MCF Weekly Capital Market Review - January 2nd, 2020

What a strange and eventful 2019. Unlike the December 2018 equity drawdown, 2019 was able to keep its gains with the S&P 500 returning above 31%. All broad equity indices finished strongly positive with the US leading international markets. Oil finished the year at $61.06 per barrel, up from $45.41 at the end of 2018.[1] Gold was another commodity that saw large gains despite low inflation, up to $1,519/ounce from $1,278 the year prior.[2] High yield bonds had a stellar year, but core bond investors weren’t left out, either. Thanks largely to rate cuts by the Fed, all broad bond indices finished positive. The US 10-year Treasury yield dropped from 2.69% to 1.92%.[3]

The Treasury yield curve spent the year with some form of inversion[4] (a shorter-maturity yield was higher than a longer-maturity yield). Market practitioners believe that a yield curve inversion predicts a coming recession, and their preferred measure is the 10s/2s spread (10-year yield minus 2-year yield), which was negative (meaning inversion) for the last week in August. It is true that a yield curve inversion has preceded the past five recessions,[5] but it comes with several shortcomings. First, past inversions have remained inverted for several months. How accurate is an inversion that only lasts a week? Second, the duration of time from inversion to recession has ranged from 9 to 22 months since the 1978 inversion. Furthermore, it doesn’t inform us of the duration or severity of recession. It is one sign of caution, not the single sign of doom.

Other indicators are more optimistic. 2018 ended on a sour note with large equity drawdowns, widening credit spreads, and higher volatility. In 2019, equity indices more than gained these losses back, volatility levels decreased (as measured by the Volatility Index, or VIX),[6] and credit spreads tightened.[7] In other words, market participants favored increasing risk rather than reducing it. There are several reasons supporting this outlook. Labor markets have shown incredible strength with the latest unemployment rate at 3.5% for November (a number not seen since 1969)[8] and a continued increase in real wages.[9] Indicators such as consumer spending, confidence, and sentiment have all held strong despite uncertainties in trade policy and weakness in manufacturing. Corporate beats outnumbered misses 2:1 for Q3.[10] Core PCE, the preferred inflation measure by the Federal Reserve (Fed), remains low at 1.6%.[11]

On monetary policy, the Fed lowered the federal funds rate three times (0.75% total) in what was labeled a “mid-cycle adjustment,” or insurance cuts that pre-emptively cushion against economic fallout from potentially disruptive scenarios. As a reminder, the Fed dot plot released on December 19, 2018 had a consensus estimate of two rate hikes for the 2019 year.[12] Market participants were quick to quell this outlook by increasingly betting on rate cuts as 2019 progressed. By June 19, the word “patient” was no longer present in press releases[13] and all three cuts occurred in the latter half of the year.

This about-face by the Fed is a significant break from past monetary policies with far-reaching consequences for future decisions. First, the Fed openly admitted its assumptions for both the natural unemployment and neutral interest rates were wrong,[14] that is, they are both lower than previously thought. These mistakes contributed to the Fed’s remedial actions to lower interest rates. Second, the Fed now shows a greater willingness to respond to potential rather than actual economic negativity in order to sustain an economic expansion. Although not unprecedented, it is rhetoric not seen since 1998 during the time of then Fed chair Greenspan.[15]

Other central banks made a similar pivot. European Central Bank (ECB) President Draghi also turned dove in June, shifting expectations to lower GDP growth and low inflation.[16] As a result, his comments were the harbinger of the coming monetary stimulus for the EU. Emerging market monetary authorities were ahead of the Fed and ECB, with net cuts (total interest rate cuts minus hikes) across 37 economies beginning in February and continuing throughout the year.[17] Given our estimated location in a late-cycle economic expansion, one would expect monetary tightening (e.g. rising interest rates) as countries strive to keep inflation in check and prevent economic excess. Instead, we the see the opposite – low inflation, low growth expectations.

Optimism for 2019 faded as the realities of slowing global growth became more and more apparent. International Monetary Fund (IMF) projections from July echoed increasing downside risks, low inflation, and low growth expectations. Even though developed markets (US, EU, UK) had small upside surprises, a miasma overshadowed emerging markets, causing the IMF to revise 2019 global growth expectations downward in July.[18] This did not stop equity indices from charting stellar returns overall but it does reflect the lagging gains of international equities v. the US.

2019 was also a year pockmarked with populism that is changing the geo-political landscape and disrupting the status quo. In the US, the latest face of populism is Trump, and with this face comes a sharp departure in trade policy. Trade wars, especially with China, have created uncertainty surrounding trade policy, disrupting producers and consumers alike, both domestically and abroad. In Europe, the flagbearer of populism has been the Brexit issue (departure of the UK from the European Union). There is little reason to believe that the trend of populism will abate, and we expect more events to inflect from supranationalism toward nationalism. Sharp departures toward more nationalistic economic policies is what the Fed had in mind for “disruptive scenarios.”

Lower-than-expected GDP growth and geo-political disruptions (trade wars, Brexit, etc.) does not mean growth is simply stopping. Even though growth expectations are coming down, we are still growing rather than contracting, and growth provides an optimistic backdrop for positive investment returns. Yes, there are very real risks and disruptions that can flip risk assets on their head. Potential events to keep in mind for 2020 are another Trump trade war (Europe remains unscathed), escalating tensions with other countries (such as China or sanctioned countries of Turkey, Russia, or Iran), and electoral fallout from populist gains worldwide. So far, fundamental data in the US suggest continuing strength, rather than deterioration and an imminent recession. The current US economic expansion is the longest on record and yes, it will end at some point. We do not know when, but we do know that as investors, keeping a well-diversified portfolio is the best way to weather the ups and downs inherent in investing.

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