theme throughout has been shortfalls of inflation below central-bank targets and a consequent belief that deflation was the bigger risk. After the latest bout of deflation fears caused by quantitative tightening, investors are extremely defensively positioned to a degree seldom seen by traditional metrics. For example, according to Empirical Research Partners, utilities have been valued at more than twice the multiples of banks. During the half century up until the financial crisis, they tended to sport the same multiple on average over the business cycle, with only cyclical shifts reflecting rising and falling defensiveness.

Global earnings have tracked these waves of rising and falling defensiveness. Our leading indicators suggest the third profits downturn is bottoming ahead of a 2020 uptrend (Exhibit 1). In addition, an incipient turn away from the deflationary defensiveness of the past decade is hinted at by the third-quarter earnings results for sectors. If global monetary easing succeeds in its reflation efforts, the pervasive risk-off positioning could give way to a sustained rotation toward less defensive areas of the market. Importantly, Fed Chair Powell confirmed at his October 30 press conference that it would take a significant and persistent rise in inflation above the 2% target before policymakers would consider a rate hike. This provides the fundamental basis for an increasing reallocation to the pro-cyclical reflation trade.

Exhibit 1: Fourth-wave Upturn in Global Economy Should Boost Profits in 2020.

Earnings results tell the tale. With just over two-thirds of the S&P 500 companies having reported earnings by October 31, it appears that profits could likely be about five-percentage points higher than the roughly three-percent decline that had been expected before the announcements kicked off. About 77% of companies have reported positive earnings surprises, with an average beat of about 5%. The share of beats is well-above average and helps explain the market's relatively good performance so far during the reporting season.

The results confirm why, until recently, investors have been focused on defensive sectors like utilities, real estate, communications services and staples, where yields have tended to be higher and/or demand less vulnerable to economic slowdowns. Earnings growth has been positive in all these sectors. Not surprisingly, the biggest earnings declines have been in cyclical areas, such as energy and materials, where double-digit declines have led the downside, not least because of lower commodity prices compared to a year ago. With prices stabilizing on the outlook for improving growth, 2020 comparisons should be more positive by our estimation. The rotation away from defensive areas since August seems to reflect the view that a cyclical upswing is likely developing that will have relatively more positive impact on the less defensive, undervalued parts of the market, which were hit harder by the impact of the global slowdown on earnings evident in Exhibit 1.

Other sectors show a more mixed picture than these extremes. Information technology stocks are a good example. Overall, sales growth has been running under 2% compared to average sales for all sectors, which have been running just over 4%, about a point higher than had been expected. Hardware-related businesses have been hit hard by the cyclical downturn, while software and cloud-related business has been booming at multiple times the economy's underlying growth rate. Furthermore, heavy investment in the booming build-out of the cloud has squeezed margins, with overall tech earnings down about 6% despite the slight positive growth in revenues. Consumer discretionary companies on balance have had double the average revenue growth yet, like technology, have posted negative earnings growth so far, partly because of the cloud build-out margin squeeze by its biggest companies.

Financials are another area with mixed results. Revenue growth is currently in line with the 4% overall pace of the S&P 500, while earnings slipped a bit compared to a year ago. Big banks, however, saw earnings gains overall, with solid loan growth more than offsetting low rates and a flatter yield curve to push interest income higher. The weaker overall sector earnings reflect weaker results from non-banks. Industrial companies, in contrast to technology companies, have seen weaker revenues over the past year yet still have managed to eke out a small gain in earnings, suggesting better margin management, presumably because of more severe capex control.

Over the past year, health care has enjoyed the strongest revenue (+15.94%) and profit growth (+8.24%) of all the sectors, yet it has not benefited as much as other defensive sectors overall. The bifurcation between pharma/biotech and the devices/tools subsectors has been sharp. After consolidating for over a year, the sector has started to outperform in October. As always, political/regulatory risk prevent the strong demand and innovation fundamentals from surfacing as clearly as in other high growth, techheavy sectors.

Putting it all together, a look back at earnings over the past year helps explain the relative outperformance of defensive stocks and bond proxies in a world hungry for yield. This has left investors positioned for a continued subpar economy with mostly downside risks. Worries about a hard Brexit and escalating tariffs played a role in creating this investment mindset. In our view, the impact of quantitative tightening and Fed rate hikes were an even bigger drag on the global growth and business pricing power that generated such flat earnings over the past year.

The odds of a hard Brexit seem to have dropped significantly, as has the outlook for significant further tariff escalation. The Fed's 180-degree policy shift is an even bigger catalyst for the year ahead. Other central banks have shifted with the Fed. Overall, instead of draining another trillion dollars, central banks are committed to adding over a trillion dollars to the global financial system in the year ahead. Given these fundamental changes, it should not be surprising that the market is starting to revalue riskier assets on the expectation that economic growth, corporate revenues and profits will likely accelerate in 2020.

Global Demographics: The World is M.A.D.

Demographics, so goes the refrain, are boring and glacial, and too centered on the future to effect today's investment climate. We disagree. Shaped by three powerful forces—unprecedented waves of migration; record-breaking levels of global ageing; and accelerating rates of population decline in a number of key nations—the future contours of global demographics are already exerting a powerful pull on global economic activity. The population of the world is in a state of dynamic flux. It's M.A.D—(M)igrating, (A)geing, and (D)eclining. We discuss each variable below.


Around the world, a record number of people are on the move, with almost 71 million individuals forcibly displaced as a result of persecution, conflict, violence or human rights violations in 2018 according to the United Nations. Climate change—think droughts and floods—have also contributed to this tidal wave of human movement. Last year's figure (70.8 million) contrasts with 43.3 million displaced individuals in 2009. Since 2012, the refugee population under the mandate of the United Nations has nearly doubled, robbing the home country of future supply (workers) and demand (consumers), while placing undue burdens on host countries straining to accommodate surging populations.

It's the emerging markets that are bearing the brunt of the record number of individuals on the move. While Syria, Afghanistan, South Sudan, Myanmar and Somalia constitute 67% of the world's refugees (and matter little to the global capital markets), more than 3 million people had left their homes in Venezuela by the end of 2018, depleting one of Latin America's largest economies of its economic vitality. Population growth is a key ingredient/determinant of future economic growth, so the more nations like Syria and Venezuela bleed people, or de-populate, the lower their growth prospects.

By the same token, the more host countries like Turkey and Pakistan are challenged by record numbers of displaced individuals, the more resources are diverted from the economy, crimping growth and development prospects. As a footnote: Of the major host nations of refugees, Colombia, Pakistan and Turkey are included in the MSCI EM Index, while other large host nations—Jordan, Bangladesh and Lebanon—are included in the MSCI Index of frontier nations. While both indices have advanced this year, by 8.6% and 7.5%, respectively, they have underperformed the S&P 500 and other world benchmarks due, in part, to the drag from the migration crisis (Exhibit 2).

Exhibit 2: The U.S. Outperforms the Rest of the World.

As a final note, the world's record number of displaced workers has not only negatively affected home and host nations, but also the world at large. Remember, the populist, anti-immigration surge across Europe in the past few years was triggered by the Syrian civil war and attendant refugee crisis. Immigration was a key catalyst for the Brexit vote. Meanwhile, the fierce immigration debate in the U.S. stems in part from the failed and flailing economies of Central America, driving record numbers of individuals north, creating political fissions in the United States.


The world's population is not only on the move, it's ageing as well, and rapidly. The formula behind this dynamic is simple: lower fertility rates + increased longevity = an older population around the world. Some key figures to consider:

  • In 2018, for the first time in history, persons aged 65 years or over outnumbered children under age five worldwide. According to UN projections, by 2050, people aged
  • 65 or older (1.5 billion) worldwide will outnumber adolescents and youths aged 15 to 24 years (1.3 billion)
  • In 2015, 9% of the world population was aged 65 or older (617 million people), although that percentage is expected to rise to 12% by 2030 (1 billion people), and 17% (1.6 billion) by 2050, according to the U.S. Census Bureau.
  • Europe is currently the oldest region in the world, with 17.4% of the total population aged 65 or older in 2015. Looking forward, Asia's older population is expected to triple from 341 million people in 2015 to 975 million by 2050, according to the United Nations.
  • The Brooking Institute estimates that between now and 2030, the world will add 800 million people above the age of 30, while there will be fewer than 100 million people under the age of 30.
  • In the United States, the population aged 65 and over numbered roughly 51 million in 2017; that represents 15.6% of the population, or more than one in every seven Americans. By 2040, the U.S. Census Bureau expects the elder population to reach roughly 81 million, twice the level of 2000. The number is expected to approach 100 million people by 2060.

Given all of the above, it's little wonder that global health care spending remains one of the most robust variables of the global economy. Worldwide spending is set to intensify over the next 30 years with substantial variations in expenditures across countries and income levels according to the Institute for Health Metrics and Evaluation (see Exhibit 3). Unequivocally, the United States will remain the largest contributor to health care spending, representative of nearly 40% of global spending in 2018.

Exhibit 3: Global Health care Spending.


The last variable—declining populations around the world—has yet to be fully appreciated by investors (see our recent piece, "Investment Insights, October 24, 2019: The New Normal of Global Demographics"). Presently, the world's population stands at around 7.7 billion people, and according to projections from the United Nations, should top a stunning eight billion people by the middle of the next decade.

This milestone, however, belies the fact that the world's population is expanding at its slowest pace since 1950, and in the decades ahead, population growth should stabilize in many parts of the world and then go into reverse—or decline.

Today, populations are actually dropping in roughly two dozen states, and according to estimates from the United Nations, the populations of 55 nations are set to fall by at least 1% between 2019 and 2050. Key nations facing falling populations—the new normal of global demographics—include China, Japan, Russia, South Korea, Taiwan and many countries of the European Union.

The economic consequences of this dynamic are already being felt. Think slower structural growth in many key regions of the world, along with muted inflation, if not outright deflation. In Japan, three decades of economic stagnation reflects, in large part, the country's falling working-age population and overall decline in population. Ditto for Europe, where shrinking labor forces and declining fertility rates in many nations have sapped and undermined economic growth and contributed to the forces of global deflation.

All of the above reflects declining global fertility rates, notably a fertility replacement rate below 2.1 children per woman, the magic number needed to keep a population stable over time, barring migration. Around the world, women are becoming better educated, more empowered to pursue a career, and marrying later in life. They are also opting for city life, which entails fewer children, since a child on a farm is considered an asset/helping hand but a liability/cost in the city. Planetwide, women are bearing fewer children as shown in Exhibit 4, a powerful deflationary dynamic with multiple ramifications for future global growth.

Exhibit 4: Fertility Matters: The Number of Countries Below Fertility Replacement Rate.

Investment implications

So what does all of the above mean for investors? For starters, investors should lower expectations about future returns in such key emerging markets as Turkey, Pakistan and Venezuela due to migration challenges; our emerging market preference pivots on the tech giants of China and South Korea. Global ageing suggests continued earnings upside for the global health care industry, notably drugs and medical equipment/devices. For equities, the forces of demographic deflation favor companies that can grow their dividends and grow earnings at an above-average rate compared to the economy and peer group. Moreover, in a world rapidly ageing and increasingly short of workers, portfolios should be tilted toward health care and technology/innovation leaders in robotics, automation and artificial intelligence. All of the above reflects a world gone M.A.D.

What Doctor Copper's Prognosis Might Mean for Markets

Copper has long been considered one of the favored leading indicators used by analysts to help predict global economic activity, lending itself to the nickname "Doctor Copper." With the overwhelming end-usage of the red metal concentrated toward building construction, infrastructure, transportation equipment and industrial machinery, it's no wonder that its demand has shown strong leading properties as a gauge of the business cycle. As forwarddiscounting mechanisms, markets dynamically sniff out clues to help project growth patterns, which makes copper one trip to the doctor that investors don't mind taking.

Since the midpoint of last year, Doctor Copper had portrayed a bleak outlook having lost -15.4% from June 2018 through October 2019, yet equity markets seemed to shrug off the dour prognosis, posting gains of 8% in the MSCI All Country World Total Return USD Index during the period. However, while the equity market advanced, other leading indicators also declined, and a global growth slowdown was ultimately confirmed. Weaker manufacturing, lower global trade activity, and a cloudy geopolitical backdrop weighed on growth. In this case, it appears markets were able to shrug off a short-term slowdown.

Most recently the outlook has shifted positively, with copper having advanced over 4% since bottoming on September 3, 2019. This recent price spike may be influenced by supply concerns revolving around margin compression affecting miners in addition to labor disruptions in Chile and Peru, both major global suppliers of the red metal. However, copper's recent ascent also coincides with a recent pickup in other leading indicators including global manufacturing Purchasing Managers Index (PMI), shipping indexes, global money supply and financial conditions. From this perspective, copper is among the components that may be foretelling a fourth mini-wave of global expansion. Moreover, BofA Merrill Lynch (BofAML) Global Research notes that copper has been a proxy for trade disputes and may be fundamentally undervalued due to those headline risks; however, slowing demand in China could pressure prices into next year.

While BofAML Global Research expects a balanced market for the commodity, continued strength in copper may be another indication of a refreshed cycle of economic growth helping to boost markets.

Exhibit 5: Copper and Global PMI Have Recently Picked Up.