Capital Market Outlook (October 21, 2019)

In This Issue

  • Macro Strategy—There are many ways to slice and dice the U.S. equity market and a proper allocation can prove rewarding in managing risk and maximizing returns. We examine some trends and outlooks that have emerged across styles, sectors, market caps and factors.
  • Global Market View—The world's population is expanding at its slowest pace since 1950, and many key nations are poised for an outright population decline/bust in the decades ahead. The economic consequences are already being felt: think slower global growth and mounting deflationary pressures. Demographic deflation favors companies with strong dividend growth, with a sector tilt toward health care and technology.
  • Thought of the Week—Few burdens challenge global health or the impressive life expectancy gains over recent decades like the rise of chronic disease including the greater incidence of obesity globally. We expect chronic diseases to be a driving factor behind the global rise in health care spending, demanding more of our health care services, including costly procedures and pharmaceutical costs.
  • 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.

Market Styles, Sectors, Market Caps and Factors...Oh My!

Far from homogenous, the U.S. equity market can be analyzed and invested through many different lenses. Here we examine trends across style, sectors, market cap and factors.


Growth stocks trounced Value over the last decade, with an average annual growth rate of roughly 17% for Growth equities relative to just 12% for Value.1 But while Growth led during this extended bull market boosted by low rates and secular trends in technology, Value held its own and actually outperformed over the longer term, leading to what some studies promote as a Value factor premium (Exhibit 1).

Exhibit 1: While Growth Leads This Cycle, Value Has Led Over the Last Two Decades.

Growth and Value performance has tended to follow the profit cycle. Generally, Growth outperforms during the middle-to-late stage of the cycle when earnings growth is scarce, and investors place a premium on companies that can maintain earnings strength. Value excels when the profit cycle first accelerates, typically during the early stage of a cycle after macro data has bottomed out. Earnings growth is more widespread, and investors can be more price sensitive. At that point, central banks may have eased rates, helping to boost lending activity and business development and support more value-oriented sectors like Financials, Industrials and Energy.

In early September, Value made a comeback amidst a rotation away from Momentum (and Growth), led by an unwinding of short-term positioning and an improving macro backdrop. During the rotation, Financials and Energy performed especially well. Given that Financials, banks in particular, make a good portion of income from lending long and borrowing short, the sector benefited from a steeper yield curve and a 40bps spike in 10-year Treasury rates. Energy advanced amid higher crude oil prices following an attack on Saudi output.

Since that brief reversal, however, rates, inflation expectations and oil prices have fallen from their highs, and Value rolled back over. But the valuation spread remains historically high, according to Empirical Research Partners, with Value trading at a steep discount to Growth. According to BofAML Global Research, in past instances of such a wide dispersion, Value outperformed Growth 95% of the time over the following 12 months. Still, a sustained leadership shift toward Value will need stronger nominal growth to support any acceleration in corporate profits. We favor a balanced approach to both styles, enjoying exposure to secular elements and tactical opportunities across each.


Performance dispersion across sectors can be significant. The worst-performing sector yearto-date (Energy) has trailed the best (Tech) by almost 31%, but the range between Tech and Energy in 2017 reached over 40%. Allocating correctly across sectors can be very rewarding.

Patterns emerge between industry groupings such as Cyclicals versus Defensives. Cyclical sectors have handily outperformed Defensives over the past decade with more than a 40% advantage since July 2016, as calculated by the MSCI USA Cyclical Sectors— Defensive Sectors Return Spread Index. Yet from January 2001 through January 2009, Defensive sectors outperformed Cyclicals by nearly 50%. A few sectors explain much of these differences, given the outsized effects of the rise and fall of energy prices, the decline in financials market share, and the secular rise of the technology sector.

Much of the relative dispersion earlier this year was powered by the outperformance of Tech and real estate investment trusts (REITS) compared to the underperformance of Energy and Healthcare. Cyclicals built up a 13% lead over Defensives by late April but have stalled since, although the recent leadership shift toward Utilities, REITs and staples highlights a mix of lower cyclicality with higher yield characteristics.

Going forward, we prefer a less rigid approach to sector selection that blends exposure to both cyclical and defensive elements. Sector performance often boils down to themes or cycles taking place at the broader macro level that don't neatly prescribe to predetermined industry groupings. Industries within Technology can potentially offer secular growth and quality. The strength in the consumer has boosted Consumer Discretionary and staples. Finally, Financials feature attractive valuation and could benefit from a pickup in economic expectations.


Small-cap stocks, as represented by the Russell 2000, enjoyed long periods of outperformance over large caps during the past two decades, but a recent bout of underperformance has cut into their lead. Since 2017, large-cap equities outperformed small caps by nearly 23%, and this is within the broader context of an 83% small-cap advantage since 2000.

The struggle between large and small has seen its share of reversals as of late, with small-cap equities surging higher in the mid-portion of 2018 and in the strong rally to begin 2019. Each bout of relative strength was ultimately short-lived, as concerns over rising rates curbed small-cap equities in the fourth quarter of last year, and growth concerns dampened performance over the last six months. Small caps did stage a very brief comeback in September, similar to certain value-oriented segments of the market, but large caps have since reclaimed their relative momentum.

There are many performance drivers of different segments of market capitalization, but ultimately most can be categorized by their effect on earnings growth expectations and valuation. Traditionally, small-cap equities are expected to enjoy a premium due to stronger growth prospects of more rapidly maturing companies. Alternatively, in times of stress, concerns arise over the greater volatility of small-cap company revenues, increased cost of capital, and stressed balance sheets to a larger degree than largecap companies. Sector composition could also be considered as large cap indices have a significantly higher exposure to Tech and Staples whereas small caps carry a larger allocation to Financials, Industrials, and Healthcare.

We have a tactical preference toward large-cap equities over small cap due in part to our prioritization of quality. Small-cap valuations have become more attractive recently; however, over one-third of companies within the Russell 2000 Index are unprofitable, which may prove troublesome in periods of enhanced volatility.


Beyond style and size, most major factors have performed quite well in the recent past. According to MSCI USA Index data, Low Volatility, Momentum, Quality and High Dividend all outperformed the broader index last year, and each outperformed year-to-date except for High Dividend. This broad outperformance is encouraging as factors held up well in circumstances attributable to the negative returns of last year and positive returns this year. In the brutal fourth quarter of 2018, every factor except Momentum enjoyed lower drawdowns than the broader index. Momentum also underperformed this September in a turbulent market, while other factors performed better.

Relative performance can help highlight market environments in which certain factors should thrive or flounder. The sudden underperformance of Momentum in periods of episodic volatility illustrates vulnerability to reversals in leadership, while struggles for High Dividend may be the product of investors' prioritization for growth.

We maintain a bias toward Quality, as this factor historically demonstrates the greatest resilience in periods of heightened volatility and provides exposure to segments of the market that we feel are well positioned to prosper.


On balance, we find the macro outlook to be encouraging with accommodative monetary policy and more benign trade relations supporting economic expansion. A cyclical upswing should benefit Value, but also help technology where earnings are on a secular uptrend given accelerating global investment in artificial intelligence, robotics and cloud computing. With these mixed forces, keep a balance of Growth and Value. More instances of episodic volatility continues to lead us to favor Quality, and therefore U.S. large-cap equities, as they exhibit better quality relative to international peers powered by higher return on equity and healthier profit margins.

The New Normal of Global Demographics

"We do not face the challenge of a population bomb but a population bust—a relentless, generation-after-generation culling of the human herd." From "Empty Planet: The Shock of Global Population Decline" by Darrell Bricker and John Ibbitson

From Zero to Seven Billion: A Brief History of Humans

In the beginning, it wasn't easy. Life for the early inhabitants of Earth was nasty, brutish and fleeting. Homo sapiens, on average, were stunted, short and skinny. They died young and early due to the lack of food, or to illnesses and plagues that could wipe out a disproportionate share of the population. The Black Death, for instance, transmitted from Asia to Europe by seafarers, killed about one-third of Europe's population in the Middle Ages.

Constantly challenged by malnutrition, diseases, famines, plagues, the world's population flat-lined for the first 200,000 years of human existence. And little was produced in the way of economic output: as noted by Johan Norberg in his book, Progress, "despite a few ups and downs, humanity had experienced almost no economic development until the early nineteenth century."

Everything changed with the Industrial Revolution. Production became mechanized. The steam engine powered growth across multiple sectors. While working conditions remained difficult, the wave of innovation that first swept the United Kingdom and other parts of the world helped liberate a large part of humanity from the brutal living conditions of the past. Rising innovation boosted worker productivity, as well as their incomes and consumption. Children were freed from the shackles of work and were sent to schools, not factories. As a result, the next generation was set on a path of higher incomes, improving health, better education, longer life expectancies, which spread globally over the next two centuries.

It took from the dawn of humanity to the early nineteenth century for the world's population to reach one billion. 1804 was the first year the earth hosted one billion people. While it took another 123 years before the world population reached two billion (1927), it took only 33 years to reach three billion in 1960. Then things really accelerated: Only 14 years eclipsed to get to the four billion mark (1974), just 13 years to reach five billion (1987), and 12 years each to get to 6 billion (1999) and seven billion (2011) (Exhibit 2).

Exhibit 2: Human Population Over 12,000 Years by the Billions.

Summarizing, it took over 200,000 years for the world's population to reach 1 billion, but only 200 years more to reach seven billion. As of August 2019, the world's population stood at 7.7 billion, and according to projections from the United Nations, some eight billion people will inhabit the Earth by the middle of the next decade.

The Next Billion: Not so fast

"Imagine a car trundling slowly forward at more or less the same speed for mile after mile. Imagine it then increasing its speed, gradually for the first few miles, then rapidly, until it achieves tremendous, even frightening, velocity. Then, after a relatively short distance, hurtling along, the brakes are suddenly applied, resulting in rapid deceleration. This is what the world's population growth pattern has been like since 1800." From The Human Tide by Paul Morland

Yes, the brakes are being applied to population growth. Population growth has stabilized and begun to slow around the world. And in the decades ahead, it will slow even more and then go into reverse. Populations are actually dropping in roughly two dozen states right now (think Japan, South Korea, Spain, for instance), while by 2050, that number is expected to double. Italy, according to former health minister Beatrice Lorenzin, is "a dying country."

What's behind the so-called death of Italy? Think 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.

On average, and all things being equal per immigration and migration, a number below 2.1 denotes a population eventually in decline, and as Exhibit 3 underscores, falling fertility rates are not only unique to the developed nations but also to many developing countries. Around the world, whether in India or Ireland, China or Canada, 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. The upshot: Planetwide, women are bearing fewer children. Here are some of the key figures:

  • On a global basis, the world fertility rate has dropped from 5.0 in 1955 to 2.48 today.
  • In 1950, no country in the world had a fertility rate below 2.1 children per woman. Today, however, almost half of the world's nations are below the replacement rate.
  • Europe and Japan's fertility rates are well below the replacement of 2.1, with the former 1.61 in 2019 and the latter 1.38.
  • China's fertility rate is also below the replacement rate, plunging from 5.48 in 1960 to just 1.68 in 2019.
  • India's population continues to expand although the nation's fertility rate has dropped significantly over the past decades, falling from 4.97 in 1980 to an estimated 2.27 in 2019.
  • Numerous key emerging markets like Brazil, Poland, Russia and Turkey all confront the prospect of a shrinking population in the years ahead. Fertility rates in Africa remain relatively high but are trending lower.
  • In the United States, the fertility rate fell below 2.0 in 1975 and dropped to a record low of 1.72 in 2018 according to the CDC. The slump reflects, among other things, the fact that women are having children later in life and a steep decline in birth rates among teenagers and unmarried women. Birth rates among older women—ages 35 to 44—have increased but not at a pace to prevent a significant decline in U.S. fertility rates. Emblematic of America, California's 2018 population growth was the slowest in history, just 0.47%, according to State's Department of Finance.

Exhibit 3: No Exceptions: Falling Fertility Rates Around the World, by Region.











North America















Latin America










Source: United Nations. Data as of October 2019.

Summarizing: Yes, the world's population continues to expand—we'll reach 8 billion people in just a few years. This milestone, however, belies the fact that the world's population is expanding at its slowest pace since 1950, and more importantly, many nations around the world are poised for a population bust in the decade ahead. According to UN estimates, the populations of 55 nations are set to decline by at least 1% between 2019 and 2050 owing to falling fertility rates, and in some cases, emigration. In the largest of these, China, the population is projected to shrink by 31.4 million, or 2.2 percent. Other nations facing falling populations include Germany, Japan, Russia, Greece, Estonia, Japan, Taiwan and Spain, to name just a few. As Exhibit 4 outlines, the number of nation's confronting fertility rates below 2.1 continues to rise, climbing from just 4 nations in 1955, to 61 in 2000, and an estimated 91 in 2020 and 124 in 2040.

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

Source: United Nations World Population Prospects. Data as of October 2019.

Babies and Your Portfolio

Babies matter. Why? Because the growth rate of any economy is dependent on population growth. The larger the population, the greater the labor force, the more capacity for consumption as workers per capita increases, and the deeper the base of taxpayers to support retirees. Throughout history, a nation's population has always been a marker of strength or weakness. Per the latter, three decades of economic stagnation in Japan 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.

Against this backdrop, the global decline in fertility rates is already exerting a powerful force on global growth and demand. The fact that over 50 countries in the world are on track to experience declines in their population's decades from now matters today, right now. Investors beware.

While it is a well-known fact that the people of the world are getting older—in 2018, for the first time in history, persons aged 65 years or over worldwide will outnumber children under age five in 2018—less known is this: Not only is the planet's population aging, it's also declining, or set to decline, in a number of key nations over the next few decades. The economic consequences—already evident in Japan and large parts of Europe—will be slower growth, muted inflation, if not outright deflation.

This suggests that global interest rates could remain historically lower for longer, and that negative-yielding bonds might not be so untoward after all. For equities, the forces of demographic deflation favor companies that can grow their dividends and grow earnings at an above-average rate than the economy and peer group. Moreover, in a world rapidly aging and increasingly short of workers, in our opinion, portfolios should be tilted toward health care and technology/innovation leaders in robotics, automation and artificial intelligence. All of the above reflects the new normal of global demographics.

Can't Outrun the Fork…or Health Care Costs

Few burdens challenge global health or the impressive life expectancy gains over recent decades like the rise of chronic disease. These diseases often of long duration and slow progression include heart disease, cancer, diabetes, respiratory disease and obesity. Processed foods, obscene super-sized portions and the lack of physical activity worldwide have inevitably led to greater incidence of obesity, with the global obesity rate tripling since 1975. A staggering 2 billion people are now overweight/obese, including 41 million children under the age of five.

Persistent increases in levels of overweight and obesity are not only damaging to our health (obesity and overweight-related diseases reduce life expectancy by three years according to the OECD), but depresses the welfare and output of an economy, curbing annual gross domestic product (GDP) by an average of 3.3%.5 The economic weight of the overweight varies by country from under 2% in Luxembourg to over 5% in Mexico. Add it all up, and the global economic burden equates to $5.3 trillion—a total comparable to the annual GDP of Japan.

OECD countries spend on average 8.4% of their health care budget to provide treatment for overweight-related diseases. Health expenditure due to the overweight population will cost $209 on a per capita basis,6 with the U.S. three times that average. And as a percent of total health spending, this one condition is 14% of total U.S. health care expenditure (see Exhibit 5). Tack on the cost of diabetes, cardiovascular diseases, cancers and respiratory disease most familiar to the developed world, and the noncommunicable disease burden grows heavier and more costly. As for the developing world, as mortality from infectious diseases and acute illnesses wanes marginally, these countries are double burdened by the increasing incidence of chronic and degenerative illnesses.

Exhibit 5: The Skinny on Obesity's Burden on Health Care.

Notwithstanding healthy fundamentals/valuations, we remain neutral on health care owing to headline risks around the 2020 presidential election and the overhang from a tougher regulatory environment. However, over the longer term, the sector looks more attractive. We expect chronic diseases to be a driving factor behind the global rise in health care spending, demanding more of our health care services, including costly procedures and pharmaceutical costs. Case in point, overweight individuals on average have twice as many prescriptions compared to those with a healthy weight. Especially burdensome is in low- and middle-income countries where waistlines are expanding faster than GDP, putting enormous weight on inadequate public health care systems. Over the long run, the surge in global obesity represents a sizable tailwind for health care earnings.