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Investment % of US GDP is below average

Investment is the most cyclical part of the economy and a big driver of downturns is when investment is pulled back. Adding up private and government fixed investment, we would point out that US investment to GDP is currently at 21%, closer to prior recession levels (2001, 1990, 1982, 1974) than prior cycle highs of around 24%. Private fixed investment stands at 17.5% of US GDP which is slightly above historic averages while government investment (3.4% of GDP) is near the lowest levels since WWII.

We still see a solid business spending backdrop for capex and tech driven by: 1) strong profit growth this year and capex following profits with a 2-4 quarter lag; 2) capex to operating cash flow for S&P 500 ex financials is still at historic lows; 3) productivity is weak, even at the firm level, and unemployment is low; 4) business equipment and IPP spending is below trend levels after a period of overinvestment from the mid 1990s to 2007. Thus we see the balance of risks for US business spending as still to further strength rather than a turn lower.

Residential investment has weakened of late, but outside of the rise in rates, the drivers of US housing point to a cycle that is not nearing a sustained downturn, as was the case in 2005-06. Commercial real estate trends are mixed but government investment as a share of GDP is extremely low and growth in government spending has inflected higher, at the state & local level which is larger too.

Another difference this cycle is the magnitude of China's investment since the financial crisis. On a global level compared to prior cycle peaks, investment looks elevated relative to global GDP (in nominal, USD terms). Excluding China, it looks like investment has further room to run. Thus, the risk from a slowdown in China investment is notable, in a baseline of slowing growth and rebalancing.

Inventory levels are also still fairly low. Since the 2015-16 slowdown, increases in inventory as a % of US GDP have been close to zero, versus the 0.5%+ type inventory builds that have preceded recessions. Additionally, the combined reading from the ISM manufacturing and customer inventory indices is still near a low similar to levels seen early to mid-cycle.

Global investment as a % of GDP is still above prior peak levels, driven by China.

Outside of China, fixed investment as a % of GDP is still below prior peaks.

Figure 52: Gross investment % of GDP

26%		US	Global		Global ex China
25%
24%
23%
22%
21%
20%
19%
18%
54	62	70	78	86	94	02	10	18

Source: BEA, National Accounts, Haver, UBS

Figure 53: Inventories have not built up

Change in private inventories / GDP (4 qtr moving average)

1.8%			Recession
1.2%
0.6%
0.0%
-0.6%
-1.2%
54	61	68	75	82	89	96	03	10	17

Source: BEA, Haver, UBS

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Margins are high, but productivity is not

Investors have been focused on peak margins for years. While it is difficult for margins to break out absent acceleration in sales growth, we have written about the very different trends in margins drivers underneath the surface. Overall, this cycle has been a bit of conundrum when on one hand S&P margins have risen to new highs, but on the other hand US productivity growth has been so weak (i.e. output per hour has been flattish). Even at the firm level, sales per employee for the median firm and across cohorts has been flattish as well (link).

With consensus expectations for margin expansion in 2019, and mixed margin drivers, we think that margin risk and upside is a key theme for investors going into 2019. We lay out some of the broad themes as it relates to margins below, but we provide an in-depth assessment of whether margin expectations may be too high or too low – across sectors, industries, and styles – in the strategy section.

Profits and margins have turned when wage growth reached 4%. Wage growth ticked up in Sep-18 to 3.1%, but is still well below the 4% we've typically seen when profit cycles turn. Based on compensation that is ~24% of gross output for the S&P 500 (i.e. labor as a % of sales), 4% wage growth equates to a ~100bp headwind to margins, which is more material in a typical 2% pricing environment.

Productivity had been flattish, even at the firm level. The fact that corporate margins expanded post-crisis in an environment of ~0.5% productivity growth and >2% compensation growth is somewhat surprising. Productivity has begun to pick up over the last year, which would be supportive of margins.

Pricing is rising faster than wages using our proprietary econ-to-company mapping (link). The composition of the S&P 500 is very different from the composition of the economy. In terms of inflation, CPI and PCE are consumerbased, which is what the Fed is focused on, while the S&P 500 is more producerfocused. Furthermore, S&P 500 companies span various industries, which have very different price and wage trends. We created a market cap weighted price and wage signal for the S&P 500 to better assess relative corporate pricing power and wage trends, which can differ considerably from the overall economy. Pricing has ticked up ex Energy/REITs while wage growth has moderated from last year's pace.

Figure 54: Price and costs for nonfinancial corporates (Indexed at 2006)

1.35		Implicit price deflator			Wage growth		Wages
					since 2010 =
1.30		Comp per Hour			2.3% CAGR
1.25							Prices
							ticked up
		Real Output Per Hour
1.20					Prices flat		Prices
1.15							Producti
1.10							vity
1.05						Uptick in
1.00			Productivity flat at			productivity
						(1.8% CAGR)
0.95			0.5% CAGR
0.90
Q1-2004	Q1-2006	Q1-2008	Q1-2010	Q1-2012	Q1-2014	Q1-2016	Q1-2018

Source: BLS, Haver, UBS

Figure 55: S&P 500 prices vs. wages/hr (ex Energy and RE)

	5%	Pricing - cap wtd (y/y, S&P 500 ex Energy ex
		Real Estate)
	4%	Wages - cap wtd (y/y, S&P 500 ex Energy ex
		Real Estate, rolling 3m avg)
	3%

2%

1%

0%

-1%

07

08

09

10

11

12

13

14

15

16

17

18

Source: BLS, Haver, UBS

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No repatriation tax, dividends can jump

There is no longer a barrier to corporates for bringing cash home and returning it to investors, an overlooked factor about the 2018 tax plan. Thus, in our view, we see the potential for dividend growth to outpace earnings growth near-term as payout ratios get back to prior levels. We also see the potential for multinationals to increase dividend payout ratios as they have more permanent access to that foreign cash flow, and don't need to borrow to bring it back and avoid taxes.

Buybacks up 68% y/y in Q3 for those that reported, $725bn+ annual pace.

In June, we pointed out that the YTD pace of buybacks, dividends and M&A of US public targets was running at a ~$2.5tr annual pace, or ~10% of mkt cap (link). Since then, the pace of buybacks has accelerated from a ~50% y/y pace in H1 to 68% y/y in Q3 for those firms that have reported. Dividends are also growing at a healthy clip. The combined S&P 500 net buybacks plus dividends are running at a pace of over $1.2tr annualized or a pace of nearly 5% of market cap.

Repatriation is far from tapped out. After adjusting for the tax hit and leverage limitation, there is ~$1.3tr in "usable" offshore earnings. We assumed that 25% of this usable overseas cash/equity would be repatriated this year for buybacks and M&A ($325bn or 1.5% of mkt cap). In H1, S&P 500 buybacks were up ~50% y/y, or $250bn. Given earnings growth of ~20% this year, we would assume less than half the growth in buybacks is due to earnings and the rest is repatriation. Repatriation is running in line with our assumption, to a bit lower, depending on how much M&A is being funded with offshore cash (i.e. $125bn in buybacks above profit growth, out of assumed ~$325bn in repatriation for buybacks/M&A).

Dividend growth will follow buybacks, and rise above 10% in 2019.

Dividend growth of ~8% in 2018 significantly lagged profit growth of ~20% and dividend payout ratios fell. We find that dividend growth tends to lag earnings and buyback growth, and thus see the potential for higher dividend growth in 2019 than many expect. In particular, we find that dividends jumped by over 20% for the top growers in 2004-05 and 2011-12 after earnings had recovered. Thus, we look for companies that have the potential to increase their dividends the most in 2019, and see it as a key investable theme as earnings growth starts to slow.

The prior 35% rate and deemed tax upon repatriation prevented many multinationals from paying higher sustained dividends given the foreign tax wall.

Relative payouts would support Financials, Tech and Healthcare, as well as continued outperformance of growth and momentum strategies.

Figure 56: S&P 500 net buybacks+dividends, annualized

1,500		Dividends (annualized)
1,250		Net buybacks (annualized)
1,000
750
500
250

0 90 92 94 96 98 00 02 04 06 08 10 12 14 16 18

Source: S&P, IBES, Compustat, FactSet, Bloomberg, Haver, UBS

Figure 57: Dividend growth – median and 75th percentile

0.30	Dividend 1yr trailing growth (non sector neutral)
0.25			Median			75th percentile
0.20
0.15
0.10
0.05
0.00
90	93	96	99	02	05	08	11	14	17

Source: Compustat, FactSet, UBS

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Financial conditions supportive: cycles end when rates > nominal GDP

Given the age of the current cycle, investors are focused on when the cycle will end and, specifically, what level of interest rates would derail the economy and equity market. While it is difficult to make that call, we find that the end of each cycle was preceded by the Fed rate and US 10y yield going above the level of US nominal GDP growth. Sovereign debt dynamics are often unsustainable when government rates go above the level of nominal growth, as countries cannot grow their way out of a debt problem.

The UBS US economics team forecasts over 4% nominal GDP growth in 2019 and 2020, ~100bps above the current 10-year yield. As the US fiscal stimulus starts to fade in 2020 and the credit impulse begins to turn, a turn in the cycle could occur in 2020. However, the level of GDP and corporate profits is likely to be substantially higher before growth slows. Thus we position for further upside.

Figure 58: Nominal GDP growth and Fed funds rate

15%									Recession
									Nom GDP (q/q%
									annualized, 2q mov avg)
									Federal funds rate
10%
5%
0%
61	66	71	76	81	86	91	96	01	06	11	16

Source: Haver, Bureau of Labor Statistics, Federal Reserve Board, UBS

As is the case with 10yr yields, we find that the end of each cycle was preceded by the Fed rate going above the level of US nominal GDP growth.

Figure 59: Nominal GDP growth minus Fed funds rate

		Recession
10%		Nom GDP (q/q% annualized, 2q mov avg) minus Federal funds rate
6%
2%
-2%
-6%											Neg. spread signal
											for recessions
-10%
61	64	67	70	73	76	79	82	85	88	91	94	97	00	03	06	09	12	15	18

Source: Haver, Bureau of Labor Statistics, Federal Reserve Board, UBS

Debt dynamics are often unsustainable when interest rates go above the level of nominal growth, as countries and firms cannot grow their way out of a debt problem.

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