Our 2020 outlook and investment strategy
Equity markets in the USA, Europe, and Asia finished the year 2019 on a strong note. The S&P 500 has posted a new high at the end of 2019, driven by steady slide in bond yields, low inflation, rising corporate earnings, progress on the U.S./China trade front, and continued strength in the U.S. jobs market. Despite political tensions with China, Iran, the Brexit, it is a reminder that the political drama isn’t the primary driver of market performance over time. Positive economic and corporate performance news has been the driving force behind this year’s sizable gains.
What a Difference a Year Makes
It was just one year ago, at the end of 2018, that conditions were seemingly filled with projections of impending economic doom. The worldwide markets were down sharply, and headlines were dark, however, we reminded our readers at the end of 2018 to stick with a full equity allocation for 2019 as economic fundamentals remained strong and that equity markets were oriented upwards. It seems to have paid off. That was then (December 2018), and this is now at the beginning of 2020. So what’s behind this sizable swing in the investment pendulum, and what does it signal for investors?
2019: The consensus assessment of the economy has done an about-face. Economic enthusiasm, while not full steam ahead, has risen appreciably in the USA and in Europe, with continued labor-market strength and receding tariff threats drowning out recession calls.
Implications for 2020: A recession is hard to detect for 2020, but the pace of GDP growth will probably moderate a bit from this year. Favorable labor-market conditions (even in Europe) should continue as unemployment is going lower. In the US, we see additional wage gains and persistent household spending growth. While there is more stability in Europe, German’s economy is still struggling to overcome its worst industrial downturn. However, there are reasons to expect stabilization as uncertainty over global trade is receding.
Trade and Politics
2019: The market’s trade sentiment dial has turned squarely to relief, if not over-optimism. After trade-induced market sell-offs, tariffs between the US, China and Europe have been reduced, with negotiations continuing into 2020 on additional trade issues.
Implications for 2020: This first agreement between the US and China was fairly minor in the grand scheme, as larger issues will have to be negotiated. The trade tensions may continue as a source of volatility particularly as the US presidential election season heats up but probably not a catalyst for a broader downturn. Over time, if an agreement is signed, it could unlock pent-up investment demand among corporates, which would boost the economy.
2019: While interest rates were already low at the end of 2018, they went even lower in 2019. The soft patch in the world economy prompted the Fed and the other central banks to ease by cutting rates.
Implications for 2020: The rate environment is notably different today. Long-term year rates have risen over the past few months, but for positive reasons (improving economic growth outlook), though they remain still below levels of last December 2019. Central banks rate cuts and rising 10-year rates have steepened the yield curve materially, consistent with a sustained expansion. The Fed will move to the sidelines for much of 2020, offering ongoing support to the US economy. The ECB will also pursue an accommodative monetary policy.
The stock markets
2019: While the worldwide stock markets were enduring a steep sell-off at the end of 2018, predicated on a coming economic recession in 2019, our stance was that this pullback was a compelling buying opportunity.
Implications 2020: Even if 2019 was a positive year, we don’t think this exhausts the bull market’s trend heading into 2020, but we could expect the 2020 market to trail 2019’s performance due to a more moderate economic growth and earnings growth. Additionally, the central-bank stimulus and interest rate cuts are unlikely to be repeated in 2020. Interest rates are already at low levels, and instead of declining further, rates could rise modestly this year. Valuations are higher exiting 2019 compared with year-ago levels, yet they are still at reasonable levels given the economic and interest rate backdrop.
If economic fundamentals remain steady, they will most likely support additional gains in the stock market over 2020, but the market can’t be resistant to overreactions from geopolitical, trade-related headlines, war, epidemics and whatever other surprises we may have. As we know the market focus is a pendulum that swings back and forth! Fortunately, history shows that the influence of economic fundamentals is more dominant over broader periods of time.
Easy financial conditions will likely continue to support stock prices in 2020. Monetary-policy changes impact the real economy with a lag, therefore, we expect the markets and the economy to continue to benefit in 2020 from the 2019 rate cuts. Risks of a further slowdown in global growth have lessened somewhat in recent months. Inflation remains below target, providing the Fed flexibility to remain accommodative.
Equity valuations are higher exiting 2019 compared with year-ago levels, yet they are still at reasonable levels given the economic and interest rate backdrop and the forward PE ratios of equity indices are still well under their highs. The pace of market gains will be set by the earnings growth, which probably should rise at a mid-single-digit rate.
We still call for equities to outperform bonds again this year, supported by solid economic and corporate fundamentals. We still favor the US large-cap stocks as they have consistently generated the best returns this decade. The small caps have a bit of catch-up to do. As asset-class leadership often rotates, Europe and Asia may offer opportunities as they are more cheaply valued than their US counterparts. However, these continents are a lot more volatile and risky. In the fixed income allocation, we will invest in medium term durations (5 year). We will continue to reinvest our bond allocation whenever we see in a peak in the yield (of at least 2.5%). We continue to look for good quality USD bonds.
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