January 2, 2020
How quickly this annual exercise of appraising the past year and conjuring a forecast of what lies ahead has revisited us. Assessments of the future are a devilishly tricky affair. The problem with forecasts is in their construction. Most consider the future in the singular when it should be thought of in the plural. Many futures are possible as actions taken or not impact the course of events. This is especially the case for 2020, given last year’s strong market performance against the backdrop of a growing, but slowing economy, low interest rates, and geopolitical uncertainties. Below we examine the events of a remarkable 2019 and pose the larger questions with which global investors will likely have to contend in 2020 and beyond. Sometimes knowing the right questions is as important as knowing the answers. That time is now.
The year that was
As 2019 quickly slips into history, it will be noted for how well markets performed. Among the major markets, the United States was the standout. In local currency terms, Europe also turned in strong returns (Exhibit A). More broadly emerging markets were lapped by their developed market brethren, despite the evergreen narrative of stronger growth and more attractive demographics.
Fixed income of nearly every variety showed well, producing returns that few expected at the beginning of 2019 (Exhibit B). Longer-duration fixed income did particularly well as interest rates fell during the year. The performance of commodities was a mixed bag: crude oil posted solid gains, while base metals generally fell. Precious metals enjoyed double digit gains.
To the uninitiated, the impressive rise in asset prices this year would suggest robust profits astride a galloping economy set against the backdrop of Parrishian tranquility.1 Yet all of the above occurred largely unaided by any of this: profit growth for large cap U.S. stocks were expected to be essentially flat; global economic growth in both the developed and developing world slowed; and the social/commercial landscape was anything but idyllic as the trade war raged. The old world order that served many so well for so long looked increasingly frayed and geopolitical ructions flared from Eastern Europe to Eastern Asia.
The United States stood out both in capital market returns and economic growth during the year. While real GDP growth slowed from the prior year, it is nevertheless expected to have risen by 2.4% in 2019, according to the IMF. In addition, employment continued to grow pushing the unemployment rate to 50-year lows, while inflation remained effectively dormant. With roughly 82% of U.S. GDP driven by consumption, the mood of consumers is key to understanding the health of the economy. Measures of consumer confidence tend to show a weakening of confidence; thankfully, this dip is from cyclically high levels (Exhibit C).
In a worrisome development, a large disconnect between commercial leaders and consumers has formed, as CEO confidence has plummeted to levels associated with economic distress while consumers, by comparison, appear to be whistling past the graveyard. What does one group see that the other does not? The picture that consumers see is likely fairly bright, as employment remains robust, jobs are plentiful, and labor is starting to see real (inflation-adjusted) wage gains. For most of the country, real estate prices are rising, as are stock portfolios, so net worth for the population is rising.
From the vantage point of Main Street, all is well. Leaders of large companies, however, appear to be a nervous lot. Perhaps it is because their tenure at the helm continues to shorten as investors demand ‘heads to roll’ when management disappoints.2 More likely they see the chaos that the trade war is wreaking on the commercial landscape. After decades of integrating supply lines for just-in-time manufacturing and sourcing production facilities in low cost countries, traditional practices are being torn apart as the trade conflict grinds along. This privileged but endangered class can be forgiven for not committing the capital under their care to projects that create new businesses and increase productivity—things which are required to help the economy grow at a healthy pace—when the terms of trade turn on a tweet. Intelligent capital investment takes time: time to plan, execute, and evaluate. The twists and turns of trade policy via tweet are a challenge to thoughtful capital deployment.
Markets have endured bouts of optimism and pessimism with metronomic regularity as hopes of resolution were proven to be premature. While a Phase One agreement appears set to be executed, its durability as well as agreement on a larger comprehensive accord remains to be seen. If history serves as a guide in these matters, subscribing to an agreement is easier than living by its obligations. Investors will have to remain vigilant from being too optimistic about a quick and clean resolution on trade.
The Federal Reserve policy pivot to cutting interest rates was instrumental in helping investors look beyond the lack of earnings growth, a slowing economy, and the trade war, and push equity prices to all-time highs. The last interest rate hike during the long recovery from the Great Financial Crisis transpired in late December 2018. That hike happened against the backdrop of an eye-watering sell off in risk assets, which set the stage for the central bank to call time on policy normalization. We thought at the time that a December 2018 rate hike should be the last, as real rates of interest finally emerged. The softening of language about future hikes and the market expectation of a policy reversal led the central bank to cut interest rates during the summer. More importantly it once again started to expand the size of its balance sheet, which brought an end to quantitative tightening. With the price of money getting cut and the printing presses humming, asset prices continued a steady march higher. Indeed, the S&P 500 registered 33 new highs during the year and ten-year treasury yields pressed near the lows of this cycle.
This policy reversal was sufficient to overcome the agita that an inverted yield curve induced. Indeed, the impending threat of recession such a curve portends appears to have quietly receded. From our perch, this threat has receded but not disappeared.
Into the fog of the future
Investors will start the new decade with an aging but growing U.S. economy; one that tops the league table for the longest expansion. Corporate profits as measured by the S&P 500 Index are expected to rise 9.6% on revenue growth of 5.4% in 2020.3 These forecasts will likely fall over the course of the year as the trade conflict drags on and the perennial optimism of Wall Street runs into the reality of the state of play. In addition, a presidential election in the United States is a global event given our place in the economic and geopolitical world order. Consequently, the uncertainty of the process will be a cause for pause, which feeds back into softness of both CEO and consumer confidence.
One catalyst that could help a revitalization of commercial activity is a lower dollar. American consumers have enjoyed, while American manufacturers have endured, a strong dollar over the last several years. With the Federal Reserve joining the European Central Bank and others in engaging in quantitative easing combined with slowing growth in the U.S., the pillars holding the dollar higher are being chipped away. This could lead to a decline in the currency. It also helps that the president wants a more competitive (read: weak) currency that places U.S. exporters on better footings.
A development that investors should note is the change in leadership now underway in the European Union. While Brexit and protests in Hong Kong and France have grabbed the headlines, the real potential for seismic change resides in the European Union. The leadership is now changing in the major institutions of power in the European Union. The new president of the European Commission—the executive branch of the Union—has been awarded to Ursula von der Leyen. A bit of a polymath, she is a physician, politician, and former German Defense Minister. She also has a plan for European renewal that marks a significant departure from the plodding bureaucratic approach of her predecessor, who used to be unkindly drawn in political cartoons as a red-wine bacchanal. Von der Leyen’s plan could, if enacted, be the catalyst for the European project to find its way back to prosperity and popularity, thereby countering the discontent which led Britain to vote “leave.”
For 2020 to be a prosperous year, the grinding uncertainty of the trade war will have to recede enough to engender a modicum of confidence in the business community. This should catalyze organic growth, rather than the saccharine rush induced by central bank money printing. It is hard to see how this is likely to occur—especially in an election year. From our vantage point, 2020 will likely be more of the same: politics and policy will remain volatile and marginally effective, earnings growth will likely settle into a range of 3% to 5% for large U.S. publicly traded companies, and interest rates will remain flattened under the thumb of central bankers.
For investors, the question is how much to pay for those earnings next year. This will determine whether it is a profitable year or not. The robust gains enjoyed by investors in 2019 were not due to an impressive rise in profitability but to investors paying more for existing profits. This willingness pushed price-earnings multiples on large-cap U.S. equities from 16.5 to 21.6 last year, a 31% rise resulting in a level about 11% above the 25-year average.
No doubt surprises will abound over the course of the year. As is the case of late, the unthinkable often becomes inevitable. However, as long as earnings maintain their growth, inflation remains largely dormant, and credit continues to flow, investors have a habit of looking through chaos to find opportunities to profit.
A bigger picture with key questions
Over the course of the last year, a handful of longer-term themes have come into view. These subjects will not be resolved simply nor quickly. Indeed, they will be constant companions of investors in 2020 and beyond. We highlight them now as they will serve as touchstones that we return to in future notes. In many respects these themes below have the potential to frame much of what is to come.
Has Globalization Peaked?
At a Financial Times banking conference last autumn, one of the conferees discussed the notion of peak globalization. It was a provocative idea, as one of the enduring themes of the last 30 years has been the increasing interconnectedness of global trading blocs. A historical examination of trade flows supports the notion of epochs of varying connectivity (Exhibit D).
A change in connectedness tends to endure. Each epoch appears unique as events driving them are different. Given the global rise in populism, which is effectively a focus inward, the notion of the ‘global citizen’ transacting across the globe is likely to remain as fashionable as polyester leisure suits. We may be entering an era of where the growth of global trade is curbed as local economic interests reign supreme. From an investment perspective, a fractured global business landscape would require a wholesale reconsideration of the location of source material and manufacturing facilities. All have the potential to dent profit margins and place investment into a state of stasis, which ultimately hinders global growth.
Do Zero Interest Rates Discourage Growth? The Paradox of Free Money
We have touched on the idea of the Paradox of Free Money in the past and it is a warning for those who espouse modern monetary theory. Free money is not the remedy for weak growth. Quite to the contrary, it is the transmission mechanism for malinvestment and the sclerotization of an economy (Exhibit E).
Europe and Japan have been experimenting with this without success. Indeed, European bankers have publicly pleaded that this not happen in the United States. We have characterized this as the zombification of an economy where companies who are unprofitable or fail to earn a sufficient return on capital limp along, enabled by the capital markets. The presence of these zombie companies reduces return on investment for better run companies which can lead to reduced investment and innovation—both necessary for a vibrant economy.
Is the Strong Dollar Regime Ending?
An enduring feature of the last five years has been the strength of the dollar relative to the currencies of its major trading partners. This strength is principally the result of stronger growth and higher interest rates in the United States. Now that growth in the U.S. is slowing and the Federal Reserve has joined other major central banks in lowering the price of money by printing more of it, the pillars of a strong dollar are being systematically weakened. Moreover, as the dollar has been weaponized by successive U.S. administrations, the incentive for friend and foe to find alternative forms of payment is growing. This is all happening when the U.S. demand for capital grows every day, as the budget deficit has reached a trillion dollars with little sign of abating.
Are Central Bank Policies Inflating Valuations?
This theme relates to the Paradox of Free Money above. The experimentation with money printing by central banks to generate some ideal level of inflation has seen mixed results at best. During the moment of extremis when these extraordinary policies were launched, they helped arrest turmoil swirling in capital markets. They were channeling Walter Bagehot’s assertion that the role of the central bank is to be the lender of last resort.2 However, as time has passed, it is clear that quantitative easing has limited efficacy.
Growth has failed to accelerate in Europe and Japan and inflation remains stubbornly below targets. However, the asset inflation that was created as money was forced into motion to protect purchasing power will be something to be reckoned with at some point. Swollen valuations have infected both public and private markets. If past is prologue, the traveling companion of rising valuations is malinvestment. Sooner or later accounts have to be balanced and those companies that should not survive won’t. Investors in these sorry enterprises will be first in line to experience the consequences. Will central bankers see the error of their ways? Perhaps. Already the political class is being warned that monetary policy is approaching the end of its effectiveness. How and when a policy pivot occurs remains an open question.
Are We Entering a New Era of Capitalism?
The rise of Sustainable and Impact Investing (SII) and debates related to rising income inequality are part of a larger question of whether there is a new paradigm for how capitalism operates in society. Capitalism experiences epochal periods of stagnation and revival, like society in general. Problems of income inequality, environmental impact, and social elevation that accompany our commercial lives have come into sharper relief over the last decade.
Indeed, these frustrations have manifested themselves in our political parties through polarization of the electorate and in our commercial lives through the rise of SII. The drive for fairness and good stewardship tends to be focused on the transmission mechanism of prosperity: capitalism. If history serves as a guide, capitalism is adept at evolving to satisfy the needs of the private sector. It is not always quick in responding to the change, but change it does. Over the last 120 years, capitalism evolved from the Gilded Age of robber barons, where a winner takes all ethos prevailed, to our modern era, in which a social safety net has emerged. It was able to endure decades of crushing regulation and revive itself when the yoke had been loosened.
In the 1930s, when there were competing ideologies for how society orders itself and distributes rewards of its members, capitalism evolved along with democracy, cementing its primacy during the Cold War years. It appears to be taken to task once again to evolve in order to address larger societal issues. This evolution will take time and money. However, the opportunities for those in the mix could be considerable: whether they are solutions for climate change through alternative energy sources, the rise of a circular economy, new regimes for battling disease, or new modalities in education that help lift parts of society out of poverty, capitalism will likely evolve as the society in which it operates demands.
The Bottom Line
Expectations for 2020 should be moderated given the point from which we start. Earnings growth for large companies will likely return; however, valuations appear to reflect the economic underpinnings of the commercial landscape. Mid-single-digit returns would normally be expected, but the meddling of central banks via their extraordinary policy efforts will fog the best forecast. Consequently, investors will want, and central banks will likely deliver, continued low interest rates and money printing. If we are correct in expecting a reversal of the dollar’s strength, then non-U.S. investments should enjoy their time in the sun. Indeed, European and Asian developed markets could attract new capital and emerging markets, long a laggard in returns, could gather favor. Geopolitical events will also continue to shape 2020, as Brexit is expected to move forward, the U.S. presidential and congressional elections set expectations for future U.S. policies, European Union leadership changes take hold, global trade agreements evolve, and other developments influence the investment landscape. In short, 2020 will likely look quite different than 2019 as the future(s) unfold.
1 Maxfield Parrish, a painter and illustrator, was known for his “idealized neo-classical imagery.” Parrish’s 1922, Daybreak comes to mind when considering the tranquility that market returns in 2019 imply.
2 “CEO Tenure Is Getting Shorter. Maybe That’s a Good Thing,” John D. Stoll, Wall Street Journal, October 4, 2018
3 Factset Earnings Insight, December 20, 2019
4 Walter Bagehot was a Victorian businessman and journalist. He wrote Lombard Street: A Description of the Money Market in 1873 and was editor-in-chief of the Economist magazine. Undoubtedly, he was one of the greatest thinkers of his time.
The opinions expressed in this article are as of the date issued and subject to change at any time. Nothing contained herein is intended to constitute investment, legal, tax or accounting advice, and clients should discuss any proposed arrangement or transaction with their investment, legal or tax advisers.