Slow global growth, but no sign of a U.S. recession
Accommodative monetary policy extends the bull market
Earnings to drive single-digit equity returns amid increased volatility
Fixed income returns to be more muted, yield curve to steepen
An active approach to wealth management will be critical
In 2019, falling interest rates, low inflation and accommodative central bank policy rewarded investors with robust returns across all asset classes. These factors helped markets withstand increasing uncertainty around trade, geopolitics and the stability of the aging bull market. Global equity markets delivered double-digit returns, domestic equities reached record highs, and fixed income and diversifiers posted solid returns in the mid-to-high single digits.
As we look ahead to 2020, we expect a modest improvement in global economic growth given signs of stabilization in global manufacturing, synchronous central bank easing and a de-escalation of trade tensions. Returns are likely to be dispersed across asset classes in the year ahead and uncertainty will persist, especially in light of ongoing geopolitical issues and the impending 2020 U.S. presidential election. For investors looking to grow their portfolio and protect against volatility, an active approach will be critical in the year ahead.
SLOW GLOBAL GROWTH, NO SIGN OF A U.S. RECESSION
In 2020, we expect real global gross domestic product (GDP) to come in around 3%. In the U.S., growth will likely outpace the trend growth of roughly 2% in 2019.
As illustrated in Exhibits 1 and 2, high consumer confidence and spending has buoyed the U.S. economy even as manufacturing, business investment and CEO confidence have retreated amid the uncertainty around trade. We expect the consumer — who accounts for 70% of the economy — to continue spending and supporting economic growth into 2020. However, an improvement in CEO confidence, and the resulting increase in business investment that would likely follow, will be necessary to keep the current economic expansion on a stable footing.
We expect the Eurozone to continue to struggle in 2020 with growth dependent on the degree to which trade deals and Brexit help revive manufacturing and business investment. Annual real GDP growth for 2020 is likely to be near the projected GDP for 2019, 1.2%. In China, growth is expected to remain moderate, below 6%, and we expect further monetary and fiscal easing in an effort to offset the slowdown resulting from tariffs.
Central banks continue to be accommodative with the Federal Reserve, the Bank of England, the European Central Bank (ECB) and the Bank of Japan (BOJ) keeping rates low (or negative, in the cases of the ECB and BOJ) in order to stimulate growth. With inflation expectations still materially lower than its 2% target, the Fed should remain on hold in 2020. While there is a possibility of one insurance cut before June, the Fed typically does not make monetary policy changes during election years.
MUTED FIXED INCOME RETURNS
Our base case for slow growth and no U.S. recession drives our expectation for the shape of the Treasury yield curve. The short end of the curve should stay low, or move modestly lower, for many quarters ahead given the unlikelihood of a change in posture from the Fed. However, intermediate- and long-term rates will most likely drift higher, resulting in a modestly steeper yield curve.
Our projection for the 10-year Treasury note yield range during 2020 is 1.25% to 2.50%, likely ending 2020 close to 2.25%. There is a limit to how high long-term U.S. rates can go as they remain tethered to low global rates. While we do not expect the extreme interest rate volatility we saw in 2019 — where the U.S. 10-year yield moved from a high of 3.11% to a low of 1.44% — we could see some volatility in either direction. The uncertainty around the pace of growth, geopolitical concerns or the outcome of the U.S. presidential election could be the source of interest rate volatility.
Given that rates are currently quite low and credit spreads are tight, we expect fixed income returns to be more muted in 2020. Credit fundamentals are still solid with corporate bonds benefiting from decent earnings and a moderate level of defaults. However, given the significant growth of corporate indebtedness, investors are not getting paid to take a lot of risk in credit markets. High-yield corporate bond fundamentals also remain solid with default rates low; however, these bonds can become more volatile as the cycle matures and the probability of recession increases. While this is not our base case, there is the potential for volatility in spreads as well.
EARNINGS DRIVE MODEST EQUITY RETURNS
Corporate profit growth was weak in 2019. The impact of the 2018 tax cuts created a challenging comparison for year-over-year growth, and slowing demand and trade uncertainty weighed on profits. We should see profits rebound over this low hurdle in 2020, given our forecast for approximately 2% GDP growth and modest inflationary pressures.
We expect S&P 500 companies to deliver a year-over-year earnings growth rate of 4-6%, which should translate into an operating earnings range of between $165 and $175. From this, we also project an S&P 500 year-end target of between 3,300 and 3,400. Earnings growth outside the U.S. is also expected to improve. Bloomberg consensus estimates of year-over-year earnings growth are over 7% for developed international equities and 14% for emerging market equities based on a stabilization in growth, and some clarity on the direction of trade and Brexit helping to encourage business investment.
BALANCED POSITIONING ALLOWS FOR POTENTIAL SHIFTS
Overall, we maintain a relatively favorable outlook on the macroeconomic backdrop. We continue to favor U.S. equities over foreign equities, while maintaining our neutral view on equities overall. We have been adjusting our mix of equities over the course of the last 18 months to this more neutral posture. Given the prospect of increased volatility resulting from ongoing trade disputes, Brexit and the 2020 U.S. presidential election, we believe this positioning provides us the flexibility to make potential shifts depending on the impact that events, policy decisions or economic data may have on our forecast.
We have a small underweight to fixed income, but expect it to continue to play an important role as a source of diversification during periods of equity market volatility. We continue to advocate a well-diversified, high-quality bond portfolio coupled with actively managed, satellite fixed income solutions as yield remains important in these uncertain times.
We also have a slight overweight to diversifiers to buffer against the expected volatility. Private equity and real estate can provide attractive sources of return. For investors who have additional capital to put to work but are hesitant to enter the market at all-time highs, customized hedging solutions allow investors to gain exposure to the potential growth in the market while protecting against volatility.
BE ACTIVE WITH YOUR WEALTH
At this late stage of the bull market, with valuations of many asset classes near or above their long-term averages, the need for active management — from both a portfolio positioning and a security selection standpoint — is more important than ever. When working with clients, we stress the importance of regular rebalancing. After a year where the market has lifted all asset classes, it's important to ensure that portfolios remain aligned to the allocation that reflects our current best thinking and conform to the appropriate level of risk tolerance. We also highlight the importance of after-tax returns and work with clients to harvest losses to help minimize taxes where appropriate.
While the current bull market may not end in 2020, it will end eventually. Though the backdrop of low inflation, strong labor markets and ample liquidity provided by central banks has helped to extend the now more than 10-year-old business cycle, clients should continue to focus on their long-term investment plan and ensure it reflects their future goals, their current needs and their ultimate desire for what they want to accomplish with their wealth.
Powerful structural trends are testing limits — and threaten to intersect with the near-term outlook and become market drivers. Rising inequality and a surge in populism have implications for taxes and regulation.
Trade frictions and deglobalization are weighing on growth and boosting inflation. Interest rates are nearing lower bounds and crimping the effectiveness of monetary policy. And sustainability-related factors such as climate change are having real-world consequences, affecting asset prices as investors start to pay attention.
Growth should edge higher in 2020, helped by easier financial conditions. We retain our moderate pro-risk investment stance, although the unknown magnitude and duration of the coronavirus outbreak pose downside risks to the global growth outlook. This underlies our call for a focus on portfolio resilience. Financial vulnerabilities are climbing, but our overall gauge of vulnerabilities across the economy stands well short of its peaks ahead of the last recession, as the chart below shows.
The 2020 macro environment marks a big shift from the dynamics of 2019, when an unusual late-cycle dovish turn by central banks helped offset the negative effect of rising trade tensions. The U.S. dovish pivot looks to be over for now. Any meaningful support in the euro area will have to come from fiscal policy, and we do not see this in 2020. Emerging markets (EMs), however, still have room to provide monetary stimulus.
This makes growth the key support of risk assets. Our base case is still for a mild pickup supported by easy financial conditions, with a slight rise in U.S. inflation pressures. We are likely to see support from Chinese authorities to shore up growth, as we have after prior epidemics, though an ongoing desire to rein in financial excesses leaves open the question of how sizable China’s stimulus will be.
The main risk to our outlook is a gradual change in the macro regime. One such risk: Growth flatlines as inflation rises. This might pressure the negative correlation between stock and bond returns over time, reducing the diversification properties of bonds.
A deeper economic slowdown is another risk to consider. There has been a pause in the U.S.-China trade conflict, but any material escalation of global trade disputes could undermine market sentiment and cut short the expected manufacturing and capex recovery that underlies our tactical views.
We remain modestly overweight equity and credit due to the firming growth outlook and pricing that still looks reasonable against the macro backdrop. We still see potential for a bounce in cyclical assets in our base case: We prefer Japanese and EM equities, as well as EM debt and high yield. We are cautious on U.S. equities amid 2020 election uncertainties, and prefer companies with quality characteristics.
Yields that are approaching lower bounds make government bonds less effective portfolio ballast, especially outside the U.S. This causes a rethink of portfolio resilience. We prefer short-term U.S. Treasuries on a tactical basis and like both long-term Treasuries and TIPS as sources of resilience against potential regime shifts in strategic allocations.
Investors have understandably been concerned about corporate profitability in the midst of a global manufacturing slowdown and trade uncertainty. Both factors are negatively weighing on corporate earnings, as evidenced by an estimated 2.3% year-over-year earnings decrease for S&P 500 companies during the third quarter. While these results were better than expected, investors are questioning whether the deterioration in earnings has further to go or whether profits will begin to rebound.
Let's take a look at why corporate earnings have declined, our forecast for profits moving forward and what that likely means for the equity markets as we head into next year.
PUTTING SLOW EARNINGS INTO PERSPECTIVE
Earnings growth has been on the decline since the start of the year, but it is important to understand the reasons for the deterioration. In 2018, earnings got a boost from the 2017 corporate tax cuts and deregulation. The downside of 2018's record earnings growth is that it is hard to sustain such a high level. In addition, the global manufacturing slowdown, the strong U.S. dollar (which makes American goods more expensive for non-U.S. customers) and trade uncertainty have also softened demand for capital goods and business investment.
Even as earnings have slowed, domestic equity markets sit near or at all-time highs. This suggests that markets are pricing in an easing of trade tensions and some type of partial deal, which should lead to a recovery from this slow down in earnings growth.
Our economic outlook for 2020 assumes a modest rebound in growth, partly due to an easing of trade tensions and evidence of a bottoming in manufacturing weakness both here in the U.S. and globally. In addition, other areas of the economy, particularly the U.S. consumer and labor market, remain healthy and should continue to support the global economy.
Historically, global earnings have peaked just ahead of or along with the start of U.S. recessions, while tending to bottom just after them. However, year-over-year earnings changes often pierce the zero line from the upside without leading to recession (See Exhibit 1). This information requires us to determine both whether earnings are going to be flat, and if that flatness will lead to recession.
Currently, we believe that a continuation of the global expansion should allow corporate profits to improve next year and will not lead to an earnings recession globally. However, in the U.S., we think consensus estimates, illustrated in Exhibit 2, are a bit elevated and may be too optimistic about the positive economic benefits of a trade resolution. In our opinion, a"phase one" deal, which we expect, should have a modest impact on economic growth and corporate earnings. From a bottom-up perspective, third quarter earnings calls with CEOs across industries suggest an improvement in earnings, but a more cautious outlook until trade negotiations become more definitive. However, we cannot rule out a setback in trade negotiations, which is why we have a more conservative take on the degree to which corporate profitability will improve.
We expect to see a modest pickup in fourth quarter earnings, which should bring S&P 500 operating earnings for 2019 within our forecasted range of $160-170. Based on our outlook for slow but positive economic growth and subdued inflation, we believe a reasonable estimate for 2020 S&P 500 earnings per share is between $165-175. This equates to a 5% to 6% year-over-year earnings growth rate. At this later stage of the economic cycle, earnings, rather than multiples, will likely support equity markets.
Outside the U.S., the earnings cycle is likely to rebound with the U.S. economy, assuming global trade improves as expected. Earnings for Eurozone and emerging markets companies should improve in an environment of slow global growth and muted trade tensions. While this is our base case, a deterioration in trade talks could further impact business investment decisions and weigh on profit margins.
EXPECT MODEST EQUITY RETURNS WITH SOME BUMPS ALONG THE WAY
In our view, global equities will have room to move higher, given our expectations for a modest acceleration in earnings growth and accommodative central banks. Corporations should be able to deliver improved earnings growth given an expected pickup in demand, eased trade tensions and muted inflationary pressures, which will help keep a lid on costs. However, mid-single-digit earnings growth should keep equity returns more muted compared to this year.
We continue to recommend that our clients remain invested and ensure that they are at their target weights based on their investment plan. Given the uncertainty over trade, policy and politics, we have been adjusting our equity exposure over the last 18 months from an overweight posture to a neutral stance. We continue to maintain this allocation as we believe the market should continue to reward risk assets even in the midst of volatility.