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January 2020 Investment Commentary
The fourth quarter of 2019 was impressive, capping off a very strong year for investors. As the chart below shows, equity markets soared both at home and abroad, while bonds, hedge funds, and commodities also advanced, all finishing the year with solid gains. In contrast to the year before, 2019 was a year of relative calm and stability, aside from bouts of volatility in May and August. This was helped in the later months by improved trade dialogue between the U.S. and China, which supported a brighter economic outlook. Client portfolios benefited in the quarter, having been positioned on a view that recession was less likely than generally expected. A third quarter trade, in which hedged equity allocations were trimmed in favor of long-only U.S. equity exposure, added to portfolio performance.
|Fourth Quarter||2019||Five Years (ann.)|
|Developed International Stocks||8.2||22.0||5.7|
|Global Hedge Funds||2.6||8.6||1.2|
The quarter’s strength owed much to an easing of earlier-year concerns, including not only the economic growth track and issues around trade, but also monetary policy and political stability. On the economic front, a U.S. recession has been kept at bay, at least in the near term. Employment remains robust, the year-end jobless rate holding at a 50-year low of 3.5%. The December jobs growth number of 145,000 brought the year to 2.1 million and the decade to a remarkable 22.4 million. Consumer spending is strong, the 2.9% year-over-year gain in retail spending buoyed by a prosperous holiday season, undeterred by the shortened shopping calendar. With wage gains at 2.9% on an annual basis, the consumer is in solid shape heading into 2020.
On a more cautionary note, not all cylinders are firing. The manufacturing sector has been struggling, or worse, as the December Institute for Supply Management index saw its sharpest contraction in more than ten years. Also, U.S. productivity declined in the third quarter, the first negative reading since 2015, as output was scaled back, including exporters hurt by trade issues. These readings reinforce views that the 2017 corporate tax cut boost was brief and relatively minor, and to some extent was overtaken by the U.S.-China dispute. Overall, economists polled by The Wall Street Journal believe GDP growth in the U.S. will slow to just under 2% this year, down from an estimated 2.2% in 2019, and an expansion average of 2.3%.
As for trade, which has been such a dominating theme and emotional driver over the course of the last two years, we saw progress both with China and within our own hemisphere. “Phase One” of a U.S.-China settlement is expected to be signed as this is written. The deal would nix the 15% December-scheduled tariffs on $150 billion of consumer-oriented Chinese goods, including cell phones, laptops, clothes, and toys. Also, previously enacted tariffs on $120 billion of industrial goods would be reduced from 15% to 7.5%. In exchange, China agreed to cancel its own retaliatory tariffs and committed to increase U.S. agriculture purchases by $32 billion over the next two years. It is important to note, however, that the toughest issues remain largely unaddressed: intellectual property theft, currency devaluation, and ongoing enforcement presumably would be on the docket in Phase Two and beyond.
Closer to home, the new NAFTA was passed in the House in December, after about a year of negotiations with the White House. While keeping much of the original NAFTA, the update requires that 75% of any car made in North America be duty-free, up from 62.5%. Also, at least 40-50% of that car’s internal components must be made by workers earning $16 per hour, or the equivalent in pesos. The U.S. will contribute $45 million to Mexico, over the course of four years, to beef up its legal system and labor rights enforcement. Further, the deal would expand access to Canadian dairy markets and protect digital trade. The International Trade Commission estimates that the trilateral agreement could add some $70 billion, or about 0.3%, to U.S. GDP, adding 176,000 jobs.
Angst around the Federal Reserve, and central bank policy more broadly, also appeared to recede. The Fed cut rates by 0.25%, to 1.50-1.75%, in October, a third cut for the year. The bank elected to take no action in December, which was widely deemed as appropriate and still supportive of economic expansion. Perhaps more importantly, Chair Jerome Powell suggested that changes in 2020 are unlikely, given continued strength in the labor market and benign inflation, and again, this neutrality seemed to provide a sense of equilibrium. Overseas, the ECB mirrored its American counterpart, holding interest rates steady during its December meeting, which was the first to be presided over by new head Christine Lagarde. As expected, she also affirmed an agenda to push for fiscal support from Germany and elsewhere, also generally seen as desirable.
Politically, we saw an uptick in stability as 2019 ended. On December 18th, President Trump was impeached in the House, but it was a market non-event. Subject to current negotiation regarding the evidence to be weighed, the Senate trial likely will be wrapped up speedily and predictably. Meanwhile, in the U.K., Boris Johnson delivered an unexpectedly robust December victory to his Conservative party, which won the most seats in a general election since 1987 and now claims an outright majority in Parliament. Brexit’s Withdrawal Agreement was passed by the House of Commons in early January and is expected to pass the House of Lords shortly. Johnson thus appears to have a mandate for a U.K. exit of the E.U. at month-end.
Entering 2020, investors will have to search hard for value, and gauge prospective corporate performance. U.S. earnings growth may have been flat at best in 2019, with 7-8% potential growth arguably lost to trade dislocation. This follows 20% higher earnings in 2018, about half due to the corporate tax cut. Combining the recent earnings stall with their big 2019 price gain, U.S. stocks are trading at a moderately elevated valuation. The forward price/earnings ratio stands at around 18.2 times, compared to a 25-year average of 16.3 times. Overseas stocks, at 14.2 times, are in line with historical levels. Upper single-digit earnings growth is expected for both groups in 2020, assuming continuation of economic growth and avoidance of major trade setbacks. As said in the last letter, we think President Trump will want to avoid a trade war-induced recession in an election year, and this could be supportive for earnings and stocks.
Bonds continue to be even more expensive than stocks on a relative income/earnings yield basis, as has been the case for more than a decade. Real 10-year Treasury yields ended 2019 at a negative 0.40%, as the 1.92% nominal, or actual, yield was more than offset by a 2.32% year to year advance in the consumer price index. This compares to a 60-year average real yield of 2.32% (5.98% nominal yield less 3.66% inflation). Even with a no-action Fed, there is certainly room for an uptick in yields. On the other hand, even at lofty valuations, any slump in economic activity, escalation of geopolitical tensions or setback in the trade war could send yields tumbling back down on a flight to safety, possibly toward the 2019 low of 1.46%, reached in early September.
Investor fortunes in 2020 will depend in part on avoiding reversals. We’ve already seen new, very acute tensions in the wake of the killing of Iran’s Maj. Gen. Qassem Soleimani. However, there are opportunities that may be currently under-recognized. If we could firmly close the book on the trade war, even without everything on the wish list, businesses would recalibrate and plan. Whatever the new reality is, supply chains would be restored, and manufacturing investment, long deferred, could be rekindled. This is something the U.S. needs as it competes on the world stage in key fields such as 5G telecommunications and digital payments. There may already be green shoots in the memory chip sector, affirmed by Micron Technology and Samsung Electronics, each indicating recently that a cyclical bottom has been passed.
The U.S. election will take much of the stage as the year unfolds, and markets may take more notice than has been the case in the impeachment proceedings. With the parties at least rhetorically farther apart than historical norms, investors may have to gauge the possibility of wider policy swings in the event of a party power shift. While arguably the least likely of three outcomes (the other two a Trump reelection and a win by the moderate left), a progressive victory would be a big event, at a time when annual federal borrowing already has reclaimed the $1 trillion level. Tallying the cost of Medicare For All and various other programs, J.P. Morgan provided a chart showing that tax receipts as a percent of GDP would need to reach almost 25%, roughly four times the peak under FDR.
Considering the above, we are counseling a few changes in positioning this quarter. We are exiting the broad commodity space on recent strength. The proceeds from this trade will be put into a low-cost U.S. bond exchange-traded fund, providing a modicum of insurance in the event of a negative surprise, including recession. Elsewhere in the bond book, we are swapping a currency-focused fund into a more traditional global manager that can provide a similar overall risk and return experience, but in a smoother, less volatile manner. Overall, these moves allow us to add some portfolio defense and lower portfolio costs, while not sacrificing equity exposure.
We wish all of you the best for 2020 and the start of a new decade. As always, thank you for your continued support. Please feel free to reach out at any time with questions or concerns.
David S. Beckwith, CFA
Managing Director & Chief Investment Officer
Jason D. Edinger, CFA
This letter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.