Tokyo Bay
A year ago, few could have imagined the S&P 500 delivering a gain of more than 31.5% in 2019 (including dividends) with flat earnings. Volatility was extreme in Q4 2018 and a sell-off in December 2018 left the S&P 500 near bear market territory (defined as a 20% decline from its closing peak). Accounting for compounding returns, the near 20% decline suffered by the S&P 500 in Q4 2018 required a 25% rebound to get back to even.
Throughout 2019, we went from concerns of a bear market to recovery only to have recession fears resurface in the third quarter as trade friction and China’s slowing economy rattled markets. We began Q4 2019 at about S&P 500 2930 level — the market treaded water, so to speak, for nearly 18 months.
2019 performance for key indices:
Equity market:
• S&P 500: 31.5% (including dividends)
• MSCI EAFE: (index of developed market economies): 22%
• MSCI Emerging Markets Index: 18.5%
Bond market:
• Barclays U.S Aggregate Index: 8.7%
• Intermediate-term municipal bonds: 5.7%
Real assets:
• Spot gold returned 18.5%.
• REITs gained more than 20%.
Note: UBS tracks 18 asset classes to include in its year-end investor report, and all asset classes reported positive returns compared to only two in 2018 (cash and bonds).
Apple and Microsoft accounted for nearly 15% (almost half including dividends) of the S&P 500 index returns in 2019.
A change of heart at the Fed
So, what changed to finally break the market’s range-bound movement? Our president stopped tweeting about the U.S.- China trade war. Seriously: Much of the stock market’s gains in 2019 can be attributed to a dramatic policy shift at the Federal Reserve.
In 2018, the Fed raised rates four times, including a December 2018 hike that took its key rate to 2.5%, sending a major shockwave throughout global markets. However, in 2019, the Fed lowered rates three times, in one-quarter percentage point steps, due to concerns over a slowing global economy tied to trade war concerns and lackluster business spending. And for an added safety measure, the Fed announced the buying of Treasury bills in September to stabilize the short-term repo market. The Fed’s intervention injected the market with an extra boost to liquidity and investor confidence.
Gross domestic product (GDP) in the U.S. is expected to slow to about 2.0% in 2020, down from 2.2% in 2019 and well off the “sugar highs” induced by the 2017 tax cut package.
Trade deals Signed
We spent much of the year being whipsawed by the U.S.- China trade war headlines and our president’s erratic tweets on the subject.
As the year came to a close, the House passed the United States-Mexico-Canada Agreement, which is President Trump’s replacement for NAFTA. Equally important, the Trump administration came to a phase-one trade agreement with China. All in all, very welcome news for markets.
Trump’s China tariffs and the uncertainty surrounding them were troubling U.S. businesses that have built supply chains in China or that rely on Chinese imports. Their concerns were a reason U.S. businesses’ capital investment fell throughout the year.
Looking ahead: Key themes for 2020
Corporate earnings: Paying up
As we enter 2020, markets are riding high. Indeed, the mood is ebullient as we experience a continued “melt-up” in markets. The market rally has been driven by expectations of a snap-back in earnings growth and a synchronized global economic recovery.
Price/earnings (P/E) ratios rose to 18.3 forward earnings for the S&P 500 from 15.6 a year ago. The P/E multiple expansion resulted from a decline in interest rates. Are markets expensive? Multiplying the current P/E of 18.4 times the consensus S&P earnings estimate for 2020 of $177.88 results in an index level of 3,202. Based on these forecasts, the market is overvalued at current levels.
According to FactSet Earnings Insight, January 10, 2020:
“Targets & Ratings: Analysts Project 6% Increase in Price Over Next 12 Months. The bottom-up target price for the S&P 500 is 3474.50. At the sector level, the Energy (+12.7%) sector is expected to see the largest price increase, as this sector has the largest upside difference between the bottom-up target price and the closing price. On the other hand, the Information Technology (+1.7%) sector is expected to see the smallest price increase.”
Earnings growth estimates were down drastically this past year. Analysts estimated S&P 500 earnings growth for the year would be around 7.6%, according to FactSet. That number is now about 0.3% or flat.
A key theme to watch in 2020 will be companies ability to continue to grow earnings and meet current expectations.
Portfolio implications for 2020:
Sector profit margins at risk of earning misses are Consumer Staples, Industrials, Technology, Consumer Discretionary, and Basic Materials sectors where 25% tariffs on $250 billion array of Chinese industrial goods and components used by U.S. manufacturers remain in place. Note: The fierce rotation into value that began in September, led by major banks like JP Morgan (a beneficiary of the U.S.-China Trade deal) still has room to run.
Some key earnings forecasts to watch this month: Apple, Amazon, and Boeing.
The market has bid up Apple shares, anticipating strong growth from Services. Some analysts are predicting production cuts in March for the iPhone 11 line (iPhone 11 Pro retails for $1149) in Chinese markets due to low demand and increasing headwinds from aggressive 5g smartphone launches in China by Huawei. Apple has fallen behind Asian competitors in its 5g product launch.
Deglobalization or Fair Trade?
What began as campaign rhetoric became reality when president Trump announced his trade reform agenda at the World Economic Forum at Davos in January 2018. He stated: “The United States will no longer turn a blind eye to unfair economic practices, including massive intellectual property theft, industrial subsidies, and pervasive state-led economic planning. These and other predatory behaviors are distorting the global markets and harming businesses and workers, not just in the U.S., but around the globe…The United States is prepared to negotiate mutually beneficial, bilateral trade agreements with all countries.”
A phase-one trade deal is important from a psychological perspective because it removes some of the fog of uncertainty clouding business activity for the current fiscal year. A phase-two trade deal with China will not be negotiated until after the 2020 elections. Going forward, we should see a pickup in capital expenditures.
Overseas, growth continues to be more challenging than in the U.S, but green-shoots are emerging and valuations are attractive. The U.K. is expected to negotiate a favorable trade agreement with continental Europe and a soft-landing for Brexit is now widely anticipated.
Portfolio implications for 2020
Trade wars, tariffs, and talk of more tariffs have created a cautious business atmosphere, restraining investment, and concomitant global growth. While a phase-one deal has provided clarity for businesses, trade will remain a top policy issue throughout 2020 and beyond.
In November 2019, the FCC labeled Huawei and ZTE a national security threat and cut Federal funding going to equipment from these companies. Huawei, now the world’s largest telecommunications equipment manufacturer and second-largest smartphone manufacturer, is currently appealing the ban, deeming it unconstitutional. Additionally, the Trump administration has banned U.S companies from doing business with Huawei. In November, the U.S gave Huawei a third 90-day support window that allows current Huawei customers to continue to receive support for existing devices from U.S companies who apply for a “general export license.” The U.S. is also requesting Meng Wanzhou, Huawei’s CFO, be extradited and tried for fraud.
Countries and companies that rely heavily on exports who adapt quickly to this changing trade dynamic as they plan capital expenditures and rethink their supply chains will fare better than those who don’t. Earnings for Google Mobile Services(GMS) and certain semiconductor manufacturers could be negatively impacted should the U.S. fail to grant Huawei a fourth 90-day support window. Note: Chinese companies stockpiled U.S. semiconductors in 2018, but inventories are now running low. Huawei is developing their own mobile services, called HMS, to replace Google.
The Fed and Central Banks: On hold?
It appears the recent rate cuts by our Fed have been enough to extend the economic cycle. Bond yields generally remain in their lowest decile relative to history thanks to easy monetary policy and subdued credit conditions. While the Fed is usually on hold during an election year, it may be forced to cut rates again due to concerns over a slowing economy and cautious business spending.
Portfolio Implications for 2020
Interest rates should remain range-bound with the 10-year U.S. Treasury bond trading between a yield of 1.75% and 2.0%. The current rate environment will continue to support an elevated P/E ratio of 18. Companies should continue to take advantage of low rates and buy back shares of their stock, helping boost prices as supply is reduced. Unlike the rally in 2019, Bond returns will likely remain constrained due to dovish central banks and soft global growth. Investors should stick with investment-grade corporates for taxable accounts and avoid reaching for yield this late in the cycle.
U.S. Elections: Facebook, Google, Healthcare, and Energy in focus
First, a word about impeachment. The consensus view is that the current situation is similar to president Bill Clinton's impeachment in 1998, which didn’t affect markets. Perhaps the current impeachment proceeding is more about the Democrats taking control of the Senate? Four Republican senators are at risk: Martha McSally (Arizona), Cory Gardner (Colorado), Joni Ernst (Iowa), and Susan Collins (Maine).
As always, the big wild card to market forecasts this year will be the 2020 elections, though markets likely won’t focus on this X-factor until June. I should note, even though the market’s performance has generally been positive in election years, the gains usually come later.
Many things are going right. With central banks now acting in sync with each other and new trade deals in place, talks of a synchronized global recovery have resurfaced. Improving corporate earnings, business confidence, and an accommodative Fed should help drive market gains in 2020. In all, I expect a good year for financial markets, but as always, I’m prepared for the inevitable surprises that could impact my outlook. Trade frictions with China centered on Huawei and their CFO could heat up again in March as business support exemptions expire, giving current exuberance a healthy dose of reality.
IMPORTANT DISCLOSURES: This material is for general information only and is not intended to provide specific advice or recommendations for any individual. The opinions and information expressed herein are obtained from sources believed to be reliable. However, their accuracy and completeness cannot be guaranteed. All data is driven from publicly available information and has not been independently verified by Cambridge Wealth Management, LLC. Opinions expressed are current as of the date of this publication and are subject to change. Some of the conclusions in this report are intended to be generalizations. There is no assurance that the views or strategies discussed are suitable for all investors or will yield positive outcomes. Investing involves risks including possible loss of principal. Any economic forecasts set forth may not develop as predicted and are subject to change.
INDEX DESCRIPTIONS:
The following descriptions, while believed to be accurate, are in some cases abbreviated versions of more detailed or comprehensive definitions
available from the sponsors or originators of the respective indices. Anyone interested in such further details is free to consult each such sponsor’s or originator’s website. Each index reflects an unmanaged universe of securities without any deduction for advisory fees or other expenses that would reduce actual returns, as well as the reinvestment of all income and dividends. An actual investment in the securities included in the index could require an investor to incur transaction costs, which would lower the performance results. Indices are not actively managed and investors cannot invest directly in the indices.
S&P 500®: Standard & Poor’s (S&P) 500®) index. The S&P 500® Index is an unmanaged, capitalization-weighted index designed to measure the performance of the broad US economy through changes in the aggregate market value of 500 stocks representing all major industries.