Closing Out the Decade on a Strong Note
Domestic equities continued to move higher in December on the back of positive trade news, a favorable monetary policy stance, and growing expectations for a pickup in business investment in 2020. The S&P 500® was up 3.0% in December and 31.5% for full-year 2019, delivering its second strongest year since 1997 on a total return basis. While equities were generally strong across styles, capitalizations, and sectors, the strongest performance for the year was delivered by the faster-growing Information Technology sector, which had a total return of 50.4% in 2019.
With earnings growth expected to be essentially flat for 2019, virtually all of the S&P 500’s total return for the year came from multiple expansion, with the forward price-to-earnings (P/E) ratio climbing from a depressed 14.4 times (x) at the start of the year to a little over 18.2x on December 31. This valuation is well above the 20-year average of 15.6x but still below the current cycle peak of 18.5x reached in January 2018. With earnings growth expected to accelerate in 2020, we view valuations as supportive of further equity gains, particularly if macro headwinds continue to abate. Please see our first-quarter 2020 Strategy Insights, 20/20 Vision, for our full 2020 market outlook.
Providing a key catalyst for market performance, the United States and China reached a long-anticipated “phase one” trade agreement just before the December 15 deadline, when the United States was set to impose additional tariffs on $160 billion of Chinese consumer goods. The United States also agreed to reduce the level of tariffs on some existing Chinese goods. In return, China pledged to purchase more US agricultural products, make a greater effort to prevent intellectual property theft, and to not manipulate its currency.
In other positive news, US lawmakers agreed to a bipartisan spending bill funding the government through next September, avoiding a repeat of last December’s government shutdown. Furthermore, Congress finalized the terms of the US-Mexico-Canada Agreement, replacing the North American Free Trade Agreement. In our view, resolutions to some of the political/macro risks that hung over markets throughout 2019 should allow investors to refocus on solid underlying market fundamentals and help set the stage for further potential gains in 2020.
A theme throughout 2019 was the divergent paths of the US consumer and manufacturing economies. Economic data released in December continued to reflect these trends, with the unemployment rate falling back to a 50-year low of 3.5%.
The economy added a well-above-consensus 266,000 jobs, and average hourly earnings rose 3.1% year over year. Job openings have exceeded the number of unemployed persons for 19 straight months, signaling potential for further employment gains despite being late in the business cycle. In general, the latest employment report aligns with the Federal Reserve’s (Fed’s) view that the economy remains “in a good place” on the back of a strong labor market and provides support for a continuation in strong consumer spending in 2020.
Conversely, November’s US Institute for Supply Management® (ISM®) Manufacturing PMI reading dipped slightly to 48.1, marking the fourth consecutive month below 50. While a reading below 50 indicates a contracting US manufacturing economy, a reading above 42.9 is consistent with an expansion of the overall economy. The US manufacturing economy has been in a 15-month downtrend, weighed down largely by trade tensions between the United States and China and tighter financial conditions entering 2019. With a favorable trade resolution between the two countries, we have a more optimistic outlook for the manufacturing economy heading into 2020.
As widely expected, the Federal Open Market Committee left its policy rate unchanged at its final meeting of 2019. Fed Chairman Jerome Powell reiterated that the Fed is on “pause” and stated it would take a material change in the Fed’s economic and inflation outlook to induce a move in either direction. Chairman Powell set the bar fairly high for interest rate hikes in 2020, suggesting it would only be appropriate in the event of a significant and persistent rise in inflation (that is, an overshoot to the Fed’s 2.0% target). The Fed’s preferred measure of inflation, the year-over-year change in the US Core Personal Consumption Expenditure Index, is currently at 1.6%.
In conjunction with the Fed’s actions, favorable trade developments, and resilient economic data, Treasury yields moved higher for a fourth consecutive month. Following suit, corporate investment-grade and high-yield credit spreads declined to new lows in December, driving the total return on the Bloomberg Barclays US Aggregate bond index to 8.7% for the year, its strongest annual return since 2002.
Our business cycle analysis continues to suggest the overall economy remains in a slowing expansion. We anticipate the lagged effects of easier monetary policy and reduced trade tensions could have the potential to encourage a rebound in corporate spending and lead to a modest pickup in global growth in 2020.
We are encouraged by accommodative monetary policy that appears to be providing a boost to the US housing market, one of the most cyclically sensitive components of the US economy. This is not to say we do not see any potential headwinds as we head into the new year: We expect the US presidential election to likely dominate headlines as we enter the second half of the year, potentially leading to greater market volatility. However, the US economy and the equity market look to be in much more fundamentally sound positions today than at the start of 2019, in our view.
International Developed Markets
With Key Risks Easing, Green Shoots May Continue to Take Hold in 2020
A continuation of accommodative monetary policy and optimism around easing trade tensions are supportive for a stabilization of economic growth and a path higher for developed international market assets. Investor confidence has improved in recent months, with two key macro headwinds reaching favorable conclusions: 1) the United States and China agreed on a phase one trade deal, and 2) the UK snap election provided a clearer path for a smooth exit from the European Union (EU). Reflecting these positives, the STOXX® Euro 600 Index, FTSE 250 Index, and the German DAX all notched new all-time highs in December, and Japan’s Nikkei 225 Index is just shy of its all-time high.
On December 12, Prime Minister Boris Johnson’s Conservative party secured its largest Parliamentary majority since 1987, winning 365 seats in the 650- seat British House of Commons. The result paves the way for the United Kingdom to finally exit the EU as scheduled on January 31, 2020, and decreases the likelihood of a “hard” Brexit, in our view. The focus now shifts toward the UK’s ability to successfully negotiate a trade agreement with the EU by the end of 2020. The FTSE 250 Index rallied more than 4% in reaction to the news and remains near its all-time high.
While the ultimate Brexit outcome depends on a successful trade agreement between the United Kingdom and the EU, we believe fundamentals for British equities remain on solid footing, and we continue to recommend diversified, actively managed solutions for exposure to UK equities.
In Christine Lagarde’s debut as European Central Bank president, the policy rate was unchanged at -0.5% and the central bank maintained bond purchases of €20 billion per month. Most importantly, in our view, Ms. Lagarde acknowledged the Eurozone economy is showing signs of bottoming and noted further rate cuts are unlikely in the near future. The Bank of Japan also left rates on hold in negative territory and will likely continue to do so amid persistently low inflation. Despite the continuation of negative central bank policy rates, developed sovereign debt yields continued to move higher in December, with the 10-year government bond yields of Belgium and France closing above zero for the first time since June 2019. The increase in government bond yields over the past four months has reduced the amount of global negative yielding debt from an August peak of $17 trillion to less than $12 trillion at year end.
In December, Sweden’s Riksbank became the first central bank to lift policy rates out of negative territory, increasing the repo rate by 25 basis points (bps) to 0%. The central bank highlighted that its negative interest rate policy was only intended to be a short-term measure and cited potential distortions to the pricing of risk assets over the long term, as it ended the five-year long experiment.
Germany remains at the forefront of a potential economic recovery in the EU. Although industrial production dipped in December, the Ifo Business Expectations Index continued to turn higher and the ZEW survey (expectations of economic growth) jumped to 10.7, the first positive reading since April and the highest level since February 2018. This likely reflects improvements in recent survey/macro readings in Germany and a domestic stock market near an all- time high. Because Germany is exposed to a variety of macro crosswinds and represents nearly one-third of EU economic growth, a meaningful improvement in economic growth in the country is an important catalyst to an economic recovery in the Eurozone.
In conjunction with December rallies in developed international equities, the MSCI World ex-US Index was up 3.2% on a total return basis, modestly outperforming the S&P 500. However, the index continues to trade at a more than three-turn valuation discount to US equities. (Please see our first-quarter Strategy Insights, 20/20 Vision for further discussion on the drivers of this valuation differential.) While many concerns remain across international developed markets, we believe the positive developments in December should help remove some business uncertainty, supporting a relatively more favorable investment backdrop into 2020.
Emerging Markets Rally on Easing Trade Tensions
Supported by encouraging headlines on global trade, the MSCI Emerging Markets (EM) Index had a total return of nearly 7.5% and delivered its second best performance month of the year.
As sectors like Financials and Materials grind higher on the ongoing global cyclical rotation, the EM Information Technology sector also surged higher in December, led by the semiconductor industry and supported by easing trade tensions.
EM central banks in Brazil, Mexico, Russia, and Turkey lowered policy rates in December in their bid to ease financial conditions amid slower-than-expected economic growth and tame inflation. Given the lag between monetary policy implementation and its impact on local economies, we expect the shift toward more accommodative policy to crystallize over the coming year, supporting the outlook for stronger growth in 2020. Lower interest rates served as the primary catalyst for the 13.1% total return generated by the Bloomberg Barclays EM USD Aggregate bond index in 2019.
Notably absent from the list of central banks easing in December was the People’s Bank of China (PBOC). In our view, the PBOC has been providing stimulus throughout 2019; however, December’s economic data were strong enough that further material monetary support was not warranted. The yuan strengthened to levels not seen since August, and both industrial production and retail sales growth bested consensus estimates. Caixin China Composite PMITM Index also reached its highest level since February 2018 (53.2), and the manufacturing component of the index also moved further into expansion (>50) for the fourth consecutive month (51.8).
The Latin America region had the best performance for the month, led by stocks in Argentina, which were up more than 13%. Argentina was upgraded by MSCI Inc. to EM status in the beginning of June; however, its time in the index has been tumultuous at best, lagging the EM Index by 3,500 bps. The saga took an even worse turn after the surprise victory by President-elect Alberto Fernandez in late October, which prompted MSCI to threaten downgrading Argentina back out of the EM Index due to potential capital controls that could limit investor access. However, in mid-December, MSCI announced Argentina will remain in the index, prompting stocks to rally across the country and Latin America.
From a valuation perspective, the MSCI EM forward P/E ended December at a year-to-date high of 12.8x but still below prior peaks from 2018. Although the consensus next-12-month earnings-per-share estimate has yet to return to its April 2018 high, the consensus earnings growth estimate for 2020 is currently 15%, creating a solid growth outlook for EM equities. For perspective, consensus growth expectations for 2019 started the year at 8% but finished the year at -9% due to significant downward revisions in the Information Technology sector, given the negative earnings impacts from trade. However, we believe the worst of the global trade tensions are behind us. We expect lower downward revisions to earnings estimates for 2020, providing a far better fundamental backdrop heading into the new year.
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