Market and Economic Outlook - Released 12/31/19

Key takeaways

• The U.S. economy is still growing at a moderate rate supported by a strong labor market, solid consumer spending, and low interest rates.
• Elections, trade tensions, and social unrest could feed uncertainty and contribute to global market volatility in 2020.
• We continue to seek pockets of opportunities but are applying a neutral approach to our multi-asset portfolios as neither stocks nor bonds appear cheap in our view.

While 2018 is remembered as a year when almost nothing worked, 2019 turned out to be a year when almost everything did. Whether it was stocks, bonds, or commodities almost every asset class had positive total returns (Figure 1). An additional rate cut during the fourth quarter (the third for the year) by U.S. Federal Reserve helped to sustain the economic expansion and propel the S&P 500 to record highs. What a difference a year makes.

As Warren Buffet stated, “whether we are talking about socks or stocks, I like buying quality merchandise when it is marked down.” One can still find deals on socks, although over the decade Amazon has supplanted the mall for most shoppers. However, in our view, when it comes to investments there are few bargains to be had currently. As a result, we are maintaining our neutral stance between stocks and bonds in multi-asset portfolios.

Trade tensions ease

During the fourth quarter, global trade dominated the headlines as stock and bond prices were largely influenced by news of progress or setbacks in the trade negotiations between the U.S. and China. A Phase One trade deal was finally agreed to, and both sides are due to formally sign the agreement later in January. The deal de-escalates the tension between the world’s two largest economies and lowers the risks to global growth. However, the deal does not seem to fully address key issues such as intellectual property protection and the opening of some markets to U.S. goods. We expect these items will be part of ongoing Phase Two discussions this year and will likely generate additional headlines and market volatility in 2020.

U.S. economic expansion continues

The U.S. economic expansion continues at its moderate pace with early Q4 GDP figures looking similar to Q3’s 2.1% growth rate. The expansion, the longest in history, is now in its 11th year supported by a strong labor market, solid consumer spending, and low inflation. While it’s the longest expansion, it’s not the strongest (Figure 2), and the economy has shown few signs of the excesses that have ended past expansions.

In a 2016 research report¹, Fed researchers concluded that “expansions during the past 70 years do not become progressively more fragile with age” and “expansions, like Peter Pan, endure but never seem to grow old”. Indeed, other countries have experienced expansions that lasted far longer than ours – the UK had a 15-year expansion until 2008 and Australia is currently in the 28th year of their expansion. Given the lack of excesses and supportive macroeconomic backdrop, we do not foresee a recession in the next few quarters. However, the U.S. elections in 2020 could have a significant impact on the economy depending on the platforms and priorities of the frontrunners and eventual winner.

Corporate earnings growth

The U.S. stock market appears to be pricing in a continuation of the expansion. S&P 500 earnings growth was fairly moderate for 2019 with some sectors stronger than others. The main driver of the strong S&P 500 returns during 2019 was almost entirely due to higher price-to-earnings ratio multiples (Figure 3).

We are skeptical of further increases in the S&P 500’s price to earnings ratio in 2020. However, continued strength in consumer confidence, strong employment, and compelling wage growth data, could support moderate earnings growth forecasts for the year.

Despite outstanding returns during 2019, we have seen large outflows from U.S. stock mutual funds and ETFs (Figure 4). As of early December, investors had placed approximately $277 billion into U.S. bond funds, the third biggest total over the past 10 years according to Refinitiv. This may suggest that investors are relatively cautious around some of the risks present. If the outlook on any of these risks are mitigated and investors begin to allocate funds back to stocks, this could provide additional support to stock prices.

Bond spreads tighten

A decline in global interest rates and continued stability in corporate fundamentals resulted in an exceptional year for bond market returns. When the Treasury yield curve inverted this summer, it caused concerns about an economic slowdown. However, the Fed’s rate cuts, along with Treasury bill purchases to improve functioning of the short-term lending markets calmed investors. Against this backdrop, longer term bonds with lower credit quality produced the strongest returns for 2019.

The steady economic environment and demand for income has caused the spread on U.S. corporate bonds rated BBB to continue to tighten. (Figure 5) In early December, the average yield spread of the JP Morgan U.S. Liquid Corporate Bond Index was only 1.08% over similar maturity Treasury bonds. This level remains near the record low spreads experienced in 2005. Commercial mortgage rates are also at record lows and below investment grade companies can easily borrow at very attractive rates. These factors lead us to believe investors aren’t being paid to take risk in bonds.

Despite the low yields for all bonds, investor appetite for income producing assets continues to be strong. Foreign demand for yield continues. There is still over $11 trillion in global bonds trading with negative yields making U.S. bonds look attractive to foreign investors even after hedging their currency risk. This strong demand, along with subdued inflation, make us think bond yields aren’t likely to test the highs seen in November 2018 anytime soon.

Investors need to be aware at these low yields, even a small increase in interest rates can lead to significant bond price declines. Despite the challenging environment, we continue to favor high quality intermediate term bonds, as we feel high quality bonds are an important way to diversify against the unexpected for our multi-asset portfolios.

The bottom line

In our view, the current economic expansion still has some legs and is unlikely to end in the near term. However, we feel U.S. stocks and bonds appear to be fully-priced. Charlie Munger, Buffet’s often-overshadowed colleague and vice chairman of Berkshire Hathaway, wrote, “… the wise ones bet heavily when the world offers them that opportunity. They bet big when they have the odds. And the rest of the time, they don’t. It’s just that simple.” Right now, we do not feel the odds are in our favor and are maintaining our neutral stance between stocks and bonds within multi-asset portfolios.