ECONOMIC FLASH — After a Successful Year

January 3rd, 2020

Even if US corporate earnings growth picks up in 2020, a major question is how much of that increase has already been represented in stock prices given the 2019 rally. Quite a bit, most certainly. Aside from high valuations, we do not see a catalyst for a significant market drop at this time.

US Economy: Slow, stable growth.

The latest 3Q US economic growth reading remained constant at 2.1 percent annualized. However, corporate investment was revised somewhat higher, offsetting a reduction in the volatile inventory component.

US Stocks: At all-time highs.

In December, US shares rose on the prospect of a partial US-China trade agreement and improved global growth forecasts. The best sectors were technology (+5.2%) and energy (+6.0%), although strong holiday sales provided a late boost to consumer stocks as well.

Foreign Stocks: Year-end surge.

Improved GDP and trade expectations bolstered international equities, which were boosted further by a weaker US currency, which added about 1.7 percent to returns. Returns in emerging market stocks were led by China and a comeback in Latin America.

Fixed Income: Rates tick higher.

Long-term interest rates have risen modestly in recent months, with the 10-year US Treasury bond reaching 1.9 percent. Interest rate-based likelihood estimates for a 2020 US recession have dropped to around 25% from over 50% last summer.

Real Assets: Commodities lead.

With the notable exception of REITs, which were harmed by the rise in interest rates, real assets performed well. Commodities rebounded broadly, with economically sensitive oil (+6.9 percent) and trade-war-depressed soft commodities (+6.2 percent) leading the way.

Alternatives: Mixed bag for hedge funds.

Because stock returns have been so good, hedge funds that were long equities outperformed the market. In contrast, the stock market surge that lifted most ships did not do as well for hedge funds that employ more specialized methods based on security selection.

Our Take

There are numerous reasons to be positive about the US and global economies. Within the United States, consumer activity continues high, the labor market is strong, and some geopolitical concerns appear to be easing as trade progress is achieved and Brexit (once again) appears to be a matter to be dealt with later. Nonetheless, we have a bleak prognosis for US corporate earnings in 2020, as well as weak business confidence and manufacturing, all of which appear unlikely to improve much based on what we know so far about the trade deal with China. All of this, combined with the recent escalation of relations with Iran, implies that 2020 and the years ahead should be approached with caution.

Furthermore, the December rise in the S&P 500 Index closed off one of the best years for US equities markets since the mid-to-late 1990s. This return, along with corporate earnings that were practically flat year over year, results in an equity market that is pricey by historical standards.

Even if corporate earnings growth improves significantly in 2020, investors must consider how much of that increase has already been baked in. Quite a bit, most certainly. Aside from valuations, as we've stated in recent months, we don't see a trigger for a significant market drop on the horizon, and we don't believe the present climate necessitates drastic portfolio modifications.

As a result, as we enter 2020, we advocate making minor portfolio tweaks to highlight the strongest return potential while improving the downside characteristics. We are rebalancing our non-US stock exposure to favor developing markets over established markets, which we believe have less upside. We are also increasing our exposure to infrastructure shares, which we believe offer some of the finest risk-adjusted return potential. Finally, we are boosting our core fixed-income holdings, which provide the strongest diversification to stock markets and should benefit portfolios if 2020 turns out to be less promising than anticipated.

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