HIGHLIGHTS:
Stocks hit fresh records again in November.
Fed adopts a wait-and-see policy approach after third rate cut.
U.S. consumer leading the global economy.
Signs of global stability emerging.
Corporate profits continue to beat lowered expectations.
Early thoughts on 2020.
Stocks hit fresh records again in November.
Stocks enjoyed another good month of performance in November in what has been a very good year. The S&P 500 gained over 3½% for the month and is up over 27% through the end of November with one month remaining. Market rebounds like the one we have enjoyed this year are common on the heels of a weak period. The strong year-to-date performance is triple the historic average annual gain, but it followed a 5% decline in 2018.
The composition of the healthy market gain reflected improving global economic and policy momentum. Manufacturing surveys in China and the EU showed signs of strength following recent weakness, and central banks signaled their intention to keep interest rates low for the foreseeable future. Not surprisingly, the more pro-cyclical stock market sectors like technology, industrials and financials outperformed the rest of the market, while the more defensive utilities sector declined. Small cap stocks outperformed the S&P 500, while international and emerging market equities lagged.
In fixed income markets, the decision by the Federal Reserve to shift from cutting interest rates to a wait-and-see posture pushed bond yields modestly higher and consequently bond returns slightly lower. Bond returns move in the opposite direction of interest rates; lower rates mean higher returns, while higher rates translate into lower fixed income bond returns. Year-to-date, bonds also generated above-average returns, but with interest rates near historic lows, a repeat of this year’s performance is unlikely.
In other markets, higher interest rates weighed on REITS (Real Estate Investment Trusts), and gold prices fell, while the price of oil and the value of the dollar rose. The healthy dollar has been a headwind for corporate earnings, because it makes our exports more expensive in foreign markets and it reduces the value of profits earned overseas. Fortunately, the pace of the dollar rise has slowed and is up just 1½% from a year ago. We believe the value of the dollar could decline moderately in the coming year if foreign economies improve as we expect. A weaker dollar would be a positive for exports and earnings.
Fed adopts a wait-and-see policy approach after third rate cut.
The Federal Reserve Federal Open Market Committee (FOMC) lowered short term interest rates by another quarter percent in October, but the central bank signaled that they have adopted a wait-and-see approach to additional rate cuts. The October quarter point rate drop was the third this year and nearly reversed the four rate increases in 2018 which helped lift short term rates above long term rates; a phenomenon known as an inverted yield curve. Historically, inverted yield curves have been followed by economic recessions. Fortunately, the Fed’s policy reversal helped restore the interest rates to a more normal structure where long term interest rates are higher than short term rates. Via Nova believes there is a possibility of an additional rate cut in 2020 if the U.S. economy remains at risk from the impact of the U.S./China trade dispute, but we believe we are close to the end of Federal Reserve easing for this cycle.
U.S. consumer leading the global economy.
The U.S. economy has been the global leader in 2019, but it has led on the backs of a healthy U.S. consumer. Steady job growth, a 50-year low in the unemployment rate, and rising incomes have lifted consumer confidence and spending, and there is little evidence that the consumer is overextended. Consumer spending comprises 70% of overall economic activity in this country, and this heft has overshadowed weakness in business investment this year brought on by weaker earnings growth and uncertainty about the direction and duration of trade disruptions. Housing activity showed welcome signs of improvement due to a stronger consumer and lower mortgage rates. Via Nova believes that the housing market may be returning to a new state of normal after being decimated in the Financial Crisis a decade ago. Historically, financial crises typically require a full ten years to repair the damage, and we are optimistic that the worst is over.
Signs of global stability emerging.
The most encouraging news in recent months has been the stabilization and improvement in the economies of Europe and China. This shift comes at a time when international equities are attractively valued. The level of activity remains somewhat soft, but the direction of change has been positive, and it is this apparent shift in momentum that is most important to investors. A stronger EU and China in 2020 could be a major positive catalyst to corporate earnings and the global stock markets. Conversely, it could also prompt EU central bankers to begin moving away from the negative interest rate policy adopted in recent years. That shift would be good for foreign stocks but a significant negative for foreign bonds.
Corporate profits continue to beat lowered expectations.
Earnings at S&P 500 companies were down slightly from a year ago in the third quarter, but analysts are forecasting a over 10% growth by the second half of next year. The strongest profit performances are expected to come from pro-cyclical consumer discretionary, industrials, technology, communications and energy companies, while earnings growth at more defensive consumer staples and utilities companies are expected to lag.
Early thoughts on 2020.
Our most likely scenario is that economic growth will continue here in the U.S. and broaden internationally following an extended period of lackluster performance related to trade and Brexit uncertainty. Indeed, as the year unfolds, we may read about a “synchronized” global reacceleration. That is not to say that we expect clear skies and smooth sailing for the economy and the markets but rather that at least some of the major clouds of uncertainty will begin to clear. We believe this will provide a favorable backdrop for equities generally and especially international equities.
Our mostly positive outlook stems in part from our belief that 1) international economic data is stabilizing, 2) businesses are adjusting to the vagaries of the trade war and Brexit, 3) corporate earnings will increase gradually, 4) central banks will keep interest rates low and 5) the U.S. and China will at least achieve a trade truce. Inflation could inch higher from current low levels, but not enough to move the Federal Reserve from its low interest rate stance. Indeed, we believe the Fed remains biased toward additional rate cuts if economic uncertainty increases again as it did in the first half of this year.
In our most likely scenario, stocks will be lifted by the “rising tide” of a global economic stabilization and reacceleration. The S&P 500 has been the star performer so far in 2019, but international stocks, which have significantly underperformed the S&P 500 for some time have become relatively more attractive and could outperform the S&P 500 along with domestic small cap equities. Interest rates will likely remain low but relatively stable causing bond returns to be lower, more muted than in recent years.
While our baseline outlook is positive, we readily acknowledge the multiple risks already visible in the coming year. First is the potential for the U.S./China trade war to turn negative and more adversarial as it was in most of 2019. Indeed, recent events highlight this risk. However, if the scheduled December tariff increases are cancelled, investors will likely breathe a sigh of relief; but if not, we could look forward to a significant increase in market volatility. Trade uncertainty raises business investment and sales uncertainty which would weigh on revenue and profits. Second, the Federal Reserve could prematurely begin raising interest rates depressing business and consumer loan demand. Another risk is that the current impeachment inquiry gains unexpected momentum in the Republican-controlled Senate. While removal from office is highly unlikely, election years often have their own dynamic. Impeachment would greatly increase the odds of a leftist Democratic victory, which is largely viewed as negative for business generally (higher tax rates) and especially the health care, financial and energy sectors, based on the candidates’ current proposals. Finally, 2020 is a major election year. While the outcome is less than clear, we can expect a barrage of negative comments from both parties which could weigh on consumer sentiment and spending. These are some of the risks that we know, but there are others such as the Middle East and Russia that could flare up as well as something completely unexpected – a so-called “black swan” event.
We are cautiously optimistic about the outlook for next year, but we are far from sanguine.The greatest risks that we see would be largely self-inflicted policy mistakes.If politicians and central banks can avoid major blunders, we believe the equity markets can move higher in 2020.