ECONOMIC FLASH – After a Banner Year

Dave Baker

Even if US corporate earnings growth rebounds in 2020, a key question is: How much of that growth is already reflected in stock prices given the 2019 surge? A fair amount most likely. High valuations aside, we do not see a catalyst at this time for a substantial market correction.

January 2020

US Economy: Slow, stable growth.

The latest reading of 3Q US economic growth was left unchanged at 2.1% annualized. However, business investment, which has been weak recently, was revised slightly upward, offsetting a drop in the volatile inventories component.

US Stocks: At all-time highs.

US equities rallied in Dec., on the near completion of a partial US-China trade deal and brighter global growth prospects. Results were strongest in tech (+5.2%) and energy (+6.0%) but strong holiday sales provided a late boost to consumer stocks as well.

Foreign Stocks: Year-end surge.

Improved growth and trade prospects boosted foreign equities with added lift from a weakening US dollar, which tacked on roughly 1.7% to returns. Emerging market equities led returns, driven by China and a rebound in Latin America.

Fixed Income: Rates tick higher.

Long-term interest rates continued to drift slightly higher over the last few months, with the 10-Year US Treasury bond reaching 1.9%. Interest rate-based probability models for a US recession in 2020 have fallen to roughly 25% from nearly 50% this past summer.

Real Assets: Commodities lead.

Real assets performed well, with the notable exception of REITs, which were hurt by the rise in interest rates. Commodities rallied broadly with the strongest performance from economically sensitive energy (+6.9%) and trade-war-depressed soft commodities (+6.2%).

Alternatives: Mixed bag for hedge funds.

Hedge fund that were long equities posted the strongest relative performance, as equity returns have been so robust. By contrast, the stock market rally that lifted most ships did not do as much for hedge funds that apply more idiosyncratic strategies relying on security selection.

Equities Total Return

U.S. Large Cap 3.0% 9.1% 31.5%
U.S. Small Cap 2.9% 9.9% 25.5%
U.S. Growth 3.0% 10.7% 35.8%
U.S. Value 2.8% 7.5% 26.2%
Int’l Developed 3.2% 8.2% 22.0%
Emerging Markets 7.5% 11.8% 18.4%

Fixed Income Total Return

U.S. Agg. Bond (0.1%) 0.2% 8.7%
TIPS 0.4% 0.8% 8.4%
U.S. High Yield 2.1% 2.6% 14.4%
Int’l Developed 0.7% (0.4%) 4.6%
Emerging Markets 2.1% 3.6% 8.1%
Intermediate Munis 0.3% 0.9% 5.4%
Munis Broad Mkt 0.3% 0.6% 7.7%

Non-Traditional Assets Total Return

Commodities 5.0% 4.4% 7.7%
REITs 0.6% 0.1% 28.7%
Infrastructure 4.3% 5.1% 27.0%
Hedge Funds
Absolute Return 0.6% 1.6% 4.3%
Overall HF Market 1.3% 2.6% 8.7%
Managed Futures (0.5%) (2.1%) 6.4%

Economic Indicators

DEC-19 SEPT-18 DEC-18
Equity Volatility 13.8 16.2 25.4
Implied Inflation 1.8% 1.5% 1.7%
Gold Spot $/OZ $1517 $1472 $1282
Oil ($/BBL) $66 $61 $54
U.S. Dollar Index 91.5 92.7 92.0

Glossary of Indices

Our Take

There are certainly reasons to be optimistic about both the US and global economies. Within the US, consumer activity remains healthy, the labor market is strong and some geopolitical pressures appear to be moderating, as progress is made on trade and Brexit (once again) appears to be a problem to worry about at a later date. Still, we have a tepid US corporate earnings outlook for 2020, alongside weak business confidence and manufacturing, each of which seems unlikely to improve materially based on what we know so far about the trade deal with China. All this, plus the recent flair in tensions with Iran, suggests being more circumspect about 2020 and the years ahead.

Moreover, the surge in the S&P 500 Index in December capped off one of the strongest years for US equity markets dating back to the heyday of the mid-to-late 1990s. That return, alongside corporate earnings that were nearly flat on a year-over-year basis, presents us with an equity market that is expensive by historical measures.

Even if corporate earnings growth recovers substantially in 2020, a question investors must ask themselves is: How much of that growth has been baked in already? A fair amount most likely. Valuations aside, as we’ve communicated in recent months, we do not see a trigger on the horizon for a substantial market correction, and we don’t feel that the current environment warrants dramatic portfolio changes.

Consequently, as we move into 2020, we are recommending modest portfolio adjustments to highlight the best return opportunities and improve the downside characteristics. We are refocusing our non-US equity exposure to favor emerging markets at the expense of developed markets, which have less upside in our view. We also are adding to our holdings in infrastructure equities, which we believe offer among the best risk-adjusted return opportunities. Lastly, we are increasing our core fixed-income, which offers the best diversification to equity markets and should benefit portfolios if 2020 ends up less rosy than expected.