2019 Year-End Market Note
December 27, 2019
Looking back over the past year, you have to admit the markets were not boring, never boring. At times contrarian, other times unfathomable, and never predictable. In spite of the political rancor, ongoing trade tensions, and mixed signals on the economy, the equity and the credit markets put on quite the show. In fact, someone would be hard pressed to find an asset class that did not finish the year in positive territory. And this was welcomed news coming on the heels of the sell-off in the 4th quarter of 2018.
If there were any doubts regarding the impact monetary policy is playing in the markets, the transition from the 4th quarter of 2018 to the present should provide sufficient evidence. We pivoted from a Federal Reserve committed to a methodical increase in rates, while reducing liquidity, to a Federal Reserve that effectively reversed course, cut rates three times, and expanded the balance sheet.
The result? The equity markets hovering near bear market territory last Christmas Eve, rebounded sharply as the new year began and as we close out the trading year, the markets are trading at or near all-time highs. Though the trade dispute with China continues and the political environment is even more polarized with the recent impeachment vote in the House, an accommodative Federal Reserve has the power to move the markets higher in spite of numerous headwinds.
At some point investors may want to consider how long this game can continue. Interest rates are at historically low levels and the country’s balance sheet has expanded beyond what was thought possible a generation ago. Unless we embrace Modern Monetary Theory (MMT), and fervently hope we don’t, at some point central banks run out of options and the markets are left to their own devices.
A Discussion of 2020
Shifting our attention to the coming year, we begin with a number of assumptions, that combined with individual risk tolerances and objectives, frame our allocation recommendations. We monitor and challenge our underlying assumptions constantly as the economy and markets are never static and adjust as needed throughout the year. That being said, our base assumptions provide a framework for the initial allocation decisions.
Economic growth as measured by Gross Domestic Product slows but remains positive in 2020
We anticipate that economic growth as measured by the GDP (Gross Domestic Product) will remain positive in 2020. We anticipate the first half of the year to be stronger, supported by the residual impact of the tax cuts and the three rate cuts by the Federal Reserve. However, as their influence on the economy dissipates, we anticipate the rate of growth to weaken. Consensus for GDP growth is in the 2.0% neighborhood in 2020 and we would be comfortable with that forecast.
Monetary Policy remains accommodative among Central Banks, but further rate cuts by the Federal Reserve are not anticipated
Fed Chair Powell has stated, “We see the current stance of monetary policy as likely to remain appropriate as long as incoming information about the economy remains broadly consistent with our outlook of moderate economic growth, a strong labor market, and inflation near our symmetric 2 percent objective”
The current Chairman is not averse to changing his position if warranted, but the Fed’s view is they have achieved “neutral” in regard to interest rate policy and will be reluctant to make any significant changes to policy, especially as we move closer to the election.
Interest rates are range bound with the Ten-Year Treasury fluctuating between 1.5% and 2.2%
As the Federal Reserve has made it abundantly clear, they are in a holding pattern as to rates. Nothing short of a significant uptick in inflation would cause them to reconsider their position. Given that, we would expect the Ten-Year Treasury to move to the upper bands if inflation increased dramatically or the rate of growth exceeded forecasts.
At the moment inflation is fairly benign, but a weakening dollar could stimulate inflationary pressures via commodities. As commodity prices have been in a bear market for a prolonged period, our contrarian nature suggests it would be prudent to monitor over the course of the year. Barring inflationary pressures, we would anticipate if rates do rise in the first half, they could fall once again based on our forecast for slower growth in the 2nd half of the year.
Equities could advance modestly in 2020 with moderate earnings growth providing the catalyst. Multiple expansion, unlike 2019, will not contribute appreciatively to equity gains
The rise in equity prices this year was almost entirely due to multiple expansion and not robust profit growth. With the markets trading between 19-20 times earnings, it is unlikely the markets can continue to move higher without an increase in corporate profits.
When considering year-end forecasts for the S&P 500 from the major Wall Street firms and professional money managers, it comes down to expected Earnings per Share (EPS) combined with the Price to Earnings Ratio (P\E) for the index’s return. Move the P\E down from 20 to 18 or increase earnings from $165 to $185 and year-end forecasts on the S&P can range from 3,200 to 3,500 in short order.
Historically after a year of broad robust returns, the markets tend to produce more muted performance. If that holds true, investors will need to own the right companies at the right price and monitor throughout the year to generate solid returns. This may not be a year for outsized bets or complacency.
Both continuing trade tensions with China and a contentious Presidential election could magnify volatility throughout 2020
The China trade dispute has garnered the headlines, but at present all we have accomplished is avoiding the worst-case scenario. The discussion around Intellectual Property (IP) still requires consideration and meaningful enforcement and do not forget we are still in discussion with the European Union and about to start negotiations with Great Britain as Brexit is now a foregone conclusion. News surrounding trade will continue to ebb and flow and will in all probability add to the uncertainty.
Moving on to politics, we do not know what we can add that hasn’t been bandied about for the past several months. The election will be contentious, it will be tedious, and from the market’s perspective, unless we have a Progressive win in the White House, we will probably have four more years of gridlock regardless of who wins the Presidency. We do not have a dog in this fight, but we will continue to focus on potential policy outcomes as the most impactful influence on our clients’ financial lives and portfolios. Stay tuned.
We anticipate that equities could generate mid-single digit returns on a total return basis. We would favor companies with strong balance sheets, the ability to support and grow their dividend and trade at an attractive valuation to the overall markets. We understand that on a historical basis the markets are over bought, so we would recommend patience with the objective of increasing equity exposure during pullbacks.
As with equities, the bond market is trading at a premium. In recent years investors have been forced into taking undue risk in the pursuit of yield by moving down the credit ladder. High yield bonds are referred to as “junk” for a reason. Though these yields can be tempting for those desiring income, we would suggest quality over yield and shorter durations to the longer dated maturities. Investors are no longer being compensated for the risk of higher yields and we would recommend focusing on risk-adjusted returns.
We would not be surprised if the year opens with tax loss selling as investors defer the tax liability to April of 2021. For that reason, we have incrementally increased our cash position going into year-end with the goal of allocating it to our strategies during such periods. In what could be a low return environment, entry points may be key to profitable positions.
Overall, we anticipate moderate adjustments to our strategies, but no significant changes. The various risks to the economy and by extension the markets continue to jockey for dominance, but in general it is not materially changing our view of the world. The only thing that has really changed is that this bull market is a little bit older and a little bit more fragile, but probably has some life left in it.
No one truly knows what will unfold in the coming year, but as the old adage states —
“The wise man does in the beginning what the fool does in the end”
Thank you as always to our clients and those professionals who have placed their confidence in our firm and for the relationships, we have enjoyed with you over the years. We welcome those of you who we have not formally had the opportunity to work with and invite you to contact us as we start the new year.
*Opinion piece, please see Important Disclosure page