Investment Commentary: January 2020

  • January 9, 2020

BY: FRANK HOSSE
Director of Investments – Argent Trust Company  |  615.385.2720

Looking Back: 2019 Market Review

What a difference a year makes. Just about every major asset class lost money in 2018. In 2019, that was turned on its head. Pretty much everything went up. A lot.

We’ve reproduced our year-end 2018 chart below, updated with the 2019 returns.

Across global equity markets, larger-cap U.S. stocks were once again at the top of the leader board. The S&P 500 index posted gains in every quarter and surged 9% in the fourth quarter to end the year at an all-time high. Its 31% total return was its second-best year since 1997. Smaller-cap U.S. stocks rose 25.5% for the year. Foreign equity markets were also strong. European stocks gained 9.9% in the fourth quarter and 24.9% for the year. After struggling in the third quarter, emerging-market (EM) stocks shot up over 11% in the fourth quarter and returned 18.4% for the year.

Credit markets were also strong in 2019. High-yield bonds gained 14.3% and EM debt rose 15%.

Given what would appear to be a “risk-on” investment environment, it may seem surprising to see investment-grade core bonds also post very strong returns. The core bond index was flat in the fourth quarter but gained 6.8% for the year.

Why did both stocks (risky assets) and bonds (defensive assets) appreciate sharply in 2019? The key driver was the Federal Reserve’s sharp reversal to accommodative monetary policy. This was followed by other central banks across the globe.

Coming into 2019, the Fed was indicating it expected to raise the federal funds policy rate three more times (75 basis points), on the heels of four rate hikes in 2018. This led investors to fear that excessively tight monetary policy could tip the U.S. and global economies into recession, bringing an equity bear market with it. The ongoing U.S.-China trade conflict didn’t help matters.

Ultimately, the Fed ended up cutting rates three times in the second half of 2019. Late in the year, it also started expanding its balance sheet again via purchases of Treasury Bills in order to boost banking system reserves and inject liquidity into the short-term lending markets. Other major central banks also cut rates and/or provided additional stimulus to the markets via quantitative easing during the year. This lessened recession fears.

Meanwhile, inflation (and inflation expectations) remained at or below central bank targets, mitigating any concern that monetary policy would be tightened again any time soon. The bond market rallied, with the 10-year Treasury yield dropping from 2.70% at the beginning of the year to as low as 1.45% in September, ending the year at 1.92%.

The U.S. equity market responded to the Fed policy reversal and stimulus much as it has during the past 10 years—by bidding up stock prices and valuations. A détente in the U.S.-China trade war late in the year (the “phase one” deal) was an added boost to market sentiment.

Note that it wasn’t corporate profit growth that drove U.S. stocks higher in 2019. Reported earnings for the S&P 500 were flat over the first three quarters, and a mid-single-digit percentage increase is projected for the fourth quarter. The lion’s share (roughly two-thirds) of the S&P’s 31% return came from a sharp expansion in valuations: The S&P 500’s P/E ratio shot up from roughly 19x to 23x at year-end (based on the trailing four quarters of earnings).

Looking Ahead: 2020 … and Beyond

In our year-end 2018 investment commentary, we described two very different potential scenarios for the global economy and financial markets in 2019. One was bullish for stocks and bearish for bonds, and the other forecasted stock market losses and bond market gains. We said we thought either type of scenario had a reasonable chance of playing out (as well as other variations) and that our portfolios were positioned and prepared for either one, with a mix of offensive, defensive, and diversifying investments. As it turned out, both stocks and bonds rallied, and by much more than either scenario predicted.

As we look ahead to the financial markets in 2020, there are again reasons for shorter-term optimism—cautious optimism—for stocks. There are also notable risks that could lead to a volatile and challenging year. We list several of the pros and cons below. Suffice it to say, economic and geopolitical uncertainty remain elevated and the range of market outcomes wide.

Some Reasons for Market Optimism in 2020
  1. Accommodative central bank monetary policy and easier financial conditions should support at least a modest rebound in global economic growth. Assuming interest rates don’t sharply rise, this economic backdrop should be positive for equity markets and other risk assets.
  2. The majority of global central banks are now in easing mode. Historically, this is associated with global equity gains and an economic/manufacturing recovery.
  3. The Global Manufacturing Purchasing Managers’ Index (PMI), an economic leading indicator, has risen for four consecutive months and moved (barely) into expansion mode in November. Along with reduced U.S.-China trade risk, this suggests the global economy may be on the rebound.
  4. If inflation and inflation expectations remain at or below central bank targets, monetary policy is unlikely to tighten in 2020. Importantly, after the Federal Reserve’s October 30 meeting, Fed chair Jerome Powell stated, “We would need to see a really significant move up in inflation that’s persistent before we would consider raising rates to address inflation concerns.” In subsequent weeks, several other Fed committee members echoed Powell, reinforcing the view that the Fed has set a high bar to raising rates in 2020. A quiet year on the monetary policy front would be welcomed by most investors.
  5. Some key macro risks appear to have abated. A de-escalation in the U.S.-China trade war (the “phase one” deal) should be positive for the global economy, business confidence, and overall market sentiment. In the United Kingdom, Prime Minister Boris Johnson’s big election victory sets the stage for an orderly negotiated exit from the European Union (EU).
  6. The U.S. consumer remains in good shape. Ongoing labor market strength, wage growth, and low interest rates should continue to support consumer spending and the housing market.
  7. Fiscal policy may provide some (modest) additional economic stimulus in Europe, China, and Japan, and possibly the United States.
Some Key Market Risks in 2020

Overall, the economic and global macro backdrop appears to be turning to a modestly positive trajectory for 2020. However, this is the consensus view as well. Financial markets have already responded very positively to these developments and the improving outlook. The risk of an unpleasant market surprise or deterioration in the macro environment in 2020 shouldn’t be ignored.

  1. Valuation risk. From our vantage point, the U.S. stock market is already pricing in a supportive economic backdrop and sanguine macro view for 2020. With valuations stretched, the market is particularly vulnerable to disappointment or a negative surprise in any of these areas.
  2. The ongoing U.S.-China trade war. Despite the recent positive developments, the U.S.-China trade war could reignite—we’ve seen this story before—or a different area of geo-economic conflict between the two countries could escalate. This would hurt a still-weak manufacturing sector, capital spending, and business confidence. In turn, this could lead to layoffs, dragging down the still-solid service side of the economy, triggering recessionary forces, as negative sentiment and risk aversion feeds on itself in a self-reinforcing cycle.
  3. Falling CEO confidence. CEO confidence is already at recessionary levels and the year-over-year change in the index of leading economic indicators is getting close.
  4. U.S. election uncertainty. Given the polarizing differences between the Republican and Democratic presidential candidates and their policy proposals, markets will likely be volatile depending on whether the incumbent Republican president Donald Trump, a moderate Democrat, or a further-left Democrat appears most likely to be elected. Control of the Senate is an additional wildcard. It’s still too early to say how the election will play out. A solid economy favors the incumbent, but Trump’s low approval/high disapproval rating is a counterforce. Expect volatility as the markets discount each new political development in real-time right up to the election.
  5. Inflation surprises. If inflation surprises to the upside (e.g., due to accelerating wage growth or a supply shock), central banks may be forced to tighten policy. This would be a negative shock for both core bonds and stocks. On the other hand, if inflation surprises to the downside, this may rekindle fears the economy is sliding into a recession—very bad for stocks, but good for core bonds.
  6. The yield curve indicator. The Fed may have tightened too much in 2017 and 2018, and the lagged contractionary effects are still working their way through the economy. One consequence of Fed policy was the U.S. Treasury yield curve inverted for several months in 2019. An inverted yield curve has been a precursor to each of the past seven U.S. recessions. That the yield curve has now un-inverted doesn’t mean the economy is in the clear as this pattern also happened prior to the 1990, 2001, and 2008 recessions. Put differently, Fed easing in 2019 does not guarantee the economy will avoid a recession in 2020.
  7. Brexit. An orderly Brexit is not a done deal. There is still risk of a hard exit, “cliff-edge” scenario at the end of 2020 if the United Kingdom and the EU don’t negotiate a new trade agreement by then.
  8. Unexpected geopolitical risk. There is always risk of an unexpected shock in the geopolitical realm (e.g., the Middle East, North Korea, China-Hong Kong, or some other area off most investors’ radars).

Closing Thoughts

The economic consensus seems to be for decent global growth in 2020 and accommodative central bank policy. This would be a supportive environment for stocks and other financial assets. However, to some extent this outlook is already reflected in current market prices—at least for U.S. stocks—especially after the sharp year-end rally.

In our 2018 year-end commentary, we wrote, “No one knows what next year will bring. We may see some continuation of recent market trends or a stabilization or reversal in some of them. The market consensus will undoubtedly be surprised again. The only certainty is the lack of certainty.”

That turned out to be a pretty good forecast for 2019. We’ll stick with it again for 2020.

Thank you for your continued confidence and trust. All of us at Argent wish you and yours a very happy, healthy, peaceful, and prosperous New Year.

Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved.