Fourth Quarter 2019 Client Newsletter

What a year! The final year of the 2010’s had it all – a global manufacturing recession, a rock-solid US Consumer, trade policy: tweets, tirades, and truces, the greatest push to global monetary accommodation since the financial crisis, and don’t forget the earliest start to a presidential election cycle ever.  Despite a few market-wide bumps along the way, our strategies produced record-low volatility, and in most cases, double-digit returns.

In our newsletter this quarter, we’ll analyze the events that shaped 2019 and assess their potential impact on 2020.  We’ll get back to basics by providing a ‘blocking and tackling’ evaluation of corporate earnings, global interest rates, and market valuations. And throughout the review we’ll outline the potential implications for asset classes returns and our strategy in the year to come.

The Year That Was >> The Year That Is

In various newsletters over the past two years, we’ve introduced and expanded on the idea that the market had entered a consolidation phase during an otherwise healthy bull market. This consolidation phase meant that the health of the economic expansion was being questioned and needed structural support. Consolidation are not unusual for markets, and we’ve seen two other such periods since the market lows in 2009.

The most recent consolidation looks similar to the previous iterations on a technical basis but has unique fundamental drivers that were extremely consistent throughout the year.

• Global Trade Policy Constrains Business Confidence/Spending:  Uncertainty about our future trading relationships with China/Mexico/Canada/Europe caused angst in both the C-Suite and the trading pits all year.
• Central Banks Pledge Support:  After 2 years of seeking to ‘normalize’ monetary policy, global central banks have reaffirmed their pledge to sustain the expansion in both the global economy, as well as the markets.
• U.S. vs. The Rest:  Slowing world export volumes caused a global manufacturing contraction which hit developed Europe and Emerging Asia especially hard.  With a relatively small manufacturing base and hot labor market in the U.S., we’ve seen a decoupling of U.S. vs. the rest of the world. 

The chart above chronicles the ebb and flow of economic/market events throughout 2019.  Positive Consumer data sets (Retail Sales & BLS Payroll Growth) are in GREEN, Negative Manufacturing data (Manufacturing PMI & Industrial Production) are in RED, and Federal Reserve Rate Cuts are in YELLOW.  For the sake of readability, we’ve reduced the number of ‘trade headlines’ to only the most critical. Although to be fair, commentary on progressing or regressing trade talks was the proximate cause of more intraday market swings than any other topic in recent memory.

You’ll notice that each negative read on the manufacturing/industrial was met with a positive indication for the U.S. consumer.  While a few trade headlines caused rapid 5-7% drops, this seesaw effect in the data paired with a very dovish Fed kept market participants seeing the glass as half-full.

As we look to 2020, the divergent data sets of ‘Consumer vs. Manufacturing’ and ‘U.S. vs. Global’ remain at the forefront of conflicting fundamental narratives.  The Fed is likely on the sidelines pending signals of inflation or weakness in the labor market.  The expectation is that further adjustments to U.S. trade policy will be on the back burner until after the presidential election. Though it should not be overlooked that tariffs on hundreds of billions in imports from China remain in force subject to ‘phase II’ trade talks. For now, we’re likely experiencing a fickle trade ceasefire, rather than a new trade peace.

Earnings & Valuation

Markets, and the stocks that comprise them move for two reasons: either the underlying companies are earning more/less money, or investors are willing to assign a higher/lower valuation. Since there are only two fundamental ways to increase a company’s net income (increase revenue or cut costs), earnings are straightforward to measure. The rationale for a higher/lower valuation, on the other hand, generally stems from some combination of the interest rate environment, investor confidence, and the outlook for shareholder-friendly activities (dividends and buybacks). These subjective factors are tough to quantify and can make for confounding price action, especially when prices decouple completely from earnings growth.

The relationship of market price as measured by the S&P 500, and per-share earnings over the past ten years is charted below.  And as you’d expect, the two are usually very highly correlated.

Clearly 2019 was not one of the years where the positive relationship held true.  Earnings were essentially unchanged over the past 12 months while the market advanced in the double-digits.  This ‘multiple expansion’ means that investors have accepted the same amount of earnings for a higher price.  

When we look at the current price investors are willing to pay for a dollar in earnings (P/E) or sales (P/S), we see the richest price-to-sales ratio ever, and the highest price-to-earnings ratio since the Dot-Com Bubble.  

While a resumption in earnings growth would be a welcomed development in 2020, the 7% earnings growth currently expected would do little to dampen the historic valuations achieved in 2019. In the previous market consolidation (2015/2016), earnings growth was resurrected by the promise of a corporate tax cut and sweeping deregulation. We certainly can’t bank on another round of fiscal stimulus, but it’s a good bet that corporate tax rates will be a significant point of contention in the coming election.

The bottom line: stocks are not cheap. But given the unbridled fiscal and monetary support they’ve enjoyed, a coherent case can be made that they do represent relative value compared to other asset classes. Although relative value arguments for equities don’t typically provide much support in the case of outright recession.

Interest Rates and Monetary Policy

As we’ve discussed, the dynamism of 2019 was defined not by fundamental economic strength, but by the responsiveness of global central banks. After engaging in a 3 year tightening (restrictive) cycle, our Federal Reserve did an about-face in 2019. This flip to an easing (supportive) regime included three cuts to short-term interest rates and a resumption in balance sheet expansion through the open market purchase of treasury securities. This shift from restrictive to accommodative policy was the most significant such shift since the great financial crisis.

The chart below looks at both the current policy rate (green) and the 12-months forward rate (blue).   The blue line represents where market participants expect the Fed policy rate to be in one year.  When the blue line is above the green, the market is anticipating the fed to tighten monetary policy.  Up until the Spring of 2019, the consistent expectation was that the fed would continue to hike rates.  All that changed after the 20% drop in stocks in the 4th quarter of 2018.   Investors fled risk-assets and spurred the Fed to cut rates three times in 2019. Remember, lower rates equal more accommodative policy.

Global central banks followed our Fed’s lead and cut rates a collective 71 times throughout 2019. This coordinated lowering of policy rates helped to sustain historic lows in international sovereign yields.  For example, U.S. 10-year government yields (+1.77%) are effectively the lowest on record, yet they still dwarf rates earned by investors in German (-0.27%) or Japanese (0.00%) bonds.

The fact that interest rates are historically low is far from breaking news - negative yields have now been a reality for nearly 5 years.  Given the Fed’s current stance, it’s tough to see a path to substantially higher short rates in the U.S. until we see a dramatic increase in inflation expectations. The path for longer-term rates domestically will likely be driven by the comparable rate of German and Japanese debt.  Although make no mistake, outside of recession, the prospect of substantially higher rates is the greatest risks to investor confidence.

Conclusion

We’re very pleased with how our clients performed in 2019 and expect to find similar challenges and opportunities in 2020.  Throughout the year, we’ll be intently watching for upticks in global economic growth and inflation pressure. Those two areas will likely tell the story of what asset classes will perform best.  

If you have any questions on our strategy, your holdings, or the status of your financial plan, please reach out to us.  

All of us at Mader Shannon wish you a happy and prosperous new year,

Kyle