What a difference a year makes, with U.S. equities ending the decade on a high note. Looking back on 2019, it seems we can divide the year into three phases. Phase 1 was recovery from the dramatic sentiment driven sell-off at the end of 2018. For many investors, there seemed to be more reasons to be negative than positive as the trade war chatter was mounting and stock volatility was higher than average. Phase 2 was the third quarter’s resurgent talk of recession as manufacturing activity deteriorated significantly, the yield curve briefly inverted, and trade worries came to the forefront. Phase 3 was the final year-end rally in stocks and other risk assets.
In general, the economic outlook has become more optimistic since the previous quarters. We now see firmer global growth in 2020 thanks in part to central bank policy easing and the consequent loosening in global financial conditions, coupled with waning international trade policy risks. One of the biggest risks today is that higher valuations may indicate the broad stock market having already priced in much of the good news. As such, this is a stock-picker’s environment where selectivity is key. There are ample reasons to stay invested with stocks and remain focused on the long-term financial plan. Certainly though, we think flexibility, selectivity, and active management look to be winning strategies in 2020.
Investors continue to benefit from the slow-to-moderate growth track of the global economy. Recent economic data shows that U.S. business activity rose to a five-month high in December, U.S. purchasing managers struck a positive note about economic activity entering the new year, and consumer spending picked up in November. Global growth, on balance, is expected to notch a 3% rate in 2020 – slowing but still nicely positive. In the U.S., GDP growth potential is likely to remain close to the 2% annual level. Some of the credit for reducing recession risk goes to the three interest rate cuts by the Fed in 2019, successfully un-inverting the fixed income yield curve and protecting the economy from the lingering trade war that hampered business investment, harmed exports, and influenced a contraction in manufacturing. At the federal funds rate’s current range of 1.50% to 1.75%, monetary policy adjustments appear on hold for the foreseeable future. Fed Chairman Jerome Powell said he needs to “see a sustained increase in inflation before raising the cost of borrowing.”
The health of the consumer remains a significant part of the ongoing economic growth story as well. Low unemployment, continual job creation and wage growth, better balance sheet positions and manageable debt service, favorable credit conditions, and high consumer confidence all aid in a positive growth view. Sources of personal income have also changed over time, with a smaller share coming from wages (61.5% share) and a larger share from government transfers (9.5% due to aging demographics), which contributes to the reduced cyclicality of income and spending growth. Also, the wealth effect of rising values of real estate and financial assets markets typically inspires financial confidence and induces people to spend more of their disposable income. The housing and stock market wealth effects were positive drivers of consumer spending last year and we expect they will remain so in 2020.
The U.S. equity market’s attention will focus on valuations and margin pressures. It appears evident that the Fed’s accommodative stance has contributed to rising asset valuations across all sectors. Most of the excess liquidity from the easy money bias has gone into the stock market, making it a challenge to be bearish. In an environment of low-to-moderate inflation and subdued real interest rates, it is possible that equities can continue to trade at higher multiples than the historical averages. Nevertheless, price-to-earnings ratios expanded by 30% in 2019, which means that market performance was based on paying 30% more for the same dollar of company earnings. While this suggests investor optimism, it also makes stocks vulnerable to short-term pullbacks. Our view is that today’s broad-based valuations appear elevated, but not excessive. Consequently, the renewal of positive earnings growth in 2020 will be a key driver of valuations and stock market performance expectations moving forward.
Another one of the hot topics on our investors’ minds: the U.S. presidential election. History provides some key insights on what an election means for stock markets, showing us that, on average, the fourth year of a presidential term has coincided with positive returns for the S&P 500. One explanation is that presidents have tended to try and enhance the economy in any way possible heading into an election year, and thus bolster re-election campaigns ahead of the vote. This election cycle seems on trend, with the economy receiving boosts from tax cuts, deficit spending, and lower interest rates. At this point, we believe that a lot of political risk is already embedded in asset prices across both credit and equity markets, especially within certain sectors. As the debates progress, though, we will access potential market impact from proposals involving corporate and personal income tax rates, health care, fossil fuel restrictions, banking regulation, and technology sector antitrust actions. However, at this stage, it does not make sense to give too much weight to any single outcome. It is likely that heightened political and policy uncertainty sets the stage for higher stock market volatility, and a tightly contested election could mean that election uncertainty lingers into the second half of the year. The bright side is that patience can pay, as we expect moments of panic from the markets will allow for opportunistic investment at preferential pricing. As part of a well-balanced portfolio, we intend to maintain sufficient liquidity to redeploy in fundamentally sound sectors as volatility creates future entry points.
We will close by reminding investors that prudent portfolio construction in the late economic cycle is increasingly vital. While often tempting to deviate from an investment plan due to fear inducing headlines or euphoric expectations, we recommend that investors stay grounded to their long-term asset allocation objectives. This discipline is central to achieving lasting financial success. Well diversified portfolios permit such resiliency by smoothing out returns in volatile times and mitigating portfolio risk. Active management like that employed by Tellone Management Group, Inc can also be imperative by adding protections while staying growth-oriented. In 2019, we added concentration to some growth stocks that we felt would outperform. This strategic overweighting has proved to be profitable and we expect 2020 to be another year where investors will need keen vision to closely scrutinize markets and find the fewer investment opportunities that exist as enduring bull market continues to run. Among stocks, earnings growth is becoming scarcer, and companies that deliver above-consensus results will be rewarded considerably more than those simply reliant on an economic expansion or cyclical recovery. We advocate a focus on quality at a fair price, and look for strong business models within companies exhibiting healthy balance sheets, ample cash flow to innovate and reward shareholders, and the ability to sustain growth. We anticipate that conservative call and put option strategies will diminish risk during times of market volatility, as well as aid with income generation at times of heightened valuations.
Know that we are here to promote solutions for financial peace of mind in 2020 and beyond. Do not hesitate to reach out if you are ready to schedule a review of your personal financial roadmap. Wishing all of our valued clients a prosperous and Happy New Year!