The Economy and the Markets | Fourth quarter 2019

• Investors embraced a Goldilocks outlook as easier financial conditions reduced the risk of a recession in 2020, energizing animal spirits.
• Demand for U.S. assets is likely to remain strong in a low-growth, low-interest-rate world.
• We expect periodic volatility in the coming year as fundamental challenges remain unresolved despite positive headlines.   

Risk on!

Returns across asset classes were almost universally positive in 2019, a stark contrast to the story of 2018. While strong returns early in the year were a make up for a dismal fourth quarter 2018, market action in the last quarter of this year was an unambiguous scramble for returns. The success of the Federal Reserve’s (Fed) mid-cycle adjustment convinced investors that they can have their cake and eat it too in the form of lower rates and strong stock returns. After a strong recovery in the first quarter, the S&P 500® struggled to sustain new highs during the second and third quarters of the year. The fourth quarter marked a definite breakout as the S&P 500® gained over 8%, led by cyclical sectors like technology and banks, as investors shunned income producers like REITs and utilities. The S&P 500® Index produced a total return of over 30% this year. Bonds delivered strong returns as well. Rates for long treasury securities fell by over 60 basis points during 2019. Credit spreads fell to near post-crisis lows. Investment-grade corporate bonds  -- and high-yield bonds  -- joined long treasuries in producing solid double-digit returns (14-15%). Even commodities joined the party, delivering a return of over 11% for the year.

We think that the economy continued to slow in fourth quarter but is poised to do modestly better in 2020. The consumer continues to drive growth with low unemployment and higher wages supporting spending. While the stage is set for stronger growth in corporate America, the turn hasn’t happened yet. Manufacturing continues to struggle, with weakness in energy and trade putting a damper on investment. The outlook appears brighter for 2020 as shocks from tariffs and a shakeout in energy recede. Earnings should improve on more stable global growth and easier comparisons. With unemployment at a nearly 50-year low, a recession next year seems unlikely.  

The big question on investors’ minds is whether this year’s extraordinary returns are justified or if we’ve simply pulled future returns forward. Earlier this year, we acknowledged that if the Fed’s insurance cuts were effective, conditions would be good for risk assets. This scenario certainly was realized. The U.S. treasury yield curve regained its normal positive slope as short rates followed the decline in the federal funds rate and longer rates rose during the quarter. The market is pricing in a return to a Goldilocks economy where both growth and inflation are measured. This sets the stage for continued demand for risk assets. Adding to the allure, net issuance is likely to be down in many asset classes, and retail investors have dry powder to increase their risk profiles. The Fed is on hold, and the record expansion is set to extend through next year. Rhetoric around Brexit and trade has become more positive, calming markets in the near term. U.S. assets remain in demand in a low-growth, low-interest rate world.

While we can identify many strengths, these factors are tempered by real risks. A trade deal is good, but it’s unlikely to produce steadily expanding global flows. Labor markets are tight, corporate margins peaked in 2018, and corporate leverage is high. Populism remains on the rise, and we believe that political risks will remain elevated. Late cycle growth of around 2% is good but provides little room for error. The Fed’s three rate cuts in 2019 used dry powder, increasing concerns about how policy makers will counter the next downturn. With valuations stretched, we continue to think that bursts of volatility are likely in the coming year, placing a premium on risk management and investment discipline.