2020 Outlook: Stuck in First Gear?

Chief Market Strategist David Lafferty sees a slow but stable economy continuing, but expects the year will prove anything but boring.

Writing in late November 2018, our outlook for 2019 was mildly optimistic. No, the global economy wasn’t going gangbusters, but in the midst of a deep Q4 selloff, valuations across global equities and credit sectors of the bond market had returned to reasonably attractive levels. While we had reasons to be hopeful, we believed positive returns would be limited by decelerating growth, continuing trade/tariff concerns, and a lack of central bank ammunition.

While these predictions all proved to be somewhat prescient, WOW did we miss on the sea change in sentiment and the magnitude of returns. (To be fair, we warned that our crystal ball for 2019 would be even less accurate than usual.) The combination of the Fed’s abrupt dovish turn, a pop in valuations from the December 2018 lows, and positive signs on the trade front in Q4 2019 sent both stocks and bonds rocketing higher through November. Enjoy the champagne now. This surge in sentiment along with the realization of those outsized gains sets the stage for 2020.

After a Change in Sentiment – What’s Next?
So what will 2020 look like? At the risk of oversimplifying, it will largely come down to the performance of the global economy. Continued central bank support and liquidity should keep risk assets on a modest upward trajectory provided the economy doesn’t falter. In our reading of the macro tea leaves, we see no obvious shocks that will meaningfully boost or hinder global growth in 2020. But to be clear, there almost certainly will be shocks – we just don’t see them yet. Our base case is that the slow-but-steady 10+ year expansion remains on track for now.

Macro Outlook: In a Holding Pattern
At the top of everyone’s list for 2020 will be global trade. Our views remain mixed about a US/China trade deal. Both countries are feeling the pain while pressures are spilling into other export-dependent economies, notably Germany and South Korea. Presidents Trump and Xi surely recognize this, so there is a deal to be had. However, we remain skeptical that any “Phase 1” deal can truly address the underlying concerns of the US administration on intellectual property protection, technology transfer, industry subsidies, or “Made in China 2025.” A deal that tempers the rhetoric may be on the horizon, but it will do little to alleviate the underlying mistrust between the two largest economies. On a more positive note, we think a modified US/Mexico/Canada deal (USMCA) will be ratified – although it’s more like “NAFTA 2.0” than anything transformational. The bottom line on trade is that we expect to see uneven progress on several fronts. That progress will mitigate, but not eliminate, a major headwind to global activity.

Brexit Uncertainty
In the UK, Conservatives will ultimately negotiate a Brexit Withdrawal Agreement, moving negotiations to the transition phase. But while this is a positive step, the saga is far from over. Investors can expect the transition phase to extend beyond 2020, so UK and European businesses and consumers will still have Brexit uncertainty hanging over their decisions for several more years.

US Election Year
In the US, all eyes will be on the 2020 elections. Sorry to disappoint, but we have no idea who will win – and by our reading of the numbers, neither should anyone else at this juncture. This election will feature some uniquely Trumpian dynamics, while the margin of victory in the key battleground states is likely to be microscopically slim (again). Regardless of the outcome, neither the most optimistic nor pessimistic prophecies are likely to materialize. Outside of a Democratic wave victory that flips the Senate (unlikely but not impossible), there will still be plenty of sand in the gears of the US federal government. Trump’s deregulatory crusade would be at risk, but major initiatives that require legislation should remain relatively safe. So while we expect US politics to be the story of 2020, investors would be wise not to take the bait.

Steady (but Slow) Global Growth
Risks to the global economy seem balanced moving into 2020. Is recession a possibility? Yes, but not a significant one, perhaps 25%. (Our estimate was 35% just a few months ago.) It’s also possible that growth will reaccelerate, but this seems somewhat unlikely as well. In the US, economic growth may downshift slightly, to 1.8%–2.0% from just over 2% in 2019. After a strong run, consumption may weaken at the margin, but the consumer remains in relatively good shape. We expect investment and corporate spending to remain soft.

While activity metrics across Europe appear to be bottoming, the much-awaited reacceleration of growth is still nowhere to be found – especially with more Brexit negotiations still to come. A Phase 1 trade deal between the US and China could mean Germany’s economy bottoms in the first half. Like the US, euro area growth is likely to remain positive, but mired near 1.0%–1.5%.

Lastly, we view China as having sufficient short-term policy tools to maintain real GDP close to or just below 6.0%. While China’s version of “state capitalism” may not allocate resources optimally, it is well-suited to mitigating shocks and gradually implementing the transition from investment and exports toward domestic consumption. Therefore, we see only a slight downward trajectory to its near-term growth prospects.

With little change to the global growth outlook, we think the major central banks are in a holding pattern, at least for the first half. For now, the US Fed has paused and will watch incoming data to determine policy for the second half of the year. At this point, the Fed’s next move is just as likely to be up as down. In Europe, the European Central Bank (ECB) is out of options. Policy rates are already negative and there are few high quality assets left to buy. The big story coming out of the ECB in 2020 will be how much, if any, success ECB President Christine Lagarde will have in persuading euro area governments to embark on fiscal spending and structural reforms. We expect some forward progress, but the effects on growth will be modest at best.

Clipping Coupons in Stocks & Bonds
With the trajectory of global growth largely unchanged, little movement from central banks, and no meaningful pressure on inflation, yields should be range-bound. Growth is too strong to justify the US 10-year Treasury yield below 1.50%, but there is not enough escape velocity to push it above 2.25%. With some uncertainties possibly removed (a US-China trade deal or Brexit deal), rates may wander slightly higher from their current level near 1.8%. We maintain a similar view on European rates, but the range may be even narrower as ECB policy has less latitude, while greater slack in the economy should keep inflation well contained.

This interest rate outlook augurs for positive but modest bond returns in the US, composed largely of clipping the current coupon with little capital appreciation/depreciation from yield movements. The same would be true overseas, except that investors there are already subject to negative starting yields in the core of Europe (Germany, France, Netherlands, Switzerland), resulting in flat to slightly negative returns. We expect bonds from the periphery (Italy, Spain, Portugal, Greece) to generate positive returns on the back of relative political stability.

Corporate Bonds – While the credit cycle has additional room to run in aggregate, cracks will continue to appear in weaker credits, as is already happening in CCC-rated debt. Low rates and truckloads of liquidity have propped up and extended the life of many smaller and mid-sized companies, but this trend won’t last forever. We expect higher quality credits to remain in demand for the modest additional yield they offer, but in this slow growth, winner-take-all environment, the grim reaper is coming for the weaker players. Security selection (alpha) will be the key in credit as opposed to hoping for more spread tightening (beta).

Global Equities – In the US, bottom-up consensus earnings near 10% for 2020 will prove too optimistic. Combining global nominal growth with already elevated profit margins, we expect S&P 500® earnings growth to be in the 4%–6% range – positive but a bit light by historical standards. However, with bonds yielding little and central banks on hold, we expect a constant bid to stocks will keep price multiples relatively stable. The S&P 500’s forward P/E rose from 15x to 19x in 2019, generating all the gains in US stocks, while earnings growth was flattish for the year. We see a repeat of that as very unlikely. As with bonds, US stocks should “clip their coupon,” earnings plus dividends, but that’s about it.

While many of the same dynamics exist overseas, we have a modest bias to European equities. The Eurostoxx 600 trades at only 15.6x forward earnings, which offers a bit more value in both relative and absolute terms. These stocks have more room for price-earnings ratio (P/E)1 expansion if our assessment of the economy proves too dour, and less room for multiple compression given that some industries already display recession-like valuation multiples.

US Dollar – With growth, rates, and central banks seeing little action, we expect the US dollar to be largely range-bound. Fading strength in the dollar, combined with reasonable valuations and a reduction in trade rhetoric, should favor emerging market stocks. Asian countries closely tied to Chinese trade should benefit the most, while Latin America may lag due to growing political uncertainties.

Building Portfolios: Risks & Positioning
Global recession – not our base case – remains the key risk to all of our forecasts. Current valuations across broad asset classes would not be supported if the global economy were to weaken materially. As valuations are principally supported by low rates, rising inflation (realized or expected) is another important risk to monitor. US election dynamics will certainly create volatility, but as noted above, this risk is overrated. We expect well-diversified portfolios to generate positive returns in the coming year. However, the big gains across stocks and bonds in 2019 may sap 2020 of much of its performance vigor.
1 The price-earnings ratio (P/E) or price-earnings multiple is the current market price of a company share divided by the earnings per share of the company.

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