What a difference a year (and a decade) makes. The upbeat conclusion to 2019 stands in stark contrast to the turbulent end to 2018, and the U.S. equity returns of the 2010-2019 period dwarf those of the preceding decade. Despite stagnant corporate earnings, a downturn in global manufacturing, and a deluge of geopolitical headlines including Brexit, the U.S.-China trade war and U.S. presidential impeachment, the S&P 500 had its best year since 2013, and global stock markets added $17 trillion in market capitalization. Bonds did not fare so bad either with the ten-year Treasury yield dropping 77 basis points and investment-grade corporate bond spreads tightening 60 basis points on the year. Reminiscent to previous occasions in the decade that followed the Global Financial Crisis, central banks were a dominant force in 2019. With no signs of inflation and growth weakening, central banks eased monetary policy in 2019, helping to allay investor angst over a sharp economic downturn. It was the Federal Reserve’s famous “policy pivot” early in the year that set up both equity and bond markets for 2019’s outstanding run.
The fourth quarter brought a much-awaited de-escalation in the U.S.-China trade war through the draft of a “Phase One” trade deal, which breathed new life into investor sentiment. Renewed growth optimism is evident in the un-inversion of the U.S. Treasury yield curve, and the amount of negative yielding debt shrinking by $6 trillion from its summer peak of $17 trillion. The S&P 500 finished the year 880 points or 37% above its 2018 Christmas Eve low, and for the first time since the Civil War, the U.S. economy went an entire decade without a recession. As we conclude this decade, we draw your attention to the incredible outperformance of U.S. equity markets versus those of the rest of the world, driven by both outperformance of the U.S. economy and dominance of technology shares in U.S. equity markets relative to foreign markets.
Source: Bloomberg as of Dec. 31, 2019. Note: U.S. Equities = S&P 500, Developed Market Equities Excluding U.S. = MSCI World (Developed Markets Ex. U.S.), and Emerging Markets Equities = MSCI Emerging Markets.
2019: A strong end to an exceptional decade for asset returns
Similar to 2017, it is difficult to find an asset class with a negative return this past year. Substantially lower interest rates and increased liquidity from central banks were the common denominators leading to strong total returns across equity, corporate bond, and government bond markets in 2019. The Fed delivered three 25-basis point interest rate cuts in 2019. Meanwhile, the consumer-driven U.S. economy remained fairly resilient to global headwinds, and inflation remained sluggish despite historically low unemployment, providing the ideal setup for risk assets. Even if an investor shied away from equity markets and invested only in long-term Treasurys (ten-year and longer maturities), they would have earned a 15% return this past year due to the dramatic drop in interest rates.
Perhaps more remarkable than 2019’s returns are the returns of the past decade, particularly those of U.S. equity markets. The S&P 500 delivered an annualized total return of 13.5%, and the technology-focused NASDAQ an annualized return of over 16% between 2010 and 2019. In fact, the combined market cap of Apple, Amazon, Microsoft, and Google was just over $700 million coming into this decade and ended 2019 at over $4 trillion. 1 Technology makes up nearly one-third of U.S. equity market value compared to Europe where it accounts for approximately 7%. It is, however, important to note that the last decade’s returns for U.S. equity markets followed historically poor returns of the 2000-2009 period, which included the Dot-com bubble burst and the Great Financial Crisis. Although we do not foresee any economic or financial crises on the horizon and believe the next economic downturn will be relatively shallow compared to the GFC, we think it is highly unlikely that the next decade’s returns will be as favorable as those of the past decade. It is also important to recognize that 2019’s outsized returns were significantly impacted by the fourth quarter 2018 pullback, and two-year asset class returns show a more normal return pattern.
Note: U.S. Large Cap Equities – S&P 500, U.S. Small Cap Equities – Russell 2000, International Equities – MSCI EAFE Index, Emerging Markets Equities, MSCI EM Index, High Yield Bonds – Barclays High Yield Index, Investment Grade Bonds – Barclays Investment Grade Corporate Index, Emerging Markets Corporate Bonds – Credit Suisse Emerging Market Corporate Bond Industrial Index, U.S. Treasurys – Barclays Government and Treasury Index. *Inception date is Sept. 28, 2001 for 2000-2009 returns.
Phase One Trade “deal” and improving economic data have lifted sentiment
End of year market strength and newfound investor optimism have been chalked up to the U.S. and China agreeing on a Phase One Trade “deal” in December. The U.S. did not go through with tariffs on $150 billion goods planned for Dec. 15 and reduced the rate on $120 billion of imports from China from 15% to 7.5%, lowering total tariffs by $9 billion. China has agreed to substantially increase agricultural purchases over the next two years and has also reportedly agreed to certain structural reforms on intellectual property and technology transfers. We view this as more of a trade “truce” rather than a deal. In addition to 7.5% tariffs on $120 billion of goods, existing U.S. tariffs of 25% on $250 billion of Chinese imports will remain in place. On an aggregate basis, the total amount of U.S. tariffs on Chinese imports only went from around $80 billion to about $70 billion, leaving plenty to be negotiated in Phase Two.
The fourth quarter rally reflects investor confidence that we have seen the worst of the trade war, and that global growth is set to improve over the next several months. After slowing sharply in 2019 to 3.0%, global GDP growth is expected to rise modestly to 3.1% in 2020. More importantly, there are some signs of green shoots in global manufacturing with China’s manufacturing sector expanding at its fastest pace in three years in November and German business sentiment significantly improving in recent months. While it is slightly early to declare a decisive cyclical upturn, easing trade tensions and accommodative monetary policy are conducive to an improvement in business confidence and extension of the current economic cycle.
Central banks: Approaching their limits?
The shift away from restrictive monetary policy in 2019, particularly for the Fed, was arguably the biggest upside surprise for markets for the year. However, looking to 2020, how much more can (and will) central banks do? The Fed has said monetary policy is in a “good place.” We would likely need to see rising wages translate into meaningfully higher inflation for the Fed to begin hiking interest rates again. The U.S. economy is performing relatively well with unemployment at historical lows, so the bar also remains high for the Fed to reduce interest rates. While we believe the risk of recession remains low in the next twelve months, the Fed is in a rather difficult position should one eventually materialize. In the last three U.S. recessions, the Fed reduced interest rates by 5% on average. With the Fed Funds Target Rate at 1.50%-1.75%, a reduction of that magnitude is not possible (without deeply negative interest rates), leaving the central bank with much less room to further ease policy and stimulate the economy.
Speaking of negative interest rates and moving over to Europe, one of the first countries to institute negative interest rates, Sweden, has abandoned the policy. There remains an ongoing debate on the effectiveness of negative interest rates in stimulating growth and inflation, but policymakers recognize the detrimental impacts including pressure on bank profitability and challenges for pensions who are forced to buy negative-yielding government debt due to risk constraints. Regions such as Europe will likely have to turn to fiscal policy for future stimulus support with the European Central Bank’s key policy rate already at a deeply negative -0.5% and the bank purchasing €20 billion of bonds per month for the foreseeable future. With interest rates still near historic lows and central bank balance sheets near all-time highs, it is difficult to see financial conditions becoming much easier and central banks delivering upside to equity and bond markets in 2020 like they did in 2019.
Source: Bloomberg as of Dec. 31, 2019. Note U.S. = Fed Funds Target Rate Upper Bound, Canada = Bank of Canada Overnight Lending Rate, Australia = Royal Bank of Australia Cash Rate Target, United Kingdom = Bank of England Official Bank Rate, Japan = Bank of Japan Policy Rate, Eurozone = ECB Deposit Facility Rate, Switzerland = Swiss National Bank Policy Rate.
A new era: U.S. energy dominance
One asset that failed to appreciate over the last decade is crude oil. At the end of 2009, the price of West Texas Intermediate crude oil was just under $80 per barrel after rising to as much as $145 dollars a barrel in 2008. It ended 2019 at approximately $61 per barrel after falling to as low as $26 in 2016. Interestingly, oil prices actually rose 34% in 2019 (after collapsing by 38% during the fourth quarter of 2018), but energy was still the worst-performing U.S. equity sector in 2019, reflecting a number of investor concerns, including the long-term sustainability of oil prices. A primary force behind long-term downward pressure in oil prices is the tremendous growth of U.S. shale production and advancement in technologies such as fracking and horizontal drilling, resulting in a global crude oil supply imbalance. The transition towards cost-efficient, renewable energy sources is also a headwind for oil prices on the demand side. The U.S. has already surpassed Saudi Arabia and Russia as the top global oil producer, producing nearly thirteen million barrels of oil per day. According to the U.S. Energy Information Administration, in September 2019, the U.S. exported 89,000 barrels per day more petroleum than it imported. This was the first month this has happened since monthly records began in 1973. A decade ago, the U.S. was importing ten million barrels per day more petroleum than it was exporting. Energy independence is quite an economic feat for the U.S., freeing it from dependence on OPEC, and has also been a boon for the U.S. consumer paying less at the pump.
Source: Bloomberg as of Dec. 31, 2019.
2020 outlook: tempered optimism
Markets ended 2019 with positive momentum and a wave of investor optimism. Although U.S. growth is projected to slow from 2.3% in 2019 to 1.8% in 2020, the economy remains well-supported by a thriving labor market and consumer, which has helped to offset weak capital investment. After barely growing in 2019, corporate profits are expected to rebound with S&P 500 earnings per share forecast to grow around 10% year-over-year in 2020. The global growth backdrop also appears to be improving, thanks to progress on trade, but we are not out of the woods yet with a substantial amount of tariffs still in place.
U.S. markets have been unaffected by political headlines around impeachment, but we expect the Democratic primaries and the U.S. election to stir up some volatility, at least in select sectors such as healthcare and energy. Along these same lines, we continue to keep an eye on the U.S. government’s growing debt load, which now exceeds $23 trillion or almost 107% of U.S. GDP. While not an immediate risk, a significant pullback in government spending and/or change in tax policy to address the U.S.’ soaring debt load could have meaningful implications for economic growth. Lastly on the geopolitical front, renewed tensions with Iran have led to a rather rocky start to 2020, and the Middle East has quickly emerged as one of the most unpredictable sources of risk and volatility for markets.
Equity and corporate bond valuations are on the higher end of their historical ranges, particularly in U.S. markets, reflecting a sanguine outlook for 2020. However, as exhibited in 2019, fundamentals (i.e. valuations and earnings) are not always the deciding factors, and asset prices have become subject to much more dominant forces like central banks creating a global shortage of yield. As we enter a new year and a new decade, we think many current themes, including central bank influence, populist politics, and technological disruption, will persist and continue to shape the global economic and financial landscape. However, these same themes create a tremendous amount of uncertainty and volatility, and against this backdrop, we continue to encourage a disciplined, long-term investment perspective. We will see you back next quarter, hopefully with a positive tone permeating global markets, progress made on a Phase Two trade deal, a de-escalation of tensions in the Middle East, and further signs of improving global growth momentum.
1Fortune, "For Investors, the Past Decade Was a Marvelous Run. But That Tells Only Half the Story," Dec. 17 2019.