In this month's Economic Outlook, Chief Investment Officer Greg Sweeney gives perspectives on Federal Reserve policies, expectations for interest rates and inflation, and what's going on in national and global markets.
January 2020 Market Outlook
There is an entire industry built around forecasting the economy and investment markets. Such forecasts are intended as the basis for structuring investor portfolios for the coming year, with the aim of maximizing performance. Unfortunately, while these predictions are grounded in good intention, history has shown they are no better than a shot in the dark – encompassing a range of possible outcomes so wide, they become nothing more than a guess.
Last year around this time, Bank of America forecast Fed Fund rates would rise to 3.25% to 3.5% by year end (actual 1.75%). Morgan Stanley believed the credit bear market would continue into 2019 with high yield and loans underperforming (high yield was up 14% and was one of the best performing areas of the bond market). Deutsche Bank said increasingly tight Fed policy would push bond yields higher (the Fed eased, and yields moved lower throughout most of last year). Citigroup saw both equity and bonds having the potential for positive returns in 2019, with overall return levels likely to remain subdued (last year saw some of the best equity returns ever, while bond returns also were attractive). Black Rock predicted equity eking out a positive return in 2019, with asymmetric downside as the economy enters its late-cycle phase (equity returns were great, and the market ignored that stage of the business cycle). PIMCO was cautious on generic corporate credit, but saw relative value in financials and mortgages, while underweighting duration (financials did fine, while overweight duration was the place to be). Fidelity saw fertile conditions for complacency and real risk of inflation spiraling if central banks pulled back from further monetary tightening (the Fed pulled back materially and began cutting rates, while inflation remained below Fed target ranges).
We must admit to having held many similar beliefs about the markets due to recent higher-than-average market returns, late stages of the economic cycle and the direction of the Federal Reserve. How do we get around the pitfalls of using forecasts that could be completely wrong?
First, we look at long-term market average returns to structure portfolio allocations aimed at meeting client goals over their investment horizons. The idea is that a market gravitates to its mean. After all, it is the high-return years combined with the low-return years that create averages in the first place. Next, we structure allocations using a core-and-satellite approach. The core portion captures the theme of mean reversion mentioned above, while the satellite portion captures styles, sectors or categories that currently offer added the return potential of rising back to their longer-term average. (A diversified allocation might not be the best performing portfolio each year, but it is never the worst.)
For all of our efforts last year, here is how the returns stack up:
- The Bell Aggressive Growth (all-stock portfolio) had a 1-year return of 28.17% compared to the MSCI World Index of 28.44%. The Dow Jones Industrial Average Index return was 25.34%.
- The Bell Income Fund (all-bond portfolio) had a 1-year return of 7.51% compared to the Bloomberg Barclays Intermediate Government/Credit Index of 6.80%.
- The most surprising results came from Bell’s Equity Income strategy, which posted a return of 24.77%. This is an all-stock strategy aimed at generating a dividend yield at least 1.75 times higher than the S&P 500. The attractive dividend theme usually means the market value appreciation of this strategy tends to be muted. This strategy maintained a dividend yield above 5% for most of the year, while adding nearly 20% more return in market value appreciation – an unexpected, but welcome, outcome.
Ironically, the return on this last strategy gives us some insight into last year’s market as a whole. Last year’s stock market was defined by an all-inclusive theme. This theme is seconded by the equal-weighted S&P 500 return of 29.22% being close to the capitalization-weighted S&P 500 return of 31.48% –which was also close to the S&P 1500 capitalization-weighted index return of 30.89%. This suggests broad-based market performance last year, rather than just a few companies dominating performance (there was not much mention of the FAANG stocks last year).
It seems as though investors are thinking stocks rule the roost. From a shorter-term point of view, they would be correct. Many of us can remember “partying like it’s 1999,” which also overlapped the Y2K transition at the time. Now that we are 20 years into the 21st century, it may be interesting to compare stock and bond performance for the millennium so far:
Many readers may be surprised to see that bonds had a better return than stocks for nearly the first 17 years of the millennium. It’s only recently in the 21st century that stocks overtook bonds on a total return basis. Now, after 20 full years, stocks are less than 1% ahead of bonds. One thing to note is that a $100 investment in stocks lost 50% of its value twice in this 20-year time frame.
Bonds had a good year, but yield was muted. As previously mentioned, the 2019 return on the Bloomberg Barclays Intermediate Gov/Credit index was 6.80%, while the longer-duration Bloomberg Barclays Gov/Credit index was 9.71%. The yield on the 10-year U.S. Treasury bond started the year at 2.65% and went up as high as 2.78% and as low as 1.46% before finishing the year at 1.92%. Readers might be wondering how such low-interest income yield generated returns of 6.8% or 9.7%. That’s because interest income is only part of a bonds return. Just like stocks, bonds have a fluctuating market value. As yields decline, the price of bonds with fixed coupon payments rises. As yields rise, the market price of the bond declines. Since interest rates declined last year, the market value of bonds went higher, adding market value appreciation to the coupon yield.
Here’s where we provide our outlook for 2020. Our opening paragraph suggests this is nothing better than a guess – so let’s call it “expectations for the coming year,” rather than an official forecast. We anticipate several themes in 2020:
- Stock buybacks continue. We expect to see corporations collectively repurchase about $800 billion of their stock in 2020.
- Inflation finds some footing. After several years of lower-than-average inflation, we believe inflation will begin to drift higher – but not so high it will disrupt fixed income markets.
- Energy sector gets stronger. After several years of lagging the broader market, a stable economy and elevated geopolitical tensions could begin to burden the theme of increased supply due to fracking, and start to drive oil prices higher.
- Employment remains stable. We anticipate unemployment will remain below long-term averages.
- Wages stay ahead. As employment remains strong, we anticipate that wages will maintain a growth rate in excess of the inflation rate.
- Passive investing continues. Trend exhaustion happens when a particular theme in the market fades away and shifts in another direction. In the case of passive investing, we don’t see any fatigue yet.
- Federal Reserve is less active with interest rate changes. We anticipate rate changes of perhaps only 25 basis points in either direction. (Escalation of tensions with Iran could change this.)
- Global economic strength starts to improve. We anticipate some firming of growth in developed foreign economies.
The U.S. election, trade, geopolitical events, elevated stock valuations, low interest rates and a host of other market themes could combine to exert elevated volatility throughout the year. We expect solid flows from passive investing into the equity market to act as buffers to potential volatility, reducing the prospect of a long-tailed event. An equity market sell-off in the range of 10% at some point during the year would not come as a surprise. For the year overall, we look for top-line corporate earnings to rise 5% to 8% and for stock market returns of 6.5% to 9.5%. For fixed income markets, returns in the range of 2% to 4% look the most probable, with interest rates range-bound barring some sort of sustained-risk, off-market shift – which would push bond returns a bit higher.
For our part, we will move through the year day by day – evaluating opportunities as they present themselves, while focusing on the long-term objectives of our clients.