Year-to-date stocks are up 22%, and bonds are up 8%.1 It’s quite unusual for stocks and bonds to both be having such strong years. If there’s a strong outlook on the economy, stocks would be up, but interest rates would rise, muting bond returns. If the economy were weakening, the bond rally would make sense, but you’d expect stocks to be down. And, gold is up double digits.2 Gold usually responds to extreme conditions, such as the risk of a global crisis or high inflation. What can investors conclude about this environment, and what does it portend for 2020 and beyond?
The short answer is that we’re seeing continued positive, but slowing, global economic growth. That, combined with low inflation, is allowing central banks to offer accommodative monetary policy, which will help sustain the economic expansion.
Stock Market
The 22% year-to-date return of the world stock market is a bit misleading. This represents a recovery from the 18% decline in late 2018. Returns are flat over the past 12 months and, in fact, are little changed since the trade war started in January of 2018. Last year’s (2019) rally can best be explained by the idea that the market feared a recession that didn’t materialize.
U.S. stock market valuations, at 17x 2020 earnings,3 are at modest levels, just slightly above the 25-year average. Even though the market is back near record highs, it’s grown in line with earnings growth. International markets continue to be cheaper, reflecting both lower growth expectations and a different industry mix (fewer tech companies). When the inevitable recession comes and earnings fall, we can expect another market pullback. However, on a longer term basis, this is a healthy starting point.
Bond Returns
The composition of bond returns also reflects investor uncertainty. The 10-year Treasury yield dropped by half, from 3% at the beginning of the year to a low of 1.5%. Lower rates usually signify lower expected economic growth and inflation expectations. At the same time, credit spreads (the incremental yield you get for a risky corporate bond relative to a government bond) also tightened, which signifies a lower risk of default typically associated with a stronger economy.
Interest Rates
While interest rates are low, they can get lower. In Germany and Japan, 10-year yields are now negative, meaning that lenders are so worried about the future that they’re willing to accept less than their principal in exchange for safety. This unusually large gap between U.S. and international rates is creating downward pressure on U.S. yields.
Spending
Within the economy, a divergence exists between consumer and business spending. Consumer spending and confidence remain strong. With unemployment at a 50-year low and wages growing faster than inflation,4 workers are secure in the stability of their income. Consumption represents about 70% of the economy and is the key driver of a continued expansion. On the other hand, manufacturing and trade have been in decline as capital spending levels are declining, due in part to rising tariffs and uncertainty on changes in trade policy.
Outlook for 2020
While this has become the longest expansion on record, it’s also been one of the most tepid. Given how deep the 2009 recession was and how low growth has been during the recovery, the round-trip economic growth is well below what we saw in the 1980s and 1990s expansions. This type of slow recovery often happens following financial crises.
In 2019, we saw a yield curve inversion, in which short-term interest rates are higher than longer term interest rates. Inversions have been a reliable leading indicator of a recession. That said, the recession has often still been two to three years away; 2019’s inversion was small and short; and long-term rates may be artificially depressed due to purchases by central banks and non-U.S. investors. So, this may be a weaker signal than usual. Furthermore, it tends to take at least six months to see the results of monetary stimulus taken by central banks, such as cutting interest rates and adding quantitative easing. And, finally, it’s unusual to have a recession in an election year, as the government may seek to add fiscal stimulus should the economy weaken further. Most economists project the expansion to continue in 2020.5
Uncertainty around the U.S. election will affect many stocks, particularly in the financial and health care sectors, which bear significant legislative and regulatory risks. Geopolitical risk remains elevated with continued uncertainty around Brexit, depressed oil prices amidst Middle East tensions and changing trade policy. All of this means that we should expect more volatility.
When a recession becomes more likely, the market may sell off in advance. For longer term investors that can tolerate the volatility and stay invested through the full market cycle, equities have historically tended to track long-term economic growth.
Despite low interest rates, high quality bonds continue to play an important role in investor portfolios as they have been a stable asset relative to stocks. They continue to provide income that keeps up with inflation, and having a few years of interest rate duration has historically provided a hedge against economic weakness. That said, investors should be cautious with lower quality bonds, which carry higher risk, historically haven’t hedged economic weakness and may not provide enough incremental yield to justify them in portfolios.
Investors should also continue to consider alternative investments that may add to diversification. Treasury Inflation-Protected Securities and commodities can help hedge inflation risk and are selling at modest prices. Low volatility hedge funds can create returns that are independent from interest rate movements. Investments such as private equity and real estate offer the opportunity for higher returns than do public markets for investors with the capacity to bear long-term illiquidity among other incremental risks.
Was the uncertainty of 2019 rooted in evolving economic trends, international tensions or political dysfunction here and abroad? Any one of these pressures was potentially sufficient to portend the end of this economic cycle. Markets have told us that investors still aren’t sure. The year 2020 may be one in which our Federal Reserve’s intervention and a presidential election cycle ultimately set the stage for a record-breaking extended economic expansion. If this comes to pass, 2020 could be a year of renewed earnings growth and market appreciation. Today, that remains a very uncertain outcome. More conservative investors may want to consider reducing exposure to equities, while more risk-tolerant investors may want to use market pull backs as an opportunity to buy. All investors should continue to brace for uncertainty and volatile markets.
Endnotes
1. As of Nov. 8, 2019. Stocks are represented by the MSCI World (Net) Index. Bonds are represented by the Bloomberg Barclays U.S. Aggregate Index.
2. As of Nov. 8, 2019. Based on Comex Gold futures contracts.
3. Refinitiv. Forward price/earnings multiples represent market price divided by the mean earnings-per-share estimate for the next 12 months. U.S. stocks are represented by the S&P 500 Index. As of Sept. 30, 2019.
4. As of Sept. 30, 2019. Bureau of Labor Statistics. Wage growth represented by Employment Cost Index.
5. Survey of Professional Forecasters, Federal Reserve Bank of Philadelphia.
—The views expressed herein are those of the author and do not necessarily reflect the views of Capital Group Private Client Services and should not be construed as advice. The thoughts expressed herein are current as of the publication date, are based upon sources believed to be reliable and are subject to change at any time. There is no guarantee that any projection, forecast or opinion in this article will be realized. Past results are no guarantee of future results.