Despite geopolitical and traditional late-cycle headwinds, the current economic expansion has extended its record-setting streak to 128 consecutive months. Markets rebounded in 2019 from a rough 4Q18 to post some of their strongest returns of this cycle. Thanks largely to robust consumer spending and dovish monetary policy initiatives, global economies fared better than expected in the face of escalating U.S./China trade tensions, political uncertainty in Europe surrounding Brexit, and decelerating growth trends common to late-cycle expansions. As we move deeper into the late stages of this expansionary cycle, growth deceleration will likely become more pronounced throughout 2020. Furthermore, recent military aggressions in the Middle East may potentially exacerbate an already murky geopolitical environment. However, barring any unexpected developments, dovish central bank policies (the effects of which tend to lag by 2-3 quarters) and strong consumer spending will likely continue to buoy the U.S. economy well into this year and early indications suggest that global economies will manage to stave off recession for yet another year.
Following a strong 2018 that saw robust GDP growth of 2.9%, early estimates for 2019 GDP growth are considerably lower at roughly 2.0% YoY. This deceleration is primarily attributed to material declines in business investments and exports, both of which have been negatively impacted by escalating trade tensions. That being said, it’s important to consider that business investments only account for a small portion of domestic GDP (approx. 14%). Consumer spending, on the other hand, represents over two-thirds of domestic GDP and is by far the largest sector of the US economy. The consumer has continued to benefit from steady growth trends throughout 2019 and is increasingly driving the growth that is keeping this record expansion going. The Fed continues to maintain its 2.0% median GDP growth expectations for 2020.
One of the main factors driving consumer spending is a historically tight labor market. As of 11/30/19, the unemployment rate was down to 3.5%, well below the 50-year average of 6.2%, and its lowest since 1969. Wages continue to grow modestly, up 3.7% YoY, just below the 50-year average of 4.0%. Total household net worth continues to rise and household debt service ratios remain low, enhancing free cash flow. As the expansion continues, an extremely tight labor market is likely to increase upward pressure on wages, further supporting a continuation of strong consumer spending trends throughout 2020.
Though consumer confidence remains high, business sentiment has started to wilt in the face of trade uncertainty. The ISM Manufacturing PMI in the US fell to 47.2 in December, the lowest since June 2009, and well below market expectations. This was the 5th straight month of decline in manufacturing activity as new orders, production, employment and new export orders shrank and price pressures increased. Global trade remains the most significant cross-industry issue, but there are signs that several industry sectors will improve as a result of the phase-one trade agreement between the U.S. and China, according to Timothy Fiore, Chair of the ISM. As previously mentioned, business investment accounts for a relatively small portion of domestic GDP growth which has prevented these results from materially impairing overall growth prospects thus far.
In response to softening global growth and market volatility resulting from trade tensions, global central banks began cutting interest rates in 2019 for the first time since the Great Recession. In the U.S., the Fed implemented three interest rate cuts (25 bps each), bringing the Fed Funds rate down to a range of 1.50%-1.75%. Typically, rate cuts are utilized during periods of contraction to revive economic output. While these types of monetary shifts are uncommon during expansionary cycles, persistently low inflation has enabled central banks to reverse course without much consequence. Headline CPI and Core CPI were 2.0% and 2.3% respectively (as of 11/30/19), which is well below their 50-year averages of roughly 4.0%. Nevertheless, Chairman Powell has made it clear he believes the Fed has completed its “mid-cycle adjustment” and that it would take a material change in outlook for there to be any additional rate changes in 2020. Furthermore, China’s policymakers are emphasizing just enough fiscal and monetary support to maintain stability without reaccelerating growth.
Global growth continues to decelerate and will likely weaken further in 2020. The Organization for Economic Cooperation and Development recently downgraded its global growth estimate to 2.9%, its lowest such target since 2009 (the last year of the Great Recession). Among the main reasons for this subdued forecast is weak data coming from large international economies, such as China, the U.K. and Germany. China’s growth is expected to dip to 6.2% (its lowest in decades), and has been largely impacted by trade tariffs on manufacturing and exports. Similarly, manufacturing sectors in European countries have also been hit hard by tariffs, with Germany in particular seeing a substantial decline in auto sales. After experiencing negative GDP growth in 2Q19, both Germany and the U.K. are expected to see weak growth rates of 1.2% and 0.6%, respectively for 2019. Despite these trends, global growth could be a bit more favorable in 2020, thanks to a temporary easing of tensions between the U.S. and China.
Geopolitical risk appears to be a major headwind for the global economy going into 2020. As we’ve mentioned many times in the past couple years, the ongoing trade conflict between the U.S. and China will likely continue to stall business spending and manufacturing output in 2020, despite a slight easing of tensions thanks to the “Phase 1” agreement in 4Q19. Though the tangible impact of this agreement is hard to assess, the symbolism it represents could provide a small boost to business sentiment. Similarly, uncertainty around Brexit’s impact on the global economy still exists, however a decisive result in the recent U.K. election could potentially pave the way for a relatively smooth departure from the EU. Finally, recent military engagement between the U.S. and Iran provides another new layer of potential risk in the coming year. While aggressions seem to have temporarily simmered down, an escalation in hostilities between these countries could negatively impact the global economy, particularly as it relates to energy prices, given the substantial allocation of global oil reserves in this region. Despite these concerns, and barring any unexpected escalation, oil prices are expected to move sideways throughout 2020.
For 2019 overall, almost all asset classes logged sizable absolute gains, with U.S. growth stocks and the tech sector as the top performers. Despite a disappointing 2018 (down -4.4%), the S&P 500, an index of large cap US stocks, roared back in 2019 finishing the year with impressive gains of 31.5% (9.1% in 4Q19). Mid Cap and Small Cap stocks lagged slightly, up 30.5% and 25.5% respectively. In addition to continued global economic growth, the resiliency of domestic stocks over the past few years is somewhat attributed to strong buyback support following the passage of the Tax Act of 2017. However, this activity is generally starting to subside as market prices approach all-time highs. Going forward, elevated valuations within the context of a mature business cycle suggest that investors should expect below-average asset returns over the intermediate to long-term.
Substantial deceleration in economic growth throughout much of the developed world has caused the recovery in international stocks to lag the U.S. in 2019. International equities have felt the impact of global trade tensions more than domestic markets. That being said, they still managed to make meaningful gains for the year, buoyed by support from extremely dovish central bank policies. The MSCI All-World Index (excluding U.S.) finished the year up 22.1%, after finishing down -13.8% in 2018. Developed markets outperformed emerging markets, with the EAFE index (developed markets excluding U.S. and Canada) posting gains of 22.7% in 2019 (-13.4% in 2018) and emerging markets finishing the year up 18.9% (-14.2% in 2018).
Traditional fixed income assets performed well in 2019, though much of the return was due to price appreciation, a symptom of falling interest rates. The Bloomberg Barclays Aggregate Bond Index ended 2019 up 8.7% for the year. Riskier credit categories such as high yield and EM debt had strong full-year results each up 14.4%. Government bond yields declined around the world during 2019, with U.S. 10-year Treasuries dropping roughly 80 basis points. The Fed’s dovish policy tactics have resulted in a relatively flat yield curve, with the possibility for short periods of inversion sporadically throughout 2020. As of 12/31/19, rates on the 1-year, 5-year, 10-year, and 30-year treasuries were 1.59%, 1.69%, 1.92%, and 2.39%, respectively. As this trend continues, income from these investments is expected to decline further, as lower rates result in less interest income for bondholders. As bond yields continue to fall, the risk/return profile for fixed income becomes increasingly asymmetric (bond prices have more room to fall than rise in response to shocks). Nevertheless, there is still a place for core fixed income positions, particularly for conservative investors looking to hold the line in the face of a potential market downturn.
Revisiting the flat yield-curve phenomenon, it’s important to consider the context we are currently in. As we’ve discussed in prior quarters, an inverted yield-curve has traditionally been a good indicator of upcoming recessions. However, as we pointed out last quarter, there are certain factors that make the current flattening/inversion less reliable as a downturn predictor than is traditionally the case. To begin with, the current flattening has largely been distorted due to unprecedented government buybacks of long-term bonds. Perhaps even more significant, the current expansion is being driven primarily by the consumer, while previous expansions have primarily been fueled by business investment (CAPEX spending). Rates typically affecting consumer spending, such has mortgage rates, have increased slightly, but still remain relatively low compared to historic averages.
Heading into the 2020, early indications are that the U.S. economy should avoid recession for yet another year. While late-cycle deceleration trends and geopolitical risk pose potential threats to the record-setting expansion, it appears that robust consumer spending trends and the lagging impact of dovish monetary policy could sustain global growth for another year, albeit at a much subdued pace. The upcoming U.S. elections could be a source of market volatility in the coming year, particularly due to the relatively divergent perspectives each party seems to have on economic policy. It is worth mentioning that since 1928, the S&P 500 has averaged a total return of 15.3% in years that Republicans have won (11 times) and 7.6% in years Democrats have won (12 times). While past performance does not guarantee future performance, the data implies that election-related market fears may be more bark than bite and the ensuing market volatility surrounding them is generally short-lived.
Although investors should be prepared for a slightly bumpy ride into 2020, it is important to remember that the majority of economic data still supports a continuation of the current expansion over the near-to-intermediate-term. Prudent investors should consider reviewing portfolio allocations with a fiduciary advisor to ensure alignment with their personal risk tolerance and goals. Continuing to invest during times of volatility (Dollar Cost Averaging) as well as further diversifying your investment strategy utilizing alternatives such as private equity, private credit, and real estate, may provide enhanced return and reduced volatility. As always, remembering to remain disciplined in the face of uncertainty and volatility is critical.
2019 was an exciting year at Integrity, as we welcomed a number of fresh new faces to our firm. That trend continued in the 4th quarter as we invited Reid Kitagawa and Gabe Boruff to join our financial advising team. Reid comes to us from Morgan Stanley, where he previously served as a Registered Associate and prior to that was with Saturna Capital. Gabe joins us from Edward Jones, where he also served as a Financial Advisor. In each case, we feel very fortunate to have found individuals who so clearly embody the commitment to excellence and service that is at the very heart of our firm’s core values. We are happy to welcome Reid and Gabe to the Integrity family, and look forward to working with both gentlemen for many years to come.
On December 20th, a new law was established that makes some important changes to the retirement planning landscape. Specifically, the Setting Every Community Up for Retirement Enhancement Act of 2019, “SECURE Act”, includes significant provisions designed to increase access to tax-advantaged accounts and prevent individuals from out-living their assets. Although the legislation is broad in scope, the bill effectively:
In addition to the above provisions, the SECURE Act also covers a number of items aimed at making it easier (and more favorable) for employers to offer retirement plans.
Lastly, it’s never too early to start thinking about taxes. Although “tax season” is still a few months away, the IRS will soon be releasing its tax forms for 2019. As such, we encourage clients who haven’t already done so to fund their IRAs (and 401(k)s for some business owners) before the tax filing process begins.
Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA
Andrew Mescon, MBA
VP of Strategy
Chief Investment Officer
Sources: JP Morgan – Guide to the Markets (9/30/19), FS Investments – Q4 2019 Economic Outlook, Federal Reserve – as of 9/21/19, Fidelity Investments – Quarterly Market Update Q4 2019.
***The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees, and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.