Our 2020 Market Commentary was written before the killing of Iranian Maj. Gen. Qassim Suleimani. The military action does not change our outlook but does confirm the importance of geopolitical risk in our analysis.
Financial Outlook 2020
Analysts generally agree that 2020 will be a decent year for the United States economy, with a possible upturn in the global economy as well. For now, the US has avoided a recession and extended the business cycle. In addition, Congress has added an election year stimulus boost. Not a bad forecast!
As for the markets? Less predictable. The analysts we read offer a range of outcomes for the year-end S&P 500, with a concentration of predictions clustering around the low to mid-single digit returns. Key variables include geopolitical risk (which is harder to forecast than economic indicators) and vulnerable equity valuations (which rose close to 30% in 2019).
Like the analysts, our market performance expectations are muted. We would best characterize 2020 as a year in which a “pause effect” allows just enough support for the markets to remain positive a while longer.
Initial Trade Accord
The most obvious pause is the truce between President Trump and China’s Xi Jinping. The Phase-One trade deal (set to be signed early this year) will help to smooth over tensions by lowering/postponing some tariffs and increasing Chinese purchases of US agricultural products. This lull in animosity is designed to create time for a more meaningful agreement to be crafted in the future. In the meantime, both countries can focus on building and maintaining stronger economies for their own 2020 purposes.
The Fed Pause
Recessions are most often triggered by tight monetary policy. In response to high inflation, the Federal Reserve usually raises interest rates, thereby decreasing liquidity and the ability for businesses to borrow. Businesses pull back, people are laid off and the recession begins.
In 2019 the Federal Reserve (and other central banks) reset the monetary policy clock and extended the business cycle by lowering interest rates. Inflation worries are now on hold, as are any further rate changes by the Federal Reserve. Ideally, this pause can last at least through 2020, helping to maintain a floor on market volatility.
Federal Debt Discussion Ceasefire
No one is talking about the looming (albeit longer term) issue of our ballooning federal debt. Rather, both political parties have ratchetted up fiscal stimulus (spending that is funded by debt) in order to impress the voters back home. In December the Consolidated Appropriations Act of 2020 was passed and included 1.4 Trillion in discretionary spending. Bipartisanship was in full view, if only because there was no time to object to this last-minute deal. Everyone got a little of what they wanted: favorable tax adjustments, increases in national security and defense spending, as well as support for domestic priorities such as early childhood education and gun violence research. The result will be an economy in 2020 that will have a temporary boost, while conversations of our debt indulgence wait for another year.
Our positive scenario is not without risk
Most risks, as noted earlier, are geopolitical:
- China and the US tensions might flare up again
- Europe could become Trump’s next tariff target
- The election may be too close to call, keeping the markets jittery
- And foreign governments (North Korea, Iran, etc.) could create unexpected challenges
And some risks are economic:
- Inflation might rear its head, causing the Fed to raise rates
- Global economic growth could remain anemic
- Credit markets may begin to struggle if corporate debt quality decreases
That said, our base case is that the US economy will remain resilient over the next year. Unemployment is at record lows; the housing market is reviving; and the consumer is quite confident. As long as the Federal Reserve remains accommodative, we believe a recession can be held at bay.
Where does that leave the markets? One step ahead of the economy
The stock market likes to anticipate events 6-9 months out. In 2017 the equity markets rallied strongly in expectation of the Tax Cuts and Jobs Act (TCJA), even though in 2017 the economy was growing at a modest 2.2%. In 2018 the S&P 500 fell 6.2% in spite of 24% growth in company earnings. Investors were worried that Federal Reserve would raise rates too high and that the US/China trade war would escalate. Then in 2019 the markets rallied again, this time to new heights, when the Fed cut rates and talks with China appeared to progress, even though company earnings growth tumbled to approximately 2%. You get the picture. Markets ultimately care more about what could transpire in the future than what is happening today.
So the issue for the markets is how long does the 2020 “pause effect” last? And at what point will uncertainty for the future, combined with already lofty valuations, offset the current optimistic sentiment and stable economy? Right now, we could see the slow growth, no recession, economy stretch well into 2021. However, we also believe that market enthusiasm will be capped, as geopolitical risks test investor resolve throughout the year. And at some point, markets will begin to worry about the end of the current business cycle. Keep your eye on the Federal Reserve as to when that may happen.
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