An Economic & Market Commentary from Trust Point€¦ · Keeping an Eye on the Dominoes Dollar...
Transcript of An Economic & Market Commentary from Trust Point€¦ · Keeping an Eye on the Dominoes Dollar...
Fourth Quarter 2019 | Issue No. 28An Economic & Market Commentary from Trust Point
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Fourth Quarter 2019Market Point
An Economic and Market
Update from Trust Point
After an unusually weak fourth quarter in 2018, both equity and fixed-
income markets produced strong returns for investors in 2019. While
equity markets were primarily supported by rising investor sentiment,
both markets cheered the actions and words of major central banks
around the world.
U.S. and global economic growth were
positive but weaker in 2019. Not only
were GDP (Gross Domestic Product)
growth rates lower than last year, they
were also lower than what was expected
by economists at the beginning of the
year. While many factors contributed to
the slower pace of growth last year, the
trade war with China certainly played
an important role. As the trade war
unfolded, its impact on confidence,
business confidence in particular,
was of critical importance (Chart 1).
Business confidence has historically
been a very reliable leading indicator
of recessions as it correctly predicted
the past four recessions since the mid-
1970s. Without business confidence,
we know the job market could be at
risk putting the two biggest sectors of
the economy (service and consumer)
in peril. Fortunately, despite weaker
business confidence so far, the
job market has remained resilient.
While we continue to expect sluggish
economic growth in 2020, we remain
on high alert for potential outcomes on
either side of our base case. Whether
the economy surprises on the upside
or downside will be partially dependent
on the ability of the U.S. and China to
seal a comprehensive and sustainable
deal, an outcome that still remains
uncertain despite recent progress on a
“Phase One” deal.
Keeping an Eye on the Dominoes
Dollar Index Level Dec 96.4 99.4 96.2
As of Actual 3 Mos. Ago 1 Year Ago
ISM Manufacturing (>50 = Expansion) Dec 47.2 47.8 54.3
ISM Non-Manufacturing (>50 = Expansion) Nov 53.9 56.4 60.4
Non-Farm Payrolls Nov 266k 219k 196k
Unemployment Rate Nov 3.5% 3.7% 3.7%
CPI Ex-Food & Energy (yoy) Nov 2.3% 2.4% 2.2%
JP Morgan Global Manufacturing Index
(>50 = Expansion) Dec 50.1 49.7 51.4
JP Morgan Global Services Index
(>50 = Expansion) Nov 51.6 51.8 53.7
US Economic Activity
KEY ECONOMIC DATA
Global Economic Activity
Source: Bloomberg
Chart 1: Confidence - An Important Domino That Must Stay
Up Straight
Source: MRB Partners Inc © 06/2019
Trade War
Global Trade
Trade
Note: Dominoes depict trends in the U.S. and aggregate global economy
Sluggish Growth Weak Growth Recessionary
Manufacturing Sector Service Sector Consumer Sector
Hir
ing
In
ten
tio
ns
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ym
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Real W
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es
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New Orders
Cap
ex P
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Hirin
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tent
ions
Monetary Reflation
Market Point Fourth Quarter 2019
In investing, “picking up pennies in
front of a steamroller” has always been
a dangerous proposition. The term
was coined by journalist Martin Wolf
and economist John Kay years ago to
describe investments with a high prob-
ability of a small gain (pennies) but a
small probability of a very large loss
(steamroller). For investors, recessions
are like steamrollers. They can cre-
ate large losses in portfolios relatively
quickly. As investment managers and
fiduciaries of our clients’ assets, it is
our job to always be on the lookout for
steamrollers and adjust portfolios ac-
cordingly. While we never bought into
the recession story over the late sum-
mer months, we have made it clear to
our clients that we believe we are “late”
in the cycle (Chart 3). While this doesn’t
tell you when the steamroller will ar-
rive, it provides a probability gauge on
the likelihood of one appearing. At this
point, we are not calling for a recession
in 2020, but we remain on the lookout.
Over the past six months we have be-
come more selective in our position-
ings to ensure that we can provide the
best risk-adjusted returns for our cli-
ents without taking unnecessary risks.
Picking Pennies in Front of a Steamroller
Since the trade dispute with China
started to flare in early 2018, policy un-
certainty has been on the rise (Chart
2). Internally, we like to refer to policy
uncertainty as the “rules of the game”.
When the rules are unknown or chang-
ing, fewer people are willing to “play the
game”. In the world of economics, this
means decision makers and business
owners postpone or cancel decisions
to spend and invest, therefore depress-
ing economic activity. Recently, the
announcement of a “Phase One” deal
with China was received with enthu-
siasm. On the surface, it appears like
the “rules of the game” between the
two super-powers are now being de-
fined. However, under the surface, we
question how much has really been
agreed upon. Comparing statements
released from the U.S. and Chinese
administration on the “deal” is quite
telling. While the U.S. statement is full
of “agreed” commitments with specific
dollar amounts and timelines, the Chi-
nese statement is full of generalities
with no dollar amounts or timelines.
Until we get signatures on both sides,
the details of the agreement will proba-
bly remain unclear.
Policy Uncertainty is Not Going AwayChart 2: Policy Uncertainty Remains Elevated and Dependent
on the Ongoing US/China Trade Dispute
Source: Ned Davis Research; Copyright 2019 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html.
For data vendor disclaimers refer to www.ndr.com/vendorinfo/.
PPP-GDP Weighted Aggregate of Australia, Brazil, Canada, Chile, France, Germany, India, Italy, Ireland, Japan, Mexico, Russia, South Korea, Spain, UK, and US.
340Global Economic Policy Uncertainty Index (2019-11-30 = 265.8)
340
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1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Chart 3: Many Signs That The Economic Cycle Is “Late”
Source: Touchstone Investments, Bloomberg
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June 1976 through August 2019
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Late Cycle
Mid Cycle
Early Cycle
*Model based on Capacity Utilization, Unemployment Rate, Treasury yield spreads, and Consumer Confidence Indexes
An Equity Market
Update from Trust Point
Market Point
Global equities continued their march higher into year-end as the fourth
quarter was marked by expectations for improving economic growth and
an agreement on a “Phase One” trade deal between the U.S. and China.
Fourth Quarter 2019
S&P 500 3,231 2,977 2,507 2,239 2,059
Dow Jones Industrial Average 28,538 26,917 23,327 19,763 17,823
NASDAQ 8,973 7,999 6,635 5,383 4,736
US Large Cap Growth 10.6% 36.4% 36.4% 20.5% 14.6%
US Large Cap Value 7.4% 26.5% 26.5% 9.7% 8.3%
US Mid Cap Growth 8.2% 35.5% 35.5% 17.4% 11.6%
US Mid Cap Value 6.4% 27.1% 27.1% 8.1% 7.6%
US Small Cap Growth 11.4% 28.5% 28.5% 12.5% 9.3%
US Small Cap Value 8.5% 22.4% 22.4% 4.8% 7.0%
International Large Cap Developed (US Dollar) 8.2% 22.0% 22.0% 9.6% 5.7%
International Small/Mid Cap Developed (US Dollar) 11.5% 25.0% 25.0% 10.9% 8.9%
Emerging Market (US Dollar) 11.8% 18.4% 18.4% 11.6% 5.6%
Quarter-End 3 Mos. Ago 1 Year Ago 3 Years Ago 5 Years Ago
3 Month YTD 1 Year (Ann) (Ann)
3 Year 5 Year
US Economic Activity
EQUITY BENCHMARK TABLE
Equity Returns (%)
Source: Bloomberg, Morningstar
Equities Year in Review
Global stocks had a banner year in 2019
on the heels of major central bank ac-
tions that drove interest rates lower (po-
tentially extending the economic cycle)
and expectations for positive near-term
outcomes in the global trade war. What
the market lacked was a positive con-
tribution from earnings growth as lower
economic activity, particularly in the man-
ufacturing sector, kept global earnings
growth nearly flat for the year. Historically,
we know earnings have been the primary
contributor of rising equity prices. There-
fore, without stronger earnings in 2020,
it is unlikely the stock market could con-
tinue to march higher. A surging stock
market with flat earnings growth last year
lends its influence to very strong investor
sentiment reflected by higher equity valu-
ations in the U.S. and internationally. The
rising bullish sentiment as of late (Chart
4) is a measure of a more positive inves-
tors’ view of recent developments in the
trade war between the U.S. and China
and expectations of a reversal in key eco-
nomic indicators in 2020.
Source: WSJ The Daily Shot
Chart 4 : Investor Optimism Increased Throughout 2019Driving Equity Markets Higher
50
40
30
20
10
0
-10
-20
-30
-402018 2019201720162015
AAII US Investor Sentiment Bull - Bear Spread
Market Point Fourth Quarter 2019
As global equity valuations moved high-
er in 2019 on expectations for improved
global growth and positive trade war
outcomes, it leaves doubt to how much
higher global valuations can go without
more support from fundamental stock
drivers such as earnings growth. As
manufacturing activity slowed in 2019,
earnings expectations for the next twelve
months peaked and have since come
down (Chart 5). An improved economic
environment, which already appears to
be priced into stock valuations, leaves
little room for expansion of price-to-earn-
ings multiples. If we assume valuations
remain unchanged throughout the year,
or even give back some of the 2019 in-
crease, particularly in the U.S., any up-
side in stock prices is likely to parallel the
earnings increase in the coming year.
Our base case is for earnings growth
estimates to continue to decline relative
to current expectations suggesting mod-
est global equity returns consistent with
our expectation for sluggish economic
growth in 2020. At this time, valuations
outside the U.S. do not appear to have
discounted much potential improvement
in economic activity and probably rep-
resent the best opportunities for equity
investors in 2020.
Expect Equity Returns to Parallel Earnings Growth
Last year the global stock market and the
global bond market diverged so much
that bonds now appear overvalued rela-
tive to stocks. A regression to the mean
is a reasonable outlook for the coming
year, particularly as major central bank
actions now appear to be on hold in
2020. In a period of rising long-term inter-
est rates, the financial sector could be a
major beneficiary as bank services tend
to see profit margins improve when rates
rise (Chart 6). As such, we continue to
favor this sector of the market relative to
our benchmarks. For many of the same
reasons we prefer the financial services
sector, we have relative underweights to
bond proxy sectors such as utilities and
consumer staples. Each of these sectors
pays relatively high dividend yields that
become less attractive on a risk-reward
basis with improving bond yields. As
yields came down over the past several
months these sectors became more ex-
pensive. On a regional basis, we continue
to overweight the Eurozone area relative
to our benchmarks. The region remains
under the watchful eye of the European
Central Bank, valuations remain relative-
ly attractive, and an expected upturn in
global economic growth is poised to dis-
proportionately benefit the region.
Equity Positioning in 2020
Chart 5 : Global Earnings Growth Expectations Slowing Down
Source: MRB Partners
*U.S. dollars; rebased
Note shaded for NBER-designated U.S. recessions
2006 2008 2010 2012 2014 2016 2018
120120
160160
200200
120120
160160
12-Month Forward Earnings*: Global
Global ex-U.S.U.S.
Chart 6 : Steeper Yield Curve Should Benefit Financials
Source: BCA Research (BCA Analytics)
*Shown rebased to Jan. 2016 = 100. Source: MSCI Inc. (See copyright declaration).
**10-Year Minus 2-Year Government Bond Yield. Germany Used for Euro Area. For Global, G7 10-Year Government
Bond Yield Minus 3-Month Euro Rate is shown.
104
100
96
92
88 -40
40
80
120
BpsGlobal
0
16 17 18 19
Yield Curve** (RS)
Stocks: Financials Relative to
Broad Market* (LS)
Over the last five years, the Federal
Reserve has driven monetary policy by
raising interest-rates nine times; from
zero-bound to a range of 2.25%-2.5%.
In 2019, it lowered the Fed Funds rate
three times and is now targeting a range
of 1.5%-1.75% (Chart 7). Interestingly,
throughout its journey, the Fed has not
only influenced the direction of the bond
market but the equity market as well.
In late 2018, the Fed contributed to the
equity market correction by hiking rates
too much and too quickly while it also
contributed to the equity market rally in
2019 with their rate cuts. In 2020, we
expect the Fed to take a back seat and
remain on hold the entire year for two
main reasons. First, the independent
Fed will not want to give the impression
of a political bias by impacting markets
during an election year. We have seen
how markets have reacted to changes in
monetary policy in the past and rate cuts
or hikes could give the impression of a
partisan Fed. Second, with core PCE
(personal consumption expenditure)
inflation still well below the Fed’s target,
there is little reason for the Fed to hike
rates. With the Fed taking a back seat,
we expect Fed policy to become less of a
driver of asset prices in 2020.
Federal Reserve - Taking a Back Seat in 2020
A Fixed Income Market
Update from Trust Point
Market Point
During the first three quarters of 2019, the bond market had a tremendous
run in response to weakness stemming from the trade war’s effect on
growth and confidence. The recession fears which drove bond returns
began to unwind in the fourth quarter. Decreasing trade tensions and a
Fed on hold have so far proven that the “worst-case scenario” narrative
implied in the bond market was overdone.
Fourth Quarter 2019
3 Month T-Bill 1.5% 1.8% 2.4% 0.5% 0.0%
2 Yr US Treasury 1.6% 1.6% 2.5% 1.2% 0.7%
10 Yr US Treasury 1.9% 1.7% 2.7% 2.5% 2.2%
US Intermediate Treasuries -0.8% 7.5% 7.5% 3.6% 2.7%
US Treasury Inflation Protected Sec. 0.8% 8.4% 8.4% 3.3% 2.6%
US Mortgages 0.7% 6.4% 6.4% 3.2% 2.6%
US Short-Intermediate T/E Munis 0.9% 5.4% 5.4% 3.3% 2.4%
US Investment Grade Corporates 1.2% 14.5% 14.5% 5.9% 4.6%
US Senior Bank Loans 1.7% 8.6% 8.6% 4.3% 4.4%
US High Yield 2.6% 14.4% 14.4% 6.3% 6.1%
US Convertibles 7.4% 23.2% 23.2% 11.9% 8.5%
Int’l Bonds Ex-US (Hedged) -1.9% 8.0% 8.0% 4.5% 4.1%
Int’l Bonds (Unhedged) 0.5% 6.8% 6.8% 4.3% 2.3%
Emerging Market Debt (US Dollar) 2.1% 14.4% 14.4% 6.1% 5.9%
Quarter-End 3 Mos. Ago 1 Year Ago 3 Years Ago 5 Years Ago
3 Month YTD 1 Year (Ann) (Ann)
3 Year 5 Year
US Yields (%)
FIXED INCOME BENCHMARK TABLE
Global Economic Activity
Source: Bloomberg, Morningstar
Chart 7 : Fed Funds Effective Rate
Source: Bloomberg
1.55
0.00
0.50
1.00
2.00
2.50
2015 2016 2017 2018 2019
Market Point Fourth Quarter 2019
A consistent slowdown in global activity
during 2019 occurred through deteriora-
tion in manufacturing activity stemming
from trade war uncertainty. Growing
recession fears forced investors into
safe-haven bonds and led to some of
the best annual returns from high quality
bonds since the last recession. How-
ever, at the same time investors bought
safe-haven bonds, the stock market rose
to new highs; an unusual and unexpect-
ed divergence. This divergence remains
dramatic today and we believe bond
yields may have fallen too far in 2019. In
fact, during the fourth quarter, we have
started to see bond yields rise well off
the lows from last August. Trade tensions
have eased with the “Phase One” deal,
allowing recession fears in the bond mar-
ket to unwind. Last but not least, the yield
curve—which was possibly sending the
biggest recession signal—is no longer
inverted and has steepened to the high-
est level since November 2018 (Chart
8). These recent positive developments
have all contributed to unwinding reces-
sion fears which were being aggressively
priced into the bond market. We expect
this trend will continue into the first half
of 2020.
Recession Fears Subsiding
The steady rise in corporate borrowing
and leverage has increased concerns
that risks are high in corporate credit. In a
low interest rate world, it is advantageous
for companies to issue debt, so this
development is not surprising. Although
elevated debt and leverage levels have
led to rising defaults historically (Chart
9), the corporate bond market has yet to
show signs of stress. Interest-coverage
and cash flows are the key. Because
interest rates remain low, interest cov-
erage has remained positive and above
historical median levels. Corporations
have been able to generate sufficient
cash flows to service elevated levels of
debt. Lower corporate tax rates resulting
from the Tax Cuts and Jobs Act in late
2017 have also boosted cash flows and
are supportive of interest-coverage.
However, the longer companies increase
leverage, the greater the risk for credit
losses when companies are no longer
able to service debt. Among others, we
continue to monitor profits, lending stan-
dards, and interest coverage as negative
developments in these metrics could
change the outlook. Our positioning in
credit has become more cautious given
elevated risks, but we remain optimistic
that an accommodative Fed and positive
profits will continue to provide a support-
ive environment for corporate credit.
Corporate Leverage Rising
Chart 8 : Yield Curve Climb Accelerates
Source: CNBC
The gap between the 2-year and 10-year Treasury yields is the widest in a year
2019
28
20
10
0
-4
Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
Chart 9 : High-Yield Leverage Steadily Rising
Source: BCA Analytics
U.S. 12-Month Trailing High-Yield Corporate Bond Default Rate*
U.S. Nonfinancial Corporate Sector Gross Leverage**
15
15
10
10
5
1995 2000 2005 2010 2015 2020
5
% x
Market Point Fourth Quarter 2019
Key Investment Themes
Macroeconomics
Asset Allocation
Fixed Income
Equities
• Structurally, Debt, Demographics, and Deglobalization may influence global growth and inflation for years
• Cyclically, economic growth has been slow but positive, while inflation expectations remain low for now
• Closely monitoring global confidence & the labor market for signs of contagion to services/consumers
• Biggest wild cards for 2020: Trade disputes and fiscal response from China & Germany
• Investment cycle is maturing. The risk/reward outlook no longer favors equities over fixed income
• Low bond yields & pricier equity valuations call for modest returns from financial assets over the next 3-5 yrs
• Global policy uncertainty (including trade disputes) has important implications for various asset classes
• Disconnect between equities/credit and the interest rate market will eventually need to be reconciled
• Longer-maturity bond yields do not currently offer a very attractive risk-reward proposition
• Overweight USD denominated debt over local-currency international bonds
• Low yields on high quality bonds provide little value and cushion against unexpected risk. Stay short duration
• Credit sensitive bonds should still outperform; however, absolute and relative returns will be unexciting
• Global equities have priced in some improvement in economic activity already
• Typical warning signs of an equity bear market are not present
• Corporate earnings are slowing down, recent earnings revisions can’t justify the recent move up in stock prices
• Hedged U.S. equity strategies offer the best value in an increasingly volatile market environment
Market Point Fourth Quarter 2019
Tactical Asset Allocation
Equity
- Underweight + Overweight
Fixed IncomeAsset
Allocation
U.S. Equity
Value
Large Cap
Consumer Staples
International Equity
Growth
Small Cap
Financials
Equity
Interest-rate risk
Government Debt
Foreign Bonds
Short-Term Bonds
Inflation Protection
Corporate Credit
Fixed
Income
We have reduced exposure to equities in portfolios and are now slightly underweight equities vs. fixed income. While we acknowledge
the potential benefits of lower short-term rates on the economy, we must also recognize that “late cycle” signs are accumulating. We
have therefore positioned portfolios to ensure that we can provide the best risk-adjusted returns without taking unnecessary risks. We
are focusing duration in the U.S. on the front end of the curve, as short-term bonds are more attractive relative to longer-maturity term
structures. We are also positioned to capture yield in credit sensitive bonds while being cautious on interest-rate risk. Equity exposure
remains focused on growth and small and mid-cap stocks. Int’l equities are also favored as relative valuations remain attractive.
Profile Summary
Tactical Asset Allocation
Individual client portfolio positioning, performance and transactions therein can vary greatly based on factors including investment strategy, objective, limitations, risk tolerance, time horizon, asset allocation and tax implications.
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