MARKET COMMENTARY

Will Risk Be Rewarded in 2020?

12.19.2019 - Ronald J. Sanchez, CFA

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The economy and markets suggest a more cautious approach

2019 was another robust year for risk asset returns and another weak year relative to historic standards for economic growth. In this sense, it was a microcosm of the entire decade. Markets persistently outperformed despite a plodding, muddle-through type of economy.

The scars from the Great Financial Crisis (GFC) remained never far from investors’ minds as the least loved stock rally in living memory continued for a decade.

Looking back to look forward

As we approach 2020, it may be helpful to recall some of the past decade’s highlights. Coming out of 2009, the world was still racked by the GFC. Although US economic growth had returned, it remained mired at a slower pace than its pre-crisis peak. Terms such as “quantitative easing (QE),” “zero interest rate policy (ZIRP)” and “Troubled Asset Relief Program (TARP)” were heard with an increasing frequency as policymakers sought to mitigate the global downturn via new monetary policy tools. A bottom had, with the benefit of hindsight, been reached by the S&P 500, but to shell-shocked investors, the next downturn never felt too far away.

Economic fallout provided seeds for rebirth

Despite the economy feeling closer to recession than growth, the economic slack created by the recession provided the fuel for the ensuing recovery. At the time, with unemployment near double digits, the precariousness of the situation masked the vast amount of idle potential existing within the economy, which would drive innovations in everything from labor to automobiles to houses.

The move toward energy independence led by the US shale revolution helped contain and even depress oil prices. More than just a boon to consumers, this also proved helpful to the Federal Reserve’s ability to maintain lower interest rates longer than previously thought possible. Global conditions also contributed, with anemic growth in Europe and a slowing China dampening inflationary pressures.

Outperformers for the past ten years

The shift from a nascent recovery beginning in 2009 to today’s mature environment was characterized by three key macroeconomic themes: a lack of global growth, a lack of inflation, and a lack of yield combined with accommodative monetary policies.

The confluence of these factors produced a not-too-hot, not-too-cold (Goldilocks) economy which, perhaps surprisingly, provided an enormous boost to a host of financial assets (CHART 1). A robust returns environment arose for both “risky” stocks and “safe” bonds. A typical portfolio mix of 60% stocks and 40% bonds proved to be ideal as both asset classes delivered returns well in excess of their historical averages.

 

The weaker global growth trajectory caused investors to place an ever-increasing premium on the regions, industries and companies capable of exponentially increasing revenues. That kind of revenue growth was in short supply and the few firms, mainly in the US, that offered it were outsize winners. Investors became so accustomed to discussing these US technology highflyers that they were colloquially termed “FAANG”—Facebook, Amazon, Apple, Netflix and Google— as these companies provided a large portion of the S&P 500’s return advantage versus the rest of the world.

While investors increasingly searched for growth, they also sought safety and income via global fixed income markets. As interest rates neared 0%, investors looked beyond government bonds to augment yield. Central banks, via QE policies, had purchased massive amounts of fixed income securities, effectively encouraging investors to purchase riskier assets while the low absolute level of yields encouraged a stronger appetite for credit risk and a further reach for yield (CHART 2).

Fixed income performed on par with non-US equity markets, while US Treasuries produced a comparable return to emerging markets equity with considerably less risk. The search for yield went beyond fixed income and also impacted the pricing of the highest quality income-oriented equities. For instance, Procter & Gamble, perhaps the gold standard for high quality, dividend-paying stocks, saw its valuation advantage relative to its peers remain in place, even as low interest rates helped the broader index move toward higher price-to-equity (P/E) levels. These higher valuations occurred within an environment of greatly lower volatility, as steady though uninspiring growth met investor demand for US equities.



Diversification wasn't rewarded

Dips and corrections in equity prices seemed to all but disappear, as consistent strength in domestic equity markets became the norm (CHART 3). This dearth of volatility challenged traditional investment orthodoxy which argues that outperformers will vary from year to year and, as such, provide an incentive to diversify an overall portfolio. However, over the decade, asset class winners did not rotate, but simply kept on winning. For example, large-cap equities ranked as one of the top three performers for five out of the last six calendar years. That singularity of success is largely contrary to the market’s performance during prior market cycles.

Will Goldilocks keep her charm?

With 2020 on the horizon, the US economy finds itself in its tenth consecutive year of expansion, the longest period on record. The country’s unemployment rate stands at its lowest level in modern history and there are indications that workers may finally be gaining bargaining power regarding wages. Yet, inflation has largely proved absent and interest rates seem poised to hover at multigenerational lows.

From a market perspective, the S&P 500 is currently near all-time highs. As volatility has remained contained near its lows, P/E levels have richened considerably and are now near levels that are considered full to slightly overvalued. Investors’ unrelenting appetite for growth and technology companies is being challenged by the next generation of IPOs struggling to move from highgrowth, high cash-burn business models to sustainable, investable ones. While a continuation of the same Goldilocks economic backdrop seems likely, more of the same does not seem capable of generating the same return profile as the last decade.



In search of catalysts

We believe these factors add up to a world without obvious catalysts. In our opinion, the peak effects of monetary policy are likely in the past. The trajectory of global growth seems lower, pulling inflation and interest rates lower with it. While the drivers were hard to see 10 years ago as we emerged from the recession, the valuations were palatable. Now, with near all-time highs in US equities and lows in global interest rates, the lack of new catalysts makes us more wary about the year ahead.

A time to reassess risk

Given the economic backdrop, we believe that risk management, while always of the utmost importance, must become an even larger focus for investors. We no longer foresee a world in which the balance of risks is unambiguously tilted to the upside and must adjust our expectations accordingly.

We still believe that the economy will keep growing in 2020, albeit more slowly than in 2019. We believe that if GDP growth in the US hovers around 2%, coupled with equities trading near all-time highs, market participants could start to reassess the Goldilocks economy. Relatedly, both low interest rates and accommodative monetary policy support equity prices only so far. If such a tipping point were reached, falling rates, instead of supporting higher stock prices, could signal a darkening growth outlook.

In our opinion, the best way to manage through this environment is with a more cautious approach to portfolio construction. While we acknowledge that this has been a remarkably long cycle, we feel it will continue through the near term, despite current market valuations that seem stretched, economic growth and policy that leave much to be desired, and an absence of obvious change drivers in the marketplace.

We note the present policy uncertainty regarding trade in particular as a potential (though we believe unlikely) boon to equities.

Our assessment of the risk backdrop views the current situation as part of the investment foundation for the foreseeable future. It is always challenging to predict the future. It felt difficult to commit to an equity bull market 10 years ago and it feels equally hard to commit to one now. We are cognizant that a high-return, low-risk Goldilocks environment is not the norm. The fact that it was the hallmark of the last decade makes it a hard act to follow.



This analysis is provided for illustration and discussion purposes only and does not guarantee future results. Please speak to your Fiduciary Trust contact if you have questions or would like more information. This communication is intended solely to provide general information. The information and opinions stated are as of December 1, 2019, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA and Chartered Financial Analyst are trademarks owned by CFA institute.

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