- The Fed reversed course at the start of 2019 amid signs of a slowing economy, stagnating corporate earnings, and escalating trade tensions
- With the Fed once again signaling monetary accommodation, equity markets rallied, driving valuations back up over the course of the year
- Political uncertainties in the US will reshape the investment environment in important and unpredictable ways
- The combination of elevated market valuations, overly positive investor sentiment (often a contrary indicator) and an uncertain domestic political environment warrant continued caution and careful diversification in 2020
The Federal Reserve charged to the rescue in a big way in 2019. In the face of increasing trade tensions and recessionary forces bearing down on the economy, US central bankers reversed course and reduced short-term rates three times starting in late July and in October, took steps to increase liquidity in short-term lending markets. By December, investors began embracing the idea that the worst of the US-China trade war was behind us. The S&P 500 finished the fourth quarter with one of the best annual gains since 2013, while most other equity indices finished the year in record territory. As a result, we start 2020 with the unnerving combination of overly positive investor sentiment, elevated market valuations, and a presidential election campaign that is becoming a major source of market uncertainty.
The US economy began to moderate in 2019 as the effects of the 2017 tax cuts faded and Chinese trade tensions escalated. Despite historically low unemployment, Q3 growth slowed to 2% year over year, compared to 3.2% in 2018, reflecting weakness in business investment spending, exports, and inventory growth. (These effects are, to some extent, all attributable to heightened trade tensions during the year.) Corporate earnings, which were extremely strong in 2018, flatlined in 2019.
The weak inflation picture that has restrained the Fed in recent years remained a bugbear in 2019. While ten years of easy monetary policy successfully boosted home prices, bond prices and stock prices, it has not had a meaningful impact on consumer prices, which remain stubbornly below the Fed’s long-term target of 2%. Even as businesses report having trouble finding qualified workers, productivity gains seem to continually blunt labor’s ability to demand higher wages and ultimately drive inflation higher. As the economy slows and the effects of the 2017 tax cuts fade, we would expect this low-inflation conundrum to continue.
This economic backdrop gave the Fed room to reverse course in 2019, cutting rates three consecutive times in the latter part of the year. The Fed justified the “mid-cycle adjustment” as a prudent response to low inflation, heightened trade tensions, and slowing global growth. Furthermore, the Fed may have had a protective eye on the US export sector as monetary easing by other global central banks threatened to put further upward pressure on the US dollar. By year end however, the Fed had made it clear that it believes its mid-cycle adjustment is complete and that it would take a material change in the outlook to tighten or loosen rates in 2020. Whether intended or not, the Fed has positioned itself to remain neutral on rates during a presidential election year.
The Fed’s change in course had big implications for asset markets. As interest rates declined, investors ‘recalibrated’ their views on valuations, driving equity markets to all-time highs. In a flat earnings environment this meant that the S&P 500’s 30% gain in 2019 was almost entirely due to declining yields and multiple expansion (meaning investors were simply willing to pay a higher price for the same amount of earnings). Even though valuations only returned to their September 2018 levels, they ended the year well above their 25-year average, an average that is pushed up by the so-called “irrational exuberance” of the late 90’s dotcom boom. Whether these valuation levels are sustainable in the short run is anybody’s guess, but they definitely warrant caution. Likewise, fixed income had a surprisingly strong year on the back of declining interest rates and a flat yield curve.
Markets start 2020 in an uncomfortable place. Investor sentiment is overly positive, equity valuations are stretched and, while the global economy has largely recovered from the Great Recession, the recovery has fostered extreme political forces around the world. (The same easy monetary policy that boosted the prices of homes, stocks and bonds largely benefited asset owners, while stagnant wages have left many income earners behind.) In this environment, some political solutions are limiting economic growth and shaping the investment environment in unpredictable ways. In the US specifically, those forces seem to be coming to a head in this year’s presidential contest, with voters contemplating choices across an unusually broad political spectrum. We believe political outcomes, which more often trail economic phenomena, will have a large impact on investment returns going forward. Given the uncertainty around those choices, we are taking a cautious and diversified approach to portfolio construction.
Ultimately, valuation is usually the best guide to long-term returns. Global equities, which have lagged US markets for the better part of a decade, are notably cheaper. Most large developed economies, who were slower to respond to the Great Recession, are significantly earlier in their economic cycles now. A slowing US economy and rising trade deficit will likely lead to a weaker dollar, further supporting non-dollar assets. With phase one of a trade agreement with China now signed and a viable path to Brexit mapped out, meaningful obstacles to global growth seem to be receding as well. Emerging Market stocks have the most favorable long-term growth prospects and should experience some relief in the wake of US rate cuts (and resulting weak dollar). By broad valuation measures, international opportunities remain attractive at the moment, and we will continue to build on that theme in portfolios.
Within US markets, perhaps the most pronounced valuation difference is between growth and value stocks. Growth stocks have generally led value during this market cycle, but in 2019 that difference reached an extreme. Growth stocks are now trading at their highest premium to value stocks since 2002. At present, the growth premium to value is at 52%. Historically, when growth stocks have been priced above a 50% premium to value, value has outperformed in the subsequent 10 years by more than 50%. Our portfolio construction is mindful of this late-cycle distortion and we are putting a heavy emphasis on our Low Correlation Growth strategies to take advantage of it. Most notably, our low volatility strategies inherently tilt toward more value-oriented names.
Without question, this is a late-cycle market. With real yields close to zero, investors are reaching for returns in the equity markets, without fully appreciating or understanding the risks involved. High valuations invariably limit the returns a portfolio can be expected to generate. Political uncertainty only compounds this reality.