The economy continued to grow in 2019, bucking recessionary fears and extending the country’s longest economic expansion. While the pace of growth over the past 12 months slowed, asset returns remained positive, with U.S. stocks reaching all-time highs, up a total of 31.5 percent for the year. ¹
Heading into 2020, we believe that even in the face of election uncertainties, the economy has further room to run, with stocks capable of outperforming alternatives, such as bonds and cash. Yet, it is critical that investors view this outlook in the context of their own, unique portfolio strategies, which align with their equally diverse individual financial goals and objectives. Given the length of the economic expansion and where we are in the business cycle, predicting economic conditions going forward will only become more challenging.
Despite somewhat slower growth in 2019, overall economic data looks rather strong heading into the new decade. Following are some of the most relevant issues and factors to consider when gauging where the economy is currently and where it may go in the year ahead.
Central Bank Policies and Inflation
As indicated in the graph below, central banks across the globe adopted more accommodative monetary policies last year, cutting rather than hiking already-low interest rates. Given the degree of rate reductions and the historic relationship with Global Manufacturing PMI (a leading indicator of economic activity), global economic growth can be expected to pick up in the next six-to-nine months.
In the U.S., the Federal Reserve lowered interest rates three times in 2019, marking the first rate-cuts since 2008 and clearly indicating the Fed is trying to extend the current expansion. While rate reductions can help to spur economic growth, they rarely occur when interest rates and unemployment are as low as they are now. With the current federal funds rate at 1.75 percent, and assuming they are bound at the lower end of zero, the Fed has little room to lower rates further should it need to do so. By lowering rates now, the intention is to fend off a recession, extend the expansion, and eventually be able to raise rates to a higher level.
2020 Presidential Election
Uncertainties surrounding the 2020 presidential election may create some short-term market volatility, but we do not expect them to impact the economy in the current year.
From a historic perspective, the better the economy and the stronger the stock market, the more likely an incumbent president will be reelected. Furthermore, as indicated by the chart below, economic data tends to pick up during election years. This is not surprising when considering that a sitting president up for reelection has a vested interest in painting a rosy picture of a strong U.S. economy. For example, it should not come as a surprise that the U.S. recently made progress on a trade deal with China, and we can expect the president to move closer to center as election day approaches.
Source: Wells Fargo ²
Labor Market, Wages, and Consumer Confidence
By some measures, the labor market is the strongest it has been in 50 years. Unemployment is currently at 3.5 percent, businesses continue to hire workers, and wages continue to grow. Even with recent declines in job openings and a slight uptick in initial jobless claims, consumer spending continues to be robust, helping to fuel approximately 70 percent of the U.S. economy. While we recognize that any further weakening of economic indicators may impact already high consumer confidence, we do not expect there to be any material impact on household spending.
The U.S.’s ongoing trade war with China took a positive turn last month when both countries agreed to Phase 1 of a trade deal, the details of which are rather vague. One thing that is sure is that the agreement is not likely to remove all tariffs, which could prove positive for the U.S. economy. For example, minimal and targeted tariffs could keep more jobs and production in the U.S., thereby strengthening an already strong job market and allowing U.S. monetary policy to be more effective. However, any trade agreement with China is a slippery slope that could have negative implications in other segments of the economy.
Looking Beyond 2020
While we expect modest growth to continue in 2020, it is important to remember that economic data points tend to be negative in the year following a presidential election. In addition, because markets are forward-looking, any signs of stalling growth, especially in an election year, will raise recessionary concerns. Given the extended length of the economic expansion, accommodative monetary policy and a polarized political environment, changes must occur elsewhere to propel growth to the next level and continue beyond 2020.
Productivity has been holding steady at a subdued pace, averaging 1.3 percent per year since 2004, as compared to 2.5 percent per year from 1995 through 2004. While empirical studies suggest that these numbers are not understated, they do acknowledge that there is a measurement problem. For example, despite all the benefits consumers receive from the internet and smartphones, there is little to no real boost to economic output.³ Given the rapid pace of innovation since 2004, it is difficult to believe that we are not more productive. If recent advancements in artificial intelligence (AI), blockchain, 3D printing and the Internet of Things (IoT) can better allocate resources and increase productivity, there can be a significant boost to economic growth going forward.
There are almost as many millennials born between 1981 and 1996 as there are baby boomers. However, many members of the younger generation left college during or soon after the financial crisis, often saddled with significant student debt, at a time when the job market was grim. As a result, millennials have been far slower than previous generations to start families, buy homes or make other big-ticket purchases that contribute to consumer spending and fuel economic growth. For growth to continue beyond 2020, millennials must become more confident in the economy and their financial footing by putting their earnings into the economy.
Animal Spirits & Business Investment
British economist John Maynard coined the term “animal spirit” to refer to the tendency for human emotions to drive financial decisions. While we are indeed in the longest expansion in U.S. history, the scars and fears of the financial crisis continue to linger as does the polarity of our political environment. What this has meant is safer more conservative decisions across all specters of the economy, from household spending to capital allocation decisions for businesses. For perspective, despite the economy being relatively strong, CEO confidence has declined, which has a strong correlation with equipment investment.
Source: Capital Economics, ⁴
Considering that equipment investment accounts for roughly 13% of the U.S. economy, this is certainly alarming. However, it is also understandable given the uncertainties created from trade negotiations and wide array of possibilities after the upcoming election. To the extent that growth can stabilize, uncertainty over policy changes from the upcoming election decline, and there is further clarity on trade, CEO’s could have much greater visibility into what future economic conditions may look like, allowing animal spirits to rebound and boost economic growth.
The U.S. has been one of the few consistently bright spots in the global economy over the past decade. However, while the U.S. accounts for roughly 25 percent of the global economy, it represents just 4.4 percent of the global population. As other economies around the world grow and strengthen, even expected to surpass the U.S. by some estimates, U.S. exports would be expected to increase. As the chart below illustrates, U.S. exports have grown by an average of approximately 5 percent per year over the past 20 years, faster than the general economy, and correlating well with the growth of China and India.
Source: Federal Reserve ⁵
Stock prices rose 31.5 percent in 2019, producing the strongest returns since 2013, up almost 500 percent from the March 2009 market lows. ¹ Even with this impressive performance, the market may have further room to run in 2020 based on some historical facts.
For example, recent gains came off an almost 20 percent market decline heading into the year, meaning that stocks ended 2019 just 10 percent above the highs that occurred prior to the pullback in the fourth quarter of 2018. In addition, the S&P 500’s returns of 16 percent per year for the past 11 years remain below the impressive 18 percent average annual returns produced between 1980 and 1998. ⁶
Looking at stock performance during election years, the market yielded positive returns 67 percent of the time since 1964. During these years, the stock market increased an average of 7.9 percent and 4 percent during the 12-months following an election. ⁷ Going back to 1873 and looking only at election years when a sitting president was eligible to run for a second term, the average annual return jumped to 11.9 percent. ⁸ However, in the first year of a president’s second term, the average annual return was -2.4 percent, with annualized 2.3 percent returns for the entire second term, as compared to an average 8.3 percent return for the first term.
Although it is important to look back and learn from the experience of past performance, a better gauge for where equities may be headed in the future requires a closer look at earnings growth, valuations and dividends.
The current dividend yield is close to 2 percent (1.93 percent), with a 25-year average of 2.09 percent. ¹ A consensus of analyst expectations calls for 2020 earnings growth to be at 9.6 percent. ⁹ The forward price per earnings (P/E) on the S&P 500 currently stands at 18.18, roughly 11.8 percent above its 25-year average. Current valuations, while admittedly a bit high, are not surprising given recent economic events and the tendency for them to be higher when interest rates and inflation are relatively low, as they are right now. Assuming the dividend yield remains level, earnings come in as expected, and valuations move down halfway to their long-term average, one would expect a return of 5.7 percent.
2.0% Dividends + 9.6% Earnings Growth – 5.9% Valuation = 5.7% Rate of Return
Putting this into a mathematical equation may be an oversimplified projection, but it allows us to establish a baseline from which we can consider a variety of scenarios.
Assume recent shifts in global monetary policies have a positive impact, animal spirits pick up, corporate earnings meet expectation, growth begins to accelerate and uncertainties over the election abate. Should inflation remain low, the Fed will be able to maintain its accommodative stance. While this is unlikely to occur at this stage of the longest expansion in U.S. history, it is not out of the question, especially given the relative strength of the labor market the accommodative policies of central banks across the globe. In this scenario, we would expect earnings to increase to 14.6 percent, valuations to remain level, and the dividend yield to remain constant, resulting in a return of 16.6 percent.
Assume that a strong labor market, low interest rates and accommodative monetary policy across the globe do not accelerate economic growth, and the economy continues to sputter along just enough to fend off a recession. This coupled with a close and nasty presidential election could create uncertainty and undermine consumer confidence. In this scenario, we would expect earnings to come in at approximately half of the expected rate with valuations declining by 8.9 percent, which is much closer to their long-term average. This would result in returns coming in at -2.1 percent.
Assume the same facts as Scenario 3 except that the U.S. does enter a recession and employers begin to reduce their workforce to minimize the fallout and cut costs. While we believe the chance of this scenario becoming a reality is relatively muted, we recognize it is a possibility. Since 1949, there have been 13 bear markets, 11 of which corresponded with recessions producing declines that averaged 45 percent and from which full recovery lasted approximately 4.5 years.
|Scenario||Expected Return||Probability||Weighted Average Return|
As this exercise illustrates, we maintain an optimistic market outlook and place higher probabilities on those scenarios that yield positive returns. However, the possibility of a recession pushes the weighted average expected return to a modest 2.2 percent.
It is critical that investors view these possible scenarios through the lens of their unique needs and goals. For example, investors who are close to or in retirement should exercise caution at this time, given that portfolios relied upon for cash flow are more sensitive to market declines.
After the U.S. treasury yield curve inverted in 2019, the Fed lowered rates, bringing down short-term yields. Although longer term yields have moved up slightly in recent months, the yield curve remains relatively flat compared to a more traditional upward sloping curve, leaving little additional compensation for accepting greater duration.
Credit spreads, which are the additional yield lower-credit-quality bonds pay above treasuries, are fairly tight, and the overall credit quality of the bond market has declined with roughly 51 percent of investment-grade debt, just one notch above investment grade, the highest it’s been in 20 years. At the same time, it appears that inflation, which has remained relatively tame and below the Fed’s target, is beginning to firm. We do not expect an excessive increase in inflation any time soon, but small increases in current inflation and inflation expectations could have significant impacts on longer-term yields.
Given these factors, we have a bias towards higher-quality and shorter-maturity bonds. While bond returns are likely to be lower going forward, they remain a critical component of a well-diversified portfolio, especially for those investors who currently or will soon need to rely on their portfolios for cash-flow needs. Their price stability and income production can act as a buffer for the more volatile and growth-oriented stock portion of an investment portfolio.
The U.S. continues to enjoy the longest expansion in its history. Based on current data and modest growth expected over the next 12 months, we believe that there is further room for economic expansion in 2020. However, as we embark on what is likely to be a contentious election year in a highly polarized political climate, investors must avoid letting election uncertainty drive their investment decisions. Rather, investors should meet with their financial advisors on a regular basis to review existing goals and strategies and make adjustments, as needed, based on their unique, personal and professional circumstances and needs.
About the Author: Joseph Karl, CFA, is chief investment strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email firstname.lastname@example.org.
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Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors and Accountants. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.
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The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors.
The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary.
Every investor’s situation is unique, and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected.
There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed, and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.