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Macro & Market Perspectives Quarterly Outlook & Overview

1st Quarter 2020

2019 Overview & Key Takeaways

Large cap US stocks were the best performing primary asset class in 2019. What a difference a year makes!
Despite all of the concerns about Brexit, trade wars with the Chinese, inverted yield curves, dysfunction in Washington, and the Federal Reserve, 2019 was one of the least volatile years in the stock market in recent history.
US economic activity was better than advertised at the end of 2018. It wasn’t great, but it was okay enough to drive stock prices higher.
In 2019, a lot of people probably heard the phrase ‘inverted yield curve’ for the first time. While most probably couldn’t explain what one is, they knew it wasn't good for economic growth.
You can sum up 2019 by simply saying:

"Don’t fight the Fed."

A Quick Look Back at Another Good Quarter and a Fantastic Year

At the beginning of 2019, we told clients to expect a decent, positive year in the markets with one caveat: it would probably get pretty bumpy along the way. We were only partially right. The markets were indeed positive, but decent isn’t the best descriptor. The word awesome would be more appropriate. As for volatility, outside of couple of choppy months, the markets pretty much went in one direction, and one direction only: up.

Who would have seen it coming?

After all, what has fundamentally changed since the disastrous 4th Quarter of 2018? Brexit still hasn’t happened, although we think it might at the end of January 2020. We still have dysfunctional politics, perhaps even more so now. We don’t have a trade agreement with China, even if there is be a faint light at the end of the tunnel. In essence, virtually all our worries from the end of 2018 are still here, save one: The Federal Reserve.

The markets ended 2018 believing the Fed might actually have a couple of more rate hikes left. The suspicion was it wanted to get the overnight lending target to 3.00% while it could in order to have tools for future slowdowns. We can debate this logic, but it was real. Then, during the 1st Quarter, investors went from believing the Fed might hike rates to thinking it wouldn’t do anything in 2019. In the 2nd Quarter, the sentiment changed from it doing nothing to actually cutting rates. During the 3rd Quarter, shifts in the long-end of the yield curve pretty much validated a more aggressive, accommodative monetary policy. Finally, during the last three months, the Fed finally unwound its unwinding of its quantitative easing programs.

In essence, you can sum up 2019’s strong returns with the following: don’t fight the Fed. When the Fed is providing liquidity, take your fair share and don’t complain about it. After all, asset prices like cheaper money. Conversely, when the Fed is soaking up liquidity…oh ho, who am I kidding? The Fed soaking up liquidity? That is the best laugh I have had all morning, because bad things tend to happen when the Fed tries to soak up liquidity and NO ONE likes bad things. Investors don’t; politicians don’t, Joe Six-Pack, and even bureaucrats don’t.

In the end, as a result of an almost complete change in monetary policy as the year went along, virtually every primary asset class posted a positive return. It felt great, but it likely won’t continue to the same degree in 2020 for a very simple reason: The Fed did the market friendly ‘about face’ LAST year, and two about faces get you back to where you started.

…and no one would want that.

So, What Worked and What Didn’t?

In a nutshell, just about everything worked in 2019 unless you invested in an obscure asset class, company, or country. It was a complete reversal from 2018, when it was almost impossible to find a positive asset class unless, of course, you invested in an obscure asset class, company, or country.

Simply put, investors only had to invest their money in something, anything, to make money last year. While parts of the following chart might be difficult to read, the message isn’t: 2019 was a great year for paper assets.

But where are we in this rally?

We have been telling people we are in the proverbial 7th inning of the economic cycle for a long time. However, given the length of this recovery, US monetary policy, and the slope of the yield curve, this has been the safe call. For this reason, Oakworth has gradually shifted from more ‘cyclical’ economic sectors to more conservative ones over the last 5 quarters. This makes sense.

For instance, investments in financial and real estate companies tend to outperform the market at the start of an economic recovery. The technology and industrial sectors typically do their best as the recovery turns into an expansion. Finally, defensive industries like utilities and consumer staples tend to do their best when economic activity starts to cool down.

Interestingly, despite the length of this particular economic cycle, the shift in US monetary policy, and the flattening of the yield curve, sector performance in the S&P 500 last year was more indicative of a mid-cycle economic expansion, as opposed to being in the proverbial 7th inning or later.

As the following table shows, technology, telecommunications, financial, and industrial stocks led the way last year. Conservative sectors like utilities, healthcare, energy, and staples all under performed the broader S&P 500. However, there Is a caveat: under performance is a relative term, and utilities were still UP 26.4% in 2019.

Does this change our sector asset allocation outlook?

In a lot of ways, we view 2019 as the ‘pendulum swinging back the other way’ after going way to far into the negative during the 4th Quarter of 2018. As previously discussed, the Fed was the reason for this, and it would probably like to stay on the sidelines during 2020 as much as it can. It WILL have to continue to provide liquidity in the repo market and will NOT be able to shrink its balance sheet any further at this time. However, it will WON’T raise the overnight lending target unless economic activity and inflation accelerate further. While not impossible, this doesn’t seem likely. Combined, monetary policy will be neither restrictive or accommodative, simply practical.

With this said, there is little reason to believe there will be continued ‘multiple expansion’ in 2020 with the Fed largely ‘on hold.’ In 2019, the price/earnings ratio on the S&P 500 increased from roughly 16.5x at the beginning of the year to about 21.5x by the end of it. This was due to the decline in interest rates, thanks largely to the US Federal Reserve. Typically, stocks can ‘support’ a higher absolute valuation (i.e. a higher P/E) when interest rates fall. IF interest rates aren’t falling and the Fed isn’t cutting the overnight rate, etc., it is hard to forecast higher valuations for stocks. This takes us back to more ‘normalized’ return predictions, in the roughly 6-8% range.

Given the likelihood for a lower return environment and the probability of a relatively inactive Federal Reserve, it is hard to make a shift into riskier asset classes and economic sectors. As a result, at the start of 2020, Oakworth believes this is the longest 7th inning in history, and its primary economic sector allocations remain:

Basic Sector Allocations at the End of 2019

Not much has changed in our primary asset class targets either (for now).

The chart below shows Oakworth’s current asset allocation target weights relative to the index. In the current environment, our forecast favors:

  1. Overweight stocks relative to bonds
  2. Underweight cash
  3. Overweight large cap relative to small/mid cap
  4. Neutral on international relative to the index.

Of course, 2020 is a Presidential election year, and our asset allocation targets could change depending on the political winds closer to November. Could is the key word here, as we don’t believe it necessarily likely.

If the election were held tomorrow, Joe Biden would be the Democratic candidate, and investors probably wouldn’t make major shifts in investment strategy due to a Trump vs. Biden election.

Until such time as we observe meaningful change in the economy, markets, and even election process, our broad asset class weights will remain:

A Few Predictions for 2020

Next year, the US economy will grow modestly, in the 2% range. The US consumer should be strong enough to ‘offset’ a slowdown in the ‘private fixed investment’ portion of the GDP equation (C+I+G +/- NE).

The Federal Reserve would like to be able to ‘sit this one out’ in 2020, and not have to move the overnight lending target in either direction. It WILL have to continue to provide liquidity in the repo market and will NOT be able to shrink its balance sheet (unwind quantitative easing). In fact, it will likely have to grow it slightly over the course of the year as there are too many Treasuries to finance and too few players with the means of doing so in the overnight market. Combined, monetary policy will be neither restrictive or accommodative…simply practical.

Expect a more modest 6-8% return on US stocks next year. This is the proverbial low-hanging fruit forecast. Throw a 5% ‘equity risk premium’ on top of the 1.90% yield to maturity on the 10-Year US Treasury Note and voila! Tricks of the trade my friends.

There is little reason to believe there will be continued ‘multiple expansion’ in 2020. In 2019, the price/earnings ratio on the S&P 500 increased from roughly 16.5x at the beginning of the year to about 21.5x by the end of it. This was due to the decline in interest rates, thanks largely to the US Federal Reserve (let alone other major central banks). Typically, stocks can ‘support’ a higher absolute valuation (i.e. a higher P/E) when interest rates fall…otherwise known as multiple expansion. IF interest rates aren’t falling and the Fed isn’t cutting the overnight rate, etc., it is hard to forecast higher valuations for stocks. This takes us back to more ‘normalized’ return predictions, like the one in the previous bullet point.

So, if the US market should grow 6-8% next year, what does that make the range with the S&P 500 at roughly 3,220 at year-end? 3,413 - 3,478. Now, what is the chance of that being right? I would give it the flip of a coin, but it is a reasonable, explainable return assumption.

If the Fed is on hold and if the rest of the world’s central banks aren’t in a hurry to do anything either, currency trading could be pretty boring in 2020, with the US dollar trading in a relative tight range against a trade-weighted basket of primary currencies. The moral of the story? If the dollar isn’t going to weaken sharply, it is hard to recommend realizing a bunch of capital gains by selling US stocks to, say, double your international allocation. However, after years of continued underperformance, the easy money betting against international stocks might be over…might. That is NOT an endorsement as much as a statement of the obvious.

Expect a decent, positive year in the markets with one caveat: it is likely going to be more volatile than 2019 was.

A well-diversified balanced portfolio should expect a 5-7% total rate of return; however, it proves to be a roller coaster ride, with politics taking center stage.

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Created By
Sara McPherson
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