- The “everything” rally of 2019 makes it difficult to get truly excited about stocks or bonds going into 2020. Yet we don’t think investors should hide under a rock and by focusing on the calendar return one misses the late 2018 sell-off.
- A massive wave of global monetary stimulus over the course of 2019 and the change in the tide of the U.S./China tariff war does provide opportunity for assets in more cyclical sectors that have relatively lower valuations. This would include emerging market stocks and domestic value stocks.
- We don’t want to overcommit. Given the maturity of the cycle, a likely contentious election, and lingering geopolitical risks, we want to keep our eyes wide open in adding cyclical exposure. We will be watching a number of different indicators to help inform and adjust our level of conviction in this cyclical rotation.
Despite further weakening in economic conditions, a ratcheting up in tariffs, and flat or declining earnings, seemingly everything rallied in 2019. But we need to recognize that a portion of those returns achieved in 2019 were simply yardage gained back from the late 2018 sell-off. Wouldn’t it make sense to include the sell-off? For example if we include the fourth quarter of 2018, the total return for the S&P 500 is 14 percent (11 percent annualized) versus 31 percent for calendar 2019. Even better, maybe we should ignore past performance and just focus on relative valuations and the underlying relative growth prospects in making capital allocation decisions.
Admittedly the “everything” rally of 2019 does make it difficult to get truly excited about stocks and bonds; but we are seeing some areas of interest where there is still some valuation support and the potential for earnings surprises on the equity side. Over the course of 2019 there was a tremendous amount of global monetary stimulus. 67 different central banks cut rates. But a lot of this stimulus hasn’t gotten much traction due to the uncertainties created by the escalating tariff war between the US and China. With a phase one trade deal looking likely we think this de-escalation may help unleash some of the monetary stimulus, helping global economic growth and pushing out the threat of recession. This suggests opportunities in assets with greater cyclicality that are currently undervalued. On the equity side this would include value stocks (up and down the market cap) and emerging market stocks.
On the fixed income side it is admittedly more difficult as interest rates are low across the board. Should we get a manufacturing rebound it is likely to put some upward pressure on longer term interest rates, suggesting some near-term downward pressure on the prices of those bonds. If you are holding individual bonds to maturity, that shouldn’t be an issue, but you might want to consider reducing your duration otherwise. With respect to credit risk, namely high yield bonds, a better economic backdrop should be supportive, but it is hard to get excited about this space given historically low yield spreads over Treasuries. There is just less room for error.
For more, please see my 2020 Investment Letter.
Global Monetary StimulusWith respect to growth prospects, throughout 2019 we have seen a massive wave of global monetary stimulus. Sixty-seven different central banks cut rates in 2019, a cumulative 157 times. This was the most stimulus seen since the global financial crisis. The majority of it was put in place to offset trade related weakness seen in the manufacturing sector. In addition to rate cuts, central banks have taken other measures to ease monetary conditions such as cuts to reserve requirements and asset purchases. Beyond monetary policy there have been a number of countries enacting fiscal stimulus measures. The most recent fiscal stimulus announcement came from Japan.
U.S./China “Phase One” Trade Deal on Deck
Yet because of the escalating tariff war, much of this monetary stimulus has lain dormant. We believe the “phase one” trade deal with China is important simply because it indicates a change in the direction of the tide. This trade deal could be the match that ignites the monetary fuel dispatched over the course of 2019. And we are already seeing early signs that the global economy is beginning to regain its footing. Note the stabilization seen in global manufacturing in Exhibit 1.
Even the U.S. Federal Reserve Board (Fed) is changing its tune. The Fed has indicated that it would need to see a significant and persistent rise in inflation above its 2 percent target before responding with monetary action. This is unheard of. As such we see a market friendly Fed that will lower rates if needed but is unlikely to raises rates even if the economy or inflation picks up.
Earnings have not been a market driver. Based on estimates for the fourth quarter of 2019 U.S. large cap stocks (as measured by the S&P 500 index) represents one of the only markets that will even produce positive earnings growth in calendar 2019 (and very little at that). U.S. small and mid-cap stocks as well as international (developed and emerging) are all expected to report negative earnings growth in 2019. While this doesn’t sound positive, it does set a low bar from which to grow in 2020 and creates the potential for upside surprises should global economic growth gain some traction.
Cyclicality + Low Valuation = Opportunity
Relative equity valuations favor Value domestically and emerging markets internationally. Looking at the broad Russell 3000 Growth and Value indexes one can see a growing valuation gap between their forward Price/Earnings multiples. Currently this valuation gap is the widest seen in this cycle. Much of the Value universe tends to be more economically sensitive and would benefit more from a global economic growth upturn. A similar picture can be drawn for emerging markets, where the relative value looks increasingly attractive and they tend to be more economically sensitive. We believe valuations for international developed markets are not as attractive due to our perception of higher geopolitical risks (namely in Europe).
We don’t want to paint too optimistic of a picture. U.S. stocks and bonds in general have high valuations. There are a number of risks to consider at home and abroad. And a global economic upturn is not a fait accompli. As such, we are suggesting a measured approach, taking gains in areas that saw strong outperformance in 2019 and redeploying those gains into areas that saw underperformance; have more attractive valuations; and should get more traction from a cyclical rebound. We will be watching a number of factors that will help us decide whether we want to become bolder with this cyclical rotation or possibly pull away from it. A sampling of the factors we will be monitoring to help guide our decisions include the following.
- The Punchbowl. What central banks give, can easily be taken away. While we don’t anticipate an about face there are a number of central banks (especially those with negative rates) that would dearly love to normalize policy before the next downturn.
- Trade Policy. Many expect President Trump to be less combative with tariffs in this election year, but second guessing Trump has been an unrewarding exercise. The Trump Administration has initiated a trade investigation with Europe, should this escalate into a new front in the tariff war it would take a lot of wind out of the more cyclical sectors.
- Commodities. Confirmation of a rotation towards more cyclical areas should be realized by a firming in industrial commodity prices. We are still very early in this process (see chart below).
- The Dollar. A weakening dollar would be another confirmatory signal of a pickup in global economic activity as capital tends to flow out of the U.S. when global growth strengthens.
- Earnings. Ultimately we need to get some flesh on the bone. If global economic growth rebounds to any extent, earnings must accompany them.
Should our expectation of an upturn in global economic growth occur we would expect some upward pressure on long-term rates. That upward pressure could be compounded if inflation measures begin to increase, as the Fed has indicated that it would not immediately respond to inflation readings above its 2 percent target. By most measures the labor market is very tight with an unemployment rate at 50 year lows. We assume our economy continues to grow in 2020, which would lead to an even tighter labor market. While there can be significant lags, historically a tight labor market has led to higher wages and eventually higher inflation. All of this suggests maintaining a lower-than-average duration.
What about credit? We are somewhat torn here, credit is more economically sensitive and we are envisioning an environment that would seem favorable. Yet, unlike domestic Value and emerging market equities, most of the credit universe is much more highly valued in a historical context. Therefore, there isn’t much cushion if we are wrong or as much upside potential if we are right. We do believe higher yielding, below investment grade bonds should be able to earn their yield assuming recession fears are held in abeyance. And there are pockets within the higher yielding marketplace where valuations have become attractive. For those clients desirous of more income, we recommend a highly flexible and selective approach that can be found with active management.
Can we just do a repeat of 2019? While many see the strong returns of 2019 as a hurdle for 2020, history doesn’t support this notion. Investment decisions based solely on past performance have very poor records. Even high valuations mean little with a one year time horizon. On the other hand monetary policy has historically been a very important market driver. Hence our focus on central banks. Keep an eye on our website, as we will provide updates on the signals we are watching and how we are adjusting our views based on what we are seeing.
The information provided represents Touchstone’s views and observations regarding past and current market conditions and investor behaviors. The information and statements provided herein are believed to be true and accurate. There can be no assurance however that the beliefs expressed herein will be consistent with future market conditions and investor behaviors.
J.P.Morgan Global Manufacturing PMI™ provides the first indication each month of world manufacturing business conditions.
The S&P 500® Index is a group of 500 widely held stocks and is commonly regarded to be representative of the large capitalization stock universe.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets.
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The U.S. Dollar Index (USDX, DXY, DX) is an index (or measure) of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners’ currencies. The Index goes up when the U.S. dollar gains “strength” (value) when compared to other currencies.
The Russell 3000® Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98% of the investable U.S. equity market.
The Russell 3000® Growth Index measures the performance of those Russell 3000 companies with higher price-to-book ratios and higher forecasted growth values.
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Fixed-income securities can lose their value as interest rates rise and are subject to credit risk which is the risk of deterioration in the financial condition of an issuer and/or general economic conditions that can cause the issuer to not make timely payments of principal and interest also causing the securities to decline in value and an investor can lose principal. When interest rates rise, the price of debt securities generally falls. Longer term securities are generally more volatile. Investment grade debt securities may be downgraded by a Nationally Recognized Statistical Rating Organization (NRSRO) to below investment grade status. Non-investment grade debt securities which are considered speculative with respect to the issuers’ ability to make timely payments of interest and principal, may lack liquidity and can have more frequent and larger price changes than other debt securities. Equities are subject to market volatility and loss. Preferred stocks are relegated below bonds for payment should the issuer be liquidated. The fixed dividend may be less attractive in a rising interest rate market. Convertible securities are subject to the risks of both debt securities and equity securities.
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