Altair Insight: Still Mostly Sunny (4Q19) – Quarterly Market Review
“Neither snow nor rain nor heat nor gloom of night…” can prevent your postal carrier from delivering the mail, the old saying goes. For the past year, markets have overcome all obstacles to write their own version: Neither the U.S.-China trade war nor impeachment nor a recession scare nor the advanced age of the economic expansion can halt their swift ascent.
Stocks and bonds both enjoyed one of their best years of the bull market last year, with the momentum carrying over into early 2020. While we do not expect full-year returns to match those of 2019 – a cloud or two could dampen this rally – our outlook continues to be positive. Occasional volatility is likely and our outlook could change as new economic data are released and as the election approaches, but for now the economy is sound.
Some key risks have diminished, from the trade war to an imminent no-deal Brexit. While geopolitical threats remain, we agree with consensus expectations that there will be an uptick in global economic activity as a result of the U.S.-China pact that will boost GDP and weaken the dollar, supporting international markets in particular. We expect President Trump to try to keep trade battles contained this year as he focuses on reelection. But just as the trade truce proved a game-changer for markets last year, it will be important for increased business spending and earnings to supply the momentum this year.
Finally, but hardly least important, the monetary policies of central banks around the world are as accommodative as they have been in years, even with the Federal Reserve planning no rate cuts. The Fed’s supportive stance continues to be a linchpin of global economic stability in 2020. As U.S. inflation and wage growth both remain lukewarm, Fed officials could still make another rate cut if necessary to support the economy.
With even less evidence than a year ago of a recession on the horizon, we advise that clients remain fully invested according to their asset allocation targets across the higher-, medium- and lower-risk categories.
Speaking of the Federal Reserve, we doff our hats in memoriam to Paul Volcker, the former Fed chair who died in December at age 92. Volcker’s chief accomplishment was reining in runaway inflation in the late 1970s and early ‘80s by raising interest rates to an unprecedented 20%. Inflation remains under control to this day. More broadly, Volcker fortified the Fed’s reputation for financial stability – a legacy upheld by his successors ever since.
Please read on for a more in-depth discussion of our thoughts and positions on top issues for the market.
1. The U.S. and global economies appear to be on increasingly solid footing, but there needs to be a pickup in corporate earnings for this cycle to be extended.
If an investor from the past or future were to drop in on the present via time machine, they would be puzzled by how such lethargic American growth could power a spectacular rally in stocks. With U.S. real growth pegged at just over 2% in 2019, well below the long-term average, only twice since 1980 has the S&P 500 risen 30% or more on less economic fuel. The short explanation is that the market’s performance is a function of today’s extremely low interest rates, which reflect a decade of having been protectively kept just above zero by the Federal Reserve in response to the financial crisis of 2008.
Plodding growth or not, the economy remains sturdy and appears in a good position to expand at a somewhat faster pace now that the United States and China have signed their “phase one” trade deal.
Globally, economic conditions are more sluggish, to use the International Monetary Fund’s characterization, due to ongoing trade uncertainty and a slowdown in investment. However, the IMF’s forecast for a modest rise in world GDP growth – from an estimated 2.9% in 2019 to 3.3% in 2020 – reaffirms our cautiously optimistic outlook for markets in 2020.
Prospects for the U.S. economy have gone mostly sideways since the second half of 2018. The Conference Board’s Leading Economic Index, a snapshot of the economy’s health based on 10 different metrics, showed scant improvement last year. Multiple indicators that we track closely, however, stabilized or turned upward toward year-end.
Consumer spending remains an area of relative strength, buoyed by healthier household finances: Household debt relative to disposable personal income remains at all-time lows, and consumers have been shedding debt steadily since the financial crisis. Rising home sales and prices have shored up the housing market, helped by low borrowing rates. Jobless claims remain low and the unemployment rate of 3.5% is the lowest since 1969. Wages grew by 2.9% last year – mediocre by historical standards but not enough to cause concern. Inflation continues to hover just below the Fed’s 2% target.
Just as importantly, the yield curve inversion that roiled markets briefly last summer as a potential indicator of a coming recession has disappeared. The yields of longer-term bonds again are comfortably higher than short-term yields, as is the norm, with pessimism about the economy having faded. We view a recession in the next 12 months as unlikely.
That being said, manufacturing, business spending and company earnings are all key indicators that would flag a weakening economy if they fail to improve in coming months.
Trade war concerns and costs have taken a toll on global manufacturing over the past two years. German manufacturing has been locked in a protracted slump and the U.S. factory sector also has slowed since 2018, with trade tensions buffeting the industry. A global bottom may have been reached, however, with the U.S.-China trade détente boosting activity levels since September. Business surveys also offer hope of improvement, suggesting that companies may now increase their capital expenditures.
Corporate profits have been declining for the past year, due in part to the tax cuts that enhanced 2018 earnings and made for challenging year-over-year comparisons. The October-through-December period is thought as of this writing to have been mostly flat. Analysts generally expect earnings to rebound starting in the first quarter, but not accelerating substantially before the second half.
We are not overly concerned about above-average stock valuations, which we see as priced fairly given the continued low interest rate and inflation environment. But any appreciation in prices in 2020 will likely have to come from an improvement in corporate profits and business spending.
2. While the U.S.-China trade pact leaves much unresolved, trade should be less of a hindrance for markets this year.
Going into 2019, the worsening trade conflict between the United States and China was one of our chief concerns, along with the rate-tightening cycle of a more hawkish Fed. A year later, the outlook has improved considerably with both trends having reversed course.
The phase one deal signed by the two sides on January 15th is more of a cease-fire than a conclusive accord. It should nonetheless stanch the bleeding from the nearly two-year battle between the two sides that caused world trade growth to be negative in 2019 for the first time in a decade.
What remains unresolved appears to us more significant than what was included in the deal. The U.S. called off its planned tariff hikes and halved tariffs added last fall on $120 billion of Chinese imports; China in turn pledged to buy $200 billion more in American goods and services over two years and to adhere to new requirements targeting intellectual property theft.
But stiff tariffs remain in place on about two-thirds of Chinese goods and a reciprocal amount of U.S. imports. Key structural issues such as cyber-espionage and China’s controversial state subsidies, industrial policies and state-owned enterprises went unaddressed. A phase two deal to settle these issues appears unlikely any time soon.
Direct damage to the world’s two largest economies has not been as great as was feared. U.S. prices have been largely unaffected, enabling consumer spending to continue at a brisk pace. China’s economy has continued to slow (while remaining at a healthy 6% rate). But investment has rebounded, some industries have recovered and the country’s stock market, while lagging the U.S. market, has flourished since mid-2019. Still, tariffs have chipped away at growth by crimping exports and trade and limiting business spending and manufacturing activity. Loath to pass tariff hikes along to consumers, companies have been taking the hit themselves, stunting their profits.
The biggest benefit of the deal is to lift uncertainty for businesses and remove the downside risk for markets of a worsening trade battle and higher tariffs.
A truce with China is no guarantee that global trade conflict falls off our list of concerns in 2020. The White House has drawn up potential tariffs on another major trading partner, the European Union, if the two sides cannot agree on a significant trade pact.
However, we expect President Trump to avoid stirring up major trade hostilities that could hinder his chances in the November election. We have seen additional evidence of that with the approval of a new North American trade deal with Mexico and Canada. The China deal and the easing for now of global trade tensions should increase trade and business spending to help boost global economic activity.
3. Even with interest rates on hold, the policies of the Fed and other central banks remain supportive of the economy and markets.
The Federal Reserve is prepared to sit out a full year for the first time since 2014 without adjusting the federal funds target rate. Its timeout, however, signals anything but a neutral or hands-off approach.
The Fed’s continuing large cash infusions into the banking system, combined with a tailwind from last year’s rate cuts and ongoing easing abroad, give us confidence that central bankers still have investors’ backs even without a U.S. rate cut this year. However, the Fed could still cut rates if conditions deteriorate, since there is little likelihood of overstimulating the economy with inflation and wage growth contained.
Politics-conscious or not, the Fed rarely introduces new policies or rate cycles during presidential election years; the last time was in 1988. We do not anticipate a significant Fed move before the election this year, either. However, we do think policymakers would be willing to make an additional, “insurance” cut should economic conditions deteriorate. That factors into our belief that central banks will continue to provide at least a partial safety net for markets.
The annual rotation of the Fed’s rate-setting Federal Open Market Committee appears to have made the FOMC even less inclined to consider a rate increase under current economic conditions. The four regional Fed bank presidents who assumed voting roles this year are considered slightly less hawkish than the four they replaced.
A closer look at the three areas where we expect the economy to benefit from central bank actions:
- Balance-sheet bounceback. The Fed’s big monetary tool besides the federal funds rate is its balance sheet. The Fed is expanding its balance sheet again after it declined from a peak of $4.5 trillion to $3.8 trillion as part of efforts to sell off the huge holdings it bought to keep the economy afloat during the financial crisis. Since the end of August, it has ballooned back above $4.1 trillion on cash injections aimed at alleviating liquidity shortages in the short-term “repo” (overnight repurchase) lending markets. That is the fastest rise since 2014, an annualized pace above 30%. While this adds to questions about the long-term consequences of the Fed carrying so much debt on its balance sheet, it is a near-term boon for markets.
- Carryover effect from rate cuts. The U.S. economy should continue to benefit from the rate reductions in the second half of 2019, even with a pause declared in December. The three longest economic expansions before this one – 1961-69, 1982-90 and 1991-2001 – all were extended when the Fed, as it did last year, rolled back earlier rate increases with a series of cuts. We anticipate a similarly positive impact this time.
The current scenario of a pause following three reductions also has proven historically good for stocks. Most recently, when the Alan Greenspan-led Fed twice followed the three-cuts-and-out path to stem an economic downturn and sustain an expansion, the economy accelerated and the S&P 500 rose more than 20% in each following year (1997 and 1999). In instances when the third cut was followed by more cuts because the economy continued to struggle, however, stocks fell.
- Global central banks’ accommodativeness. More than four-fifths of the world’s central banks reduced their policy rates in 2019 and expectations are they will mostly maintain a dovish stance this year, a plus for corporate earnings and global growth. Additionally, China injected $115 billion into its economy to start the year and the eurozone also is expected to provide some financial stimulus.
William McChesney Martin, chairman of the Federal Reserve from 1951-70, famously likened the Fed’s role to that of “the chaperone who has ordered the punch bowl removed just when the party was really warming up.” Today’s central banks are not likely to remove the punch bowl – raising rates or otherwise tightening policy – any time soon, however. Given muted growth, tepid inflation that remains around 2% and an absence of investor exuberance, this party is not yet overheating.
4. Geopolitical uncertainty is heightened, though the near-term global outlook appears clear.
Global shocks and geopolitical crises do not typically announce themselves in advance – they catch the world, and markets, by surprise. This reality was underscored in early January when Iran and the United States moved swiftly to the brink of war after having long been locked in a hostile but controlled political standoff. Only days earlier, the respected Eurasia Group geopolitical consultants had ranked the Middle East just #8 on its list of the top 10 risks for 2020.
We have lived with growing levels of geopolitical risk for nearly a decade but without a true international crisis, as the consultancy noted. Markets have ultimately absorbed all geopolitical scares with resilience, as they did during the brief U.S.-Iran showdown. Nevertheless, geopolitical uncertainty has risen of late and we consider it one of the bigger risks for investors this year now that global recession chances have faded in the near term.
Geopolitical fissures in China, India, the European Union, Latin America and Turkey were among the other international risks cited by Eurasia Group. To those we must add a potential U.S. trade fight with Europe, North Korea’s mercurial behavior, the rising threat of a deadly disease like the coronavirus spreading as a result of the ease of global travel, and the continuing risk of a hard Brexit if Britain and the EU fail to negotiate a comprehensive trade agreement by year’s end.
To be sure, none of these clearly present imminent threats to markets. But the proliferation of such risks testifies to an increasingly unpredictable global environment.
Kristalina Georgieva, the new head of the International Monetary Fund, raised a cautionary flag on the abundance of geopolitical and related issues even while unveiling the IMF’s January forecast calling for a rebound in the global economy. “If I had to identify a theme at the outset of the new decade, it would be increasing uncertainty,” Georgieva said. “We are all adjusting to live with the new normal of higher uncertainty.”
As discussed in detail above, we maintain a constructive outlook despite these risks and uncertainty for a combination of reasons that point to a stable and improving global economy in 2020. Central banks continue to underpin the economy with their easy monetary policies. The U.S.-China trade détente, assuming it holds, should reinvigorate international commerce and stimulate economies. A corresponding pickup in world GDP would boost the confidence of companies and investors alike.
Geopolitical risks are hard to predict and quantify. But they are one reason we believe in diversifying portfolios to reduce the impact of an unexpected market downturn.
5. Increased volatility during a presidential election year is normal, but history shows returns overall have been consistently positive.
Just as in 2016, jitters already have surfaced on Wall Street about the potential for market turmoil stemming from this year’s presidential election, particularly if a candidate advocating drastic change is elected. The dire predictions for stocks did not come true last time – they rarely do.
We analyzed the performance of the S&P 500 during presidential election years dating back nearly a century and found returns to be generally strong regardless whether a Republican, Democrat, incumbent or newcomer ended up winning.
- Total return has been positive in 19 of 23 presidential election years since 1928. The four exceptions were 1932 (-8.2%), 1940 (-9.8%), 2000 (-9.1%) and 2008 (-37%), when an election year coincided with the global financial crisis.
- Returns have been positive more often in election years (83%) than non-election years (52 of 71 times, or 73%).
- The average annual return has been only slightly lower in election years (11.2% overall and 9.9% in the postwar era) than non-election years (12.4% overall and 12.6% since World War II).
- Stocks generally fare better when the president is reelected – markets hate uncertainty. In the 10 election years that culminated in reelection, the market was up all but once (1940) and averaged 13.1% gains. In years a new president was elected, the market was still positive 10 of 13 times (not 1932, 2000 or 2008), returning an average of 9.9%.
What about the year after an incumbent is defeated, when the newcomer takes office and can start to implement big changes? The sample size is small, with just four instances in the past century, but only one year produced a loss (-7.2% in 1977) and the average return was 15.4%.
The economy and related developments matter more than the election outcome, as evidenced by the fact that the only three exceptions coincided with the economic shocks of the Great Depression, the dot-com collapse and the Great Recession. The president’s party is generally not a determining factor in stocks’ variations over the years.
Over the longer term, too, presidential elections generally have not meaningfully affected returns. On average since 1928, the S&P 500 has returned an annualized 10.3% over the four years starting in an election year, virtually identical to the average four-year return.
In short, abundant historical evidence suggests it is unwise to try to do speculative market positioning at this point in the election cycle, or even to take the early polls or leaders too seriously. Stocks could lurch in either direction between now and Election Day.
Global economic growth should accelerate this year, bolstered by central banks’ accommodative monetary policies. The U.S. economy is healthy and unlikely to fall into recession despite growing at only a leisurely pace by historical standards.
We anticipate additional gains for U.S. stocks in 2020 from modest earnings growth. We also recommend our clients maintain their full target allocations to non-U.S. stocks, which should benefit from reduced trade tensions, an improving global economy and a weaker dollar.
A comprehensive U.S.-China trade deal remains elusive even after the initial accord, leaving trade uncertainty an ongoing issue for businesses and global markets. An expected pickup in capital spending would be jeopardized by any new tariff frictions with China or Europe, but we expect the Trump administration to minimize conflicts during its reelection campaign.
Geopolitical uncertainty remains one of the biggest risks for markets even after the United States and Iran backed away from open conflict in January. But near-term risks appear to have subsided, with a hard Brexit still possible but only at the end of the year.
Bonds face challenges in duplicating strong 2019 returns but should remain stable with the lessened threat of a recession and tepid prospects for inflation and wage growth. We expect yields to remain range-bound for the near to medium term even with a pickup in economic growth.
Quotes of the Quarter
“After a synchronized slowdown in 2019, we expect a moderate pickup in global growth this year and next.” – Kristalina Georgieva, International Monetary Fund managing director
“I think we would need to see a really significant move up in inflation that’s persistent before we would even consider raising rates to address inflation concerns.” – Jerome Powell, Federal Reserve chair
“Who would have thought that after suffering through a near 60% decline in the S&P 500 through early March 2009, the worst bear market since the Great Depression, the bull would still be alive and kicking 10 years later?” – Sam Stovall, CFRA Research chief investment strategist
The stock market ended 2019 the way it started – with a bang.
Just a year after a December collapse ruined what had been a good 2018 performance, investors shrugged off any concerns and powered the benchmark to a 9.0% fourth-quarter gain, a bookend to the 13.7% first-quarter advance that began the year. That left the market with a 31.4% annual return for the iShares S&P 500 ETF, the most in six years, boosted by the late-year truce in the U.S.-China trade war, a brighter global economic outlook and unflagging consumer spending.
Tech stocks led the way as they did for much of the decade. The information technology sector surged 50.3% for the year with dividends, including 14.3% in the fourth quarter, ignited by full-year price rises of 86% for Apple and 55% for Microsoft. Financials were the second-best performing S&P 500 sector, up 31.9% for the year, and every other sector rose 20% except for energy, up 11.8%.
Small-cap stocks, which gave ground in the third quarter before summer recession worries faded, outgained large caps for the final three months (+9.9%) as investors’ risk appetite returned. The iShares Russell 2000 Index ETF returned 25.4% for the year, its best performance since 2013.
Growth stocks maintained their dominance over value stocks, although both categories were high flyers in the fourth quarter and throughout 2019. The iShares Russell 1000 Growth ETF was up 10.5% for the quarter and 35.9% for the year, compared with 7.3% and 26.1%, respectively, for the iShares Russell 1000 Value ETF. The growth edge was similar at the small-, mid- and micro- cap levels.
International stocks logged their second-best year of the decade, thanks in large part to late-year progress toward a U.S.-China trade deal. While they continued to deliver less than their U.S. peers, their 2019 total return of 21.0% as proxied by the iShares MSCI All-Country World ex-US ETF – 8.4% in the fourth quarter – trailed only 2017 (27.2%) in the 2010s.
Foreign stocks’ performance has been hampered in recent years by the strong dollar, eroding returns when converting back to U.S. currency. That impact was minimal in 2019, and even tilted to non-U.S. stocks’ advantage in the fourth quarter as the dollar weakened with an easing of trade tensions and corresponding optimism about the global economy. The greenback declined 3% against a basket of other major currencies in the fourth quarter.
Developed-world stocks as measured by the iShares MSCI EAFE ETF rose 7.7% in the final quarter, or 5.2% when measured in local currencies, and 22.0% for the year, or 22.3% without the impact of currency translation. European stocks as a whole had their best year since 2009, 23.2% (price only) for the Stoxx Europe 600, paced by Germany’s DAX (25.5%). Japan’s Nikkei 225 climbed 18.2%. The United Kingdom’s FTSE 100 advanced 12.1%.
Emerging-markets stocks trailed the field for the year with an 18.1% return for the iShares MSCI Emerging Markets ETF but outperformed all other major asset classes with a 12.1% surge in the final quarter. Chinese stocks bounced back from a challenging third quarter; the Shanghai Composite finished up 22.3% for 2019 and the smaller Shenzhen composite rose 35.9% while the Hang Seng Index lagged at 9.1% in a reflection of Hong Kong’s months-long protests. Markets in Brazil (+32%) and Russia (+29%) also were big 2019 winners; Chile (-11.3%) was the only notable decliner.
U.S. real estate investment trusts finished 2019 with their second-best performance of the decade even after investors signaled a bigger preference for stocks than the yield-oriented REIT sector in the fourth quarter. Recovering from their first calendar-year loss of the bull market in 2018, REITs as gauged by the Vanguard REIT Index Fund edged up 0.6% from October through December to close the year with a 28.9% return, highest since 2014 (30.3%).
The late-year stall, including a net decline for the final two months, coincided with the Fed’s decision to sit tight on interest rates and enabled large-cap stocks to surpass REITs as the top-performing major asset class of 2019.
International REITs as benchmarked by the Vanguard Global ex-U.S. Real Estate ETF finished more strongly with a 6.9% fourth-quarter gain for a 21.3% yearly return.
Diversified Real Assets
Investments in real assets, including securities of natural resource companies, commodities, master limited partnerships, global real estate and inflation-indexed bonds, posted a solid quarter and year. Altair’s benchmark for diversified real assets jumped 3.0% in December to finish up 3.9% for the fourth quarter and 14.9% for the year.
Timber companies posted a strong finish to 2019 as prices rose on a buoyant housing market and expectations for increased demand. Similarly, miners of precious and industrial metals salvaged a flat 2019 with a 15.4% rally in the fourth quarter to finish up 14.4% as trade war and global slowdown concerns eased.
Commodities also were boosted by the trade truce, which brightened views of global growth in 2020. Palladium was the top performer with a 52% advance amid a global supply shortfall, U.S. crude oil surged 34% in its largest annual gain since 2016 and gold was up 18% in its best year since 2010.
Master Limited Partnerships (MLPs) gave up most of their gains at year-end amid a lack of investor enthusiasm, falling 4.6% in the fourth quarter to finish the year up 6%.
Treasury Inflation-Protected Securities, or TIPS, advanced 8.3% for the year as falling rates boosted returns.
Hedge funds had their best year of the decade, delivering unspectacular but solid gains – double-digit percentages in some stocks-related categories. They continued to lag stocks, however, as they have throughout the bull market, and also trailed taxable bonds in 2019.
The HFRX Global Index, a benchmark representing the entire hedge fund universe, rose 2.6% in the fourth quarter to finish with an 8.6% gain for the year. That was its best full-year return since 2009 and also the best return per unit of risk among major asset classes. The HFRX Equity Hedge Index, which tracks both long and short strategies related to stocks, was up 2.6% and 10.7%, respectively.
Bonds delivered more muted returns in the final three months of the year as the Federal Reserve halted its string of three interest-rate cuts between July and October. But a small quarterly gain was enough to ensure the best year of the decade for taxable bonds, with municipal bonds also positive but further back.
The Vanguard Total Bond Market Index ETF, measuring the performance of investment-grade U.S. bonds, inched up 0.2% in the fourth quarter for an 8.8% return in 2019. Driving the strong yearly performance was the Fed’s accommodative monetary policy, which pushed the 10-year U.S. Treasury yield below 2% for the first time in three years. Bond prices rise as yields fall. All told, the 10-year yield fell three-quarters of a percentage point for the year to end at 1.9%.
Trade tensions and recession fears for much of the year also spurred investors’ interest in bonds. A yield curve inversion in August – when two-year bonds carried higher yields than 10-year bonds for two weeks –reflected widespread investor pessimism about the economy. By year-end, the curve was normalized again as new economic data reduced concerns about a recession.
Tax-exempt municipal bonds benefited from investor demand and a lack of issuance from cities and states before slowing in the year’s second half as expectations of continued low rates lessened investors’ interest in paying handsomely for munis. A blend of the Market Vectors’ short and intermediate ETFs that serves as Altair’s investable benchmark for the muni market returned 0.8% for the fourth quarter and 5.8% for the year.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.