Perspectives & Planning
2019 was icing on the cake to a decade that began with trepidation coming out of the financial crisis and the Great Recession but proved to be extremely rewarding for U.S. investors. We are relatively positive on the 2020 outlook for financial markets and the economy but do not want to get carried away. We would not claim any foreknowledge as to how the 2020’s will unfold beyond the next six months to a year. As the great Yogi Berra said, “It’s tough to make predictions, especially about the future.”
The U.S. economy enters the New Year and new decade on solid ground. Despite fears of a slowdown in the summer, GDP advanced at a healthy rate of just over 2% in the second half of 20191. For the full year, the economy overcame a number of largely self-imposed hurdles and likely grew by 2.3%2, a pace not very different from the tax cut fueled 2.5% growth of 20181. The U.S. is now in the midst of a record long expansion approaching 11 years in duration over which time our economy and financial markets have outperformed that of our peers. For 2020, Washington Trust believes growth will decelerate modestly to 2%2.
A healthy consumer has been the driver of U.S. growth over the past five years and we expect this trend to continue with consumer spending likely to increase by 2.5% in 20202. The economy is at, or near full employment, and incomes are rising. Americans have also significantly increased their savings rate in recent years and with interest rates low, they not only have wherewithal to spend, but the ability to borrow and service their debt. As such, in addition to consumption, housing should continue to make progress over the year and residential investment will likely contribute measurably to GDP. Government spending and widening budget deficits will continue to provide stimulus, although not to the same extent as last year.
Not all areas of the economy are booming, however. Weakness in the industrial sector has persisted. The trade war has taken a toll on business confidence and capital spending has suffered. While the passage of the USMCA (NAFTA 2.0) by Congress and a de-escalation of trade tensions with China offer hope, there is little sign of an imminent turn. The ISM Manufacturing Index is at a multi-year low and the impact of the production halt on the 737 Max by Boeing is on a scale such that it alone could shave 0.2% alone from Q1 GDP5.
Manufacturing could improve as the year progresses and the 737 returns to production and to the air. Greater certainty on trade may also begin to reignite investment. Higher oil prices, which rose sharply in 2019, may revive spending in the oil patch. A softer dollar would help the competitive position of U.S. manufacturers and lessen the trade deficit as would stronger global growth which the IMF forecasts will rise to 3.2% from an estimated 3.0% last year3.
2019 was a great year for financial markets, particularly in the U.S. The S&P 500 Index surged 31.5% while the Bloomberg Barclays Aggregate Bond Index returned a stunning 8.7%3. It was a remarkable turnabout after a disastrous 2018 fourth quarter when the S&P 500 Index declined by 13.4% resulting in a 2018 4.4% full-year loss3. Interestingly, despite the dismal stock market performance, both 2018 economic and corporate earnings growth were superior to that of 2019. 2019 S&P 500 Index earnings edged higher by the low single digits in 20192 versus a 20% jump in 20184.
The gradual transition in Federal Reserve policy from tightening to easing over a six-month period beginning in late December of 2018 and apparently fueled the rally. Investors clearly are more comfortable with a slower ”Goldilocks” scenario than a rapidly growing economy that ultimately results in restrictive monetary policy. The steep decline in interest rates across the yield curve driven by three Federal Reserve rate cuts spurred investors to embrace additional risk in 2019. Not only did stocks rally, but corporate debt also generated mid-teens returns3.
We think the potential exists for U.S. markets to provide additional gains in 2020, although on a more modest scale. Equity market valuation is rather lofty with the S&P 500 Index trading at 18.7x our 2020 earnings estimate2, and Federal Reserve interest rate policy could well be on hold for the year. However, the Central Bank remains extremely accommodative and is pumping liquidity into the money market. More importantly, we believe that the Fed is operating under a new dovish paradigm and remains committed to supporting the expansion. The odds of a rate hike appear to be slim; if the Fed does make an interest rate move it will most likely lower rates. We think the probability of a 2020 recession is generally low as financial conditions are highly supportive of growth and believe the 2020 S&P 500 Index earnings will grow at a slightly faster 5% pace2, although past performance does not guarantee future results. Therefore, stocks may well sustain higher valuations and advance mid- to high-single digits, a pace in line with projected earnings growth.
We are also expecting more subdued but positive returns from the fixed income market. Structural factors, especially aging demographics and low or negative rates overseas, will continue to cap U.S. yields. While the short-end of the yield curve appears well anchored at the current level just over 1.5%, the yield curve could steepen a bit if economic optimism continues to improve. We currently forecast that the yield on the 10-year Treasury note will hold in a band of 1.5% to 2.25% over the course of the year2. The 10-year is now trading at a 1.9% yield or just above the midpoint of our target range. With corporate bonds having rallied so sharply in 2019, we do not expect much excess return in this sector. Overall, we suspect that low single digit returns are in store for fixed income investors.
After a decade of terrific equity returns, investors should not become complacent and remain mindful of downside risks. The recent flare-up in the Middle East is a case in point. Over the past decade, the S&P 500 Index’s 13.4% annualized return far surpassed other asset classes including international stocks. However, during the 2000’s, the S&P 500 Index declined 1% annualized while emerging markets compounded at almost 10%3. With returns having again diverged dramatically, this would seem to be an excellent time to review asset allocation with your portfolio manager. As our market guru Yogi Berra also pointed out, “The future isn’t what it used to be.”
(1) U.S. Bureau of Economic Analysis (BEA)
(2) Washington Trust Wealth Management
(5) Capital Economics
The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.