Capital Market Outlook (September 30, 2019)

In This Issue

  • Macro Strategy—With most central banks in easing mode, the direction of global growth will likely play an outsized role in the direction of the dollar over the rest of the year. The dollar is expensive versus most major currencies, so to the extent the global monetary easing cycle leads to a stabilization and eventual pickup in global growth, the dollar should stabilize or move lower. In the short-term, however, elevated global policy uncertainty, strong domestic private sector growth and a muddy global growth outlook should keep the dollar well bid.
  • Global Market View—No country in the world attracts as much overseas capital as the United States, whether in the form of foreign direct investment (FDI) or portfolio investment. We believe strong capital inflows point to bullish underlying economic and market conditions in the U.S.
  • Thought of the Week—The launch of a formal presidential impeachment inquiry last Tuesday caused a one-day risk-off reaction in markets. A number of steps would still be required for an impeachment event to take place, and we expect the fundamental drivers of the current expansion to continue to matter most for the directional trend in markets.
  • U.S. Tax Policy Agenda—The summer may be over, the temperature may be dropping, but things are heating up in our nation's capital. If history is any guide, we expect to see some tax changes before Congress adjourns in mid-December.

Dollar Outlook

The U.S. dollar has benefitted from a number of tailwinds over the last few years. For one, the U.S. economy has performed relatively better than most other economies around the world, driven by the strength of the U.S. consumer. The housing market is now showing signs of life and should reinforce the strong domestic demand cycle. Weak global growth ex-U.S. also generally tends to be bullish for the dollar. The resilience of the U.S. economy has allowed the Federal Reserve (the Fed) to keep interest rates relatively higher for longer and has favored the dollar from an interest rate differential perspective as well. For example, the average 3-month deposit rate for G10 countries excluding the U.S. is around 50 basis points, compared to 215 basis points in the U.S. While the Fed is back in easing mode, there is a significant gap to cover. Nonetheless, the gap should narrow.

Elevated global policy uncertainty has also favored safe-haven currencies like the dollar and Japanese yen. Thus far, the political risk from Brexit and Euro Area stresses, for example, have outweighed domestic policy-related stresses in the U.S. Overall, elevated global policy uncertainty has hurt global growth more than domestic growth, benefitting the dollar.

Widening deficits and extended valuation have emerged as medium-to-long term headwinds for the dollar, with the latter likely to be a bigger factor, in our view. Valuation normalization tends to play out over longer time frames, leaving other factors as more important for tactical calls. In the near term, we think the direction of global growth will play an outsized tactical role in the direction of the dollar. If global growth picks up as we expect, we think the dollar could eventually come under pressure. For now, the muddy global growth outlook means dollar tailwinds are likely to persist, but we continue to expect global growth to pick up as we head into 2020.

For domestic investors, the potential for a weaker dollar in 2020 should not necessarily be construed as a negative dynamic. Along with the inverted yield curve, the strength of the dollar is a signal that financial conditions are tight (Exhibit 1). Thus the dollar is adding to the potentially slippery backdrop for the U.S. business cycle and risk assets, including equities and high yield credit. Fortunately, policymakers have a hand to play. Aggressive Fed policy easing to address deflationary risks could serve to ease dollar pressures and support the expansion and risk assets. A Fed easing cycle will likely help the dollar not only through domestic channels, but also by easing pressures on the rest of the world, particularly emerging markets with dollar denominated debt.

Exhibit 1: CIO Macro Financial Conditions Indicator.

Looking at individual currencies versus the dollar, in addition to growth differentials favoring the dollar, politics continues to play an important tactical role. As mentioned, thus far the political risk from Brexit and Euro Area stresses have outweighed policyrelated stresses in the U.S. and have contributed to undervaluation of the euro and the British pound in purchasing power parity terms.

The pound is a good example of a currency where the outcome of politics (Brexit) will play an important role in the direction of the currency. The pound appears to be more significantly undervalued than the euro in purchasing power parity (PPP) terms, a medium term catalyst, but would likely depreciate further in a "hard Brexit" scenario. In a benign-Brexit scenario, the pound would likely get a boost. In the interim, politics is likely to outweigh the tailwind from valuation. The U.K. economy also appears vulnerable as the consumer appears more stretched relative to the U.S. consumer, and the current account deficit as a percent of gross domestic product (GDP) has widened the last few quarters. The next few months will likely be rocky for the pound with politics steering the ship, but BofA Merrill Lynch Global Research (BofAML) expects a slight appreciation of the pound through the end of 2020 as valuation begins to play out in a potentially less ambiguous political environment.

The Japanese Yen remains deeply undervalued as well, but zero interest rates remain an offsetting factor. It continues to be the case that a cheaper yen is an important tool in reflating the economy which may mean that the catalyst from valuation may be even more muted. The Japanese economy, would benefit the most from a pickup in global growth and that could help narrow the growth differential with the U.S., but this may also encourage risk-taking, and the yen appears to be particularly sensitive to financial market sentiment. The yen tends to weaken when risk appetites pick up. Overall we have a neutral view of the yen through year-end 2020. In the near term, if the risk of a global recession goes up and global policy uncertainty remains high, the yen will likely be a beneficiary.

Like the Bank of Japan, the European Central Bank has not come close to hitting its inflation target, making it likely that interest rates in the Euro area are also likely to stay near zero for the foreseeable future. Thus, interest rate differentials will continue to work against the euro versus the dollar. Global growth will be an important factor in the health of the European economy and the direction of the euro as a pickup would likely narrow growth differentials with the U.S. An easing of trade tensions could be a catalyst for the euro. The euro is also slightly undervalued in purchasing power parity terms versus the dollar. Putting this all together, we think the euro has more upside versus the dollar through the end of 2020, but the direction of global growth will be the driving force. Importantly, the euro holds the most weight in broader dollar indexes, making our call on the euro a key factor in our call for the broad dollar overall.

Commodity currencies like the Canadian dollar and Australian dollar are obvious beneficiaries of a pickup in global growth, if it materializes. Global monetary reflation strategies are a tailwind, and an easing of trade tensions would also likely be a significant catalyst, particularly for the Australian dollar. Valuations in purchasing power parity terms are neutral to slightly undervalued. BofAML sees the Australian dollar under pressure through year-end but has a more neutral outlook through 2020.

Looking at China, they also expect further depreciation through year-end and potentially into 2020. The direction of tariffs will have a role in the direction of Chinese Yuan (CNY), as will China monetary policy, which will likely remain dovish.

In sum, tactically, the dollar still has tailwinds from relative growth/weak global growth, relative interest rates and elevated global policy uncertainty. The main factors that could cause a reversal and broad depreciation of the dollar include a pickup in global growth and/or an easing of global policy uncertainty (for example, an easing of trade tensions). A fiscal deficit that has widened even as the expansion has persisted will also be a headwind for the dollar when the next recession comes.

Bullish Indicators: U.S. Capital Inflows Remain Robust

For all the anti-trade rhetoric coming from Washington, notwithstanding the rising mood of isolation in America, and in spite of the White House's rejection of globalization— foreign investors still want a piece of America. For a variety of reasons, no country in the world attracts as much overseas capital as the United States, whether in the form of foreign direct investment (long-term) or portfolio investment (short-term). As icing on the cake, repatriated earnings from U.S. corporations have remained robust this year, following last year's record inflows in light of the Tax Cuts and Jobs Act enacted at the end of 2017. All of the above is supportive of the U.S. dollar, which remains, by a wide margin, the world's reserve currency.

We briefly unpack each one of these dynamics below but before going deeper, keep in mind the following: Robust capital inflows generally translate into more U.S. economic output, more jobs and rising incomes for U.S. workers, rising corporate earnings (via share buybacks) as well as more demand for U.S. assets like Treasuries, government agency bonds, corporate bonds and U.S. equities. Strong capital inflows, in other words, point to bullish underlying economic/market conditions in the U.S.

U.S. Foreign Direct Investment inflows solid, despite globalization risks

Global FDI flows weakened by 13% in 2018, with many countries in the developed world recording large negative inward flows from the U.S. The U.S., however, continued to attract large amounts of foreign capital. As shown in Exhibit 2, America remains the top destination for global FDI, representing 19% of total inflows in 2018 and 17% of cumulative FDI since 2000. Flows to second-place China came in at just half of that amount.

Exhibit 2: U.S. Remains Top Destination for FDI Flows.

Many attributes make for an attractive investment environment in the U.S. including a large and wealthy consumer market, strong institutions, a stable regulatory climate, top ranked research universities, advanced innovation capabilities, and a skilled workforce. Recently, the reduction in the corporate tax rate from 35% to 21% has made the U.S. an even more competitive destination for foreign capital. Indeed, as we highlighted in the 9-3-2019 CMO, U.S. greenfield investments (new foreign capital investments) jumped 14% in the first half of 2019, while other major economies saw more than 20% declines.

Foreign firms continue to grow their presence in the U.S. The U.S. inward FDI position grew 7.9% to $4.3 trillion in 2018—an acceleration from 6.9% growth in 2017. That contrasts with a 1% fall in the U.S. FDI position abroad for the same period, mostly due to a repatriation of overseas earnings by U.S. companies. Total U.S. FDI inflows in the first half of 2019 of $143 billion were roughly in line with the historical average this decade, but behind the peak FDI flows levels reached in 2015–2016.

America and the underlying demand for U.S. securities

Foreign investors are not only prominent players in the U.S. "real economy," they are also quite important in the U.S. capital markets. To wit, according to the latest Flow of Funds data from the Federal Reserve, foreign ownership of U.S. securities (specifically: Treasuries, government agency bonds, corporate bonds and U.S. equities) hit a record high of $19.2 trillion in the second quarter of this year. Foreign ownership of U.S. securities has doubled since the start of the financial crisis (Q4 2007) and has surged more than five-fold since the start of the century.

According to the latest figures, foreign holdings of U.S. Treasuries and U.S. equities are presently at or near record highs. Foreign investors owned some $6.6 trillion in U.S. Treasuries at the end of the second quarter of 2019, up 6.6% from the prior year, with yield-hungry investors from China, Japan and Europe the primary foreign holders. Reaching for more yield, foreign holdings of U.S. equities rose 4.0% from the same period a year ago, totaling $7.5 trillion. That is a near-record high, and solid evidence that foreign investors, rather than pulling back, have taken the combative/unpredictable rhetoric of Washington in stride, much like U.S. investors.

Notably, foreign investors have continued to reallocate funds toward U.S. equities versus U.S. Treasuries, with foreign holdings of equities some 13% larger than Treasuries in the second quarter. In other words, the preference for equities over Treasuries among foreign investors has shifted markedly over the past few years—a historic shift that has helped power U.S. equities to new highs this year.

We believe the growing attractiveness of U.S. equities among foreign investors is a secular trend and in the middle stages, with plenty of future upside. Not lost on foreign investors is this: The U.S. remains among the strongest economies in the world. It has also clearly emerged as the most competitive and innovative economy in the world in the post-crisis era, with U.S. companies global champions in a number of key sectors, ranging from agriculture to aerospace, to e-commerce to e-health.

All tallied, foreign demand for U.S. securities has remained healthy. That is the good news. The more worrisome news is the flip side of this dynamic: that foreign investors play a critical role in U.S. capital markets. Note from Exhibit 3 that foreign investors own roughly 37% of marketable U.S. Treasuries and are significant holders of U.S. equities (18.3%). Meanwhile, foreigners account for nearly 37% ownership of U.S. corporate bonds, a significant stake that can be market-moving.

Exhibit 3: Percent of U.S. Securities Held by Foreigners.

Bringing the money home

Also bolstering inflows this year is the reduction in the tax rate for repatriated corporate earnings. After a record $777 billion was repatriated in 2018, we are continuing to see companies repatriating larger-than-average sums of cash. Recently released balanceof-payments data show that for the first half of 2019, parent companies repatriated an additional $185 billion from their foreign subsidiaries, almost double the amount that was reinvested in affiliates abroad (Exhibit 4).

Exhibit 4: Homecoming for U.S. Corporate Profits.

While this is a slower pace than what we saw last year, it still represents a significant amount of cash, and well in excess of the ~$40 billion quarterly average in the years leading up to tax reform. It is also bullish for equity markets, with corporate buybacks and dividends rising to a record $1.26 trillion in 2018. After those record highs, S&P 500 buybacks and dividends are tracking at a slower pace so far this year.

The U.S. dollar currently remains king

All of the above leads to the U.S. dollar and its dominant role in global finance. Nothing underscores the latter point like Exhibit 5, which shows foreign exchange (FX) market trading by currency. Of the $6.6 trillion of daily FX transactions, the U.S. dollar was on one side of 88% of all trades. The euro is the next largest currency traded, representing 32% of all market transactions, slightly higher than the figure from the last survey conducted in 2016. Despite China's push into international markets, the renminbi continues to be underutilized compared with its importance in international trade and investment. The renminbi was the eighth most-traded currency with a share of just 4.3% of FX market turnover, according to the Bank for International Settlements.

Exhibit 5: Foreign Exchange Market Turnover by Currency.

As two currencies are involved in each transaction, the sum of shares in individual currencies will total 200%. EME = Emerging Market Economies' Currencies. Source: Bank for International Settlements. Data as of September 2019.

In sum, strong international demand for U.S. assets and the U.S. dollar has bestowed numerous financial benefits on the U.S., the world's largest debtor nation. We believe continued strong capital flows to the U.S. will help support solid economic and market conditions this year, despite the heightened trade and investment uncertainty.

Is Impeachment a Major Risk for Markets?

The launch of a formal presidential impeachment inquiry by the U.S. House speaker last Tuesday caused a risk-off reaction in markets, with both stock prices and bond yields posting one-day declines. How these investigations proceed from here will bear watching by investors, but for two main reasons, we would not expect the market impact to persist at this stage.

First, there are a number of steps that would be required for an actual impeachment event to take place or for the president to be removed from office, and only one of these steps has been taken so far. The findings of the six committee investigations announced by the speaker last week will first be subject to review by the House Judiciary Committee. Any offenses deemed to be impeachable would then be put to a House vote, where a simple majority would be needed for the president to be impeached. The articles would then be taken up by the Senate, first in a trial, then in a second vote in which a two-thirds majority would be required to convict the president and remove him from office.

Second, though there are few historical observations, past impeachment episodes have not been major drivers of market direction. Presidential impeachment proceedings have been initiated in only three previous cases—Andrew Johnson in 1868, Richard Nixon in 1974 and Bill Clinton in 1998. Only Johnson and Clinton were impeached, with both acquitted, while Nixon resigned before a House vote could be taken. None were removed from office. The two post-war cases coincided with large market declines, but these were due to the economic conditions of the time rather than the impeachment episodes themselves.

Monetary policy tightening, high inflation and recession were behind the 1973–1974 bear market, which ended as the Fed eased and the economy returned to expansion. And the 1998 Russian debt default led to a near-20% market correction just ahead of the Clinton impeachment, but the market uptrend ultimately remained in place until the end of the dot-com boom and the 2001 recession (Exhibit 6). Similarly, the fundamental drivers of the current expansion are likely to matter most in this episode. So while investors monitor developments in Washington, economic growth, earnings, Fed policy and trade should continue to determine the directional trend in markets as we move into the fourth quarter.

Exhibit 6: S&P 500 Equity Index and Post-War Impeachment Episodes.

Washington Tax Matters

The summer may be over, the temperature may be dropping, but things are heating up in our nation's capital. Congress has returned to Washington and that means we are in the home stretch for passage of one or more year-end tax changes. If history is any guide, we are likely to see some tax changes before Congress adjourns in mid-December.

Congress will consider numerous items before year-end, some with far greater priority than taxes. High on the priority list is passage of numerous appropriations bills to fund the government for fiscal year 2020, which begins October 1, 2019. Without passage of those bills (or a so-called Continuing Resolution) the government will shut down—and that is not likely to happen. The likely outcome is a Continuing Resolution that provides for spending through mid- to late November. In fact, congress passed and the president signed a continuing resolution on September 27, funding the government through November 21, 2019. The process may repeat itself in November resulting in another continuing resolution or a comprehensive omnibus bill that provides for spending into next year. Between now and year-end, there is much to do, but only a limited amount of time to get it done.

Between Labor Day 2019 and the end of the legislative session there are only 41 working days. Although Congress reconvenes next year, historically not much legislation is enacted in a presidential election year. This puts considerable pressure on Congress to address a number of important tax topics in a limited—and quickly closing—legislative window.

Here's a look at some tax items Congress will be talking about before year-end. Most will remain only that—talk—but a few items are likely to be enacted before we head into the election year.

  • Extenders Tax Bill—Every year or so, numerous temporary tax provisions expire. Nearly 30 tax provisions covering tax credits, deductions and incentives expired over the past two years without renewal. Another nine will expire at the end of 2019. While many of these provisions do not affect many individual income tax payers, there will be a push to renew some or all of them—as there always is. The question is whether Congress will look to find a way to offset the cost of extending these provisions. One proposed way of paying for the cost would be to accelerate the reduction of the increased estate, gift and GST exemption from 2026 to 2023. While some or all of the expiring tax provisions will likely be renewed, it is almost unimaginable that the Republicans would agree to these estate-tax changes. We believe many expiring tax provisions will be extended without offsetting "pay-fors."
  • Retirement Bill—The House will try to revive the House-passed (H.R. 1994) bipartisan SECURE bill to enhance or modify certain retirement tax incentives. That measure passed on a wide bipartisan basis, but has stalled in the Senate. The bill would change the age for mandatory required minimum distributions to 72 and curtail lifetime payouts to non-spouse beneficiaries to 10 years, among many other changes. There appears to be a high likelihood of passage of these changes before year-end by means of possible inclusion in must-pass legislation such as a potential November omnibus spending bill. That could be the retirement bill's "ticket to passage."
  • State and Local Taxes (SALT)—Attempts to make changes to SALT provisions will be largely a symbolic effort by Democrats. Republicans will likely hold firm and not let this important part of their 2017 tax reform legislation be undone. House Democrats may move forward on a symbolic effort to undo the repeal of the federal deduction for unlimited state and local taxes. Some preliminary proposals include increasing the SALT deduction cap to $30,000 for couples ($15,000 for individuals) or restoring the unlimited deduction in return for higher marginal tax rates for upper-income taxpayers. The chance of any legislation in this area becoming law is negligible.
  • 2017 Tax Reform Technical Corrections Bill—It is abundantly clear that many technical corrections need to be made to the 2017 tax reform legislation. The hard part: getting it done. Democrats generally feel that they were left out of the tax writing process when the 2017 tax changes became law. Democrats generally feel that the cost of making technical corrections should come at the price of reexamining broader provisions and considering policy changes in areas such as the earned income tax credit. A broad technical correction bill seems unlikely, but targeted changes could be wrapped into a year-end spending bill.
  • Social Security Bill (Social Security 2100 Act)— A House proposal would attempt to shore up Social Security by raising payroll taxes on wages over $400,000 (currently the cap is $132,900) and increasing the payroll contribution rate from 6.2% to 7.4% (that rate would be phased in from 2020 to 2043). The proposal would also raise the threshold for taxing social security benefits to $100,000 for couples ($50,000 for individuals). There seems to be no clear path forward for such changes.
  • Indexing Capital Gains Rate—The idea of indexing capital gains to inflation by way of executive order first surfaced nearly a year ago. While highly controversial and likely subject to prolonged litigation, its status seemed to be "on-again, off-again" every few weeks. It once again appears that the president is backing away from this proposal. Indexing capital gains seems to carry contrary messages: On the one hand, it could provide a stimulus to the economy. On the other, why is a stimulus needed when the president believes the economy is in great shape? In the end, it is another tax matter that is likely going nowhere fast.
  • Cats and Dogs—Other miscellaneous, yet important, tax items may be addressed in the House before Congress adjourns for the year, but there seems to be almost no chance any would become law in a highly partisan divided Congress. These miscellaneous items would range from changes in the earned income tax credit and child tax credit to a clean energy tax package.