Macro backdrop: Stability may lay ahead, but improved earnings and modifications to portfolio protection will be needed
A trade war pause, friendly monetary policy, positive earnings and healthy dividends should drive high single-digit equity market gains globally. We expect emerging markets to outperform primarily as a result of world-leading earnings growth.
A return to trade policy normalcy stabilizes the economic outlook
While the U.S.-China trade war may have been intended to improve the U.S. economic outlook, it had the reverse effect—at least in the short term and ignoring broader geopolitical considerations. Many estimate that the U.S. economy would have grown an additional 0.25% to 0.50% had it not been for the tariffs and resulting corporate uncertainty. We mistakenly believed that, like other trade skirmishes started by previous U.S. administrations, the reversal of the trade policy status quo would be mercifully short. After all, in the past, negative financial market reactions caused a reversal of policy. But this time, markets remained strong even as economic statistics weakened. That being said, Phase 1 of a new trade policy was signed on January 15 and Phase 2 discussions are planned to begin shortly. Global economic statistics and U.S. business sentiment are now modestly rebounding, and financial markets have surged (Exhibits 1A–1C).
Now, the U.S. economy has a substantially reduced probability of recession and is likely to grow at trend-line levels or better, depending on whether corporate investment picks up against the backdrop of still solid consumer demand. Outside the United States, the prospects for growth also appear to be improving. While we do not anticipate a strong rebound à la 2017, we expect 2020 to be a better year.
This steady-to-better outlook partially reflects the consistent but cautious stimulus put in place by China after tapping on the policy brakes back in 2018 to stifle excesses in its financial system. China’s very strong stimulus in 2016–17 lifted not only its own growth, but also gave a strong boost to the entire world. This time around, the ripple effects are unlikely to be as strong. However, with most economies being more trade sensitive than the United States, the prospects for stable to improving global growth seem reasonable.
The easing of trade tensions is helping to stabilize the global economy and boosting confidence
Central bank policies contributed to economic stability and may provide a boost in the quarters ahead
Central banks have responded forcefully to the weakness and uncertainty generated by the trade war (Exhibit 2). To induce new lending, they have reduced policy rates, cut reserve requirements and injected liquidity into the system. So far not much new lending has taken place; that is not surprising because the effects of monetary policy typically take six to nine months to work their way through the economy. We expect the positive impact to materialize in the coming months and to be reinforced by the better tone of U.S.-China trade negotiations as well as the ratification of a new trade pact with Canada and Mexico. Additionally, investors believe the Fed and central banks globally are prepared to provide further accommodation should the economic outlook weaken. Future stimulus also may entail more fiscal spending, given that policy rates are already low and liquidity appears ample. In a time of populist politics, high levels of debt and the asymmetry of downside to upside risk, we expect the Fed and other central bankers to continue to be policy-accommodating, inflation-tolerant and guidance-friendly.
Major central banks returned to balance sheet expansion
Financial markets need to see earnings gains, as valuations are mostly stretched
Multiple expansion, not earnings growth, explained almost all of the U.S. equity market’s more than 30% gain in 2019 (Exhibit 3). In fact, S&P 500 earnings are expected to finish the year up only about 2.5%. Two factors may have helped investors in rationalizing these valuation gains: (1) falling interest rates and (2) the possibility that the earnings weaknesses experienced by Apple, Boeing, Exxon, Chevron and Micron Technology—without which the final earnings growth rate tally would have been closer to 5.0%—will prove transitory.¹
While we are mindful that earnings expectations typically deteriorate as the year progresses, consensus appears a little more grounded for 2020 after a disappointing 2019. Expectations are for the emerging markets to lead global earnings growth, rising 15%. The United States, Europe and Japan follow in order with 9%, 8% and 5% EPS growth estimates, respectively.
It is hard to make the case that equity valuations are attractive without viewing them against the fixed income market’s currently low yields. However, we believe that, which makes it our opinion that the economic expansion will continue and corporate earnings will grow 5%–6%. Accommodating central bank policy around the world, plentiful liquidity in the United States and an election cycle, in which equity markets historically have delivered strong gains, should keep the tone of markets positive in 2020, though perhaps more volatile than in 2019.
Equity returns in 2019 were driven by multiple expansion
Portfolio protection may need to be modified in the environment ahead
Despite our expectations that the cycle has longer to run, we are firmly convinced—by tensions in the Middle East, other geopolitical events and U.S. political drama—that portfolios need diversified protection. With U.S. 10-year Treasury rates now at roughly 1.8%, there is plenty of rally potential should a major economic or financial event take place. But a benchmark bond portfolio has less to offer as an effective portfolio diversifier today than it did only a couple of years ago. As many of our long-standing clients are aware, we believe gold and gold miners added to portfolios in late 2018 offer another and potentially more potent protection, especially as the macro environment evolves. Two dynamics should help support gold assets: (1) The Fed and other central banks will, we believe, be accommodating and asymmetric in their use of policy to extend the economic cycle, thus keeping rates—as well as the opportunity cost of holding non-interest bearing assets like gold—from rising meaningfully; and (2) the geopolitical temperature may remain elevated for a while. Although gold is now somewhat crowded with renters, it is satisfying to know that central banks have been net buyers of the metal for the past 10 years, while the U.S. dollar is slowly declining in terms of its allocation across central bank portfolios.2
Long-term portfolio positioning and key tactical adjustments
We derive our strategic positioning primarily from J.P. Morgan’s Long-Term Capital Market Assumptions. Those 10-year-plus return and risk assumptions suggest global equities are the right reference point for maximizing returns for long-term investors. Currently, we are overweight emerging markets, reflecting the relative valuation opportunity and the leverage inherent in these markets to a stabilization (if not acceleration) of global growth. That investment posture was misplaced during the approximately 18 months of the active trade war. The United States having come to an interim agreement with China in December of 2019 catalyzed substantial emerging market equity outperformance that continued in the early days of the new year (Exhibit 4). We expect this outperformance to persist in 2020 to the extent that emerging market earnings outperform those in the United States and other developed markets.
The easing of trade tensions drove a rotation toward emerging markets
Our U.S. equity allocation is being executed through a combination of mostly very low-cost S&P 500 passive vehicles and, to a lesser extent, focused tactical calls. This implementation is complemented with some active managers whose philosophy and positioning we believe are likely to capture the less defensive sectoral tone ahead versus the low economic risk sector positioning that drove an important part of the market performance over the last 18 months. While we would expect some rotation into value in 2020, a longer-term growth bias fits the profile of a slower–growth economy. In a modest growth environment, sectors with above-average, top-line growth and a high level of innovation are more likely to experience earnings growth and consistently higher valuations. Currently, our tactical exposures include health care, financials, technology, oil equity and gold miners.
In fixed income, we expect U.S. rates to drift up modestly. For example, we see U.S. 10-year Treasury yields moving from 2.00% to 2.25% over the course of the year. We are slightly underweight duration through our active managers, but are utilizing benchmark-tracking ETFs and inflation-linked bonds to execute a portion of the allocation.
With an extended economic cycle as the likeliest outlook and one in which the trade war is not eliminated but placed on the back burner, we expect high single–digit total returns in the United States as well as other developed markets, and believe emerging markets will post better but not spectacular returns. We will continue to look to add value through tactical moves, and fully expect at least one roughly 10% correction, consistent with the course of equity market volatility, even in normal times.