IN THIS ISSUE
Despite a strong labor market and still-elevated consumer confidence, weaker-than-expected global manufacturing and trade growth, negative tariff-related sentiment, an inverted yield curve, and disagreement about the appropriate level of Fed interest rates have increased uncertainty about the economic outlook and financial-market turmoil. We were not surprised to see a rising risk of recession given that the Fed has long ignored: 1) the strengthening dollar, which has weakened U.S. corporate revenue growth and hurt countries that have borrowed heavily in dollars; 2) the waning growth and inflation pressures around the globe; 3) increasingly depressed University of Michigan Consumer Survey home-buying sentiment and persistent U.S. housing weakness; 4) weak profits growth and the related deceleration in U.S. industrial activity and business investment; and 5) the slowing leading indicators of growth, including a worsening inversion of the yield curve, a clear symptom of an overly tight Fed policy.
Because of the strengthening dollar, a global manufacturing recession, and a fading nominal growth environment, our research indicates persistently soft business revenues growth and fixed investment into 2020. Soft revenue growth and much lower profit margins than apparent before the sharp downward revision to National Income and Product Accounts (NIPA) profits in July pose downside risks to business investment and raise questions about the sustainability of the expansion. Before-tax NIPA profits have stalled for four years. Tax cuts are the only reason that after-tax NIPA profits reached new records. Given their stronger correlation with fixed business investment, it is not surprising that weak pre-tax domestic profits growth has been accompanied by increasingly disappointing capital expenditures (capex) over the past year.
Basically, the nominal growth environment needs to strengthen for corporate profits and capex to avoid sustained contraction, but this requires an accommodative Fed, a softer dollar, and stronger global manufacturing activity. Because of solid fundamentals, consumer spending is tracking over a 3% growth pace in the third quarter according to the latest Atlanta Fed GDPNow forecast, helping to mitigate headwinds coming from capex, housing and net exports. However, high policy uncertainty, stock-market turmoil, and a likely slowing of aggregate labor income growth pose downside risks to the outlook for consumer spending as well.
That said, we believe that all is not lost, and a recession can potentially be avoided. The leads and lags involved between changes in interest rates and real economic activity suggest there's still time for the Fed to affect the outcome in a favorable way. Refinancing activity is up strongly as a result of the sharp drop in mortgage rates, and home-buying activity has also benefited from lower rates. In addition, leading indicators of employment don't suggest meaningful weakness through late 2019, helping strong consumer fundamentals to cushion the economy for a while.
The fact that credit spreads remain tame, inconsistent with an imminent recession, and that leading Organisation for Economic Co-operation and Development (OECD) indicators of global growth have stabilized and appear poised to turn up in coming months, supports this view. While these two favorable signals are somewhat surprising given recent equitymarket volatility and the inverted yield curve, they appear consistent with each other. For example, high-yield credit spreads have widened somewhat but remain below average, while other credit spreads, such as the TED spread (difference between the interest rates on interbank loans and on short-term U.S. government debt), and the 2-year swap spread have in fact narrowed. These typically reliable financial-market stress indicators suggest that the current panic about recession is misplaced.
Exhibit 1: OECD Leading Indicator Points to at Least a Stabilization in U.S. Growth Momentum.
This is consistent with the improvement quietly shaping up in the OECD leading economic indicators (LEI), which, given past correlation, appears to preclude credit spreads from deteriorating. Indeed, as shown in Exhibit 1, the OECD LEI improvement is consistent with the stabilization in the U.S. Conference Board index of leading indicators and thus growth momentum through year-end. The solid July rise in the index of leading indicators seems to corroborate this view. With the OECD LEI likely to turn up in coming months, stabilization and renewed growth in international trade volume is also likely, given past correlations. So is stabilization and a pickup in the global composite Purchasing Managers Index (PMI) new orders component, whose small gains over the past two months should thus not be surprising, as well as in the Institute for Supply Management (ISM) U.S. manufacturing index. The fact that the global Markit purchasing managers' index for manufacturing declined at a slower pace over the past two months while its global services counterpart inched higher into expansion territory is encouraging in this respect.
Renewed growth in the OECD leading indicator through year-end would make sense. Oil prices are down about 20% year over year, which is positive for global growth, dozens of central banks have eased monetary policy, and China has introduced substantial stimulus over the past year. European Union (EU) tax cuts this year have also helped cushion consumer spending there while manufacturing and business sentiment sharply weakened, especially in Germany, which has been disproportionately affected by the structural moderation of Chinese growth as well as by ongoing auto-sector emissions-related challenges in the Eurozone and new emissions standards in China and India, as discussed in our Capital Market Outlook last week. With German car production in 2018 down almost as much as during 2008–2009, the worst downdraft on manufacturing activity from that source may be behind us for now. An apparent stabilization in auto sales in Germany in July and a surge in manufacturing new orders, led by non-Eurozone orders, are encouraging and consistent with a potential global manufacturing stabilization and incipient upturn.
Last but not least, as noted above, the sharp drop in mortgage rates has imparted substantial stimulus to the U.S. housing market and refinancing activity. Following a year of rapid deceleration, real money-supply growth has also strengthened since the Fed pivot in early 2019. This is important because periods of shrinking real money supply tend to precede recessions, while periods of acceleration don't.
All in all, we continue to believe that a recession is not baked in the cake and can still be averted. Some stabilization and improvement in global manufacturing and trade data is likely in coming months. Also, the yield-curve spread has not been negative long enough compared to the pre-recession inversions of the past 60 years. With "core" Personal Consumption Expenditures (PCE) inflation likely to remain below 2% through 2020, in our view, despite short-term fake outs, the Fed has room to stimulate the U.S. economy and to create sustainably healthier real growth and inflation. Otherwise, with corporate profits growth persistently weak and downside risks to nominal growth, a recession may eventually materialize. The yield curve leads profits growth, business investment, and credit spreads, and the increasingly inverted yield curve shows that the Fed remains way behind the curve, likely causing these indicators to deteriorate absent a reprieve in coming months. In other words, a sustained turnaround requires faster money-supply growth and an urgent steepening of the yield curve.
On the back of the recent comments from the White House that American companies should start to look for an alternative to China, there have been some questions as to what the overall impact would be and if the directive can actually take place. This has created additional uncertainty in the markets recently.
Whether or not U.S. firms heed the suggestion of the White House to bring their production back to the United States remains to be seen. This exorbitant amount of spending power keeps most U.S. multinationals anchored in America. It is also a major draw for many foreign firms, who for a variety of reasons, seem to have embraced the call "to make it in America". To be fair to U.S. multinationals, the scope and scale of their operations require they leverage resources in Boston as well as Bangalore, and access consumers in London and Lagos in addition to Los Angeles. What's more, U.S. multinationals are more domestically focused than investors and policy makers realize. More on that in a moment, but first back to the "make it in America" theme.
As background, it is no secret that global capital expenditures have slumped this year, but the magnitude of the decline is stunning: according to the Financial Times' database on corporate foreign direct investment, global greenfield investment projects in the first half of 2019 (6,243) dropped back to levels not seen since the second half of 2009, when the global economy was still on its knees. Outlays on new investment in plants, factories, R&D centers, and buildings (or so-called "greenfield investment") cratered by nearly 25% in the first half of 2019 versus the same period a year ago.
The investment swoon reflects multiple factors ranging from the uncertainty and declining business sentiment associated with the U.S.-Sino trade war, to plunging global auto sales, to the general slowing of global economic activity, among other variables. The world is in the midst of a capex recession.
One country, however, stands out—the United States, which has bucked the downturn in greenfield investment this year. As Exhibit 2 depicts, new greenfield investment in virtually every part of the world dropped sharply in the first half of this year, with China, the eurozone, Japan and even Africa all posting sizable year-over-year declines. In contrast, greenfield investment in the U.S. jumped 14% in the first half of this year as more and more foreign companies, fearing additional U.S. protectionist measures from the Trump Administration, opted for tariff-jumping investment in the United States. The increase in U.S. foreign investment reflects the prevailing mindset of many foreign CEOs. It's better to be inside in the U.S. market via foreign investment than left outside due to trade restrictions.
Exhibit 2: Changes in Number of Foreign Companies Setting Up Operations.
Additional lures of investing in the U.S. include a large and wealthy consumer market; deep and liquid capital markets; cutting-edge technological capabilities and talents; the ease of doing business, including a predictable rule of law; lower corporate tax rates; and some of the lowest energy costs in the world. Against this backdrop, is it any wonder that year in and year out, the United States remains the largest recipient of global foreign direct investment?
Between 2000 and 2018, cumulative global foreign direct investment inflows to the United States were in excess of $4 trillion, or 17.1% of the global total, and well above comparable levels in China (Exhibit 3).
Exhibit 3: Top 10 Destinations for Foreign Direct Investment Inflows (Cumulative 2000–2018).
What does this mean for the real economy in the U.S.? Well, it's worth noting U.S. affiliates of foreign multinationals add roughly a trillion dollars to U.S. output every year; employ over 7 million U.S. workers, or nearly 6% of the private sector labor force; spend over $60 billion on R&D in the U.S. according to the latest figures from the Bureau of Economic Analysis; and are huge players in U.S. exports and imports, with U.S. affiliates accounting for more than 25% of U.S. goods exports in 2016, the last year of available data, and nearly 30% of imports. Suffice it to say that foreign investment in the United States is an important generator of real economic growth—a consequential driver of American output, jobs, income and trade.
Seen in this context, the fact that the rest of the world has seemingly embraced the White House's mantra to "make it in America" is bullish for the long-term health of the U.S. economy. It's a growth differentiator.
While the preference of many foreign firms is to operate inside the United States, the same argument can be made for U.S. multinationals, who, unbeknownst to many investors, are more leveraged to the U.S. market than the rest of the world. In other words, they are already "home." The bulk of their activities are concentrated in the United States, as shown in Exhibit 4.
Exhibit 4: Activities of U.S. Multinational Enterprises.
Note the following from the chart: First, U.S. multinationals produced $5.3 trillion in output in 2017, the last year of available data, although nearly three-fourths was in the United States, not abroad. Second, and similar to the first point, roughly 77% of worldwide expenditures on property, plant and equipment of U.S. multinationals in 2017 was sunk into the United States. That's another way of saying that the capital infrastructure of U.S. multinationals is heavily tilted toward the U.S. Finally, when it comes to employment, while U.S. foreign affiliates employed roughly 14 million workers overseas at last count, that figure pales in comparison to the number of workers U.S. parent firms employ in the United States: 28.1 million, or 66% of worldwide employment of U.S. multinationals.
The bottom line: The majority of activities of U.S. multinationals pivot around the U.S., the home market, not overseas. This simple fact reflects another simple fact: that on a relative basis, the U.S. is home to the wealthiest, largest and most dynamic economy in the world. With less than 5% of the world population, the U.S. accounts for nearly 30% of global personal consumption. This exorbitant amount of spending power keeps most U.S. multinationals anchored in America. It is also a major draw for foreign firms, who for a variety of reasons, have embraced the call "to make it in America."
Investment summary: With capital from both U.S. firms and foreign multinationals, the U.S. economy remains one of the most dynamic and competitive in the world, supporting our investment bias toward U.S. equities in general, and large-cap U.S. multinationals in particular.
The numbers are staggering. Nearly $17 trillion of negative yielding debt is outstanding, with most sourced by the EU and Japan. Total sovereign debt, as measured by the Bloomberg Barclays Global Aggregate Treasuries Index, currently has a yield of just 0.66% and approximately half of weighted constituents are negatively yielding. The U.S. has avoided succumbing to negative rates for the time being, but as domestic yields continue to creep lower across the curve, could we ultimately join the party below zero?
It's important to recognize the drivers of rates across the curve. Short-term rates are more directly influenced by monetary policy. For example, shorter rates are anchored closer to the effective fed funds rate of 2.12%. With expectations of additional rate cuts, short rates may fall but likely not below zero without more aggressive easing. Market-implied probabilities illustrate a low likelihood of negative fed funds through 2022. Furthermore, the Fed has indicated a reluctance to breach the zero bound even in case of recession. Rather the playbook may favor rate cuts to zero followed by guidance and quantitative easing.
Longer maturity yields are more influenced by expectations for growth, inflation and uncertainty of future rates ("term premium"). While U.S. growth and inflation expectations have ticked down recently, current market conditions appear to be signaling more concern for the global economy as opposed to domestically. This may be manifesting in a historically low term premium which depresses U.S. yields as global investors seek out less risky assets. Relative valuations come into play. For example, a currency agnostic investor may prefer Treasuries to a German Bund currently yielding -0.70%. To be fair, the yield advantage is more than wiped out when currency hedging is considered, which could help set a floor under Treasury yields. However, the broader trend demonstrates how U.S. policy rates may remain positive or at zero while a negative term premium could induce certain portions of the curve into negative territory.
Could U.S. yields creep below zero? For the time being, it seems unlikely, but a further deterioration of the macro environment leading to lower policy rates and a flight to safety could be the recipe.
Exhibit 5: The Term Premium Has Shrunk as Negative Debt Piles Up.