Highlights:
The tentative phase-one trade deal between the U.S. and China added clarity for investors, as did the U.K. vote that paves the way for Brexit to finally proceed.
Investors should not count on central banks being as accommodative in 2020 as they were in 2019.
After a strong, and relatively calm, year in the equity markets, we anticipate volatility picking up in 2020, an election year in the U.S. Nevertheless, we continue to espouse an investment policy that avoids timing markets.
Commentary:
“Economic globalization is a historical trend. Although there are at times some waves going backward, and even though there are many shoals, the rivers are rushing forward and no one can stop them.”
-China President Xi Jinping
Arguably, the two biggest geopolitical risks threatening global growth seemed to get meaningfully closer to a resolution during December, capping off a fourth quarter rally in the global equity markets. Specifically, the U.S. and China reached a tentative agreement on phase one of a trade accord in which the U.S. agreed to roll back existing tariffs on Chinese goods and cancel new levies that were set to take place in December, while China agreed to boost purchases of U.S. farm goods. President Trump recently announced that this phase-one trade deal would be signed on January 15th and that he planned to travel to China later this year to negotiate a broader trade pact. Across the pond, UK Prime Minister Boris Johnson’s Conservative Party received a resounding election victory and pledged to move quickly to take Britain out of the European Union (EU). This was a welcome sign of clarity, as Brexit has been weighing on investors for more than three years. Mr. Johnson also promised to deliver billions of pounds in public spending to help working-class voters who are still hurting from the financial crisis.
Despite the positive progress on the political front during the quarter, political risk remains a prominent topic for investors and corporate executives and is not likely going away anytime soon. When President Trump first levied China with tariffs more than a year ago, he was fundamentally seeking a smaller bilateral trade deficit and better treatment of U.S. companies inside China. The truce reached between the U.S. and China during the quarter is essentially a purchase and sale agreement that does very little to address the United States’ concerns with China’s trade practices. The fundamental issues that led to heightened tensions between the U.S. and China in the first place include the forced transfer of technology, limits on the movement of data and subsidies enjoyed by Chinese competitors. Reaching a long-term trade agreement that addresses these issues is further complicated by continuing economic and security disagreements, including Beijing’s handing of protests in Hong Kong and accusations by Vice President Mike Pence that Beijing is continuing to allow intellectual property violations and theft of trade secrets. In response to Mr. Pence’s accusations, China’s government called for quicker introductions on penalties and punitive action for infringement of patents and copyrights.
Meanwhile, with Prime Minister Johnson’s new majority, his Brexit Withdrawal Agreement Bill will now likely pass and pave the way for Britain’s exit from the EU by the end of 2020, with or without a trade deal with the EU. Eventually, Mr. Johnson will still have the challenge of securing a long-term trade deal with the EU, as his election makes it more likely that the UK will withdraw from what many economists would call the world’s largest and most successful free trade agreement ever without a trade deal in place. Mr. Johnson has previously stated that he intends to negotiate a trade and migration deal by the end of 2020, but this might be a lofty goal, given his intent to end free movement between the EU and the UK and to implement a new points-based immigration system. His government will also look to negotiate free trade agreements with other trading partners around the world. These trade agreements are likely to be critical in helping UK economic growth pick up from its slowest pace in a decade.
In spite of the recent positive developments with Brexit and U.S.-China trade negotiations, ongoing trade tensions and geopolitical uncertainties continued to contribute to a slowdown in world trade growth and manufacturing output in 2019 which has, in turn, depressed global economic growth. Many central banks and governments continued to respond aggressively to these conditions during the final quarter of 2019. The U.S. Federal Reserve (the Fed) cut interest rates for the third time since July. The European Central Bank (ECB) restarted a paused program of bond purchases in November, after having cut its already negative interest rate in September. Finally, Japan’s cabinet approved a $120 billion stimulus program, citing the same global economic risk that led other central banks to cut interest rates, while also attempting to heal a self-inflicted wound from its October increase in the national sales tax.
China, on the other hand, is determined boost small business lending and infrastructure investment. In this regard, the People’s Bank of China lowered the amount of reserves banks need hold at the central bank, essentially freeing up cash for lending. China’s central bank does not want to resort to competitive quantitative easing, even as interest rates in other major economies approach zero. Having seen how several major advanced economies, such as the U.S. and Europe, have had trouble exiting from quantitative-easing measures put in place during the global financial crisis over a decade ago, they intend to avoid this. While lower rates do make it cheaper to borrow and, in theory, encourage companies to apply for loans and invest in their businesses, China’s system is more dependent on government-directed loans.
China’s economy is currently growing at its slowest pace since it began publishing quarterly growth data over 25 years ago, and Hong Kong entered its first recession in a decade. In response to its slowing economy, China has embarked on a corporate debt reckoning that, until recently, would have been swallowed by state banks and other creditors. Specifically, China is a building a U.S.-style bankruptcy system to deal with a significant pickup in corporate default that is aimed at allowing companies to restructure under court protection to keep businesses alive and pay creditors over time. One difference in China’s systems is that their bankruptcy courts are sometimes inclined to protect shareholders over debt holders to avoid social unrest. After years of rivalry and mutual suspicion, China has also recently started to develop an economic and strategic partnership with Russia which is likely to influence global politics, trade and energy markets. Case in point, a $55 billion, and 1,800-mile pipeline started delivering Russian natural gas to China in December.
As we enter 2020, investors should not count on central banks being as accommodating as they were in 2019, when preemptive cuts were made largely in response to the trade war between the U.S. and China. Stabilization in overseas manufacturing activity, better-than-expected corporate earnings and improvements in business activity and consumer spending is likely to give central banks flexibility to pause and assess the effects of their recent policy efforts, economic fundamentals, and trade tensions. At its most recent meeting, the Fed left interest rates unchanged and signaled it would likely keep them on hold through the 2020 election year. Following three interest rate cuts in 2019, Fed Chairman Powell believes that monetary policy is now well positioned to support a strong labor market and return inflation to the Fed’s 2% target. The U.S. consumer has remained confident, with solid job and wage gains that continue to support strong consumer spending. It would likely take an abrupt economic slowdown for the Fed’s outlook on future rate cuts to change, especially with Mr. Powell explicitly stating that he does not believe the extremely low negative rates seen around the world are appropriate for the U.S. economy.
The U.S. presidential election promises to add further intrigue to 2020 for investors. Voters could be facing a situation where they have to choose between a candidate that brings with him continued trade tensions, unpredictable policy shifts and the possible stain of impeachment, or a candidate that campaigns on wealth and investment taxes, new bank regulations and/or limits on oil drilling.
Now, almost eleven years in to the longest equity bull market on record, predictions of a market crash or imminent recession grow louder by the day. While this bull market is clearly long in the tooth, the current economic cycle to this point is largely absent of the economic imbalances or excessive buildups that typically cause recessions. Trying to sit out a crash often means missing many of the market’s best days, which are inclined to happen during volatile periods. A study by Putnam Investments found that missing the U.S. market’s 10 best days in the 15-year period through 2018 would have cut ending domestic equity portfolios in half, and missing the 20 best days during this period would have left these portfolios with two-thirds less value. This is why history shows it is better to stay the course and ignore the daily headlines and market gyrations rather than try to time the market, because so much can change so quickly. Recall that going in to 2019, investor sentiment was quite negative and fears of recession were widespread, as markets had just declined sharply in the fourth quarter of 2018 in response to the Fed raising rates and President Trump accelerating his trade war with China. In 2019, the Fed quickly corrected its December 2018 mistake of raising interest rates, inflation stayed under control, President Trump decided he wanted a trade truce with China, and the job market stayed strong despite a trade-induced recession in manufacturing. The result was a major boost to net worth for equity investors that stayed the course.
We enter 2020 with the same political and economic uncertainty with which we entered 2019, along with additional concerns surrounding an election year in the U.S. and rising tensions with both Iran and North Korea. The usual economic and policy concerns, are accompanied by questions about whether President Trump will revert to trade populism if his re-election looks to be in jeopardy, or whether equity markets will fall if Elizabeth Warren or Bernie Sanders appear likely to win the Democratic presidential nod. After a relatively calm and extremely strong year for equity markets in 2019, we would expect more volatility in 2020 and would not be surprised to see equity markets take a step back, although that always remains uncertain. Investors would be wise to remember that political conjuncture should not replace economic fundamentals. The S&P 500 closed at 2,141 on October 21, 2016, the day POLITICO Magazine infamously began an article by saying, “Wall Street is set up for a major crash if Donald Trump shocks the world on Election Day and wins the White House.” The closing price of the S&P 500 on December 31, 2019 was 3,230, marking an increase of over 50% since this article was published.
Historically, long-term equity returns have provided a significant return premium relative to lower risk cash and fixed income investments, but the price of admission is having to live through periods when equities are not in vogue and portfolio balances can drop precipitously. This is why we do not attempt to forecast the macro-economy or the equity markets. Rather, we espouse an investment policy that concedes that markets are inherently volatile, occasionally retract and sometimes even crash, but over time have rewarded patient, long-term investors with the strong returns needed by many investors to ensure sufficiency of liquid assets over their lifetimes. This is in contrast to the fixed income portion of a portfolio that is intended to maintain purchasing power and provide liquidity for ongoing withdrawals regardless of whether equity markets good or bad.
Urban Financial Advisory Corporation – January 2020