2019 capped an outstanding decade for investors. It was the polar opposite of 2018, as every major asset class finished up more than 5% while U.S. equities averaged gains of more than 25%.
While many of the market headwinds dissipated late in 2019 (trade, Brexit, yield curve inversion), the leading contributor to the strong year was the Federal Reserve’s (Fed’s) shift in policy.
From 2015 until late 2018, the Fed had been methodically withdrawing stimulus from the system. With the market sensing that the Fed was becoming too restrictive with its policy, rate-sensitive securities were repriced, resulting in the 20% decline in the major indices late in 2018.
In February of 2019, Fed Chairman Jerome Powell recognized the need for more stimulus and pledged to stop raising rates. The Fed took subsequent actions throughout the year, lowering rates three times while also allowing its balance sheet to expand through the purchase of Treasury Bills (similar to the “quantitative easing” of the past decade).
Ultimately, the Fed’s ability to keep rates in check has had a spillover effect as borrowing costs for companies and municipalities remain low, unemployment remains at a 50-year low, and consumers continue to spend. That being said, some economic data has decelerated over the past year, highlighted by a decline in manufacturing activity.
As expected, geopolitics and trade disputes were also significant drivers of return in 2019. Going into the year, we focused on the elevated macroeconomic uncertainty and hence reiterated our call for building portfolio resilience. We believed that maintaining a blend of high-quality U.S. stocks and bonds while underweighting international assets would play a key role in protecting portfolios against equity sell-offs. While a sizable correction never occurred, the strategy rewarded investors during the 7% pullback in May and the 6% pullback in August.
Looking to 2020, the biggest risk to the market remains geopolitical — specifically an escalation of the trade war with China. While a phase one trade deal looks promising, the effects of the ongoing dispute have hurt parts of the economy. A contraction in the factory sector continues as the ISM manufacturing index remained below 50 for the fifth straight month in December and is at its lowest levels since June 2009. With business investment currently falling in most major economies, an increase in tariffs could see capital investment freeze ahead of the U.S. election. While not our base case, this would raise the odds of a recession.
Despite this cautious outlook, we do anticipate slow and steady economic growth, low inflation, and accommodative policy here in the U.S. In our view, a recession seems more likely for 2021 or 2022. The yield curve did briefly invert in August, but based on historical data, including lag times, a recession is not likely in 2020. Other indicators used to predict recessions such as service sector surveys, high-yield bond spreads and unemployment trends continue to point to a slow but healthy economic expansion. This is very important as the service sector now represents roughly 70% of the economy.
While the markets have recently priced out several tail risks (related to Brexit, the U.S./China trade war, and USMCA), they have not yet priced in stronger global growth, an escalation of Middle East unrest, or U.S. politics. As a result, investors should prepare for a more volatile equity market in the year ahead.
Globally, central banks remain dedicated to reaching their still elusive inflation targets, in part by maintaining asset-friendly financial conditions. This should stimulate growth in corporate earnings, dividends and buybacks. As a result, we expect risk assets to perform relatively well, although not without volatility.
Near term, central bank liquidity could help boost the S&P 500 (even beyond the average forecasted year-end target), but by April, the liquidity tailwind should fade. The market will focus more on the fundamentals where uncertainty is higher than usual. Therefore, a stock market correction in the first half is a possibility. We can envision one in April due to the Fed’s preannounced decision to end Treasury Bill purchases after Q1.
We see room for higher equity valuations this year but believe a focus will be placed on fundamentals. Multiple expansion (rising P/E ratios) was a primary contributor to equity performance globally in 2019. This contrasted with 2018 when multiples contracted as earnings rose. While currently stretched, earnings growth is likely to re-accelerate this year, which should keep the market from getting too expensive. Based on Wall Street expectations, the S&P forward-looking price-to-earnings ratio will be 18x. If earnings growth fails to materialize, look for lower price expectations as the current level is already meaningfully higher than the average over the past 25 years (16.3x).
Much like 2016, we also expect a high degree of market volatility ahead of the November election, but we are not ready to completely ignore the potential positives of an election year either. The election could potentially have a positive effect on equities if debates turn to fiscal stimulus in the form of infrastructure spending or additional tax reform. Strategas Research Partners, a leading economic research firm, reports that the S&P 500 has historically advanced by an average of 5% in the run-up to presidential elections (with a positive return 77% of the time).
The two most likely outcomes of U.S. elections are Trump’s re-election or the election of Biden, an experienced centrist Democrat; initially, both should be viewed as neutral or positive for markets. The election of a more left-leaning U.S. government would have a muted impact on short-term growth forecasts but would negatively affect the corporate earnings outlook in the U.S., given the likelihood of higher corporate taxation and potential regulatory changes. At this point, we believe that elections alone are not a risk that should keep investors out of the market.
Our Emerging Market (EM) views reflect our bias toward diversifying risk, where the macroeconomic backdrop seems extraordinarily attractive for fixed income. A troughing of global growth without a robust cyclical rebound means emerging market investors should have minimal growth concerns, while also avoiding the pressures of higher interest rates and a stronger dollar. As a result, we expect several EM central banks to be able to sustain growth prospects by cutting interest rates. If this, in turn, tempers dollar strength, it could additionally unlock the valuation opportunities in EM and Asian equity markets.
While growth rates in emerging markets will be higher than in developed markets over the long term, and the growing middle classes in Asia remain prominent, we still favor U.S. markets. This is due to robust consumer demand, stronger fundamentals, and a lower probability of earnings disappointment.
In 2019, the Fed’s pivot to a looser policy served as a tailwind for equities, but much of the advance was driven by multiple expansion (rising price-to-earnings ratios). For the markets to continue to grow, we believe earnings growth will be crucial. Wall Street consensus is that there will be earnings growth of 6% to 9% in 2020, which would support the continuation of the bull market. As we move through the quarter, we will be listening to corporate guidance as the value of a stock ultimately depends on the outlook for earnings.
We continue to build our portfolios with a focus on quality characteristics such as strong balance sheets, which tend to be more resilient to late-cycle risks. At the same time, managed-volatility and dividend strategies may offer additional protection in this environment.
We are not ruling out the possibility of a market pullback or correction; on average, a 10% correction occurs every year. As we have stated in previous reports, volatility is a normal part of the investment cycle, and periodic declines are to be expected.
Throughout the year, investors will need to be nimble while actively seeking opportunities and remaining largely defensive in this low return, high-risk world. We see no reason to completely avoid risk, as we do not anticipate a recession this year. With that in mind, investors should prioritize portfolio diversification amid continued and significant uncertainty.
Current investment observations:
- The service sector of the U.S. economy is more important than manufacturing sectors.
- U.S. markets remain in a secular bull market, which continues to reward long-term investors who benefit from staying invested over time. Cyclical soft patches will occur.
- While the markets have recently priced out several tail risks (related to Brexit, the U.S./China trade war, and USMCA), they have not yet priced in stronger global growth, an escalation of Middle East unrest, or U.S. politics. A re-escalation of the trade war remains a concern.
- Headlines remain a distraction that should generally be downplayed. Emotions should be suppressed as long-term objectives and risk tolerance should guide your investment decisions.
- Market corrections, like those experienced in May and August, are normal. These corrections ultimately are opportunities to buy risk assets at lower prices.
- Fixed income investments provide a hedge to equity risk.
Again, we would like to thank you for your relationship and interest in following our thoughts. We encourage you to contact your portfolio manager with any investment questions, concerns, or perspectives as 2020 continues to unfold.
You may reach us at 610-975-4300, or email email@example.com.
Mr. Heckscher is Senior Vice President, Director of Fixed Income, and Chief Investment Officer of Pennsylvania Trust.
Disclosure: This Commentary represents a review of topics of possible interest to Pennsylvania Trust’s clients and is not personalized investment advice. It contains Pennsylvania Trust’s opinions, which may change following the date of publication. Information obtained from third-party sources is assumed to be reliable but is not guaranteed. No outcome — including performance — is guaranteed, due to various uncertainties and risks. This document is not a recommendation of any particular investment. Investment decisions for clients are made on an individualized basis and may be different from what is expressed here. Past performance is no guarantee of future results.