January 2020 Market View
As we begin 2020, we would first like to review 2019 and then offer our thoughts for the coming year.
2019 – Regaining Lost Ground and Then Some
Few investors can forget the fourth quarter of 2018, a period in which the S&P 500 lost more than 20% from peak to trough. We have written in the past about the culprit for that market decline: Federal Reserve Chairman Jerome Powell and his injudicious comments in October 2018 about aggressively raising interest rates. Powell’s pulling back from the brink of interest rate Armageddon started the rally which lasted throughout 2019 and gained steam in the fourth quarter of last year.
In early 2019 we forecast a year-end S&P 500 print of 3,100. In fact, the Index did better than we had thought possible, closing at 3,230.78. While the Fed helped propel the stock market with lower interest rates, the market overcame several headwinds, the most significant of which was trade tension with China. Other headwinds were: 1) a slowdown in corporate capital spending, 2) a strong U.S. Dollar, 3) domestic political strife, and 4) mediocre economies in Japan & the European Union. It is notable that the market advance last year was almost entirely due to price/earnings multiple expansion, as earnings growth for the S&P 500 was nearly flat in 2019. We note that several Wall Street strategists who forecasted flat earnings for 2019 in their year-end prognostications missed a wonderful recovery from the dismal fourth quarter of 2018 and a strong 2019. It just goes to show that markets can move on more than just earnings alone. The price/valuation puzzle is complex and multi-dimensional.
2020 – Headwinds Turning Into Tailwinds
The headwinds that the stock market faced in 2019 are seemingly turning into tailwinds. On earnings, many Wall Street strategists see 5 – 7% growth this year after no growth last year. That range would be higher if not for the energy sector’s weakness and Boeing’s troubles with the 737 Max.
Trade represents another negative turning into a positive. In mid-January, President Trump expects to sign the Phase I trade deal agreement with China. While the final details have yet to be released, especially the amount of Chinese purchases of U.S. agricultural goods, it appears the Administration has reached an agreement that Wall Street accepts. While we all understand the virtues of free trade, we never believed those who forecasted a weak domestic economy simply due to the imposition of tariffs on one country: China. We believe those who did make such forecasts neglected to closely study the Smoot-Hawley Tariff Act of 1930 which was a main culprit of the Great Depression. Smoot-Hawley created tariffs on over 20,000 foreign goods (affecting nearly all U.S. trading partners) and was thus extraordinarily restrictive to domestic economic growth. While China is a significant trading partner of the United States, Canada and Mexico together represent a larger share of our imports. Further, in this global economy, many companies have the flexibility to move their supply chains to avoid tariffs. Many of those supply chains have indeed moved, probably permanently, to the chagrin of China. Thus far, the Administration’s trade policy has worked to squeeze some concessions from China. We will get the details in about one week on Phase I, but difficult negotiations remain. The issues are complex and the relationship with China is intractable.
Another major trade initiative of the Administration, revamping the North American Free Trade Agreement (NAFTA) into one with more favorable terms to the United States, finally passed the House of Representatives on December 19. More votes are yet to come; the U.S. Senate will vote soon and Mexico & Canada will vote again in the near future. Some Wall Street strategists believe that a revamped NAFTA (now USMCA) could add between .2 – .3% to Gross Domestic Product growth of the United States.
While corporate management teams have been very conservative in their outlook as a whole, we believe movement on China trade, USMCA and perhaps BREXIT (the U.K.’s withdrawal from the European Union) will cause them to become more positive. More positive outlooks from the C-Suites in the U.S. could translate into increased capital spending. We will be listening very carefully on our fourth quarter earnings conference calls for this improved outlook. In this era, technology companies are typically the largest beneficiaries from increased capital spending, as payback periods from computer software and hardware are much shorter than from bricks-and-mortar & capital equipment.
With trade deals emerging, corporate management teams becoming more positive, interest rates forecasted to remain low for an extended period, and U.S. consumer spending remaining strong, we will be watching for a pick-up in economic growth in Europe and the Emerging Market countries. It seems that every January the same set of analysts forecast a pick-up in these areas and we’ve been quite skeptical in the past. This year however, we are starting to see “green shoots”: the U.S. Dollar has recently weakened notably, several emerging market ETFs have perked up, and a few large European banks and industrials have also started to move. Could we be seeing the beginning of an uptick in global growth? Time will tell, and we will be watching extremely closely for new opportunities in overseas markets.
Near-term Risks
What could upend the positive picture that now presents itself? There are several developments which we are monitoring that could negatively impact the outlook this year:
- A protracted conflict in the Middle East
We would be naïve to think that markets could completely withstand the economic uncertainty from a lengthy conflict in the Middle East. We invested through the first Gulf War in 1990, and the Iraq War from 2003 to 2011. Both were unique in their duration and effect, and any conflict with Iran would be different from the prior two Middle East wars. Our energy independence now versus then is one factor that would insulate the United States from a major economic shock, unlike before. The facts that Iran is economically crippled from U.S. sanctions, and the U.S. military is vastly more powerful than Iran’s, also lead us to believe that any conflict would be short-lived. We put the odds of an outright lengthy conflict with Iran at less than 10%, but that could increase with unforeseen events.
- A meaningful pickup in U.S. price inflation
While no signs are emerging of a meaningful pickup in price inflation, if inflation were to somehow emerge it would bring the Federal Reserve’s current policy on interest rates into question. Today, artificial intelligence, robotics, communications, and software are exerting deflationary pressures. They, along with the decline in labor’s bargaining power, increased speed of retail price adjustments, and the reduced inclination of companies to raise prices, contribute to inflation that remains below the Fed’s target. We believe it would take quite an external shock to drive inflation meaningfully higher – therefore we put the odds of a meaningful pickup in inflation at less than 10%.
- A Progressive Overhaul of the U.S. Economy
2020 is a presidential election year. We note that Sen. Sanders had the largest fundraising haul among Democrats in the fourth quarter of 2019. Sen. Warren is also a worthy challenger for the Democratic Party’s nomination. Both are proposing tax, regulatory and trade policies that are far to the left of existing policy. However, if either were elected, both the Senate and House would need to be controlled by their party to make major policy changes. A full repeal of the 2017 tax reform act would require the approval of Congress. One could envision, however, the use of Executive Orders to accomplish changes in healthcare, energy, student debt and trade. We put the odds of a Progressive overhaul of the entire U.S. economy at less than 5%, but should either Sen. Sanders or Sen. Warren be elected, changes could be affected on the margin that could impact certain industries, such as those named above.
- Anti-trust Legislation Targeting Specific Technology Companies
Since the 2016 election, some Members of Congress have had the big Silicon Valley tech companies in their sights. Convinced that these companies’ influence has grown to such a degree that they disproportionately and negatively exert control over consumers and voters, some Members are searching for means to force Facebook to separate Instagram into a stand-alone entity. Other Congressional and regulatory initiatives are possible. Europe is considering establishing Digital Service Taxes on the advertising revenues of tech giants Google, Amazon and Facebook. We find it very difficult to put odds on this regulatory risk, as it is within the realm of several different countries and different legislative bodies. However, the topic has been widely discussed on Wall Street, therefore any legislative and regulatory action is unlikely to be a major surprise, if it happens.
Continuing Tailwinds
The U.S. continues to be a place of technological innovation and leadership. This technological leadership will translate into large investment opportunities in the future. In a prior letter we wrote about 5G – the next generation in wireless communications. This innovative connectivity will impact many sectors of our economy – from transportation, to healthcare, the environment, buildings & manufacturing. 5G is destined to be huge, and impact nearly every human activity. Add 5G to artificial intelligence, robotics, breakthroughs in biotechnology to treat cancer & other diseases, and it is easy to see that the U.S. remains the leader in technology and innovation.
The U.S. consumer remains buoyant. The U.S. unemployment rate is 3.5%. Consumer confidence and real consumer spending remains strong. U.S. consumer balance sheets are carrying the lowest debt service obligations in 40 years. Average FICO scores are near all-time highs. Unfilled job vacancies remain above 7 million – there just aren’t enough qualified workers to fill the jobs. Wages are rising across all levels of income.
The U.S Federal Reserve remains on hold. The Fed forecasts inflation below their target for the intermediate future, likely held down by small productivity gains and companies unwilling to raise prices. While the Federal budget deficit and national debt are longer-term concerns, at current interest rate levels the financing of the Federal debt has not been a problem. Longer term, we can see where large budget deficits and the national debt become issues – and we do not discount the chance for a period of high inflation in the distant future. If that comes to pass, we expect to be heavily exposed to real estate and other “hard” assets.
The U.S. is increasingly seen as an attractive place to do business. The Administration’s commitment to lower regulations, in addition to tax decreases, has made the U.S. a more competitive and friendly place to do business. The American market is huge, immigrants want to move here, and opportunities are great.
Bonds – An Area We Are Avoiding
With interest rates this low, we are surprised that bond funds and bond ETFs enjoyed large capital inflows during the fourth quarter of 2019. The after-tax yield on bonds now is miniscule, and while we do not expect any meaningful uptick in interest rates soon, should there be a surprising uptick in rates, recently purchased bonds could experience punishing losses. Bond funds and bond ETFs also carry their own unique risks, chief among them: illiquidity / lack of bids in a fast market. This risk is amplified the farther down on the investment-rating scale one goes, with high-yield (junk) bonds subject to the worst losses with an uptick in rates. We are simply not willing to assume these risks for our clients now – the rate of return on bonds, after-tax & net of fees, is simply not worth the risk. If anyone tries to sell you on investing in bond funds or bond ETFs in this environment – run!
Our Investment Process
Each day we spend the bulk of our time researching new investment ideas, monitoring current positions and ensuring our client portfolios closely fit their assigned models. Our research process is data-driven and repeatable. We use several institutional-quality databases, news services and research sources to assist us in our decision-making. While investing is both art and science, we lean heavily on data as we manage investments. Our personal “feelings” have no role in our investment decisions; we want hard facts.
Finally
As you can imagine, we hear many different perspectives from our clients. Part of our role as investment advisors and managers is to help our clients focus on salient facts and eliminate the constant “infield chatter” that goes on during the investment game. That chatter often comes through the broadcast financial media.
If you have visited our offices, you have undoubtedly noted the many flat screens we have running during the day tuned into CNBC or Fox Business News. Please do not let that throw you off – we do not watch them much, and neither should you. Rarely does one hear good investment ideas on TV. In fact, they are often a source of bad information, in our opinion. They are in the business of capturing your attention and will say almost anything to get it. You might ask, “Well, why do you have them on, if you feel like that?” Answer: about three times per week there is a guest worth listening to. We know who they are, simply because we’ve been around this business for so long. So, we encourage you: turn off the financial news and go enjoy your life. Don’t let them upset you. Let us worry about your investments. After all, that is what you are paying us to do.
Best wishes for a happy and prosperous 2020,
www.beckcapitalmanagement.com https://www.facebook.com/BeckCapitalManagement.com
Investment advisory services offered through Beck Capital Management LLC, a registered investment adviser. This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results. Nothing contained herein is to be considered a solicitation, research material, an investment recommendation or advice of any kind. The information contained herein may contain information that is subject to change without notice. Any investments or strategies referenced herein do not take into account the investment objectives, financial situation or particular needs of any specific person. Product suitability must be independently determined for each individual investor. Beck Capital Management explicitly disclaims any fiduciary responsibility or any responsibility for product suitability or suitability determinations related to individual investors, as may relate to the information contained herein. The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value. There is no guarantee that companies that can issue dividends will declare, continue to pay, or increase dividends.