As someone who needs glasses, I know firsthand that 20/20 vision and the ability to experience the beauty and clarity of life is amazing. As we embark on the start of a new year, clarity and foresight is exactly what investors are seeking, especially with the daily dose of unprecedented headlines we receive. In hindsight, the guidance our team of economists, strategists, and portfolio managers gave last year proved prescient as ~90% of our ten themes for 2019 were accurate. Despite the success, we will not rest on our laurels as 2020 is likely to prove more challenging. By disseminating our bird’s eye view on the US economy and various asset classes, we hope to provide investors with a sharp, reliable lens to help bring their portfolio decisions into focus …
The state of the economy is of the utmost importance when evaluating the return potential of the major asset classes. We forecast that US GDP growth will be moderate at 1.7%, but that the current record-setting economic expansion will continue unabated at least through the presidential election. A resilient labor market, robust consumer spending, and a rebound in global growth should be supportive. Although it is rare for recessions to begin in an election year, multiple dynamics will cause us to sharpen our pencils when assessing the economy post-election. Our real-time economic indicators suggest a small probability of a recession over the next twelve months, so keeping a close eye on them will be crucial should the economy meaningfully weaken.
When the US economic outlook was clouded by trade tensions and slowing global growth, the Federal Reserve (Fed) performed corrective surgery in the form of three ‘insurance’ rate cuts. Those actions recalibrated Fed policy and have extended the duration of the expansion thus far. Knowing that the impact of monetary policy lags and given that the Fed has limited ammunition with the fed funds target rate at 1.50-1.75%, we do not anticipate interest rates will be altered in 2020. The ongoing expansion of the Fed balance sheet will provide stealth easing as it provides further liquidity.
Until November 3, investors will have tunnel vision when it comes to US politics. While Congressional gridlock (Republican Senate, Democratic House) continues to be the likely outcome, uncertainty remains at the top of the ticket. The determination of the Democratic candidate may last well into the summer with an increasing probability of a ‘brokered convention’ – the first for the Democratic Party since 1952 – the longer the process lasts. If history serves as a precedent, positive economic data leads to a favorable outcome for the incumbent. But given the level of division across the country, the election may be determined by two key swing states: Pennsylvania and Wisconsin.
Investors searching for yield may need to look through the magnifying glass, as global yields and spreads remain near record lows and continue to reduce the upside return for the bond market overall. Due to more moderate US growth, muted inflation, international demand, and favorable demographics, we do not expect the 10-year Treasury yield to move significantly over the next twelve months (year-end target: 1.75%). While credit market spreads will widen slightly, we do not think this will negate the positive performance of our favored sectors—investment grade and emerging market bonds.
Following the best year for US equities since 2013, investors need to see the bigger picture. The macroeconomic backdrop remains supportive with muted risk of a recession, easing financial conditions, and lower interest rates. 2019 performance was largely driven by P/E expansion, but 2020 should renew the emphasis on earnings growth, which we forecast at 5%-6%. History will play a role too, as election years have been historically positive for the equity market. Since 1936, in presidential election years, the S&P 500 has rallied 9% on average and was positive 86% of the time. In the case of no recession (our forecast), the trend is more impressive with an average return of 10.7% and positive 94% of the time. Our base case is that the S&P 500 will notch new highs and rally to ~3,350 by year end.
We still favor cyclicals over defensives, with four of our five favorite sectors being Information Technology, Communication Services, Financials, and Industrials. Our lone defensive choice is Health Care, which lagged the broader market in 2019 due to political risk. This sector selection has us seeing double, as a bias towards these sectors is inherently beneficial to small-cap stocks. From both a market capitalization and revenue perspective, small cap carries its highest exposures and weightings towards these same sectors.
We envision the technology sector being a stand out again this year. Our near sights are focused on earnings visibility, which remains strong with the anticipated rollout of 5G. The transition from 4G to 5G is the largest enhancement in wireless technology in a decade, so our far sights believe this will be a multi-year catalyst for everything from semiconductors to phone carriers. The benefits should permeate across other industries, keeping demand for new technologies, applications, services, and software resilient.
Our preference for US equities over international equities was a relatively easy choice over the past several years. However this year, the line between the two is beginning to blur. A possible bottoming in Europe’s economic data, attractive valuations on a relative basis, an acceleration in earnings growth, and the possibility of substantial fiscal stimulus packages (especially in Germany) have the potential to propel international equities moving forward. We maintain our view on emerging markets as an appealing allocation for long-term investors.
After rallying six times in the last seven years, a further broad based rally in the US dollar is unlikely. A Fed on hold, decelerating US economic growth and burgeoning twin deficits will likely keep a stronger dollar out of view. A stable, slightly weaker dollar is a positive for commodities. Specifically, we believe that oil prices will recover to six-year highs by the end of 2020 and rally to $65/barrel. Our expectation that global oil demand will grow slightly faster in 2020 than 2019 (and mark 11 consecutive years of growth) is supportive of this view. Furthermore, the slow upward movement in oil prices has exerted pressure on the capital budgets of US oil and gas companies which should translate into a sharp slowdown in US oil production.
With 2019 being the best year for US equities since 2013 and aggregate bonds since 2002, investor complacency and elevated expectations are evident. However, with relatively more expensive markets versus last year, volatility is hiding in plain sight. From trade wars to impeachment, and from growth concerns to geopolitical tensions, there is no shortage of headline risk for 2020. The burden remains on us to decipher if, and when, any of these headlines alter our economic or asset class views in a demonstrable fashion. Increased volatility and the aging bull market make selectivity at the regional, sector, and individual stock level even more important.
We always encourage investors to keep their eyes on the prize and follow a well-thought out financial plan that tailors an appropriate asset allocation in light of specific investment objectives and risk tolerance. While we provide our lens in which to view the economy and various asset classes, your advisor can provide further insights into your portfolio as they have the depth perception needed to understand your comprehensive financial situation, the peripherals needed to account for risks to your plan, and the ability to add some color.
Lawrence V. Adam, III, CFA, CIMA®, CFP®
Chief Investment Officer, Private Client Group
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