Investors had a lot to like about 2019. Across the globe, equities, bonds, commodities, high-yield fixed income and precious metals markets all responded positively to the siren call of lower interest rates and increasingly accommodative global central bank monetary policies.
Despite strong returns from most asset classes, risk markets remained volatile over the course of the year as escalating geopolitical tensions and trade disputes on both sides of the Atlantic periodically sent securities prices in both directions. The closely watched US-China trade war took centre stage, but other cross border conflicts including the ongoing Brexit negotiations, the US-Mexico-Canada agreement and wrangling over European auto tariffs impacted both economic growth and asset prices.
In spite of the heightened trade and political volatility, developed markets registered strong gains in 2019. The MSCI World Equity Index advanced by 25.2 per cent on a price basis, making last year’s return the best since 2009. Emerging markets, led by China lagged the broader averages but began to catch up late in the year.
In terms of the US-China trade conflict, markets applauded a “Phase One” trade deal, ostensibly struck in December. The most important development on this front was no new tariffs and a reduction of some existing ones. That was good enough to take some pressure off the global economy and markets caught a bid into year-end, helping the Santa Claus rally to arrive on time.
The Phase One deal averted new levies on $156 billion of Chinese imports which were threatened to be invoked on December 15 and halved the September tariffs on $120 billion of Chinese goods from 15 per cent to 7.5 per cent. However, the 25 per cent tariff on $250 billion of Chinese imports remains, with the possibility of a “snap back” in tariffs if China doesn’t follow through on its commitments. White House officials said China agreed to increase its total US farm product purchases to $40 billion a year with a US goal to raise it to $50 billion annually.
The latest agreement is hoped to have marked “peak tariffs” for now as this deal represents the first time that trade talks have led to an actual reduction in tariffs, rather than just a delay. Time will tell if sentiment has now been encouraged enough to reduce risks to global manufacturing and consumer sentiment.
Over in Europe, Boris Johnson and his Conservative party’s landslide victory in UK’s December election ended over 3˝ years of political wrangling since a majority of the British electorate voted to leave the EU in 2016. With the Conservatives securing a large majority, the UK Parliament quickly voted in favour of Johnson’s Brexit Bill. If the European Parliament also gives the green light, the UK will officially exit the European Union on January 31, 2020. Starting then, the UK will enter a transition period until December 31, 2020.
During this time, the two parties will maintain their current trade relationship while negotiating new terms. The British pound soared to more than $1.35 after the election, its highest level since May 2018 but has since retreated to about $1.31.
Looking ahead, US and global business cycles are showing early signs of recovery. We see the more accommodative US Fed combined with similar initiatives in other countries as helping to boost global growth in 2020.
In the aggregate, S&P 500 companies are expected to deliver high-single-digit earnings progress in the year ahead. Earnings were suppressed in 2019 by trade tensions which crimped capital spending. Earnings growth likely bottomed in 3Q and should show stabilisation in 4Q, followed by stronger growth into next year.
Tariffs likely reduced 2019 earnings growth by about 8 per cent through direct and second-order trade costs. An improving outlook, as suggested by a bottoming in the global purchasing manager’s index and monetary easing across most countries portends an uptick in output. In the third quarter of 2019, 16 central banks cut rates followed by a total of 23 rate cuts in Q4.
In terms of equity market valuations, the lower interest rate environment justifies higher stock price earnings multiples. We can make a case for a forward earnings multiple of 18 times on both the S&P 500 and the MSCI World Stock Index. The MSCI Emerging Stock Index looks especially cheap at just 14 times projected forward earnings. Also worth noting is that, in the one-year run-up to a presidential election, the stock market has historically had positive returns about 90 per cent of the time with an average performance of about 12 per cent.
Final resolutions on trade are a key variable for the performance of multinational corporations in the months ahead. Likely, recent standoffs have likely been priced into the market already. However, should President Trump come through with a Phase Two deal, further gains are possible.
Meanwhile, cashflow in the largest corporations remains at record levels and share buybacks should continue to boost bottom line earnings-per-share performance. Expected heightened merger and acquisition activity as well.
While gains may continue into 2020, volatility will also likely be more pronounced. Last year’s surge in stock prices came off the back of an outsize sell-off in December of 2018 and most developed world share prices are now trading much closer to their fair values.
Against this backdrop, we continue to emphasis selectivity in building portfolios. While much has been made of the “value” versus “growth” stock debate, the real winner over the past decade has been “quality” as a factor.
Higher quality companies, or those possessing the strongest balance sheets, solid economic moats and stable cash flows, have exceeded the performance of lower quality companies as well as the broader indices which represent both the “value” and “growth” factors. We see no reason this should not continue into the year ahead.
In fixed income, we may have seen the beginning of the end of the latest round of Fed rate cuts. Last summer’s triple cut in the Federal funds rate will likely be enough to act as an economic insurance policy for the near to intermediate term. Expect the short end of the US interest rate curve to stay range-bound at the new lower levels; however, longer term rates may trend back up over 2 per cent by next summer assuming we see progress on trade talks and if the global economic recovery continues.
We wish you and yours and happy, healthy and prosperous New Year!
• Bryan Dooley, CFA is the senior portfolio manager and general manager of LOM Asset Management Ltd in Bermuda. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority