Equity markets marched higher in Q4 with the backdrop of improving economic conditions, a dovish Fed and reduced trade tensions. As we look back and reflect on what was predicted by many to be a year of worry and concern investors were rewarded for taking risk. The final month of the year brought several new highs for both the S&P 500 and the Dow Jones Industrial Average. For the year, the S&P 500 managed to deliver its best annual performance in seven years.
If someone had told you on January 1st of 2019 that the year would start off with talk of a global economic recession, that might take the U.S. economy down with it, add to that, that the U.S. would be in a trade dispute with China and that the President would face impeachment hearings, you might have wondered how much equity markets would retreat. Some feared that 2019 was going to be a challenging year for stocks with volatility again taking center stage.
Well, 2019 did not deliver a bear market for investors, and for that matter, there wasn’t even a correction. In a year that had no shortage of headwinds, the maximum pullback was less than 7%. The advancement of equities has kept the longest bull market in history intact.
2019 ended on a high note for investors, unlike 2018, where many were questioning the stability and possible end of the current economic expansion. After a year of strong returns for almost all asset classes, analysts are still mostly confident. However, most are anticipating modest gains for 2020.
CENTRAL BANK INFLUENCE
The Federal Reserve cut rates for a 3rd time in October bringing their key interest rate to a range of 1.50% - 1.75% and kept rates steady during the December meeting. Fed Chair, Jerome Powell has expressed this action was intended to help keep the current economic expansion intact at a time where growth and inflation remained tepid as a result of trade negotiations. He along with many other Fed members have made it clear that they are willing to let inflation run well above their 2% target before continuing the course of higher rates.
Toward the end of the quarter, the Fed also intervened in the overnight lending market (or Repo Market) to help stabilize bank credit and ensure that liquidity did not dry up by pumping nearly $500 billion into bond markets. Although the Fed has not openly admitted to reengaging its Quantitative Easing program (QE for short), many critics have deemed this act as a lighter version of QE that will ultimately transform into a larger scale asset purchase program designed to be an additional stimulus to the economy.
The European Central Bank (ECB), Bank of Japan (BOJ) and Bank of England (BOE) kept rates on hold for the quarter, allowing the U.S. to catch up to their loose monetary policy standards. Many of these central banks hinted at further rate cuts and some (as in the case of the BOJ) even entertained the idea of lowering rates into negative territory. This along with the continued bond purchases of these central banks is what has been the primary cause of low and negative global bond yields. The total of global negative yielding debt managed to recede from the record $16 trillion-dollar level toward the end of the quarter as the ECB discussed the ineffectiveness of utilizing negative rates as an effective means of ongoing stimulus.
US AND GLOBAL ECONOMY
The U.S. economy grew at nearly 2% for both the year and quarter despite slowing manufacturing growth and trade tensions which started to diminish in the final months of the year. The resilience of the U.S. economy can be attributed to the strong consumer which continued to experience record low unemployment of just 3.5% and modest annual wage growth of over 3.7%
The U.S. ISM Manufacturing PMI (an index that shows a trend in broad manufacturing activity) declined to the lowest level since 2009 to a level of just 47.2 in December. Readings below 50 indicate a contraction in manufacturing activity while readings above 50 signal manufacturing growth. This was a symptom of businesses being reluctant to invest in inventory or capital-intensive projects during the quarter as they awaited a formal resolution to the almost 2-year long trade dispute with China. Nevertheless, the U.S. services sector (which represents nearly 80% of the U.S. economy) managed to compensate for manufacturing weakness by sustaining an expansionary trend.
Global GDP grew at approximately 2.7% for year as international manufacturing activity seemed to have bottomed during the quarter. Increased factory output from China, France and Brazil helped contribute to this while output from Germany and South Korea continued to disappoint.
TRADE AGREEMENTS ON THE HORIZON
As the quarter came to a close, many of the uncertainties surrounding global trade began to abate. The U.S. and China expressed their intent to solidify a phase-one trade deal which was formally signed on January 15 (the time of this writing). The initial deal reduced tariffs on $120 billion of Chinese products from 15% to 7.5% and set forth an agreement for China to purchase $100 billion of products from the U.S. as well as an additional $200 billion of goods and services over the next 2 years. This event set the stage for the second phase of an agreement later this year, aimed at confronting intellectual property theft, Chinese currency manipulation and further tariff cuts.
This milestone first agreement with China along with the U.S.-Japan trade deal and the passage of the United States-Mexico-Canada Agreement (USMCA) by the House during the quarter, helped strengthen market confidence on the prospects that they would help to rekindle global trade which had been languishing for over a year.
US EQUITY MARKETS
The U.S. market posted its best gain since 2013, beating international equities for both the year and quarter. It is remarkable that the market was able to achieve this in a year where S&P 500 earnings only managed to grow at a pace of just 0.7%. Earnings for the quarter rebounded by 3.2% from the 3rd quarter earnings drop of 1.2% which managed to move the equity market to new highs.
The trend of growth stocks outpacing value stocks continued for the quarter given the backdrop of a slower growth environment. This performance disparity tends to be very typical in that later stages of the business cycle as growth-oriented companies are capable of delivery earnings that have the potential to outpace value companies which have earnings that are more in line with the trend of broad economic growth. Our portfolio positioning has been reflective of this late cycle trend.
Technology and healthcare were the two leading sectors for Q4 while the more defensive sectors of utilities and real estate were the worst performing. This year, technology was the best performing growth sector while energy was the most notable underperformer despite a 35% advance in crude oil prices.
Smaller companies managed to beat larger capitalization stocks for the quarter but still trailed their total returns by a wide margin for the year. We believe that this divergence is primarily caused by rising wage pressure. Larger companies tend to have more resources than smaller organizations to help increase efficiency and thereby controlling both labor and operational costs more effectively. This translates into more stable profit margins and earnings growth and is congruent with regard to our equity positioning in portfolios as well.
INTERNATIONAL EQUITY MARKETS
The improving global economic data and advancing trade talks sparked a rally in international equities for the quarter. Although international developed stocks lagged the U.S. markets slightly, emerging markets were the best performing due to higher factory output and the prospects for a weakening U.S. dollar. Since the broad trend has been a strengthening U.S. dollar over the past decade, it has explained why U.S. equity returns have been dominant. This has been the central reason that we have been consistently overweight U.S. stocks over the past few years. However, with emerging market stocks trading at steep discounts relative to developed markets as well as being the greatest beneficiary to dollar weakness, we remain optimistic on the asset class.
FIXED INCOME MARKETS
The U.S. broad bond market was essentially unchanged for the quarter as yields recovered from their Labor Day lows. During the quarter, investors welcomed the Fed’s easy monetary policy and injections of additional liquidity as a sign of renewed optimism and inflationary expectations. This in turn put pressure on longer-term bond prices which steepened the yield curve. Overall demand for treasury bonds declined during the quarter, pushing the 10-year yield to 1.92%. Concerns regarding an inverted yield curve were also put to rest as increased growth and inflation expectations lifted long-term rates.
International bonds delivered similar returns to U.S. bonds as yields rebounded. Even though global bond yields ended the quarter higher, international government bond yields are still substantially lower than U.S. government yields as a result of the ECB and BOJ’s more aggressive monetary policy stance. This yield disparity as well as the threat that bond markets may be underpricing inflation is why our bond positioning continues to be almost exclusively in U.S. holdings.
The riskier parts of the global bond market managed to fare slightly better than the lower risk sectors. However, investment grade and high yield bonds (the two most credit sensitive sectors of the bond market) ended the quarter at historically high valuation levels. Given that the current economic cycle is well over 10 years old, we do not believe that it is prudent to take unnecessary risks in bonds, the asset class intended to help minimize the volatility of a well diversified portfolio.
MARKET OUTLOOK FOR 2020
Even though U.S. GDP growth is expected to pick up for the first half of the year, we still see a potential for slower growth should optimism fade. U.S. corporate earnings should accelerate to 5.5% which could justify higher valuations. However, we want to caution investors expecting a recurrence of last year’s equity returns. Given the above average returns of last year across almost all asset classes, our range for equity returns is in the mid-single digits for 2020.
With starting yields of bonds still at lower levels than last year and the Fed on hold with interest rate hikes, we believe that most of the return for the year will come from income and not price appreciation. Therefore, we are assigning a low to mid-single digit range for returns here.
Despite the more attractive valuations of international markets, we are still favoring an overweight in U.S. stocks as many of the international developed market economies still face several headwinds. However, we still favor emerging markets to developed markets as we believe that cheaper valuations and the case for a weakening U.S. dollar may be more impactful to their return potential.
We still prefer larger capitalization and growth-oriented stocks to smaller and value focused companies at this stage in the economic cycle. With global growth expected to moderate later in the year, growth companies may be able to outpace peers with accelerated earnings. Also, the threat of higher inflation expectations may continue to strain smaller companies that lack scale and cost efficiencies.
The market seems prone to fewer uncertainties this year now that trade agreements have been or are in the process of being solidified. Aside from day-to-day headlines, we do not expect too much risk from the phase 2 China trade negotiations until after November 2nd when the deliberations are set to start. With investors now focused on 4th quarter earnings reports and guidance, markets may continue to trend higher in the first half if results are in line with expectations. However, we still caution investors against ruling out the potential for increased volatility or a market pull-back as the impending election and potential for Middle Eastern geopolitical risks could contribute to market concerns.
DISCUSS YOUR CONCERNS WITH US
Regardless of market conditions, it is always wise to have realistic time horizons and return expectations for your own personal situation. Having a disciplined investment approach will help you to better navigate the market environment.
Our advice is not one-size-fits-all. We will always consider your feelings about risk and the markets. We'll review your unique financial situation when making recommendations. If you would like to revisit your portfolio allocation or risk tolerance please call our office or discuss this at our next scheduled meeting.