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Each year, investment managers dutifully present their outlooks for the economy and financial markets. We gather data, we analyze, we pontificate and prognosticate, but in the end a forecast is just that... a forecast. We can provide an outlook based upon our current environment and a most likely path. However, there will be unknowns. I like this quote from Donald Rumsfeld.
"There are known knowns. These are the things we know that we know. There are the known unknowns. That is to say, there are things that we know we don't know. But there are also the unknown unknowns. There are things we don't know we don't know."
That is the way I want both my Secretary of Defense and my investment manager thinking.
The value in these yearly forecasts is not so much in the predicted outcome, as it is in the exercise by which we arrive at the prediction. Even though we are constantly assessing information and thinking about the implications, the annual practice of looking forward into the year ahead serves as an opportunity to reflect, test conclusions, and ask questions. It is not a single outcome, but a range of possibilities we must consider.
Let's look back before we look forward. Calendar year 2019 was one of the best in a long time for financial markets. Stock markets provided very high returns, and lower risk bonds even hit the high single-digits.
Last year had a unique start. Recall the last quarter of 2018 was just plain bad. December 2018 was very bad. Markets were unsure of the Fed's interest rate position while economic data suggested slowing momentum. The markets were concerned the Fed would raise interest rates too high. The S&P 500 bottomed during that sell-off on December 24, 2018. If 2019 was a homerun for market returns, it had the benefit of starting on third base from a low bottom. Last year's market action could be thought of in different phases. The fourth quarter of 2018 produced overdone selling leading to the first quarter rebound based on a change in the Fed's tone. Global growth slowed and trade uncertainty escalated during the middle of 2019 resulting in a sideways market. And finally, markets rallied as lower interest rates (the Fed rode to the rescue again) and improved trade negotiations sparked expectations for better growth and improved business confidence as we exited 2019.
The big lift in the first quarter, sideways movement in the second and third quarter, and final lift in the fourth quarter produced a total return for the S&P 500 Index of 31.49% for 2019. Fundamentally, how did we get there? There are two basic ways to make money owning stocks. They can pay the holder a dividend or they can go up in price. Dividends are straightforward. Shareholders receive a share of earnings, usually quarterly, in cash from the corporation. Earnings support the payment and growth of dividends, and dividends are highly predictable. The price movement for a stock holding is more volatile. Earnings do drive price appreciation over time, but in any given year, changes in valuation often have a larger impact. Earnings growth for the S&P 500 Index will be flat for 2019 as compared to 2018. That means, after accounting for dividends, almost all of last year's performance came from higher stock market valuations rather than earnings growth. This was the mirror image of 2018, during which earnings growth topped 20% during the year, but contracting valuations produced a negative S&P 500 Index return.
The bond market had a similar extreme bottom (peak in yields) to begin 2019. The 10 year Treasury yield was above 3% as the fourth quarter of 2018 began and credit spreads on BAA rated corporate bonds were as low 138 basis points. Recall that GDP growth was running around 3% and the Fed was raising interest rates. The first signs of slowing growth and fears of the Fed raising rates too much drove the 10 year yield down to 2.5% and took credit spreads out to 200 basis points by December of 2019. Growth did indeed slow and the Fed not only stopped raising rates, but began cutting them. This set up the perfect scenario for the bond market. Lower short term rates and slower growth took the 10 year Treasury yield down to 1.46% by the end of August. The Fed's quick stimulus action calmed the credit markets and the cost of credit declined with BAA spreads closing out the year at only 125 basis points. The combination of Treasury and corporate credit yield changes during 2019 was positive for the economy. At the beginning of 2019, a BAA rated borrower could borrow at something close to 4.56% in the corporate credit bond market. By the end of 2019, that same borrower could borrow much lower at 3.17%. We will reference this again later.
We wrote multiple times last year about the strength of the U.S. consumer as compared to weakness in the business and manufacturing sector. The difference really was striking. Consumers benefitted from attractive real wage growth, a decline in interest rates, low oil prices, low inflation, and low unemployment. The services side of the economy, and areas like retail spending and housing benefitted. It was the opposite story for manufacturing, not only in the U.S. but globally. There were several factors. The corporate tax cut from 2018 made corporate earnings growth comparisons for 2019 difficult. Continued geopolitical instability impacted business confidence. Uncertainty over tariffs and global trade delayed business spending decisions, impacted input costs, and disrupted supply chains. The consumer and services components carried us last year, while manufacturing activity appeared recession-like. Looking at the ISM (Institute of Supply Management) Surveys of Manufacturing and Non-Manufacturing (Services) tells the story.
U.S. Real GDP growth slowed in each quarter last year. Other countries followed the same trend. First quarter's U.S. Real GDP growth registered 3.1%, while we are expected to have a fourth quarter reading of 1.6% growth. The estimate for 2020 currently stands at 1.8% for a slight improvement versus how we expect to end 2019. This is still slower than the growth trend from the past few years.
We enter 2020 with a strong consumer but weak manufacturing. We expect a return to positive S&P 500 earnings growth after a flat 2019, but valuations are already high. The Fed seems most eager to do nothing after cutting last year, and tepid GDP growth expectations provide little other argument. The 10 year Treasury yield bottomed in August. There has been some yield curve steepening, but that likely signals waning fears of a recession from earlier in 2019. Growth expectations don't seem to be high enough to drive the 10 year yield to its prior cyclical highs in the 3% area. Neither should inflation provide this impetus. Credit spreads for corporate bonds in both the investment grade and high yield sectors are very tight, meaning credit is cheap. This is good for borrowers, reflects a slow but steady growth environment, and the hope of a manufacturing activity lift. For the stock market, the questions are about earnings and valuations. Is the current 2020 earnings growth estimate of 7.2% for the S&P 500 reasonable? Where are the weak points in this expectation? How do valuations expand from this point? Why should the stock market be any more or less expensive than it is today? For the bond market, do interest rates across the yield curve rise or fall? Does credit remain cheap for borrowers?
Let's consider interest rates first. The yield curve is a plot of short and long term interest rates. In normal times, it appears as a gently upwards sloping curve. Shorter term rates are lower than longer term rates. This relationship can change when economic prospects deteriorate. The curve can invert, losing its upward slope and suggesting a recession may be in the near future. We currently have a mostly normal, upwards sloping yield curve. We call this "mostly normal" because in a better growth environment the shortest time at the beginning of the curve should be steeper. But we have slow growth right now, so this is our current normal. This is in contrast to the middle of 2019 when the yield curve inverted on economic growth fears. Shorter term rates were higher than longer term rates. That isn't normal and suggested the odds of a recession had increased.
Investors attempt to predict how the yield curve might change. Interest rates have a direct impact on the value of everything. All else equal, higher interest rates mean lower valuations. If growth is accelerating at the same time, then both interest rates and asset values can move higher simultaneously, assuming inflation is tame. Will economic growth accelerate or contract? What about inflation? Rising inflation should translate to higher yields, and vice-versa. And finally, what is the term premium, or the compensation to an investor for committing capital over longer time periods? All of this can get into the weeds quickly, and this is not supposed to be an economic study of the yield curve. Suffice to say this: The curve currently expects tepid growth and inflation with continued central bank provided liquidity. That will not likely change much over the coming year. What may be a larger component of interest rates changes could involve the term premium. Permit me to get ankle-deep in the weeds for just a minute.
Central bank intervention in the global bond markets is simply reality these days. This has an impact on the yield curve. Investors are supposed to be compensated for owning longer maturity bonds. Central bank bond purchases have functioned to lower interest rates across all maturities, not just the shortest ones. And foreign investors faced with zero to negative interest rates in their home countries are seeking yield in US Treasury bonds. All of this serves to increase demand. In this low growth, low inflation environment, the term premiums are often negative. They recently went positive as the economy strengthened, the Fed increased the Fed Funds rate and shrunk its balance sheet, but turned around when the economy softened and the Fed cut rates and grew its balance sheet. Term premiums have the most room to move near-term, as opposed to real yields or inflation, and explain much of the yield curve's movement the past several years. We do not look for interest rates to move drastically. However, if the trend of stable to slightly better growth does materialize during 2020, we would expect to see interest rates drift higher and the yield curve steepen. Should the 10 year term premium reach levels from early 2018, the bond market could reasonably add 40 to 60 basis points to the current 10 year yield of 1.85% for an upside of 2.25% to 2.45% on the 10 year Treasury. This type of move in longer term interest rates would put some pressure on valuations and the housing market, but not likely so much to cause worry.
Recall the chart above of the "Treasury and Corporate Bond Market in 2019". The prior discussion on interest rates focused on the 10 year US Treasury yield. What about the corporate credit spread that is added to the appropriate Treasury maturity when pricing corporate debt? The cost of credit is very low for corporations. They have taken advantage of these low financing costs by increasing debt to fund various things from business investment to repayment of higher cost debt to share repurchases. Some of these uses give investors heartburn, and indeed the level of corporate debt has risen. That may one day make a weakening economic environment worst but that isn't likely to be this year. There is stimulus in the pipeline from the lower rates as shown in the "Treasury and Corporate Bond Market in 2019" chart. Plus, the Fed jumped back on the liquidity train during 2019 with rate cuts and balance sheet growth. The Fed also had to undertake efforts to support the Treasury repurchase agreement markets during the fourth quarter of 2019, and that increased liquidity. See our Investment Insight from September 2019 for a brief mention of this topic. The Fed wasn't the only central bank acting. Liquidity increased globally late last year. All of this is supportive for both economic growth and corporate credit spreads.
Finally, we have the impact of uncertainty. Rather than show all the consumer versus business confidence charts again, we will refer you to our October 2019 Investment Insight. The Federal Reserve has a nice data set that measures overall and specific factors of uncertainty. Trade had a large impact during 2019. We can see a pause in the S&P 500 as trade uncertainty rose, and a reacceleration of the S&P 500 as trade uncertainty declined. Business and CEO confidence have not yet recovered, but we would expect them to as 2020 unfolds. This feeds into our expectations for better manufacturing and business growth. Confidence is also a support to valuations in the stock market.
Corporate earnings growth should rebound during 2020 after practically no growth during 2019. We are entering earnings season for the fourth quarter of 2019 now, so we will know within the next few weeks exactly how much earnings grew, or not, last year. It is instructive to see where analysts expect earnings to rebound in 2020. It is the cyclical sectors, not the defensive sectors that carry the highest expectations. Energy, industrial, and materials sectors are expected to be the fastest growing sectors. This is consistent with an expectation for accelerating economic growth, and why the tepid rebound thesis is important for the 2020 outlook. Absent a reacceleration, these EPS growth estimates will come down, and bring the overall expectations for the S&P 500 with them. The silver lining here is the high-single-digit growth expected for Health Care and Consumer Staples. Those are both large and relatively stable parts of the stock market. So even if the smaller, cyclical sectors disappoint on growth, we aren't likely to have a repeat of 2019's flat earnings growth in 2020.
Wrapping these things altogether brings us to what we believe is a reasonable outlook for 2020 stock market performance. We consider the current 2020 earnings per share growth expectation of 7.2%. We consider valuations and what data supports either contraction or expansion of PE ratios from the current levels. Supportive of both earnings and valuations are lower interest rates, low inflation, inexpensive credit, a strong consumer, and improved economic certainty overall and with respect to trade. The market knows these things and expects growth improvement because of them. Disappointments that could result in lowered earnings expectations and/or valuations would include the failure of business confidence to rebound, lackluster business capital spending, a sudden shock to either interest rates or energy prices, or some unexpected global financial system or geopolitical issue (the unknown unknowns). I feel like I should point out that this is not an exhaustive list on either side of the coin.
The tricky part really is forecasting the PE multiple. Even if that $174.39 earnings per share estimate for the S&P 500 Index proves close to what we experience in 12 months, just a few points of PE multiple change can have a large impact on investor experience for the year. If we start with that 7.2% earnings growth number as a base case for returns, we can say that taking the current PE multiple of 18.5 up to 19.5 would improve the market price return to 12.6%. Taking the 18.5 PE down the 17.5 would take the price return down to 1.8%. That is a large difference.
Since we are entering a year in which the markets expect better economic growth, it's safe to say current valuations have "priced in" that expectation. Our base case is for better growth in 2020 and a relatively supportive environment for PE multiples. Because we, and most other investors, don't like expensive markets, it is difficult for us to argue for higher PE multiples from here. It could happen, but that is not our base case. We also add dividend yield to the market's price return to arrive at a total return. The S&P 500's dividend yield is currently 1.8%. If we maintain current valuations, and expected earnings growth of 7.2% for 2020, an investment return of 9% is not unreasonable at all. A total return range of +14.4% to +3.6% is an easily attainable range with only one PE multiple point change up or down. We believe this should frame stock market return expectations for 2020.
We would be remiss if we didn't say something about this being an election year. This really falls into the "unknown unknowns" category. A report from Goldman Sachs serendipitously came to my inbox this morning. It is dated January 12, 2020 and authored by Jan Hatzius, Goldman's Chief Economist. Hatzius points out that election year impact on actual economic data is minimal. He does not find a relationship worth using for forecasting. However, he does find a relationship between election years and economic uncertainty. As already discussed, uncertainty often does impact markets by reducing confidence and thereby behavior. He finds slower business investment growth and slower durable goods growth on the consumer side. Given the candidates vying for this year's Democratic nomination, I think we can throw health care and financials in as two sectors to watch, depending on the nominee. So, for a year in which markets expect a rebound in business spending as a base case scenario, the presence of a national election could have a negative impact on business spending behavior. We would expect this to be more pronounced in the second half of the year, if it occurs this time.
So, that is what our crystal ball suggests at this point. We believe the consumer remains healthy and the labor market strong. We do not necessarily expect consumer spending to accelerate, but neither should it weaken appreciably. Stimulus in the form of lower interest rates, lower borrowing costs, greater liquidity, and reduced uncertainty should improve business confidence and in turn business spending. The Fed should remain quiet and supportive. The overall stable-to-improved business and manufacturing outlook for 2020 should support earnings expectations, inexpensive credit costs, and current valuations. An S&P 500 Index total return in the mid to high single digits seems reasonable. Bond market returns are likely to be consistent with coupon yields or possibly lower, as we see support from some increase in intermediate to long term yields. The uncertainty of an election year is a concern for both business and consumer confidence. Because of this, and the expectation for growth to accelerate later in the year, our outlook for the second half of the year is considerably less certain as compared to the first half.
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Executive Vice President, Director of Equity Strategies
Tracy joined the IBERIA Wealth Advisors team in September 2010 and has over 20 years of investment management experience. She has a broad background in fiduciary asset management which includes portfolio management for high net worth individuals and institutions, asset allocation policy making, investment management consulting, equity research, and equity and fixed income trading. Tracy manages client accounts across the IBERIA Wealth Advisors footprint and oversees the construction and management of IWA's three proprietary equity strategies, Dividend Focus, Growth Focus, and Total Return. She serves as a member of the IWA Asset Allocation Council and chairs the IWA Investment Policy Council. Tracy is a frequent speaker on economic and investment topics within the community and authors many of IWA's investment publications. She has been included twice in the Birmingham Business Journal's Table of Experts Series. Tracy graduated from the University of Alabama with a Bachelor of Science degree in finance and is a CFA Charterholder. She is a member of the CFA Institute of Alabama and has a Series 65 license. She has served as an industry mentor for the CFA Student Research Teams from both The University of Alabama and Samford University. Tracy is a past member of the Episcopal Dioceses of Alabama Finance Department and the University of Alabama at Birmingham (UAB) Finance Department Advisory Board. She is currently a Board member for Girls, Inc. of Central Alabama.
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Disclosures
Views are as of the date above and are subject to change based on market conditions and other factors. The views expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from the Advisor.
The information contained in this presentation has been compiled from third party sources and is believed to be reliable, but its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This information does not constitute, and should not be construed as, investment advice or recommendations with respect to the securities or sectors listed. Diversification and asset allocation do not assure a profit nor protect against loss.
The actual return and value of an account fluctuate and, at any time, the account may be worth more or less than the amount invested. Past performance results are not indicative of future results.
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Presentation is prepared by: IBERIA Wealth Advisors
Copyright © 2020, by IBERIA Wealth Advisors; All rights reserved.
Investment Products: * Not FDIC Insured * Not a Bank Deposit
* Not Insured By Any Federal Government Agency * No Bank Guarantee * May Lose Value
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