After 2019’s banner year in the equity markets (the best since 2013) and positive returns in most other asset classes, what can we expect in 2020 and beyond? Of course, we can only make educated guesses about what will happen in the future, but let’s take a look at what is informing our decisions here at Coastline.
In large part, the stock and bond markets are a reflection of the economy, both what is currently happening, and what investors expect or fear will happen. In the U.S., consensus estimates for Real GDP hover around 1.8% for 2020. This is in line with the economy’s long term potential rate of growth, which, according to most economists, lies somewhere between 1.75% and 2%. Economic growth is likely to be bolstered by tempering of trade rhetoric between the US and China, continuing robust consumer spending with some wage increase, and a slight pick up in manufacturing. Risks to this growth include a worsening of trade tensions with China, or if we don’t see a pick up in business capital expenditures that is baked into those numbers. Our takeaway is that a recession is unlikely in 2020, but blockbuster growth should not be expected either.
With expectations for the S&P 500 Price-to-Earnings ratio to be around 18.6x over the next twelve months (this means how many times higher is the stock price than the earnings per share), the stock market will likely need to see some growth in the underlying earnings to post positive returns this year. Analysts are estimating earnings will grow around 9.5% in 20202, and when paired with a 1.9% dividend yield, we are looking at a 7% return for the S&P 500. It bears repeating that these are just estimates, and almost certainly, the performance will be something other than 7%, but it does give us something to build on. Overall, we are slightly overweight US stocks versus bonds and international stocks and expect the Information Technology, Financials, and Health Care sectors to perform well over the near term.
Our move from significantly overweight US stocks to just slightly overweight results in an increase in international holdings. International markets are starting to become more attractive from an investing standpoint. Having lagged the US for several years, valuations overseas are at more reasonable levels than here at home; you just don’t have to pay as much for the same earnings with international stocks currently. As Brexit and other political uncertainties unwind themselves and emerging market countries form stronger alliances with European trade partners, we are cautiously optimistic that geographic diversification can start to improve risk-adjusted returns client portfolios.
As animosity simmers (or grows) between the US and China, expect to see ties between the EU and China strengthen, to the benefit of both economies. We think emerging market stocks have more upside potential than those from more developed countries because of the resource-rich nature of their exports and more capacity to benefit from modernization and globalization. However, emerging markets remain a much smaller allocation in portfolios than their developed counterparts because those higher potential returns come at the price of more significant risks.
The Bond Markets
With Treasury yields remaining depressed and income being hard to come by, an increased focus on the bond portion of portfolios is warranted. The Federal Reserve is unlikely to cut rates in the first half of the year and if history is any indication, with this being an election year, what occurs in the first half the year is likely to continue through the end of the year because the Fed does not want its’ moves to be seen as politically motivated. “Lower for longer” is still the refrain for fixed income markets, with many analysts expecting the 10 yr treasury yield to end the year essentially unchanged from its’ 1.9% 2019 ending value.
The Federal Reserve has already dismissed the idea of negative rates in the US, and with rates low or negative elsewhere around the world, it might appear that bonds have a skewed trade-off of risk for return, meaning there is more downside than upside. However, it is crucial to remember that we include bonds in our portfolios not just for income but to act as ballast against volatility in the stock market as well. We need to be careful about “reaching” for yield and overexposing portfolios to parts of the bond market that move more in tandem with stocks like corporate debt and high yield bonds. Those are essential pieces of a fixed income allocation, but we feel the majority should be in US Treasuries and Agencies with high credit quality. We have started to build individual bond ladders where cash flow is necessary as well to avoid the risks of interest rates going up and negatively impacting bond funds at liquidation.
Political Climate in the US
All eyes, both in the US and abroad, will be on the US presidential election this year. Favorable tailwinds for incumbent Donald Trump include a growing economy, fractured Democratic party with no clear candidate yet, and a resolution to the ongoing impeachment trial are likely to propel him to victory in November. Since 1900 only five incumbents have lost reelection (Taft ’12, Hoover ’32, Ford ‘76, Carter ’80, and Bush Sr. ’92), and in all cases, the economy was contracting or already in recession, making President Trump a statistically likely winner. This bodes well for the market, as President Trump has made stock market performance a measuring stick for the success of his presidency, and will hopefully avoid escalating trade disputes and tariff wars because of their potential negative impacts on the markets. The markets would surely react negatively should a more progressive liberal candidate like Bernie Sanders or Elizabeth Warren manage to defeat President Trump because of their anti-business policy platforms. I think investors should be prepared for a more significant pullback than usual if Sanders or Warren even just become the Democratic nominee, though this will likely be short-lived.
Perhaps more important than the presidential race are the congressional elections for 2020. The Democrats built a substantial majority in the House of Representatives in 2018, and Republicans would need to pick up 20 seats regain control. Not impossible, but not extremely likely either. In the Senate, Republicans currently hold a 53-47 majority, and 35 seats will come up for reelection this year. Six of those seats are in districts that are considered competitive, with Republicans holding five of the six. If the Democrats were to win four of the six seats at risk of flipping and retain their majority in the House, that could mean significant impacts to the markets.
What does it all mean?
Taking all these parts together, we expect a modestly positive year for equity and bond markets. Don’t expect those returns to come without increased volatility (price movement), though, perhaps significantly increased compared to the relatively calm markets we have seen in the past few years. We encourage you to remember that pullbacks are healthy and ordinary, and we don’t construct portfolios expecting stocks only to go up, we build them to be prepared for when they go down. That is why we talk about emergency cash positions and not investing in the market that we can’t afford to sit on for a while.
It is essential that you have a firm understanding of your capacity and tolerance for taking risk, meaning how much uncomfortableness you can endure before you do the worse thing possible for building long term wealth; panic and sell your holdings and hide in cash. We have seen it many, many times, and rarely do people get that timing correct, to not only get out before the bottom but to have the courage to get back in. More often, investors wait until the market is past where they got out because they never felt comfortable things had turned firmly positive, and end up with lower returns and the same amount of stress as if they had just held on and stayed invested! These last two charts can hopefully illustrate how much more powerful TIME IN the market is compared TIMING, and how the proper long term asset allocation can make that ride a whole lot more bearable.
Happy Mardi Gras everyone,
Jonathan A. Murdock
There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. Past performance is not indicative of future results. Asset allocation and diversification do not ensure a profit or protect against a loss.
Opinions expressed are those of Jonathan Murdock and not necessarily those of RJFS or Raymond James. All opinions are as of this date and are subject to change without notice.
THIS MATERIAL IS FOR INFORMATIONAL PURPOSES ONLY AND SHOULD NOT BE USED OR CONSTRUED AS A
RECOMMENDATION REGARDING ANY SECURITY OUTSIDE OF A MANAGED ACCOUNT.
There is no assurance that any investment strategy will be successful or that any securities transaction, holdings, sectors or allocations discussed will be profitable. It should not be assumed that any investment recommendation or decisions made in the future will be profitable or will equal any investment performance discussed herein. Investing involves risk, including loss.
International investing involves special risks, including currency fluctuations, different financial accounting standards, and possible political and economic volatility. Investing in emerging and frontier markets can be riskier than investing in well-established foreign markets.
Investing in small- and mid-cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor.
There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices rise. US government bonds and Treasury bills are guaranteed by the US government and, if held to maturity, offer a fixed rate of return and guaranteed principal value. US government bonds are issued and guaranteed as to the timely payment of principal and interest by the federal government. Treasury bills are certificates reflecting short-term obligations of the US government.
While interest on municipal bonds is generally exempt from federal income tax, they may be subject to the federal alternative minimum tax, or state or local taxes. In addition, certain municipal bonds (such as Build America Bonds) are issued without a federal tax exemption, which subjects the related interest income to federal income tax. Municipal bonds may be subject to capital gains taxes if sold or redeemed at a profit.
If bonds are sold prior to maturity, the proceeds may be more or less than original cost. A credit rating of a security is not a recommendation to buy, sell or hold securities and may be subject to review, revisions, suspension, reduction or withdrawal at any time by the assigning rating agency.
Commodities and currencies are generally considered speculative because of the significant potential for investment loss. They are volatile investments and should only form a small part of a diversified portfolio. Markets for precious metals and other commodities are likely to be volatile and there may be sharp price fluctuations even during periods when prices overall are rising.
Investing in REITs can be subject to declines in the value of real estate. Economic conditions, property taxes, tax laws and interest rates all present potential risks to real estate investments.
High-yield bonds are not suitable for all investors. The risk of default may increase due to changes in the issuer’s credit quality. Price changes may occur due to changes in interest rates and the liquidity of the bond. When appropriate, these bonds should only comprise a modest portion of your portfolio.
Beta compares volatility of a security with an index. Alpha is a measure of performance on a risk-adjusted basis.
The process of rebalancing may result in tax consequences.
Alternative investments involve specific risks that may be greater than those associated with traditional investments and may be offered only to clients who meet specific suitability requirements, including minimum net worth tests. Investors should consider the special risks with alternative investments including limited liquidity, tax considerations, incentive fee structures, potentially speculative investment strategies, and different regulatory and reporting requirements. Investors should only invest in hedge funds, managed futures, distressed credit or other similar strategies if they do not require a liquid investment and can bear the risk of substantial losses. There can be no assurance that any investment will meet its performance objectives or that substantial losses will be avoided.
The companies engaged in business related to a specific sector are subject to fierce competition and their products and services may be subject to rapid obsolescence.
The indexes are unmanaged and an investment cannot be made directly into them. The Dow Jones Industrial Average is an unmanaged index of 30 widely held securities. The NASDAQ Composite Index is an unmanaged index of all stocks traded on the NASDAQ over-the-counter market. The S&P 500 is an unmanaged index of 500 widely held securities. The Shanghai Composite Index tracks the daily price performance of all A-shares and B-shares listed on the Shanghai Stock Exchange.
The VIX is the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility.
Small-Cap Stocks refers to a company’s capitalization as determined by the total market value of its publicly traded shares.
Large-Cap Stocks are generally defined as those with market capitalizations of more than $10 billion.
Energy Sector is a category of stocks that relate to producing or supplying energy.
Commodity is a basic good used in commerce that is interchangeable with other commodities of the same type.
Commodities are most often used as inputs in the production of other goods or services.
Fixed Income is a type of investment in which real return rates or periodic income is received at regular intervals and at reasonably predictable levels.
High-Yield Bond is a high paying bond with a lower credit rating than investment-grade corporate bonds, Treasury bonds and municipal bonds.
International: This asset class represents managers that seek long term capital appreciation by investing primarily in companies outside of the United States, including emerging markets in some instances. Companies of all cap sizes may be considered. Investments are primarily ADR equities and may be subject to additional risks such as currency fluctuations, differing financial accounting standards by country, and possible political and economic risks.
Source: Kliesen, K. L. (2019, November 25). Forecasters See Lower U.S. GDP Growth in 2020 as Headwinds Continue. Retrieved from https://www.stlouisfed.org/publications/regional-economist/fourth-quarter-2019/forecasters-see-lower-gdp-growth-2020
Source: John Butters (2020, January 17) Factset Earnings Insight. Retrieved from https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_011720.pdf
Source: J.P. Morgan Global Market Insights Strategy Team (2020, January) Guide to the Markets. Retrieved from https://am.jpmorgan.com/us/en/asset-management/gim/protected/adv/insights/guide-to-the-markets/viewer
Source: Investment Strategy Committee, R. J. (2020). Investment Strategy Quarterly. Investment Strategy Quarterly , 12(1), 1–31. Retrieved from https://www.raymondjames.com/branches/library/features/investment_strategy/investment_strategy.pdf