U.S. Equities: Volatility but Growth
The S&P 500 Index made new all-time highs in 2019, as on-and-off trade tensions with China eased, the Federal Reserve cut interest rates three times and corporate earnings held up better than anticipated. Strong market performance came against a backdrop of weakening economic activity, reflected in the overall signal for the ClearBridge Recession Risk Dashboard turning yellow in June, indicating caution.
As we enter 2020, both the U.S. and global economies are clearly slowing; the key question is whether we are on the cusp of a recession or a late-cycle slowdown. The economy typically sees an inflection point six to nine months after our Dashboard turns yellow, so we should have confirmation by early next year of the severity of the current soft patch.
Our base case is for a slowdown within an ongoing economic expansion. While we expect the contraction of the manufacturing sector to marginally worsen as the ongoing trade war hurts business confidence and slows capex, the consumer side of the economy should remain strong enough to avert recession. The labor market and wage growth are healthy, which should underpin consumer spending, while the Fed has joined with central banks around the world in ramping up monetary accommodation.
The potential strength of this support is reflected by all four consumer indicators in the dashboard flashing green, indicating expansion.
- After slowing in line with rising mortgage rates, housing permit growth has resumed since the Fed shifted its monetary policy stance and mortgage rates eased.
- A strong October jobs print and upward revisions for the prior two months are consistent with jobless claims continuing to trend around 50-year lows -- while job sentiment has improved after a mid-year decline, with job openings outnumbering unemployed workers by a significant margin.
- The wildcard among our consumer indicators is retail sales, which posted a surprise decline in September ahead of robust October jobs data.
- Monthly sales numbers can be noisy, but a drop in spending – which accounts for 70% of the U.S. economy – would be a major concern.
While volatility will likely remain elevated, a market drawdown next year is not imminent. In fact, over the last 19 U.S. presidential election cycles, stocks have suffered losses just twice in the 12 months leading up to election day, delivering an average return of 8%. Equities have also tended to do well in periods following a yield curve inversion, especially if no recession occurs, rising 13.5% on average in the subsequent 12 months. The 2-year/10-year U.S. Treasury yield curve inverted in August, suggesting that stocks could climb through most of next year.
Cyclicals have gotten a bid from the Fed easing, but this rally could be short-lived; we do not believe the manufacturing side of the economy is out of the woods yet. For example, corporate credit spreads at the lowest quality ratings, which encompass energy, industrials and some retail names, are at their widest levels in over a year.
Instead, the likelihood of continued volatility in 2020 steers us to high-quality growth companies with strong moats around their businesses and more defensive areas of the market that have tended to hold up well during turbulent periods. Consumer staples and utilities should continue to lead unless we see a clear resolution of the trade war and improvement in global growth.
One of the benefits of these stocks is dividends, particularly given the low yields on bonds in general. It’s worth noting that through the third quarter of 2019, 42% of S&P 500 stocks had a higher dividend yield than the 30-year U.S. Treasury bond.
Dividend Stocks Look Attractive
% of S&P 500 stocks with Dividend Yields > 30-year Treasury yield
International Equities Could Surpass Low Expectations
Economic sentiment in most international regions worsened over the course of 2019, which we believe sets a low bar for non-U.S. equities heading into 2020. Manufacturing data continued to weaken, yet consumers held up relatively well. We see reasons for optimism that are underpinned by policy moves. The European Central Bank has resumed a measured program of quantitative easing, and the U.S. Federal Reserve is lowering interest rates while China and Japan continue to provide ample liquidity. In past cycles, increasing money supply has supported stock values after a several-month lag, with the manufacturing sector picking up soon after. If we do not see a hardening of the U.S.-China trade tensions, this could be the case again.
Europe: Valuations in the United Kingdom and Europe are attractive, particularly compared with U.S. equities (as indicated in the chart). European stocks are at 50-year lows vs the U.S., which has represented a good entry point the last two times performance dispersions became this extreme. Near-term risks in Italy are contained for now with a new moderate government in place. Fiscal stimulus is being discussed within the EU, which would be a clear positive. Brexit remains a wild card with Prime Minister Boris Johnson calling for December elections after his initial Brexit deal was rejected by Parliament and the EU granted an extension for a deal until the end of January.
European Equities Are Historically Cheap
Relative performance (in basis points) between European and U.S. stocks
Asia: Japan, China and emerging markets are very dependent on progress in trade talks. A positive trade resolution should cause the U.S. dollar to weaken, which would most benefit emerging markets. How Beijing deals with the protests in Hong Kong and the ongoing trade standoff will provide important signs of where the global economy and equity markets are headed. Geopolitical risks are a constant but can represent opportunity for investors.
Growth in the Slow Lane
Cautious Optimism Amid Change
Looking Beyond the U.S.
Shifting the Global Balance
Uncertainty on the Horizon
How Infrastructure Is Evolving
Royce Investment Partners
Positive Signs for Small-Caps
Resilient Growth, Despite Risks
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
“Print” As a noun, refers to the publication of a price or economic data point.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
Moat refers to a defensive boundary that’s difficult to cross; an obstacle to invasion.
The yield curve is the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.
Inverted yield curve refers to a market condition when yields for longer-maturity bonds have yields which are lower than shorter-maturity issues.
The European Central Bank (ECB) is responsible for the monetary system of the European Union (EU) and the euro currency.
The European Union (EU) is an economic and political union established in 1993 by members of the European Community. The EU now comprises 28 countries after its expansion to include numerous Central and Eastern European nations.
"Brexit" is a shorthand term referring to the UK vote to exit the European Union.
Emerging markets (EM) are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.
The MSCI World Index is an unmanaged index of large- and mid-cap common stocks across 23 developed market countries.
The MSCI USA Index is is an unmanaged index of common stocks designed to broadly and fairly represent the full diversity of business activities in the United States.
Capital expenditures (Capex) , also called capital spending, is an amount spent by a company to acquire or upgrade productive assets (such as buildings, machinery and equipment, vehicles) in order to increase the capacity or efficiency of a company for more than one accounting period.
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