2019 Year in Review
2019 was a spectacular year for global financial markets. US equities (the S&P 500) rose 31.5%, international developed market equities increased by 22.0% while laggard emerging market equities posted a quite respectable 18.4% gain. Fixed income markets also performed well with total returns in a range of 5%-7% depending on the type of bond and index.
Despite the excellent year, 2019 was quite peculiar as most catalysts for the strong performance had nothing to do with actual 2019 fundamentals. In fact, looking specifically at 2019, one would have expected very modest investment returns. Global economic growth was impaired by uncertainty regarding trade policy. This uncertainty had an outsized impact on both the U.S. and international industrial/manufacturing sectors. In addition, while final figures are not yet available, U.S. corporate earnings growth for the year will likely be flat with 2018 - not normally conducive to a 30%-plus jump in the S&P 500.
So why did equity markets do so well? The explanation for 2019 returns rests mostly with the events of the fourth quarter of 2018 as well as expectations for 2020.
Equity markets underwent three distinct phases in 2019. From January through April, the S&P 500 gained 18.3%. But, recall that during the 4th quarter of 2018, the S&P 500 declined by 13.5% (and 20% from peak to trough). Investors had priced in an expected recession given Federal Reserve indications of multiple forthcoming rate hikes. Fortunately, the Fed backtracked entirely from their stance in early January 2019. Investors no longer expected recession thus equity markets entirely reversed their decline. Essentially, equity markets corrected from their 4th quarter of 2018 correction and, by the end of April, touched new all-time highs.
The second period of 2019 was the May through late-October “Great Muddle Along”. During this timeframe, markets meandered without making much progress. This middle period was hampered by uncertainty surrounding global economic growth and tepid earnings due mostly to uncertainty related to the worsening trade war. Regarding trade, uncertainty has been the much bigger drag rather than actual tariffs. In an uncertain environment, decision making slows to a crawl which can dramatically influence an economy. While tariffs are detrimental to economic growth, if companies have certainty as to their magnitude, they can make adjustments, thereby mitigating their impacts.
The final period of 2019, from late October through the end of December, once again produced strong returns with the S&P 500 advancing 8% (10/23-12/31). The trade détente coupled with growing optimism surrounding a re-acceleration of global economic and earnings growth from 2019’s mediocrity were the catalysts for the year-end advance.
To reiterate, the events of the fourth quarter of 2018 coupled with optimism surrounding 2020 have basically been responsible for 2019’s incredible year.
2020 Market Outlook
Given 2019’s outsized gains, should we be worried about what is in store for 2020? Probably not, but we should obviously not expect 2019 to repeat itself.
U.S. Equities With a focus on the United States, the key drivers of equity markets – employment and corporate earnings growth – look to be firmly in place in 2020.
As anyone who has read our past commentaries is aware, trends in employment have been highly correlated to the direction of the U.S. stock market for decades. Employment directly impacts consumer spending (2/3 of the U.S. economy) thus driving U.S equities. Heading into 2020, U.S. employment has risen for 110 consecutive months. Given low initial jobless claims and a potential improving global economy, we expect this record streak to continue through all of 2020.
Likewise, U.S. corporate earnings growth seems poised to re-accelerate in 2020 from 2019’s expected 0% growth. 2019 earnings growth was hampered by several factors including a) challenging comparisons to 2018’s 23% earnings growth partially aided by corporate tax cuts, b) difficulties in the manufacturing and industrial sectors related to uncertainty over trade policy and c) some distress in the Energy sector, particularly in some cash-flow challenged smaller companies. Given better news on the global economy and trade, it is reasonable to expect corporate earnings growth to re-accelerate to the 5%-10% range.
While trends in employment and earnings would normally suggest a fairly strong U.S. equity market in 2020, it is possible that some of this good news is already reflected in current equity valuations. The S&P 500’s price-earnings ratio (P/E) now stands at 20X, a little elevated from the ideal 14X-18X range. As such, while we put heavier emphasis on the positive employment and earnings picture, we are restraining our enthusiasm for 2020 and forecast U.S. equity returns in the mid-to-high single digits.
Global Fixed Income
In thinking about our outlook for U.S. fixed income, we need to broaden our view to encompass global bond markets. Due to deteriorating global economies and negative interest rate monetary policy of many global central banks, 10-year bond yields through much of the world were negative for most of 2019. U.S. bond yields were not impervious to global forces and fell from 2.69% at the beginning of 2019 to a low of 1.46% in September before ending the year at 1.91%.
We expect that 2020 will be a year of normalization in global fixed income markets. As such, we forecast U.S. 10-year bond yields to rise back towards 2.5%. Importantly, we expect many global 10-year bond yields to turn positive once again in 2020. Supporting our forecasts are our expectation for solid U.S. growth, improving global growth and an increasing realization by global central banks that a longer-term policy of negative interest rates can actually be counterproductive to a healthy economy. To be clear, we expect a normalization of bond yields rather than a sharp increase.
Regarding the U.S. yield curve, in the past, we have pointed out the importance of the shape of the yield curve as a signal for future economic growth. Positively, after turning briefly negative in August, the spread between the 10-year and 2-year U.S. bond yields expanded to 0.34% at the end of 2019, a positive signal for future growth. We expect this relationship to continue to expand in 2020 as 10-year bond yields rise while 2-year yields remain fairly constant due to expected inaction of the Federal Reserve. A positive signal for the U.S. economy.
International Equities
For years we have favored U.S. over international equity markets due to a more certain growth profile of the U.S economy compared to international economies. This relative enthusiasm has been rewarded given that U.S. equities outperformed international equities for 6 of the last 7 years. While much uncertainty remains, there is a case to be made for some budding optimism in international markets. Supporting our more sanguine view is an easing trade environment (or lack of escalation). Also, as mentioned earlier, global central banks may be realizing that while negative interest rates can be a good emergency tool, over the longer-term, the policy can become detrimental to a country’s banking system and growth prospects. While minor, after five years of negative interest rate policy, the Swedish Riksbank recently raised their policy rate back up to 0% as their economy normalizes. As such, we forecast international equities to mildly outperform U.S. equities in 2020 but this is reliant on global economic improvement.
In summary, our 2020 outlook is positive but somewhat restrained. Importantly, our outlook does not suggest that major changes to broad asset allocation targets are necessary.
Volatility comment While there is always uncertainty in any set of forecasts, we have high conviction that markets will experience multiple bouts of volatility throughout 2020. Volatility is normal, should be expected and does not alter the long-term investment thesis.
In 2020, the most likely catalysts for volatility surround the following:
a) Politics – This year’s U.S. election will certainly drive uncertainty and discomfort. Regardless of who emerges victorious, investors’ worst fears will likely not be realized.
b) Trade - Will probably re-emerge as an issue. Ultimately the issues surrounding the trade war are more profound than a simple economic dispute. Rather, the clash is more about geopolitics and global dominance between the United States and China in the decades to come.
c) Geo-politics – The Middle East, North Korea, South China Sea, Hong Kong, Taiwan, Ukraine, Russia, Terrorism, Cyber-Terrorism, Left, Right. Any of these topics can create disturbances. From a market perspective, their true economic impact is often limited.
d) The Unexpected – This is probably the most dangerous item to the markets. Events that the market cannot actually predict are, by definition, not priced in. Inevitably, this is the wildcard that we try to pay most attention to.
To view market gyrations with a little more philosophical view, equity markets tend to trade higher over time since economies and corporate earnings tend to grow over time. Given this is the general trend, trying to predict and trade small market downturns usually proves to be counterproductive. The exception being at market extremes or just before recession. We don’t believe that either are currently the case.
Of course, despite all of our best laid plans, events through 2020 will likely conspire to force us to alter our thinking in one direction or another. We will continue to be vigilant and adjust our thinking and strategy as events warrant.
Wishing you a Happy, Healthy and Successful 2020!