January 2020 Market and Economic Outlook

Let’s start with some great news: 2019 was a stellar year for nearly all categories of investments, and especially so for U.S. stocks. Considering that the year began in the shadow of a sizeable sell-off in Q4 2018 and featured trade wars, political tensions, a global manufacturing slowdown, and a veritable parade of market analysts ringing alarm bells about a recession or bear market, 2019 serves a reminder of the resiliency of our economy and the capital markets.

2019 Caps a Strong Decade for U.S. Stocks

Total Returns (%) as of December 31, 2019

U.S. large company stocks, as measured by the S&P 500, gained 31.5% in 2019. For the first time since 2013, all sectors of the S&P 500 were up double-digits for the year. Technology, in the continuation of a now-familiar theme, led the way with an eye-popping 50% gain for the year. Communication Services and Financials stocks also produced strong gains of over 32%. The Energy sector provided the lowest returns of the 11 S&P sectors, up just 12% (S&P, Morningstar).

Non-U.S. stocks of both developed (MSCI EAFE Index, 22%) and emerging countries (MSCI EM, 18%) also posted strong returns in ‘19, while trailing U.S. large caps on a relative basis.

The bond market was spurred by both falling interest rates (the 30-year U.S. Treasury hit an all-time low yield of 1.9% in 2019) and a strong investor appetite for credit risk. The popular gauge of the broad, investment-grade bond universe, Bloomberg Barclays U.S. Aggregate Bond Index, generated a total return of nearly 9%, its highest return since 2002. Intermediate-term U.S. Treasury bonds returned 7%, while corporate bonds had their highest return of the decade (BBgBarc U.S. Corporate 7-10 Yr Index). Non-investment grade (aka “junk”) bonds also had their best year since 2009 (Bloomberg).

The shape of the bond market’s yield curve is no longer inverted—i.e., the yield of shorter-term bonds is no longer higher than longer-term. (We wrote about yield curve inversions—and how they are seen as an indicator of future recessions—in the first quarter MEO). At year-end, the 10-year Treasury carried a yield of 34 basis points (0.34%) higher than the two-year.

2019 capped a great decade for U.S. stocks

What Will the Fed Do?

The effective federal funds rate is set by the Federal Reserve’s Federal Open Market Committee (FOMC; aka “the Fed”). This monetary policy rate is a key input for economic growth, employment, and inflation, which is why investors everywhere monitor its path and wait with bated breath for the Fed’s decision following each FOMC meeting. Below is a graph of the effective federal funds rate going back to 1990. We can observe that the Fed has provided stimulus to the economy and capital markets by aggressively lowering rates in response to recessions and bear markets. The extended period—roughly 2009–2016—of “ZIRP” (zero interest rate policy) following the ’08 Financial Crisis is unprecedented. While a strong monetary policy response surely helped arrest a severe meltdown and provided a path to recovery after the crisis, there are those who argue that rates were held to zero for too long, with artificially cheap capital potentially causing imbalances.

Another possible concern about the current low effective fund rates is that it leaves the Fed with precious little “ammunition” to fight the next downturn, whenever it may come. Having lowered three times in 2019—notably, in the absence of a bear market in stocks or recession—the funds rate is already below 2%. But as other central banks around the world have demonstrated, 0% is not necessarily the floor on rates. Even former Fed chairman, Alan Greenspan, stated publicly in September that “it’s only a matter of time before it [negative interest rates] is more in the United States.”

Feds Funds Rates Since 1990

There are other tools the Fed can use, though. They can also attempt to guide the economy and the markets via its balance sheet. (See 5-yr graph below, Federal Reserve Balance Sheet – Rising Again, of Fed’s balance sheet [i.e.,total assets held].)

Before the Financial Crisis, the Fed balance sheet was well under $1 trillion dollars. By 2014, however, it had swollen to approximately $4.5 trillion. What happened? The Fed, in response to the crisis, began buying (with “printed money”—which is to say, money that the Fed creates electronically) a lot of financial assets from banks and other institutions. Having bought these assets—mostly U.S Treasury and mortgage-backed bonds—the Fed carries them on their balance sheet. This process, described by the Fed with the term “quantitative easing” (QE), is economically stimulative as it supports the prices of bonds and injects money into the banking system.

Beginning in about 2017, the Fed embarked on a campaign of “balance sheet normalization,” resulting in a slow-but-steady reduction to under $3.8 trillion by mid-2019. In the last quarter of 2019, however, the Fed hit “pause”’ on normalization and began inflating its balance sheet once again. (The reason for this involves “repos”, aka repurchase agreements; the repo market is a large but arcane corner of the capital markets that involves overnight lending between banks. The Fed has had to pump large amounts of liquidity—sometimes tens of billions per day—into the repo markets to ensure they operate smoothly. The Fed describes this intervention as “technical” and not worrisome over the long term. Regardless, this repo market intervention has once again ballooned the Fed’s balance sheet.)

It may be instructive to note that the Fed is not the only central bank engaging in this extraordinary sort of stimulus. Take Japan’s central bank, for example. Not only does the Bank of Japan (BOJ) buy government bonds with printed money, it buys stocks, and lots of them. The BOJ owns nearly 80% of the shares of Japanese equity ETFs (Bloomberg, as of April 2019). Another example is the Swiss National Bank (SNB), the world’s most interventionist central bank. The SNB’s balance sheet is 123% of its annualized GDP (for comparison, our Fed’s approximately $4 trillion balance sheet is less than 20% of GDP). The SNB has been a large buyer of publicly traded stocks. It owns a U.S. stock portfolio of nearly $100 billion and is one of Apple’s largest shareholders (Bloomberg, Dec. 2019). Could the Fed someday resort to supporting equity market prices by directly buying stocks or ETFs?

In the summary, although it may appear they are “low on ammunition,” the Fed, in fact, has a deep arsenal. The Fed’s array of powerful monetary stimulus tools and their willingness to implement them are reasons to remain optimistic about the continuation of the economic expansion and risk assets.

Federal Reserve Balance Sheet - Rising Again

 

Broad Economic Backdrop for 2020 and Beyond

U.S. consumers, in aggregate, are on sound footing. This is vital as the U.S. economy is driven primarily by consumer spending (nearly 70% of Gross Domestic Product is Consumption; Bureau of Economic Analysis, 3Q19 nominal GDP). We currently enjoy generationally low unemployment (3.5%). Consumer finances, as measured by metrics such as household debt service ratio and household net worth, are strong and continue to trend positively. Wage growth, long moribund in the post-Crisis period, has been stronger in recent quarters (sources: 4Q19 data from BEA and JPMorgan). Additionally, the 2019 holiday season saw a 3.4% increase in retail spending from 2018, despite a shorter shopping season this year (Mastercard SpendingPulse data).

As for corporate earnings and profits, the picture is cloudier. Analysts generally expect earnings to accelerate in 2020 (see chart below). Lower corporate tax rates and low interest rates continue to bode well for S&P earnings. From a market sentiment perspective, the fact that 2019’s generally lackluster earnings growth may make for easier “comps” (year-over-year comparisons) in 2020 may be a good thing for share prices.

Corporate profits, however, have been slowing. A broad measure of profit margin relative to GDP is displayed below. From a long-term perspective, corporate profits have been strong the last several decades, with globalization and technological innovation providing tailwinds. Going forward, profits may shrink due to wage growth, trade disputes, and regulatory pressures (especially against large tech companies). The recent decline in profits is also typical of a “late cycle” economic environment. Further profits compression—especially if combined with downward earnings revisions, if a less-rosy environment appears—poses a risk for equity prices.

Source: JP Morgan, FactSet

Corporate Profits Are Shrinking by Some Measures

(Profits data above via Bureau of Economic Analysis measures profitability without the benefits of non-GAAP adjustments; “IVA & CCAdj” refers to inventory valuation and capital consumption adjustments)

Geopolitical Risks Create Uncertainty

One of the key risks for U.S. growth is the ongoing U.S.-China trade dispute. As we’ve discussed previously, an escalation of this dispute could lead to a severe downturn in global trade which, in turn, could spark a recession. At the very least, uncertainty around the trade dispute is seen to have caused companies in both countries to delay investments, hurting capital expenditures. This dispute continues to take many twists and turns and, at times, dominates the financial news cycle. In December, a so-called “phase one” deal was struck. This interim agreement—due to be signed in January—features some constructive give-and-take, with the U.S. pledging to reduce some tariffs in exchange for China agreeing to purchase more American products and provide better protections of U.S. intellectual property. As both sides of this have so much at stake, we feel a worst-case outcome (i.e., all-out trade war, leading to global recession) is unlikely.

In a turbulent and uncertain world, geopolitical risk is an unavoidable, chronic issue. As we begin 2020, Iran is an acute concern. In early January, the U.S. government killed top Iranian general Qasem Soleimani. Several days later, Iran retaliated by staging ballistic missile attacks on two Iraqi military bases which house U.S. soldiers. In the hours immediately following these attacks, there was high volatility in the oil market (crude prices surged) and global equity markets (foreign stocks and U.S. futures markets gapped down). Although both markets returned to “equilibrium” the next day, this episode highlights how escalating tensions in the Middle East and elsewhere can cause short-term distress in the markets.

Equity Valuations

Valuation is an important investment concept. It refers to measuring an individual security’s (or a basket of securities, like the S&P 500) relative value. Valuation metrics allow one to compare a security’s current valuation to historical averages or other types of securities as a way to determine if the security could be described as “cheap, expensive, or fairly valued.” Analysts can make inferences about expected long-term returns with this information. When markets are “expensive,” it correlates with lower forward returns over the long term. “Cheap” markets correlate with higher future returns.

There are many different valuation metrics. The exhibit below includes a snapshot of several widely used valuation metrics compared to long-run, 25-year averages. Here is a brief description of each valuation metric highlighted:

• P/E (Price-to-earnings): generated by dividing the share price by the earnings per share (EPS). There are different ways to obtain the “earnings” denominator, either using historical, reported earnings, or (as in the chart below) using the “forward” (i.e., estimated) earnings for the next twelve months
• CAPE (Cyclically Adjusted P/E): developed by Nobel prize-winning economist Robert Shiller, this ratio uses the inflation-adjusted earnings from the previous ten years for the earnings denominator
• Dividend Yield: calculated as the trailing 12-month dividend payments divided by the current price
• P/B (Price-to-Book): calculated as the current price per share divided by book value, which is defined by a company’s total assets minus liabilities. P/B is a commonly-used ratio to define growth stocks (which have higher P/B) and value stocks (lower P/B)
• P/CF (Price-to-Cash Flow): calculated as price per share divided by a company’s operating cash flow
• EY Spread (Earnings Yield Spread): this ratio, sometimes called the “Fed model,” measures earnings yield relative to the yield available from corporate bonds. In the graph below, it is calculated as the earnings yield (12-month forward-looking earnings per share divided by price) minus the yield of Moody’s Baa-rated (medium quality) corporate bonds

Source: FactSet, FRB, Robert Shiller, Standard & Poor's, Thomson Reuters, J.P. Morgan Asset Management 

It would be fair to conclude from the data above that the S&P 500 is overvalued—but only moderately so. For example, the current forward P/E is above the 25-year average, but far less extended than during the Internet Bubble era of the late ‘90s.

It is also interesting to note the valuation differences between U.S. and International stocks. Since the Great Financial Crisis, the S&P 500 has outperformed international by a wide margin. There are several key forces behind this U.S. relative outperformance, including foreign political turmoil and a strong U.S. dollar. Additionally, U.S. equity returns have been driven in large part by mega-cap, consumer technology stocks (“FAANG” stocks). International stock indexes, meanwhile, have had more concentration in value-oriented sectors, such as financials, materials, and energy (sources: MSCI and American Funds). No cycle lasts forever though, and international stocks are more attractive from a valuation standpoint. International stocks have a lower P/E and pay higher dividends than the S&P 500.

One final point regarding valuations: valuations matter a great deal over the long term but are not helpful for market timing. In other words, markets that are overvalued can stay overvalued for a longer period or go farther into overvalued territory than seems “reasonable.” The same is true for the reverse condition; undervalued markets can become more undervalued.

Forward-Looking Return Expectations

As we begin a new decade, it seems a good time to once again examine what the research tells us about what investment returns may look like in the years to come. This is a useful exercise from a practical standpoint—as future returns are obviously an important input for financial planning—and from an investor psychology standpoint, to establish clear-eyed expectations.

Instead of just relying on one source for long-term capital market assumptions, we use an ensemble approach. The numbers below represent the average of approximately 20 different investment management and consulting firms. These are not short-term predictions, but long-term (7–10 years) forward-looking estimates.

The straightforward point is this: the average assumption is that for publicly-traded stocks and bonds over the next 7–10 years A) returns will likely be lower and B) volatility will likely be higher than the previous decade. (For comparison, U.S. large cap stocks [S&P 500] trailing 10-year return as of Dec. 31, 2019, is 13.6%, with volatility of 12.5%.)

This is intuitive based on relatively high equity valuations and the fact that the previous 10-year period provided high returns. These long-range forecasts are useful for financial planning, and it is prudent to heed them. However, we would urge investors not to despair of these lower return assumptions. Neither the exact level of future returns—nor their path—can be known with certainty. The macroeconomic environment and capital market returns are also totally out of one’s control. As ever, we urge investors to focus on those things over which one does have control: managing the risk/reward trade-offs in your portfolio, maintaining prudent diversification, etc.

A Word on Predictions

When we turn the calendar to a new year, the financial press is often filled with predictions for the year to come. (For example, “What Wall Street strategists say to expect from the S&P in 2020.”) The legendary Yogi Berra gets attribution for many famous quotes, with many having become so famous as to become clichés, which we typically try to avoid. There is one Yogi-ism, however, which applies so perfectly here that we can’t resist using it: “It’s tough to make predictions, especially about the future.”

Admittedly, reading and listening to the short-term predictions of famous market pundits or money managers can be fun and interesting—perhaps even enlightening. It is important to remember, though, that the future is unknown. The global economy and capital markets are affected by innumerable forces. Even the most thoughtfully and carefully crafted predictions can end up “wrong” based on random events.

One academic paper (Bailey, David H. and Borwein, Jonathan and Salehipour, Amir and López de Prado, Marcos, Evaluation and Ranking of Market Forecasters [May 31, 2017]) examined the accuracy of market forecasts. The research included more than 6,600 forecasts made for the S&P 500 by 68 market forecasters over the time period of 1998-2012. The research’s primary finding was that the majority of forecasters perform at levels not significantly different than chance. The accuracy of all forecasts was under 50% (48%, specifically). Two-thirds of forecasters had accuracy levels under 50%.

In other words, making short-term predictions that are reliably accurate enough to be useful is effectively impossible. That’s why at CLA we focus our efforts on preparing our clients for the future—instead of trying to predict it.

Conclusion

2019 was a year in which nearly everything worked, capping a decade of attractive returns for risk assets. The capital markets will likely provide less attractive returns over the decade to come. However, there is no clear evidence of an imminent recession. Generally strong consumer balance sheets, a healthy labor market, and accommodating central bank policy provide a constructive backdrop as we enter 2020.

CliftonLarsonAllen Wealth Advisors, LLC
Investment Committee
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