4th Quarter 2019: Market and Economy

Market & Economy

Markets ended 2019 on a high note, with the S&P 500 rising 9.1% in the fourth quarter. For the full year, the S&P returned a whopping 31.5%. This was the second-best annual return of the decade and pushed the total cumulative return for the S&P for the last ten years to more than 255% (13.6% annualized).

International equities eked out even better returns than the S&P 500 in the fourth quarter. Particularly strong were emerging markets stocks, with the MSCI EM Index up 11.8% on a weakening US dollar. As shown in the table below, international equities have lagged US markets for several years now, so we are waiting to see if the recent outperformance becomes a lasting trend.

Fixed income held onto large returns in the fourth quarter even as the ten-year Treasury yield drifted higher from July’s lows of 1.45% to end the year at 1.92%. The Barclays US Aggregate Bond Index had its best year of the decade on the heels of three rate cuts by the Federal Reserve, with an impressive 8.7% return for 2019. Minutes released from the last meeting show Fed governors are mixed on what to do next, which likely means rate changes are on hold entering 2020.

No impending US recession

The longest economic expansion in US history continued throughout 2019. Most estimates show a 2.3% growth rate for GDP in 2019 and a projected 2.0% in 2020. While a bit uninspiring, those estimates show that most economists think we are still a ways off from the next recession.

The November labor report from the Bureau of Labor and Statistics showed the unemployment rate at 3.5%, a fifty-year low. The same report also indicated that wages have begun rising which may finally be signaling we are at or near “full employment”— meaning nearly everyone who wants a job has one. Hourly wages grew at a rate of 3.1% for the twelve months ending November 30. Meanwhile inflation was 2% for the same period. Fed governors watch wage growth relative to inflation very closely. Further accelerating wage growth could cause the Fed to resume pushing interest rates higher to head off inflation.

Source: U.S. Bureau of Labor Statistics, fred.stlouisfed.org

Trade disputes weigh on manufacturing

While much of the economy is stable and growing, manufacturing has struggled due to ongoing trade disputes that have hurt sales and caused domestic companies to delay new investments in property, plants and equipment. The Institute for Supply Management publishes a monthly report on manufacturing activity called the Purchasing Managers Index (PMI). December’s PMI score was 47.2%. A score below 50% indicates contraction within manufacturing and this reading was the weakest since June 2009. While it only accounts for about 11% of US economic output and about 8.5% of total jobs, manufacturing tends to punch above its weight in the total health of the economy due to its more cyclical nature. Weakness in manufacturing is the primary reason some economists have worried that the US might tip into recession.

In Germany and Japan, where manufacturing accounts for a much larger part of the economy than in the US, each saw its PMI number fall into contractionary areas late in 2019. While neither is in a recession, they are much closer to recession than the US.

We may see a turnaround in manufacturing in 2020 as a result of a “phase one” trade deal reached last month between the US and China that will be signed on January 15. Perhaps more truce than deal, the US agreed to maintain previous tariffs of 25% on $250 billion worth of goods imported from China, to reduce duties to 7.5% on another $120 billion of imports and to put off additional tariffs planned for December. China agreed to increase imports of US goods by over $200 billion over the next two years while also promising to do more to protect foreign intellectual property and not manipulate China’s currency.

While far from a final resolution, the deal removes much of the uncertainty we have dealt with over the past few years. Combine this accord with significant trade deals the US has signed with Japan, South Korea, Canada, and Mexico recently and it is hard not to see opportunities for growth in 2020.

British vote yes for Brexit (again)

The US is also likely to rework trade agreements with the United Kingdom and the European Union now that the path to Brexit is clear. Prime Minister Boris Johnson called for an early December election as a proxy for another referendum on whether or not Brexit should happen. Despite mixed polls before the election, the results were decidedly pro-Brexit as PM Johnson’s Conservative Party won a resounding victory. It is now almost 100% certain that the UK will leave the EU on January 31.

While markets fell on Brexit headlines in the past, global markets rose following this most recent vote, presumably because it offers clarity in what has been a murky situation since the 2016 referendum. There are still questions about how the monumental split will go through but the three-and-a-half-year delay has given lawmakers extra time to prepare.

Stocks outpace fundamentals

While stock prices took off in 2019, earnings remained little changed. Revenue growth has been offset by stagnating profit margins. As a result, valuations (price compared to projected earnings over the next twelve months) are back near the highest levels we have seen since the financial crisis. As the market is forward looking, the high valuations indicate that investors have high expectations for corporate earnings growth in 2020. We will be watching closely to see if earnings improve and justify these high prices.

Source: FactSet, FRB, Robert Shiller, Standard & Poor’s, Thomson Reuters, J.P. Morgan Asset Management. Price to earnings is price divided by consensus analyst estimates of earnings per share for the next 12 months as provided by IBES since January 1995, and FactSet for December 31, 2019. Average P/E and standard deviations are calculated using 25 years of IBES history. Shiller’s P/E uses trailing 10-years of inflation-adjusted earnings as reported by companies. Dividend yield is calculated as the next 12-month consensus dividend divided by most recent price. Price to book ratio is the price divided by book value per share. Price to cash flow is price divided by NTM cash flow. EY minus Baa yield is the forward earnings yield (consensus analyst estimates of EPS over the next 12 months divided by price) minus the Moody’s Baa seasoned corporate bond yield. Std. dev. over-/under-valued is calculated using the average and standard deviation over 25 years for each measure. *P/CF is a 20-year average due to cash flow data availability.

2019 will be a tough act to follow

While 2019 wasn’t a bad year for economic growth or earnings, it was a great year for investors. We may find that 2020 is a so-so year for investors but a much better year for earnings and economic growth as a result of the trade deals and Brexit certainty. Were this scenario to unfold, it would allow earnings to catch up with stock prices which would certainly make us more comfortable with valuations. In summary, compared to 2019, we think it makes sense for investors to lower their expectations for returns in 2020.

There are of course a few clouds of uncertainty on the horizon. One is the question of how events will unfold with Iran. Hopefully this situation will not mark a turning point toward significant hostilities. The other big uncertainty of course is the 2020 election. Will the Democrats nominate a moderate or a more liberal candidate? Will the House or Senate change leadership? While we are not qualified to answer these types of questions, we can say that little is likely to change economically between now and then. Falling stock markets in an election year could dampen an incumbent president’s chances for re-election. Knowing this, President Trump is unlikely to do much to upset trade or any other part of the economy.

Like most years, we think it makes sense to be prepared for a bumpy ride. Please let us know if you would like to discuss your portfolio allocation.