Introduction
Taking Stock
Baseball legend Yogi Berra is as well-known for his eccentric quotes as he is for his ten World Series championships. During the 1973 National League pennant race Yogi was managing the New York Mets and they were trailing the Chicago Cubs by 9.5 games. Yogi then coined the phrase “it ain’t over, ‘til it’s over,” and the Mets went on to win the National League East division, eventually appearing in that year’s World Series. If taken literally, this now ubiquitous tautology has no meaning – if it’s not over…well, of course, then it’s not over. However, the spirit of the saying is well understood and provides hope when all might appear lost.
If 2019 showed us anything it’s that when all hope appears lost, financial markets have a way of surprising even some of the most discerning investors. If we can remember back to December of 2018, the Federal Reserve had increased interest rates for the fourth time that year and the S&P 500 was experiencing its worst December since 1929 (ultimately dropping 19.7% from its previous peak). Prospects for the economy and stock market seemed grim, and many well-known investors were predicting an imminent recession.
As we all now know, the expansion endured. The global economy continued to grow, albeit modestly, and asset classes produced strong returns across the board. Throughout the volatility, we urged our clients not to panic, keeping our eye on a fundamental picture that we believed would continue to support financial markets.
What’s Next?
Looking ahead to 2020, we would still say, “it ain’t over.” Since the Financial Crisis, the average annual price return of the S&P 500 has been 12.7% (2010- 2019) compared to the long-term average of 7.3% (1929 – 2019). The persistence of above-average stock market performance, combined with the fact that July of 2019 marked the longest U.S. economic expansion on record, has some investors convinced that the end must be near. But let’s be clear, the passage of time does not necessitate an economic contraction or bear market. The Australian economy hasn’t had a recession since the early 1990s, and the U.S. bull market that began in 1982 lasted nearly two decades.
2020 will undoubtedly present some unique challenges – the presidential election could result in dramatic policy shifts, U.S.-China trade negotiations will continue, Brexit has yet to be resolved, corporate profit margins may be challenged by rising wages, and financial assets are generally expensive relative to historical averages. We are closely monitoring all these risks; however, we believe the highest probability outcome in each case is relatively benign.
We also think a combination of forces will work in favor of financial markets in 2020:
- Accommodative monetary policy: global central banks are no longer raising interest rates and, as is the case with the Federal Reserve, have lowered rates in many cases. The combination of low interest rates and a stable economy should be a positive for financial assets.
- Bottoming in global manufacturing: the economic soft-patch experienced in 2019 had many investors concerned about a recession. With economic data improving throughout the world, a waning fear of recession should also be supportive of risk assets.
- The U.S. consumer: as the primary growth engine of the U.S. economy, a healthy consumer is critical to a continuation of the current economic cycle. The December 2019 jobs report indicated that the economy added 266,000 jobs and wages grew again at over 3% on a year-over-year basis. With an elevated personal savings rate of almost 8% and debt to disposable income at its lowest level in nearly 20 years, consumers remain in a strong position.
- Corporate earnings: supported by a stabilizing global economic picture, our forecast for the S&P 500 is a resumption of earnings growth in the mid to high single-digits. With equity multiples extended, earnings growth will be a primary driver of stock market prices.
- Investor sentiment: Major market tops are usually accompanied by optimistic investor sentiment. We see no signs of euphoria in this market (yet). A continued shift from pessimism to optimism could be an important feature of the market in 2020.
Perhaps most critical to our market view is that we do not believe a recession will occur in 2020. Bear markets that coincide with recessions have historically been the most severe, so our portfolios will unlikely reflect an overly defensive posture unless we believe an economic contraction is probable. This view, along with the belief that the global manufacturing cycle will reaccelerate amid a continuation of accommodative monetary policy, should be enough to lift stocks higher. This backdrop should re-steepen the yield curve and increase optimistic investor sentiment. In such an environment we would favor:
- Equities: value over growth, cyclical over defensive, small over large, and developed international over domestic.
- Fixed Income: below benchmark duration and investment-grade over high yield.
Some Perspective – What’s in a Forecast?
Although perhaps ironic when writing a market outlook, we should always start by recognizing that no one can predict the future with precision. With a myriad of possible outcomes and often unforeseen variables, our investment philosophy is driven by avoiding the dire consequences that can result from being overly confident in a market forecast. Our mission, above all others, is to make sure our clients’ wealth is managed in a way that is consistent with their goals and values. With the help of a dedicated advisor, finding an approach you can stick with may be the most important ingredient for investment success. Know what you own, understand how they are likely to behave in different market environments, recognize your behavioral biases, and generally stick with a thoughtfully conceived long-term plan.
We believe our edge is understanding what is happening in the short-term, but usually not reacting to it. We believe the emotional swings of others can play to a long-term investor’s advantage. An understanding of human behavior, and only making significant portfolio changes when our conviction is at its highest, is key to our process.
Finally, we believe a thoughtful and purpose-built asset allocation is the foundation of investment success. Investments cannot be viewed as singular holdings in a vacuum. We must understand how each holding interacts with the other, resulting in a holistic portfolio that is durable and diversified.
The following pages will provide more detail supporting our outlook for 2020.
All Things Politics – U.S. Presidential Election, China, and Impeachment
Investing in an Election Year
Making investment decisions based on the binary outcome of elections is generally not advisable. Not only does one need to guess the outcome of the election correctly, but one also needs to accurately anticipate the market’s reaction to that outcome. As history tells us, successfully doing this is very difficult. Perhaps the best example is the 2016 election of Donald Trump. Polls were predicting a Trump loss, and most investors assumed that if Trump was elected markets would struggle to digest the uncertainty. As we now know, the majority was wrong on both counts – Donald Trump was elected to be the 45th President of the United States, and the S&P 500 has since returned 60%. Although making drastic portfolio changes based on anticipated election results may feel like the right thing to do, it can often disrupt a sound long-term strategy.
With that philosophical view in mind, let us review some historical market statistics related to presidential election years. Using average returns since 1933:
- The S&P 500 does better in non-presidential election years versus presidential election years (9.2% annual return versus 6.9% annual return).
- Stocks have done better in re-election years versus open-election years (10.3% annual return versus 2.5% annual return).
- Stocks have also performed materially better in the year of an incumbent president victory versus an incumbent president loss (10.0% annual return versus 2.8% annual return).
- Every president who was able to avoid a recession in the two years leading up to his re-election went on to win. Coolidge was the only president to win re-election and experience a recession in the two years prior (Chart 1).
Chart 1: a president has never lost re-election when avoiding a recession in the prior two years
Source: Strategas Research Partners, LLC
Assuming no recession in 2020, history would predict the re-election of President Trump and a reasonably good year for stocks.
The Road to the Presidency – Potential Market Impact
Although we are unlikely to make dramatic portfolio changes based on an election forecast, we do believe it is important to understand the possible market implications.
The eventual Democratic nominee will have a significant impact on the market’s interpretation of potential market risks as we move through 2020. Joe Biden is currently ahead in the polls and is a known quantity for the market. However, we have seen the emergence of the progressive movement which creates a wider spectrum of possible outcomes. Regardless of one’s politics, the market interprets the policy agenda of Elizabeth Warren, for example, as unfriendly to business. If Elizabeth Warren, or someone similar, were to become the democratic nominee equity sectors such as technology, financial services, energy, and healthcare would be directly in the policy-crosshairs.
We believe equity markets would come under meaningful pressure should a progressive candidate become president. Should such a candidate win the democratic nomination, markets would likely begin to price in a higher probability of that reality. Using Elizabeth Warren as an example, her policy agenda is explicitly designed to reduce corporate profits. Central to her agenda is a redesign of capitalism that focuses less on the maximization of shareholder value, compelling companies to also consider a broader array of stakeholders. This agenda includes a reduction in corporate profits with a focus on ensuring workers get more. Additionally, the increase in both corporate taxes and regulation would further reduce profitability. Almost by rule, an agenda that is designed to shrink corporate profits would put downward pressure on stocks both from an earnings and valuation perspective.
Given that the core of the progressive agenda is the reformation of capitalism, our guess is that Medicare for All may take a backseat to other policy initiatives. The market affirms this view, with the Healthcare sector recently breaking out to all-time highs. Our view is that companies within the technology, financial services, and energy sectors would be most at risk. Policy items outlined below may be accomplished via executive action [1]:
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- Technology: break-up the big companies, appoint strict regulators at the Federal Trade Commission and Department of Justice, and stop mergers.
- Energy: no new nuclear plants, ban fracking, repeal traditional pro-energy tax treatments.
- Financials: reverse Trump administration’s deregulation efforts, place limits on executive compensation, and pursue legal action against certain banks.
It does not appear that Bernie Sanders or Elizabeth Warren will become the nominee, so none of the above should be considered our base-case forecast, but understanding the potential market implications is worthwhile.
China Trade Negotiations
We think the outcome of the trade war with China is inextricably linked to the re-election campaign of President Trump. Operating under the assumption that like all politicians President Trump wants to be re-elected, he is likely very focused on his approval rating. Throughout history, a president’s approval rating is a fair approximation for the percentage share of the two-party vote they are likely to receive (Chart 2).
Chart 2: a president’s approval rating is a good predictor of voting results
Source: Strategas Research Partners, LLC
As of this writing, President Trump’s approval rating is relatively low. If the election were held today, based on this metric, he would have little chance of winning. That said, there is still time before the election, and China trade negotiations have had a meaningful impact on the president’s approval rating. As seen in Chart 3, a basket of stocks that tend to perform well when trade tensions ease exhibits a high correlation with Trump’s approval rating. In other words, when those stocks outperform as trade tensions ease, Trump’s approval rating goes up. The president is likely aware of this dynamic, and it should motivate him to further deescalate trade tensions.
Chart 3: Trump’s approval rating goes up when trade tensions ease
Source: Strategas Research Partners, LLC
Adding to the pressure to make a deal with China, swing states that helped secure Trump’s victory in 2016 have seen a dramatic slowdown in wage growth. Many of these states Trump only won by a small margin, and the likes of Pennsylvania and Michigan are disproportionately suffering from the trade-induced uncertainty (Chart 4).
Chart 4: battleground states have seen wage pressure
Source: BCA Research, Inc.
For these reasons, a further de-escalation of trade tensions is our base-case assumption. In our view, a credible “cease-fire” related to additional tariffs is the critical piece for markets. An all-encompassing trade deal is unlikely, but we don’t think that is what investors expect.
Trump Highly Unlikely to be Removed from Office
Notwithstanding some new information regarding Trump’s dealings with Ukraine, we do not believe enough Senate Republicans will vote to convict Trump. Needing a two-thirds majority means 20 Senate Republicans would need to vote against Trump, and given recent polling data, the chances are very small that would happen. According to an October Gallup poll, only 6% of Republican voters would support Trump’s removal from office. Additionally, Trump’s job approval rating among Republicans is just under 90%. Without the support of their constituencies, Senate Republicans will likely toe the party-line. Ultimately, we do not believe the proceedings will have a significant impact on financial markets.
Economic Outlook
United States
A question we get from clients, and often debate internally, is “how close are we to the next recession?” Interestingly, business cycle duration has lengthened since the early 1980s as corporations have been more operationally efficient (rising operating margins), central banks (i.e., The Federal Reserve) have played a more active role in administering monetary policy, and globalization has led to muted inflation. We believe all these factors, collectively, have increased the average length of the business cycle. Therefore, we think recession predictions based solely on the idea that “we are due” are destined to lead to sub-par investment outcomes.
Predicting quarter-to-quarter real growth domestic product (GDP) rates is nearly impossible; therefore, we are more interested in trying to gauge inflection points in the economy. Between recessions, the economy often travels through multiple “mini-cycles” that can have a significant impact on how financial assets perform. We believe August 2018 marked the beginning of the third cyclical slowdown within an ongoing economic expansion. There are numerous leading economic indicators one can use as a proxy for the business cycle, and we feel the Conference Board’s composite index of ten leading economic indicators (LEI)[2] has been a useful tool in this regard throughout history. As seen in Chart 5, the year-over-year change in the LEI has slowed three times since the last recession but has yet to turn negative. The LEI turning negative is not enough to predict a recession, but it has always been a precondition.
Chart 5: the YoY % change in the LEI always turns negative prior to recession. We are again close, but believe it turns higher
Sources: FactSet, Inc.; Bryn Mawr Trust
As mentioned in the introduction, the most severe and long-lasting bear markets typically coincide with recessions (Table 1).
Table 1: bear markets during a recession are significantly more severe, and often induce poor investor behavior
Sources: FactSet, Inc.; Bryn Mawr Trust
Therefore, determining whether we think the LEI continues lower, or begins to once again hook higher, is extremely important to our overall market forecast. As seen in Chart 6, the change in interest rates over the past 24 months has a strong relationship with the likely direction of the LEI index.
Chart 6: as the lagged impact of lower rates start to benefit the economy, the LEI should again turn higher
Sources: FactSet, Inc.; Bryn Mawr Trust
We believe we are in the early stages of a bottoming process in the LEI index, and a recession is unlikely in 2020. Recessions are typically caused by a central bank policy blunder (raising rates too aggressively), an excessive build-up of inventory, an asset/credit bubble, high levels of inflation, or a black swan event (i.e., commodity price spike or military conflict). Black swan events are definitionally unforeseeable, but the other traditional causes of a recession do not appear to be a major threat in 2020.
As leading economic indicators such as the LEI index reaccelerate, the market typically behaves a certain way. Interestingly, although growth stocks have dominated value stocks throughout this expansion, the two most consistent periods of value outperformance began just prior to a bottoming in the LEI index. Our belief is we are again approaching such an inflection point that may prove beneficial to value-oriented strategies in 2020 (Chart 7).
Chart 7: value stocks often perform better when growth reaccelerates
Sources: FactSet, Inc.; Bryn Mawr Trust
International
We believe the global economy is also approaching a similar inflection point. Again, interest rates are an important component of that forecast, and the number of central banks whose last policy moves were rate decreases have strong leading properties. In the case of Chart 8, the well-documented slowdown in global manufacturing appears to be bottoming and should continue to do so if history is an accurate guide.
Chart 8: global manufacturing data also appears to be benefiting from lower rates
Source : BCA Research
Discussed in more detail in a later section, an improving global growth backdrop should disproportionately benefit non-U.S. stocks for two reasons. First, compared to most developed economies the U.S. is far more tilted toward services versus manufacturing. The recent growth slowdown around the world was concentrated in manufacturing, so a recovery in that sector should benefit international economies more than the U.S. Similarly, the sector composition of international stock indexes is more tilted toward cyclical equity market sectors. Consequently, international stocks generally outperform the U.S. when global growth recovers. Second, although relatively cheap international stock prices will not alone help us time better performance in that asset class, combined with the catalyst of improving growth, lower prices do allow for more upside in those markets.
The U.S. Dollar (USD)
Given the countercyclical nature of our currency, an improvement in global growth would likely result in a lower dollar. Historically, the dollar has moved higher when global growth slows, as dollar assets are often viewed as a safe-haven in times of economic stress. As an example, during the Financial Crisis, the equity market here in the U.S. started to accelerate to the downside in the middle of 2008, bottoming in March of 2009. During that same period, as stresses mounted on the global economy, the USD appreciated by over 20%. If the dollar weakens in 2020, which we expect it will, this should bolster both earnings for U.S. multinational corporations and international equity returns for dollar-based U.S. investors.
Domestic Equities
Impact of Monetary Policy
Monetary policy has been – and will continue to be – a critically important variable in any equity market forecast. Heading into the final days of 2018 the Federal Reserve raised interest rates for the ninth time in their tightening cycle. As investors became nervous about additional rate increases, stocks sold-off significantly, pushing the price-to-earnings multiples (P/E ratios) on major stock indexes to below their long-term averages (reaching 13.6x forward earnings on the S&P 500 at the December 2018 lows).
In response to the violent market reaction, the Federal Reserve (Fed) quickly reversed course, cutting interest rates three times in 2019. As Chart 9 displays, the huge returns earned in the S&P 500 in 2019 were almost solely due to investors’ willingness to pay more for every dollar of earnings (increase in the P/E ratio), with earnings growth contributing almost nothing to performance.
Chart 9: earnings growth was an insignificant driver of stock prices in 2019. A valuation increase was the key driver
Sources: FactSet, Inc.; Bryn Mawr Trust
As history would indicate, the stock market acts very differently based on the prevailing interest rate regime. Table 2 details the historical market pattern, which explains much of how markets behaved in 2018 and 2019. When interest rates remain “easy,” or below the Fed’s estimated neutral rate of interest [3], stocks do considerably better than when rates are pushed above that level. When the Fed is decreasing rates, multiple expansion also tends to be the primary driver of returns.
Table 2: easy monetary policy has historically supported stock returns and valuation multiples
Increasing rates above the estimated neutral level of interest has consistently led to slower economic growth (often recessions) and lower stock returns (Chart 10). At the start of 2019, when it became clear that the Fed was no longer on a predetermined path of higher rates, earnings multiples were able to recover throughout the year. Thus far, it appears as though the Fed has engineered a rate policy like that of the mid-1990s. As is the case today, in the mid-90’s the absence of rising inflation allowed the Fed to pause at neutral, avoiding a significant economic slowdown. Going forward, we believe the Fed will continue to be extremely cautious when considering interest rate increases. As inflation remains well contained, our view is that the Fed may simply sit 2020 out, making very few, if any, policy adjustments. Fed Chairman Jerome Powell explicitly stated that we will need to see a significant and persistent rise in inflation above the Fed’s 2.0% target for them to move rates higher. We think this is unlikely in 2020, ultimately perpetuating an environment that has historically been supportive of stocks.
Chart 10: pushing rates above neutral to combat higher inflation often leads to recession. Not a risk today
Source: Cornerstone Macro Research
Valuation Analysis
This all begs the question of where do valuations (P/Es) go from here? From a historical standpoint, P/E multiples are currently above their long-term average. The case for stock prices being somewhat overvalued can be further supported by any number of metrics, a few of which are detailed in Table 3. We certainly would not argue against the point that U.S. equity valuations are a bit stretched.
Table 3: in combination, valuation metrics indicate an expensive U.S stock market
| Current | Long Term Average (30 yr.) | |
|---|---|---|
| Price/Earnings Ratio* | 19.1 | 17.8 |
| Price/Cash Flow* | 13.9 | 11.6 |
| Price/Sales* | 2.3 | 1.7 |
| PEG Ratio* | 1.8 | 1.4 |
| Market Cap/ GDP | 115% | 81% |
*Trailing 12 months as of November 30, 2019
Source: Strategas Research Partners, LLC
Valuations have a very high correlation with expected stock returns over the next 10-years, but very little relationship with how stocks are likely to perform over the next 12-months. Therefore, when providing a twelve-month market view, valuations need to be assessed relative to other investment options. Bonds are the primary competition for investor dollars, and yields remain historically low. In that regard, stocks may still be considered attractive relative to their fixed income alternative. This is reflected in the chart below which depicts the equity risk premium (ERP). The ERP is defined as the Earnings Yield (inverse of the S&P 500 P/E) less the 10-year Treasury yield. Currently, this spread is historically wide, indicating the relative attractiveness of stocks (Chart 11). While we readily acknowledge that elevated valuations make further P/E expansion more difficult in 2020, a benign Fed and attractive relative valuations, when compared to bonds, makes us believe that significant P/E contraction is also unlikely, all else equal.
Chart 11: at over 300 basis points, an ERP this wide has been good for stock returns over the next 12-months
Source: Strategas Research Partners, LLC
Taken in combination, we believe this translates to a year where earnings growth will likely be the primary driver of equity market returns, with valuation expansion/contraction being a less significant factor when compared to 2019.
Current consensus forecasts for the S&P 500 estimate earnings growth of nearly 10% for the 2020 calendar year. We believe that figure may prove a bit optimistic for a variety of reasons. First, the historical trend has been for earnings estimates to start the year at elevated levels, only to be revised down as the year unfolds – usually by about 40% – 50%. Then too, with operating margins near historic levels, the bias could be toward profitability ratios contracting, particularly with wages continuing to increase in this extremely low unemployment environment.
Consequently, a positive return for the S&P 500 in the mid-single digits seems probable, which while below the long-term average, would still be respectable, particularly when viewed from the standpoint of a two-year average (2019-2020).
Desirable Exposures – will value stocks have their day?
Style: Amid a very long run of growth outperformance, value stocks outperformed growth for a brief period in September of 2019. As Chart 12 displays, growth stocks are historically expensive relative to value.
Chart 12: relative valuation favors value stocks by a wide margin
Source: Strategas Research Partners, LLC
This disparity can largely be explained by the construct of the two indices (Chart 13). The Russell 3000 Growth Index is almost 40% technology, which has generated an average annual return of 18.5% over the past five years. Conversely, the Russell 3000 Value Index has a big exposure to Financials, which generated a return of roughly +9.8% over the same time period.
Chart 13: relative growth outperformance is a sector story which can’t persist forever
Sources: FactSet, Inc.; Bryn Mawr Trust
We would not argue the point that some added premium is warranted for growth vs. value given the digital evolution taking place in our economy. However, even acknowledging as much, the valuation disparity appears excessive, and we would opt for a tilt toward value. Although relative valuations are not a particularly useful market-timing tool, the dramatic decoupling of growth and value combined with our forecast of an upswing in the global economy lends itself to the idea that a sustainable rotation into value could occur in 2020.
Sector: Financials should have better prospects in 2020, as they are unlikely to face the same challenges of 2019 – specifically, a yield curve inversion which created a terrible operating (Net Interest Margins) environment. Instead, they should benefit from a modestly steeper yield curve, as the front end of the curve is anchored by Fed inaction, longer-term rates drift higher as growth and inflation expectations firm. We also like the slightly above-average dividend yields provided by the sector, and the relatively low payout rates (capacity to raise dividends), particularly given our belief that equities will produce below-average total returns in 2020. Finally, we would note that the regulatory spotlight seems to be shining less brightly on many of these companies, with some of the focus now shifting to large-cap technology firms.
With the expected bounce back in corporate earnings, we also favor industrials. These cyclical companies faced multiple headwinds in 2019, including issues with Boeing and a slowing economy. Many industrial companies were also more impacted by the China trade conflict when compared to other sectors. We believe that there should be improvement on each front. We also take note of the fact that Industrials are estimated to have the greatest year-over-year growth in earnings when compared to all other major S&P 500 sectors.
Size: Finally, this bias toward cyclicals also moves us to a favorable posture with respect to small-cap stocks. This group, as measured by the Russell 2000 Index of smaller sized companies, has an exposure to industrials and financials which is roughly 50% greater than what exists within the Russell 3000 Index. We believe smaller cap issues are poised to join their large-cap brethren, and finally post new all-time highs (their prior highs posted in August 2018), closing the performance gap. Over the trailing three-years, the Russell 2000 has generated average annual returns of 8.6% vs. 14.2% for the Russell 3000 Index.
Developed International Equities
An Opportunity to Outperform
International equity markets have significantly lagged U.S. markets over the last ten years due to a combination of structural factors, widening valuation disparities, and a stronger U.S. dollar. While absolute returns for international equities were strong in 2019, with the MSCI EAFE Index up 17.9% as of December 24th, the underperformance relative to U.S. Equities continued as global economies slowed and international earnings were disproportionately affected by the U.S.–China trade dispute.
As discussed in detail in our third quarter publication [4], another factor in the underperformance of international equities has been the corresponding outperformance of growth stocks, and the technology sector in particular, which has a much higher representation in the S&P 500 Index versus the MSCI EAFE Index. The technology sector has a current weight of 23% in the S&P 500 vs. just 8.1% in the MSCI EAFE Index. Similar outperformance of domestic stocks versus international stocks occurred in the 1990s when the technology sector within the S&P 500 produced average annual returns exceeding 30%.
Given the serial underperformance of international stocks over the last decade, valuations are reasonable on both a relative and historical basis (Chart 14). Also, when comparing dividend yields to current bond yields, the relative value gap is significant, particularly for international markets.
Chart 14: developed international equity markets continue to be more attractive from a valuation perspective
Source: Strategas Research Partners, LLC
Given the multitude of headline risks and the subsequent impact on growth, there is always the danger that valuations are cheaper for a reason. The key question becomes what will be the catalyst that drives international equities to close at least some of the valuation gap and potentially reverse a decade of relative underperformance. The Global Manufacturing Purchasing Managers’ Index (PMI) started to trend lower in July of 2018, just as the U.S. first implemented China-specific trade tariffs. Markets are now 18-months into a capital expenditure recession, but there is increasing evidence that we may finally be seeing a bottom. Germany has been hit particularly hard, as it is an export-driven economy, and has been caught in the middle of the China slowdown, the U.S. threatening auto tariffs and Brexit. As such, Germany could be a good leading indicator and a potential signal for a bottom of global economic growth. Although still early, recent data out of Germany, which showed a PMI reading at the highest level in 5 months, has provided hope that a bottoming process may be taking hold (Chart 15).
Chart 15: Europe’s manufacturing slowdown was much more severe versus the U.S.; therefore, a recovery should disproportionately benefit those markets.Source: Strategas Research Partners, LLC
The bottoming of manufacturing PMI data is particularly important in foreign economies that are much more reliant on industrial output (versus service output) than the U.S. Earnings in Europe have a strong positive correlation to PMI momentum (Chart 16). Therefore, a bottoming in PMI’s should be positive for forward earnings growth and could be a potential catalyst for international stocks to close the valuation gap. Current consensus is projecting 7-10% earnings growth for major foreign economies. While we believe these figures may be optimistic, and we are not anticipating a V-shape recovery in earnings, even growth in the low to mid-single digits may be viewed as a positive after several years of essentially flat earnings.
Chart 16: a recovery in PMI data could be a catalyst for better earnings
Sources: IBES; IHS Markit; J.P. Morgan
Currency Impact
While we believe that currency fluctuations net out over time for long-term domestic investors (as evidenced by the fact that the return for the EAFE Index, whether in local currency or the U.S. Dollar (USD) has roughly been the same since 1990), there is no denying that the strength in the USD has played a role in the underperformance of international stocks over the past decade for unhedged U.S. investors. The USD’s strength has been at least partly driven by the disparity in interest rates between the U.S. and major foreign economies. Although the Fed has since reversed course, the disparity in rates was further exacerbated when the Fed began tightening in 2018, whereas most other central banks continued to lower rates to stimulate growth. As seen in Chart 17, rates on the 10-year U.S. Treasury and Euro Benchmark Bond were essentially the same in 2009 at 3.2%. Today, the 10-year U.S. Treasury stands at 1.9% vs. the Euro Benchmark Bond which is in negative territory. Over that 10-year period, the dollar appreciated approximately 30% vs. the Euro.
Chart 17: a widening interest rate gap between the U.S. and Europe has led significant USD appreciation
Sources: FactSet, Inc.; Bryn Mawr Trust
If we see a pick-up in global growth and a subsequent narrowing of the interest rate differential, we believe this would be slightly negative for the USD. Thus, while we believe that currency movements are effectively a zero-sum game over longer time periods, there is reason to believe that the currency headwind that domestic investors faced over the last decade may dissipate.
It is certainly reasonable to question the merits of owning international stocks given the dominating performance of domestic stocks over the last ten years. However, we believe having exposure to international equities makes sense from both a longer-term strategic asset allocation perspective and a shorter-term tactical perspective. Strategically, owning international stocks as a component of a portfolio adds diversification benefits and reduces overall volatility. Tactically, we know that domestic stocks will not always outperform, as evidenced by the fact that international stocks have outperformed in three of the last five decades. There are certainly structural issues that persist, but expectations are low, and any positive shift in sentiment could cause a narrowing of the valuation gap in relation to domestic equities. Also, a rotation out of growth into value, a pickup in global growth, and a reversal of the USD strength would all benefit international stock performance.
Emerging Markets
The Lost Decade
As an asset class, emerging market (EM) stocks have had a terrible 10 years. The iShares MSCI Emerging Markets ETF (EEM) is still trading 20% below its October 2007 high. For over a decade, EM has been dead money and a painful reminder that buying at extended valuations can have long-term ramifications. That said, we believe it is worth taking a longer-term perspective – both looking at history and into the future.
The long-term case for owning emerging market stocks hinges on the relative growth forecasts of many developing economies. The outlook for growth in these regions is expected to outpace developed markets by a wide margin. The International Monetary Fund’s 5-year economic growth forecast indicates that developing economies should outpace their advanced peers by more than 3x.
Admittedly, strong economic growth in a region does not necessarily lead to outperformance in their respective capital markets. The past ten years are a perfect example, as EM equities have dramatically trailed their U.S counterparts. However, persistently higher economic growth should support the case for having exposure to companies that can take advantage of more rapidly growing economies. The growth rate advantage, while relatively modest when viewed in any single year, has a huge cumulative impact on how the global GDP pie is divided. Chart 18 depicts the breakdown in global GDP between EM and developed economies. Since 1995, EM’s share of total global GDP has grown from 17% to 36%, effectively doubling in just twenty-five years.
Chart 18: as EM garners an increasingly larger piece of the GDP pie, equities should benefit
Sources: FactSet, Inc.; Bryn Mawr Trust
Although EM underperformance during the last ten years has frustrated investors, the longer history is worth understanding (Chart 19). During the prior 10-year period ending November of 2009, EM returns eclipsed U.S. returns by a significant margin. Interestingly, during the last 20 years, EM equities have better average annual returns: 7.3% for the MSCI EM Index vs. 6.6% for the Russell 3000 Index. The combination of similar long-term returns and, at times, divergent short-term performance makes an allocation to EM stocks a useful component of a diversified stock portfolio. Owning asset classes that perform well at different times can create a smoother ride for investors over the long-term.
Chart 19: EM performance versus the United States over the last 20 years
Sources: FactSet, Inc.; Bryn Mawr Trust
Looking Ahead
We believe the valuation difference between EM and U.S. stocks makes emerging markets a compelling asset class over the next 10 years. EM almost always has a lower P/E ratio to compensate investors for the added risk, but when that spread becomes extreme, we take note. Chart 20 [5] shows that the current P/E ratio difference is again at one standard deviation above average, with EM being cheaper than the S&P 500. We saw a similar valuation difference in 2003, amid the last long stretch of EM outperformance. Although valuations will never help investors time the exact turning point, valuations are highly correlated to the average annual return an investor can expect over the next decade. With an extremely high correlation of 91% the spread between the S&P 500 and EEM P/E ratios has been a good indicator of relative performance shifts once reaching extended levels.
Chart 20: again reaching extremes, valuations should support better EM performance going forward
Sources: FactSet, Inc.; Bryn Mawr Trust
Positioning
For the reasons outlined above, heading into 2020 we would recommend a neutral weight exposure to EM stocks. In addition to an attractive relative valuation, we believe a stabilization in China’s economic growth will be another support for the asset class. Although the MSCI EM Index is comprised of 24 countries, to a large extent, as goes China, so goes EM equities. With a current index weighting of 35%, China’s performance has a major impact on any broad emerging market investment. Manufacturing accounts for nearly 50% of the Chinese economy, and given the downturn in global manufacturing over the past two years, China’s economy has slowed. Consistent with our view that the global manufacturing sector is now improving, Chart 21 depicts a bottoming in various manufacturing indexes.
Chart 21: early signs of better global manufacturing data should help emerging markets
Sources: FactSet, Inc.; Bryn Mawr Trust
This, along with improving trade relations, should set the stage for better earnings for Chinese equities, and thus, EM investments. As seen in Chart 22, changes in China’s manufacturing activity leads to changes in earnings growth by about 12-months. Should this manufacturing recovery prove sustainable, EM earnings growth improve.
Chart 22: better manufacturing data often leads to better earnings growth 12-months later
Sources: FactSet, Inc.; Bryn Mawr Trust
Under normal circumstances, we might be tempted to overweight emerging markets in 2020. However, EM stocks have moved ahead of the typical growth induced recovery in reaction to the Phase 1 U.S.-China trade deal. Chart 23 depicts the historical relationship between China’s manufacturing index and EM stock performance. EM stocks have already started to move higher, before a clear reacceleration in China’s manufacturing sector. Therefore, some of the equity market performance that might be expected upon economic growth stabilization may have already occurred.
Chart 23: EM stocks are moving ahead of a clear growth recovery in reaction to thawing trade relations
Sources: FactSet, Inc.; Bryn Mawr Trust
Fixed Income
Federal Reserve and Monetary Policy
The Federal Funds target interest rate was lowered three times in 2019 from 2.50% to 1.75%. The rate cuts were often characterized as “insurance” cuts, initiated to further insulate the U.S. economy from signs of internal weakness, slowing global economies, and heightened trade uncertainty. In our view, stubbornly low inflation may have been an even more important driver of the Fed’s policy pivot, as inflation continues to fall short of the Fed’s 2.0% target.
As we enter 2020, we do not believe additional stimulus measures will be needed as the lagged impact of lower rates continues to benefit the U.S. economy. Given the Fed’s stated commitment to hitting their inflation target, we believe an increase in interest rates is also unlikely, even if the economy strengthens. For the next 12 months, our base case is simply that the Fed makes no changes to their current policy. For equity investors, history would suggest fewer cuts going forward is preferable (Chart 24). In the past, after a third rate cut, a series of additional cuts indicated an economic backdrop that was too weak to support earnings growth and higher stock prices.
Chart 24: additional rate cuts may signal economic problems the Fed cannot correct
Source: Strategas Research Partners, LLC
U.S. Treasury Yield Curve
In August of 2019, an inversion[6] of the U.S. Treasury yield curve spooked many investors. This unnatural state typically occurs before recessions, reflecting concern about the health of the economy. The curve has since un-inverted, but investors continue to look for signals of potential economic deterioration/improvement. We believe the curve is likely to steepen modestly in 2020, reflecting a far less negative economic outlook.
The short-end of the yield curve should be well-anchored to the federal funds rate, which we believe will remain low throughout 2020. As the year progresses and inflation expectations rise, we would expect short-term yields to gradually trend higher in anticipation of a shift in Fed monetary policy in 2021. The longer end of the yield curve, however, will be more sensitive to U.S. inflation expectations/economic growth, global growth, and trade developments. We expect more stability in all these areas to promote modestly higher long-term interest rates. The net result, in our view, will be a moderately steeper yield curve.
Negative bond yields around the world have also received a great deal of attention, and the impact on U.S. bond yields should not be overlooked. Simply stated, lower global bond yields have put downward pressures on U.S. Treasury yields. Intuitively, demand for U.S. bonds increases as they become an attractive alternative for global bond investors when compared to German bunds or Japanese government debt, both of which carry negative yields.
Stabilizing economic growth in 2020 should allow global bond yields to rise. The economic slowdown was more pronounced abroad, therefore the recovery should have a greater impact on international interest rates. As global yields rise, the relative attractiveness of U.S. bonds fades, causing U.S. rates to also increase. As seen in Chart 25, the amount of negative yielding debt around the world has already decreased by a significant amount in response to better economic prospects abroad.
Chart 25: Bloomberg Barclays Global Agg Negative Yielding Debt Market Value USD
(12/31/2018 – 12/19/2019)
Source: Bloomberg, Inc.
Credit Spreads
Investment-grade corporate bonds performed very well in 2019. The Bloomberg Barclays Corporate Bond index returned 14.34% through December 20, 2019, while U.S. government bonds of similar maturities returned 6.72%.
In 2020, we are expecting another favorable year for investment-grade corporate bonds, but with much lower return expectations. In our view, interest rates will modestly trend higher in 2020 and any additional credit spread tightening will be somewhat muted given current valuations. Investment-grade credit spreads are yielding about 95 basis points more than U.S. Treasuries as of December 20, 2019, which is well below the 10-year average. Although the current environment is generally supportive of investment-grade corporate bonds, current valuations will certainly act as a headwind for any significant credit spread tightening in 2020. We expect that returns in 2020 will be driven by income as opposed to price appreciation.
We believe demand for corporate debt will remain healthy as investors seek higher yielding investments amid rising, but still record low, interest rates. The underlying credit metrics within investment-grade corporate credit remain favorable but do reflect rising leverage and decreasing coverage ratios. Reassuringly, higher corporate debt levels have been accompanied by increasing corporate profits. Higher levels of free cash flow will continue to support healthy interest coverage ratios. Overall, although credit metrics have been slowly deteriorating, we are not overly concerned that 2020 will represent a turning point in credit markets. As always, we will continue to look for any notable signs of weakening fundamentals that may pose a greater threat to investment-grade corporate debt investments.
Consistent with investment-grade, we think high yield bonds are well positioned to maintain their current lofty valuations given our expectations for low inflation and low interest rates. After double-digit returns in 2019, we see little room for substantial spread tightening in 2020 and expect most of the sector’s return will come from coupon payments.
Credit metrics within high yield remain stable, although we do note some modest deterioration. The sector is still enjoying below-average default rates, and we expect that to continue in 2020 as the consumer remains healthy and the Fed stays accommodative – both supportive of corporate profitability.
Overseas, emerging market debt was another strong performer in 2019. Idiosyncratic risks in areas such as Argentina did not materially spread to other emerging markets – a positive for performance. Based on the J.P. Morgan EMBI Global Bond Index, spreads closed on December 20, 2019 at 280 basis points, below their 10-year average. It will be difficult for spreads to compress much further, although the environment remains supportive for emerging markets in 2020. Our expectations for a modest depreciation of the U.S. dollar combined with low global inflation and easy central banks will provide a stable environment for emerging markets.
Municipal Bonds
In 2020, we believe municipal investor demand will remain robust as investors continue to favor the tax-free interest of municipal bonds in an environment of limited itemized tax deductions. One of the more impactful tax law changes over the past few years was the $10,000 cap placed on state and local, sales and property tax deductions introduced in the 2017 Tax Cuts and Jobs Act. The change left individuals searching for other avenues to lower their tax bill.
Investors with a 32% marginal tax rate or higher will reap the most benefits from tax-free income. When comparing a bond portfolio of short to intermediate AAA tax-free municipal bonds against a portfolio of U.S. Treasury securities, the former will provide an additional 5-20 basis points in yield on a taxable equivalent basis.
Credit quality within the general obligation sector remains mostly stable. In aggregate, state and local issuers continue to benefit from healthy consumer spending and economic growth. Over the long-term, pension concerns will continue to be the biggest credit worry as funding ratios remain pressured. Rising pension and related healthcare expenses will remain a long-term concern for the municipal bond market.
2020 is an election year and municipal investors will be particularly focused on this year’s presidential candidates, but we do not anticipate any immediate change to tax laws given the recent enactment of the 2017 Tax Cuts and Jobs Act. At the sector level, education and health care are probably two of the more sensitive sectors given the presidential candidates’ discussions and focus on initiatives that may impact issuers within these industries.
Positioning
In 2020, we believe that the U.S. Treasury yield curve will steepen with yields on the longer end of the curve increasing while the short-end of the curve is well anchored to the federal funds target rate. We expect the Fed will be on hold in 2020, leaving the target rate unchanged. We expect positive economic growth combined with an inactive Fed to lead to increased inflation pressure relative to current expectations. Continued global economic growth will be supportive of credit and emerging market debt spreads, although lofty valuations will limit any significant tightening from current levels.
Within fixed income portfolios we are maintaining a below-benchmark duration position within the intermediate taxable bond strategies in anticipation of marginally higher rates. However, for shorter duration strategies, a neutral duration position is appropriate as the Fed is unlikely to increase short-term rates in 2020.
We believe weaker credits will be more sensitive to any early signs of weaker economic fundamentals or a reescalation of certain macro concerns like trade. Although we do not anticipate materials problems, in either case, an overweight to investment-grade credit with a focus on higher quality categories is our preference.
With this in mind, we believe investors should still have some modest exposure to non-traditional fixed income sectors such as high yield and bank loans. Given our sanguine view of corporate profitability and economic fundamentals, we can use these asset classes to increase the yield of our portfolios while anchoring our exposure with higher quality investment-grade credit. Some emerging market debt exposure is also appropriate given our outlook for global growth. However, this exposure will be scaled back given current valuations after the strong performance in 2019.
Finally, we believe Treasury Inflation-Protected Securities are positioned to perform well in 2020 given the Fed’s focus of hitting and exceeding its 2.0% inflation target. Current inflation breakeven levels are reflecting expected annual inflation levels closer to 1.80% as of December 20, 2019, leaving room for outperformance if the Fed is successful in managing inflation expectations closer to its objective (Chart 26).
Chart 26: U.S. Breakeven 10-Year
(12/31/2007 – 12/19/2019)
Source: Bloomberg, Inc.
[1] Cornerstone Marco Research
[2] Conference Board Composite Index of Leading Economic Indicators. Economic variables include average weekly hours worked by manufacturing workers, initial unemployment claims, manufacturing new orders, building permits, steepness of the yield curve, among other variables.
[3] The neutral rate is the theoretical federal funds rate at which the stance of Federal Reserve monetary policy is neither accommodative nor restrictive. It is the short-term real interest rate consistent with the economy maintaining full employment with associated price stability.
[4] Bryn Mawr Trust Quarterly Market Insights Fall 2019 (MIND THE PERFORMANCE GAP)
[5] Data limitations constrained Chart 20 to 2003.
[6] When the yield curve inverts, shorter maturity bonds carry higher interest rates than longer maturity bonds. This happens because investors are concerned about economic growth and are anticipating interest rate cuts by the Fed in order to combat that slowdown. Consequently, investors would rather lock in a lower rate at a longer maturity than risk having to reinvest a shorter-term investment at lower and lower rates. This typically happens prior to a recession.
