Market and Performance Recap – Our portfolios generated strong returns over 2019, a bullish year for nearly all financial markets. The positive broad-based returns marked a dramatic and welcome turnaround from 2018, a year in which nearly all asset classes faltered. This year’s surprising returns and march toward all-time highs were fueled by a U-turn in monetary policy, as policymakers shifted gears to support a weakening global economy. After tightening financial conditions by raising short-term interest rates four times in 2018, the Federal Reserve reversed course and began implementing a more dovish monetary policy by lowering short-term rates three times. Other major central banks also cut rates or provided stimulus via quantitative easing during the year.
U.S. stocks rose in every quarter and surged an additional 9% in the fourth quarter as the United States reached a tentative “phase one” trade agreement with China. The U.S. stock market’s 31% total return was its second-best year since 1997, bested only by 2013’s 32% gain. Smaller-cap U.S. stocks rose 25.4% for the year. Foreign markets were also strong with European stocks gaining 24.9% for the year. After a weak third quarter, emerging-market (EM) stocks shot up nearly 12% in the fourth quarter and returned 20.8% for the year. The 10-year Treasury yield dropped from 2.70% at the start of the year to as low as 1.45% in September, ending the year at 1.92%. Investment-grade bonds gained nearly 9%.
What’s Next for 2020? – After a year like 2019, the obvious question looking ahead is how much higher can equities go? For many years, assets have been flowing into U.S. stocks on the back of a strong U.S. dollar and the United States’ perceived safe-haven status relative to other global economies. In this respect, 2019 was largely an exclamation point on the decade’s investment pattern. As we look ahead to financial markets in 2020, there are reasons to be cautiously optimistic for financial markets. Accommodative central bank monetary policy and easier financial conditions should continue to support at least a modest rebound in global economic growth. As just one point of reference, the Global Manufacturing Purchasing Managers’ Index (PMI) has risen for four consecutive months and inched into expansion territory (above 50) in November. Along with reduced U.S.-China trade risk, this suggests the global economy may be on the rebound. The U.S. consumer also remains in good shape as ongoing labor market strength, wage growth, and low interest rates should continue to support consumer spending and the housing market.
However, this modestly positive outlook is consistent with the consensus view, meaning that financial markets have already responded positively to these developments. The risk of an unpleasant market surprise or deterioration in the macro environment in 2020 shouldn’t be ignored. A critical question for fundamental investors like us is always, “What’s in the price?” In this regard, we note that it wasn’t corporate profit growth that drove U.S. stocks higher in 2019. Reported earnings for the S&P 500 were actually flat over the first three quarters, and mid-single-digit percentage growth is projected for the fourth quarter. The lion’s share (roughly two-thirds) of the stock market’s return in 2019, came from a sharp expansion in valuations. We believe such stretched valuations leave U.S. stocks particularly vulnerable to disappointment or negative surprises.
Despite recent positive developments, the U.S.-China trade war could reignite or a different area of geo-economic conflict between the two countries could escalate. This would hurt a still-weak manufacturing sector and impact capital spending and business confidence (CEO confidence is already at recessionary levels). U.S. election uncertainty, inflation surprises, and Brexit are also among the myriad risks that could impact markets over the coming months. Geopolitical risk is also, as always, a major unknown that we factor into our portfolio downside stress-testing. As of this writing in early January, global tensions are extremely high following the unexpected killing of Iran’s military commander by U.S. forces and now Iran’s retaliatory missile strike. While it is far too early to know how this will play out on a broad scale, equity markets have largely taken this in stride.
Portfolio Positioning and Outlook – While we watch and weigh the ramifications of short-term risks, it’s important to reiterate that we don’t invest based on 12-month market forecasts. The uncertainty is too high and the unknowns too many. More important and most relevant for our investment process is our outlook for the next several years, not months. In this respect, our assessment of the risks and opportunities remains consistent with what it’s been in recent years. With U.S. stocks reaching full value, we see somewhat more attractive opportunities elsewhere: in foreign stocks, flexible bond vehicles, and selected alternative strategies. Should the positive global growth outlook for 2020 play out, we’d expect foreign stocks to outperform U.S. stocks, given their higher cyclicality and sensitivity to overall GDP growth. Receding Brexit uncertainty should also help prop up European markets, in particular. Furthermore, to the extent the U.S. dollar weakens in this environment—due to it being a counter-cyclical currency—that will help foreign stock returns (for dollar-based investors).
Our tactical exposures to flexible bond vehicles and alternative strategies run by skilled managers are particularly attractive in this environment given their ability to actively manage their portfolio risk exposures (e.g., dialing down risk when the reward is not commensurate) and take advantage of market inefficiencies and opportunities when they appear. Not only do these strategies provide valuable portfolio diversification, but we also expect them to deliver better medium-term returns than a traditional mix of U.S. stocks and core investment-grade bonds. These tactical opportunities are relatively attractive, but none of them are without their own risks.
In Closing – There are few table-pounding, valuation-based fat pitches in the investment markets these days. Ten-plus years of unprecedented central bank stimulus and interest rate repression have inflated the prices of most financial assets, if not the actual global economy. Given this backdrop—weighing the risks and return opportunities and considering the economic fundamentals versus financial market valuations—we are cautiously optimistic in our outlook and believe the wisest course for investors continues to be a broadly diversified, moderately defensive posture.
As always, we appreciate your confidence and trust in us. We wish everyone a happy, healthy, and blessed New Year!
The Water Valley Investment Team