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MR. MICHAEL CEMBALEST:  Good morning and welcome to the 2020 Eye on the Market Outlook.  This is Michael Cembalest.  Hope everybody had a good holiday.  Our 2020 Outlook is entitled "Ghosts of Christmas Past," and if you look at the cover, you'll see some of these ghosts, some of whom have returned from the past based on their connection to certain themes that we're looking at in 2020.  So you'll see FDR, Nixon, Thatcher, Hoover, Mao, the Pets.com sock puppet and some other familiar historical figures on the cover and we're going to walk through what all those connections are to our 2020 view. 

Here's the summary: after a really positive year for investors last year, we expect lower positive returns this year.  We don't expect a global or US recession and we think that there's going to be a modest growth and profits rebound now that some of the worst case trade outcomes look like they're going to be avoided. 

Even so, high valuations in equity markets, the reduced effectiveness of monetary easing, the repricing of unprofitable companies which is a process that's been underway for a few months, and rising corporate cost pressures will probably constrain the equity market advance. 

And what we're monitoring in terms of the two big risks that could cause problems for investors-one would be a spike in inflation that forces the Fed to make a U-turn on policy rates, which we don't think is likely but is in the realm of the possible.  And the second big risk, of course, is a comprehensive progressive restructuring of the US economy after the 2020 election. 

The Outlook itself is composed of an executive summary of a few pages and then ten special topics based on questions that our clients have been asking us.  Here's an overview of some of the things you can expect to see in the Outlook: we look at how the trade war basically knocked back global manufacturing earnings and capital spending from their 2018 peaks to be roughly flat on a year on year basis by the end of 2019. 

So what's interesting about the US-China trade war is actually that Europe and Japan bore the harsher brunt of it, given their larger reliance on exports and their precarious growth trends in the first place.  And while there wasn't a GDP growth recession last year, there certainly was an earnings recession in the US, Europe and Japan, meaning two consecutive quarters of negative growth.  We do expect earnings to rebound in 2020 but that's priced into most equity markets. 

One of the reasons why we're optimistic about a growth and profits rebound next year is a surge in coordinated central bank easing which normally leads to a manufacturing boost seven to nine months later, and that includes emerging markets central banks which are now cutting rates since emerging markets inflation is at an all-time low--about 3.5% to 4%, which is an unrecognizably low number for those of us that worked in emerging markets in the 1980s and 1990s. 

Some of the evidence that there's an impact from all this easing is a rise in global new orders, now that the inventory overhang has been worked off, and a rebound in global semiconductor sales. 

Now, to be clear, even after a US-China phase one deal, there are significant trade and investment barriers that remain.  The US Department of Commerce is working on its entity restriction list and product export rules to limit exports of emerging and foundational technologies, and so while US-China trade flows may normalize, bilateral foreign direct investment will probably not. 

The Chinese are ramping up security regulations on hardware, software and data.  They have a new cryptography law which bans virtual private networks and requires all email and data transfer to be visible to China's cyber security bureau.  The US Senate is investigating the China Thousand Talents plan where it's been accessing US information and intellectual property via Chinese researchers studying in the US and funded by US taxpayers-so there's still a lot to go in the China trade war. 

I think the worst case outcomes have been avoided, but I think we're in for kind of a low level conflict for a period of years.  And remember, Trump may still impose penalties on $110 billion of US auto parts and auto imports from Europe and Japan.  The US is pursuing section 301 investigations against France and probably now Italy for their digital taxes on US technology imports, and there may be European retaliation for US tariffs on European goods as a function of the whole Airbus thing. So the worst case outcomes in the trade war have been avoided, but there are still quite a few conflict issues left. 

The foundation of our optimism for 2020, however, particularly in the US, is based on the strength of the US consumer.  US consumption is close to its highest share of overall global GDP since 2008-in other words, just the output and the activity and the demand coming from US consumers is at its highest level relative to all activity going on in the world since 2008, and US consumers are still pretty optimistic. 

Service sectors that make up a large share of the economy are doing much better than manufacturing, and most measures of wages, labor markets, household debt, consumer delinquencies and housing look pretty good.  That said, it's pretty clear from the data why Trump was trying to find a way out of this trade war. 

US manufacturing employment growth has weakened sharply since the trade war started and now the service sectors that are most exposed to manufacturing are seeing employment growth slow as well.  And when you look at falling trucking employment on a year on year basis now and you're looking at a pretty large spike in foreign loan delinquency rates and bankruptcies, it's pretty clear why the President was trying to find a way out of this trade war. 

From a valuation perspective, valuations are high.  They have been for a while and that certainly didn't prevent great returns in 2019.  The difference was from 2009 to 2018, the market advance in the US was mostly a function of earnings growth, whereas last year, it was almost exclusively or entirely a function of multiple expansion.  So another year of multiple expansion doesn't seem that likely to me-earnings growth will probably have to be the primary driver of whatever market advances we get. 

And we're also starting to see cracks in risky and poorly underwritten investments, whether that has to do with the energy sector, technology IPOs that aren't really technology IPOs-there's been a spike in weakest link companies that have very low ratings. 

And then one of the things that we do in detail in this piece is we take a look at what we call the YUCs, which is-it's an acronym and it stands for Young Unprofitable Companies that have negative net income but rapid sales growth and have been around for less than five years. 

And we go into some detail here showing that since we're at the highest level of these YUCs as a percentage of both market cap and corporate spending since the year 2000.  And if investors tire of financing these YUCs, which I think is part of what's happening is you're seeing in the IPO markets the consequences for growth and large cap tech profits could be material. 

That said, the very slow pace of net US equity supply should mitigate any downside in the next sell off, whether it takes place with or without a US recession.  And as a reminder, we had a 20% sell off in December 2018, followed by the fastest bear market recovery on record over the next 100 days.  So we live in a world where you can always have a sharp drawdown, but in our view, the supply-demand dynamics of the US equity markets right now suggest that any corrections like that would be rapidly recovered rather than the much longer drawdowns that took place in the past. 

And the big risk for 2020-obviously we discussed earlier, one is a pickup in US wage or price inflation that makes it clear that the Fed has made a mistake in cutting rates to zero again. 

And the new thinking from the Fed about policy rates estimates that the natural real rate of interest-in other words, the policy rate in excess of inflation-doesn't have to be 2% to 3% the way that it used to be.  It can be less than 1%, and right now it's almost zero.  So any unexpected resurgence in inflation could cause real problems in terms of indicating that the Fed's off-side.  I think that's less likely. 

The other thing that we're more focused on is a progressive overhaul of the US economy after the election, which we go into detail about in this piece.  But let me just summarize it as follows: in the Great Depression, US unemployment reached 22%, and FDR raised annual federal tax receipts by somewhere between 3.5% to 4% of GDP. 

Elizabeth Warren's proposals, as an example, increases taxes two and a half times the FDR tax increases to fund this progressive restructuring of the economy and I think there could be a variety of unanticipated consequences for investors, particularly given proposed bans and restrictions on stock buybacks, increased corporate tax rates, sector level collective bargaining, and a bunch of other things like that. 

And you know, the history suggests that Trump should be reelected on paper, right?  So a lot of you have seen our chart before--since 1896, no president has lost with strong economic tailwinds, with the exception of Taft, and that was back in 1912.  All of the other incumbent presidents that lost did so at a time where the market and economic scores were below 0.5, and we have a chart in here that shows that. 

And we have these scores that go back to 1896 that incorporate things like inflation and employment and unemployment, changes in employment, per capita GDP, equity markets, home prices, and on paper it looks like Trump should be reelected quite easily.  He's got the strongest tailwinds for an incumbent over the last 120 years. 

Now, the counterpoint to that is that a lot of those tailwinds were in place in the midterm elections and the GOP lost a very large number of seats at a time of strong market economic conditions.  Based on some rough math, I would have expected them to lose somewhere between 8 to 12 seats and they ended up losing 40.  So there are obviously other factors driving the electorate right now other than pure market and economic data. 

So to sum up, we think next year looks like a year of a global recovery in profits and in economic growth.  Valuations are pricing most of that in already, and there are a couple of exogenous risks, one of which is related to an inflation surge in the US which I think is unlikely, and the other one is a progressive restructuring of the economy after the election which is too close to call right now. 

In the remainder of the Outlook, we answer ten questions we've been receiving from clients as we head into 2020.  The questions include things like: Why don't I think there will be a recession in the US next year?  What are the greatest risks to investors in credit markets when the next recession does happen?  Why do US equity markets keep outperforming Europe and Japan year after year after year?  By the way, we expect them to again in 2020. How is China doing at a time of trade conflict, and what are the implications for emerging market investors?  Why is US inflation dead?  What are negative interest rates doing to European banks?  Will value stocks ever stop underperforming growth?  They actually did for a couple of months last year.  What are the greatest risks to markets from a possible progressive overhaul of the economy?  What's going on in US IPO markets?  And a final section on the most interesting breakthrough that I learned about in 2019. 

With respect to the progressive overhaul, we go into quite a bit of detail on the progressive agenda as it relates to taxation, corporate profits, labor markets, healthcare, energy, student debt, trade, as well as energy, technology. 

And then a couple of comments on these new Pillar One proposals in the OECD where they intend to tax digital services where they're consumed rather than where they're created, and so I think those are very important trends to focus on, particularly since the tech sector-which has really been driving the markets in terms of earnings growth and multiple expansion-are the ones that benefit from almost the lowest effective tax rates by sector, and have the highest foreign revenue exposure by sector.  So a change in US or foreign tech policy would have a pretty big impact on the tech sector. 

In any case, take a look--the Outlook is available as of right now on the internet, and you can read the whole thing or you can read individual sections of it, and I look forward to seeing many of you in my travels early in the new year.

FEMALE VOICE:  Michael Cembalest, Eye on the Market, offers a unique perspective on the economy, current events, markets, and investment portfolios, and is a production of JPMorgan Asset and Wealth Management.  Michael Cembalest is the Chairman of Market and Investment Strategy for JPMorgan Asset Management, and is one of our most renowned and provocative speakers. 

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