Whew, what a difference a year makes. The final quarter of the decade proved to be very different than the nerve-wracking ending of 2018, with risk assets enjoying a strong rally into the end of the year. U.S. stocks soared by almost 9% in the final months of 2019, putting the finishing touches on the best year for the S&P 500 Index since 2013. It was a nearly uninterrupted rally for three months, with the S&P 500 making 22 new record closing highs during the quarter. International stocks weren’t far behind as they gained nearly 8%. Commodities gained nearly 5%, with oil prices taking the lead this time as they jumped by 13%. In fixed income, the broad Bloomberg Barclays Aggregate Bond Index was flat, but that hid some significant dispersion as credit-related bonds rallied while high quality bonds fell. As the year came to close, investors were in great spirits as stocks were sitting just off of the most recent record high of 3,240 on the S&P, reached on December 27th.
Chipping Away at the Wall of Worry
Underpinning recent enthusiasm were signs of progress on a number of fronts that investors had been concerned about. Indeed, there was no shortage of things to worry about in 2019, and all year it seemed to be a classic example of the market scaling a “wall of worry.”
Starting with trade, tensions between the U.S. and China had ratcheted up considerably in the third quarter when the U.S. announced both an increase on existing tariffs and new tariffs, to cover more imports from China. However, negotiations between the two sides continued, and there was a noticeable sense of relief when rumors of a potential “Phase One” deal were reported. There was some initial confusion as to what was agreed to, but the main aspects of the agreement were that the U.S. will partially roll back the tariffs that were instituted in September, and will not go forward with additional tariffs on the remaining $160B of imports that consist primarily of consumer goods. In exchange, China has agreed to increase purchases of U.S. agricultural products to between $40-50B annually, to strengthen protections for intellectual property, and gradually open its financial sector to allow more foreign competition. While the majority of the existing tariffs will remain in place, and tensions between the two countries may flare up again in the future, this Phase One agreement represents a significant de-escalation of trade friction between the two countries and should allow damaged business confidence to rebound.
There was also more encouraging news from the Federal Reserve. In October, the Fed continued its dovish pivot that began earlier in the year, by cutting interest rates for the third time. However, they also announced that they were unlikely to make any additional rate cuts, barring a sudden deterioration in the economy. This message immediately caused some investors to speculate whether the Fed might resume raising interest rates in 2020 like they were doing in 2017-18 if the economy rebounds as expected. However, the Fed was quick to allay those concerns by clarifying that the economy—and particularly inflation—would need to accelerate meaningfully from current levels in order for that to happen. This was broadly interpreted to mean that the Fed is most likely on “hold” from an interest rate standpoint at least through the election later this year. In addition to another rate cut, the Fed also made an unexpected but significant announcement that they were going to grow the size of their balance sheet again through large purchases of T-bills. This was in response to temporary dislocations in overnight funding markets (blamed on a lack of sufficient liquidity due to the Fed’s prior tightening campaign). The bottom line is that the Fed has completely shifted to a more supportive stance, and is unlikely to take any restrictive actions in the near-term that could impede the economy’s progress.
The other big positive development took place over in the U.K. Boris Johnson, the newly elected Prime Minister, decided to call a general election to navigate through an impasse on the Brexit negotiations. The gambit worked, as he won a resounding victory and substantially increased his party’s margin within Parliament. While that all but ensures that Brexit will be carried out, markets also viewed the result as significantly reducing the risk of a disorderly crash out of the European Union, since the two sides had previously negotiated an exit deal. Markets also seemed relieved that after three long years of haggling, some sort of resolution may finally be at hand.
On the whole, the major developments during the quarter were warmly received by investors and contributed to the market’s surge into year-end.
But More Hurdles to Overcome
While several headwinds facing the market may have faded in recent months, it would be a mistake to assume that they’ve completely gone away, and it’s going to be nothing but blue skies ahead. There are still several important issues facing the market, even as stocks hover in record high territory. First of all, overall economic growth remains fairly sluggish. Even though there are some reasons to anticipate a marginal pickup this year, growth is slow enough that it wouldn’t take much to knock it off course. In the first half of last year, there were some early warning signals of recession that began to flash, and while those have since quieted down, it still seems prudent to heed those warnings.
In addition, the large gains last year mean that stocks enter the year in expensive territory. The forward price-to-earnings multiple for the S&P 500 has climbed above 18, which is at the higher end of the range for this cycle. This is largely due to the fact that stocks rallied while earnings barely grew, a combination that is unlikely to be sustainable going forward. Current expectations are for earnings to rebound towards a 5-10% growth rate this year, and it’s going to be critical that companies can deliver. If earnings disappoint again, then the market may be vulnerable to an adjustment to a lower valuation.
Another big hurdle for markets this year is the presidential election that looms in November. Markets are acting fairly sanguine at this point, but there’s still plenty of uncertainty as to who the Democratic nominee will be. As the year progresses and it becomes clear who’s going to run against President Trump, markets are likely to react to the different set of policy proposals that voters will be left to choose from. Even if the overall market remains resilient through all of the political jockeying, there are likely to be specific sectors and industries that are drawn into campaign promises made on the trail. There are also ongoing impeachment proceedings. At this point, the market appears to have priced in an outcome where this stalls out in the Senate and the President remains in office.
And finally, geopolitical tensions are a near constant presence in recent years. Already in the first few days of 2020, there’s been a major escalation of hostilities between the U.S. and Iran. While fears of an all-out war have settled down, it’s a delicate situation and things could flare up again at any time. It’s always a challenge for investors to try to anticipate geopolitical risks, but within diversified portfolios there are certain holdings that tend to benefit during those episodes (like Treasury bonds and gold) that help reduce overall portfolio volatility in the event of a sudden market decline.
Positioning: Beginning to Overweight Risk
Portfolio positioning has begun to reflect our assessment that the weight of the evidence has shifted in a more bullish direction. From an overall standpoint, we’ve increased the volatility of the portfolios so that they’re positioned modestly above benchmark levels of risk. We do have some concerns that the market is a little overheated in the short-term after such a strong fourth quarter (and even more gains to start the new year). But while a normal pullback could materialize at any time, the bigger picture is that investors are likely to be rewarded for maintaining exposure to risk assets.
In terms of sector positioning, we’ve begun to rotate towards more cyclical parts of the market at the expense of defensive sectors in anticipation of an improvement in the economic environment, with overweights in areas like Technology, Financials, and Industrials. We’ve also recently increased weightings in international equities, with the expectation that the U.S. dollar might weaken this year and allow global markets to potentially outperform. In fixed income, we’re positioned very close to the benchmark as far as interest rate sensitivity. Exposure to corporate credit is underweight relative to the benchmark, but we recently purchased a new position focusing on structured mortgage credit and also continue to own private real estate as an alternative. And in commodities, we continue to carry an overweight to gold.
Markets enter 2020 still carrying the positive tone that was set last year. While it may be a stretch to expect similar gains that were enjoyed in 2019, there are still solid reasons to believe that the economy can continue to grow. There will undoubtedly be pullbacks and corrections along the way, but with a global economy expected to rebound, plenty of central bank stimulus, very low interest rates, reduced trade tensions, and recovering corporate earnings, we believe that the overall environment is supportive of taking a moderately bullish amount of risk. Of course, this view is subject to change as the year progresses for the reasons described, and therefore it will continue to be important to maintain a flexible approach to asset allocation.