December 20, 2019
Q4 2019 Market Review
Year-End Wrap Up and 2020 Outlook
Performance of the equity market in 2019 was nearly the exact opposite of what occurred the year prior, both almost entirely due to Fed policy. In 2019, we saw policymakers reverse course from 2018, when investors were pricing in a policy mistake. Not only had the Fed raised rates four times in 2018, but over half of global central banks had raised rates, as well. As a result, equity prices declined precipitously into year-end 2018. Perhaps in response to the market sell-off, the Fed quickly reversed course in early 2019, initially with verbal re-posturing and then with three rate cuts in the second half of the year. Additionally, the Fed injected another round of liquidity in the system in order to stabilize the repo market, which many commentators are calling QE4, even if Fed Chairman Powell won’t. As a result, equity prices rose across the board in 2019 with all nine Russell style boxes gaining at least 20% – the most since 2013.
The question now is where are we headed in 2020? In order to answer that, we need to know where we are in the economic cycle. Generally, a good time to take risk is early in an economic cycle when valuations are cheap, monetary policy is accommodative, and the economy has ample spare capacity to grow. Conversely, late cycle is usually a good time to protect capital. When the economy is displaying signs of exuberance or overheating, higher interest rates have usually put an end to the party. Looking at the current economic environment from an assessment standpoint, it is not that clear as has both early and late-cycle characteristics.
For instance, unemployment rates are near record lows in most parts of the developed world, global PMIs have contracted, and the Fed raised rates nine times since 2015 with yield curves briefly inverting in mid-2018, suggesting the economy is very late cycle. However, neither business nor consumer spending looks toppy, and inflation is certainly not suggesting the global economy has reached its limits. In fact, central banks are preoccupied with the idea that inflation remains too low and may be getting stuck. Rather than trying to tame the expansion, the primary focus for central banks is how to get inflation back up. This makes it very hard to say confidently how much time is left on the economic clock.
There are plenty of risks out there that could jeopardize this expansion, now the longest on record. The U.S. China trade conflict still lingers and is unlikely to be fully resolved. Companies have been spooked by this, and are likely to remain reluctant to invest, which will limit the extent to which manufacturing bounces back through the course of 2020. This reluctance appears to be filtering into hiring intentions and a stagnation in overall earnings growth. Another key global problem is that tight labor markets are pushing up wage costs, with little top-line growth as pricing power remains elusive in most industries. As a result, margins are under pressure. Now, if geopolitical tensions linger but don’t re-escalate, we could be facing just a slowing rather than a stalling economy. But that’s a big “if.” We will watch the data and see what transpires.
One thing we do know is that the message to investors from the central banks is clear: should further stimulus be required, it will be delivered. The major central banks seem determined to do whatever it takes to keep the expansion going. Quantitative easing has now been accepted as a “normal” tool and central banks have accepted permanently larger balance sheets. In fact, some are happy to take an increasing share of risk markets. There is also a growing consensus that zero is not the lower bound on interest rates. In theory, this is simply an extension of normal interest rate policy; interest rates are cut to entice savers to spend, but negative interest rates have the added sting in the tail that savers will be penalized if they continue to save and invest in traditionally safe fixed income instruments. Whether negative interest rates serve to boost private sector spending remains to be seen. But this may not be the only channel of transmitting more borrowing. Low interest rates are an enormous cash windfall for governments and could encourage governments to turn on the fiscal taps, potentially providing further economic stimulus and rising asset prices.
It hasn’t paid to fight the Fed. Against a backdrop of muted inflation, interest rates could stay low in 2020, which has been a good environment for risk assets. Therefore, we will continue to stay invested within the parameters of each client’s risk profile until our factor model tips into a “risk off” mode, and then we will adjust accordingly.