To “expect the unexpected” truly captures our feelings about last year. Investors were told the Federal Reserve would raise interest rates beyond three percent and their balance sheet reduction was on “auto-pilot.” The China trade deal neared completion numerous times. Britain was heading for a “hard Brexit.” None of these issues were resolved during the year.
The Fed abruptly changed monetary policy after the severe stock market decline at the end of 2018 by not raising rates in 2019 and instead cutting rates 3 times. The Fed’s balance sheet ended the year larger than it started. There have also been no final resolutions to China or Brexit yet. Regardless, and somewhat unexpectedly, the stock market enjoyed one of the best years since 2013. Bond returns were also above average given low inflation and friendly monetary policy. As we look to 2020, we will continue to “expect the unexpected.”
The U.S. economy is expected expand in a range of 2.25% – 2.5% for 2019. Estimates for the fourth quarter are varied from as low as +1.1% from the NY Fed Nowcast to as much as 2.3% from the Atlanta GDPNow forecast. Either way, the signals of a recession (inverted yield curve, manufacturing weakness, global trade weakness) have yet to materialize. The unemployment rate ended the year at a 50-year low of 3.5% with wages rising 3.1%. That is impressive considering inflation is a tame 2.1%, right at the Fed’s target. Our economy has created 1.77 million jobs this year through November and an additional 160k expected in December.
Global manufacturing activity appears to be bottoming out. The JPMorgan Global Manufacturing Index hit a low of 49.3 (measures below 50 indicate contraction) in July yet finished the year at 50.1. While this is not a strong positive, it is no longer a drag. There is a mixed view of manufacturing data in the U.S. with the ISM Manufacturing reading coming in at 47.2 (contracting) while the Markit US Manufacturing Index was reported as 52.4 (expanding). The Markit index attributes more weight to forward-looking components which helps explain the difference.
The USMCA, the trade agreement between the U.S., Mexico & Canada which replaced NAFTA, has been ratified in the House and sent to the Senate for a vote that is expected to pass. A Phase One trade deal with China is expected to be signed in January, and a Brexit deal is scheduled for the end of January. Assuming we finally see an end to these three big issues, global trade, GDP and employment growth should be positively impacted in 2020.
The Federal Reserve has been supportive of economic growth throughout the year. The yield curve inverted such that 2-year Treasury bonds yielded 5 basis points more than 10-year bonds in August shortly after the first Fed interest rate cut. The Fed subsequently eased monetary policy with rate cuts in both September and October and normalized the curve by lowering the short end. At year-end, the 2-10 curve was positive 34 basis points.
While these cuts to interest rates were widely expected by the market, the large increase in the balance sheet was not. As we have discussed in previous letters, the Fed has been allowing bonds accumulated during the financial crisis to mature off its balance sheet hoping to normalize monetary policy. It appears they went too far (or too fast) and by year-end the balance sheet was again expanding. Below is a chart of showing the year-end balance sheet expansion:
You can see the rapid expansion of liquidity injected into the system (green line), and the resulting stock market reaction (S&P 500 red line). In total, from the end of August to the end of December, the Fed added $406 Billion to their balance sheet. In addition, the Fed agreed to purchase $60 Billion of T-Bills per month at least into the second quarter of 2020. We are curious to see the stock and bond market reaction to this program when it comes to an end. The market is expecting one more interest rate cut later in 2020. As we’ve seen in the past, those expectations can shift quickly but for now it shows stabilization.
The S&P 500 had a strong Q4 to finish out the year, returning a positive 9.1% for the quarter. For the full year, the S&P 500 was up 31.5%. Investor sentiment turned bullish on positive economic data, including the Phase One Chinese trade deal. 2019 marked a year where the stock market produced substantial gains, with little help from earnings growth. Nearly all the performance gains for the year were the result of P/E multiple expansion. 2019 also produced familiar trends to those we have seen throughout the decade; Growth stocks outperforming Value stocks, and U.S. stocks outperforming International stocks (below charts).
Looking at the sector-level performance for the fourth quarter, ten of the eleven economic sectors in the S&P 500 posted positive results. Q4 performance was led again by Technology, but also Healthcare. Technology (up 14.4%) was tied for the top performer in Q4, and also turned in the best performance for the full year (up 50.3%). Innovations in software & hardware, primarily out of the U.S., are driving increased tech spending. Healthcare was also a top performing sector in Q4 (up 14.4%), after being one of the worst sectors heading into the final quarter. Some of the negative political rhetoric around Healthcare softened late in the year. An upward sloping yield curve benefits Financials, which was the third best performing sector in Q4 (up 10.5%). After three Fed rate cuts and signs of an improving economy, the dreaded yield curve inversion unwound in the quarter. An upward sloping curve allows lenders to loan funds out at a rate higher than their borrowing costs.
The two worst performing sectors in Q4 were defensive sectors. Often when the market is rallying, and investors are becoming more bullish, defensive areas are the laggards. Real Estate (down 0.5%) was the only negative sector, while the Utility sector (up 0.8%) barely finished in the green in Q4. Investors vacated safety and income stability for riskier assets during the final quarter.
Consensus expectations for 2020 are for earnings to grow a sturdy 9.5%, which seems reasonable after essentially no growth in 2019. As mentioned earlier, equity market gains for 2019 were due to P/E multiple expansion. The forward P/E multiple for the S&P 500 began the year ~14x and ended the year at ~18x (or nearly a 30% move). We would not expect multiples to expand much from here, therefore earnings growth will need to carry the load for equites in 2020. The average return during the 4th year of a presidential cycle is traditionally more subdued than year 3 (below chart):
Bond markets in the U.S. had an above average year, with lower quality and longer bonds seeing the largest gains. The Bloomberg Barclay’s US Aggregate Bond Index was up over 8.5% on the taxable side, and the S&P Municipal Bond Index was up over 7% for the tax exempt market. Most of this return was price appreciation versus income. Yields across the spectrum fell (as bond prices rose) and as previously mentioned, the curve briefly inverted which prompted predictions of a recession. While there is a high correlation between inversions and recessions, most of the economic weakness was self-induced (trade disputes, etc.) and therefore proved self-correcting. Notice the dip in the 10-year yield in the middle of 2019 in the chart to the right. Long bonds performed very well during this period, however it appears the 10-year yield is in an uptrend now that those risks have been somewhat alleviated.
Riskier bonds also had a substantial rally over the course of the year which “tightened” the spread of risky bond yields versus high quality bonds. The chart below shows the strength of high yield bonds after the stock market correction at the end of 2018. A reduction in spreads means investors do not perceive as much risk and therefore do not demand as much additional yield to own risky bonds. Spreads appear to be pricing in perfection at these levels so opportunities may present themselves if/when turbulence begins in 2020.
Assuming the economy grows as expected and the geopolitical risks in the Middle East do not escalate, we would expect rates to rise from here. We are managing this risk by maintaining less duration and credit exposure than the overall market in this environment (i.e. shorter and higher quality). In the taxable market, portfolios can capture virtually the entire yield curve inside of 7 years with taxable municipals and callable government agencies with yields in the 2-2.25% range (30-year UST is currently 2.27%). In the tax-exempt market, portfolios need to go to the 10-year sector to achieve more than 80% of the Treasury market where we see value.
We mentioned in our last letter the pending “SECURE” Act; this was passed into law in December. There are many provisions but the most important affecting our clients is that the new Required Minimum Distribution age has been pushed back to 72. If your birthday is June 30, 1949 or earlier, you are under the old law and required to take an RMD in 2020. If your birthday is July 1, 1949 or later, you now have until age 72 to start RMDs. Additionally, non-spousal inheritors of an IRA will now be required to distribute the account within 10 years (instead of over their life expectancy). This only applies to people inheriting an IRA in 2020 and beyond; if you already have an inherited IRA, you are grandfathered into the old rules. If you have any questions about how this law will impact you or your estate plan, please do not hesitate to reach out.
We are thankful for another above average year for the markets in 2019. The Fed sent shockwaves through the market at the end of 2018 only to reverse course at the beginning of 2019. This past year has been a rebound based on investors’ new expectations. With lower interest rates and communication that rates may fall further, the Fed has successfully fostered economic growth. Households are spending and Corporate America continues to hire and increase wages. As always, the year ahead has many factors that could spike volatility and we will be watching Middle East tension (Iran), resolution to Brexit, the Presidential election and the ongoing Impeachment. We thank you for the opportunity to serve you for another year!