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Market & Economic Outlook

Market Commentary Q1 2020 - Economic Outlook

25 Minute Read

First Quarter 2020

Equity markets around the world saw strong 2019 gains and positive 10-year returns following the “Lost Decade” of the 2000s. Meanwhile, the “phase one” trade deal with China lowered trade tensions but left many details unanswered. With the 2020 election in view, investors began assessing potential winners and losers, particularly in the banking and energy sectors. Manufacturing activity hit a 10-year low and midwestern job growth was soft, raising the possibility that the key “swing states” of 2016 will be in play again this year.

Key Takeaways:

  • Manufacturing doldrums remain an area of concern, particularly if contagion to the consumer sector occurs.
  • The Federal Reserve’s expected pause in rate adjustments allows investors to shift attention to politics and the potential impact of the 2020 election on markets.
  • Strong 2019 returns for many asset classes, even as fundamentals weakened from 2018 levels, highlights the importance of avoiding short-term market timing.
  • Looking ahead to the 2020s, we expect fixed income and equity returns to be lower than those recorded in the banner year of 2019.
  • Geopolitical tensions from Iran to Ukraine to North Korea may lead to market volatility.

Market Overview: All Systems Go

In contrast to the third quarter’s bumpy ride, financial markets settled down in the fourth quarter as trade policy uncertainty de-escalated and fading economic data showed signs of bottoming. Reflecting an improving outlook for the global economy, yields on longer-dated Treasuries headed higher after approaching all-time lows in early September and even pushed the yield curve out of inversion.

Meanwhile, global equites continued to rally on the heels of global central bank easing despite a lackluster year for corporate earnings growth as investors anticipated a reacceleration of positive fundamental momentum heading into an election year.

Buoyed by a confident consumer, the domestic economy remained resilient even as the rest of the world showed signs of sluggishness. A third quarter U.S. GDP reading of 2.1% handily beat consensus expectations, which had assumed ongoing trade conflicts would affect U.S. economic growth by now. Employment, the linchpin of consumer confidence, also performed better than expected with an average of 211,000 new jobs added in October and November while wage growth remained healthy, yet in check. Perhaps most importantly, inflation remained subdued, providing air cover for Federal Reserve (Fed) liquidity injections that soothed fears of a monetary policy that was too tight for conditions.

The economic picture overseas was not as bright, but markets had been pricing in low expectations for some time. The data point most market observers have been keying on as the canary in the coal mine for global growth prospects, the German Purchasing Managers’ Index (PMI), appeared to hit a nadir in September at 41.7 (a level below 50 indicates contraction) after peaking at 63.3 in December of 2017. Other fourth quarter survey data also showed signs of improvement, which gave way to the optimistic view that the worst of the slowdown may be behind us.

With the view that the global economic expansion is on track yet fragile, as evidenced by the need for renewed monetary intervention, investors preferred to take risk in financial markets that had greater perceived relative safety. Within equities, U.S. large cap stocks, as represented by the S&P 500 Index (S&P 500), led global markets by a substantial margin in 2019, continuing the trend since the end of the Great Recession. In the same vein, defensive sectors continued to outperform cyclical areas of the equity market. As shown in the table below, 2019 also saw solid returns for many other asset classes versus a tepid 2018.

Asset Class Performance Graph
Source: Morningstar Direct

The solid fourth quarter performance for global equities capped a strong year and a remarkable decade following the so-called “Lost Decade” of 2000 to 2010 which saw global stocks, as measured by the MSCI All Country World Index (MSCI ACWI), return less than 1% per year annualized. Coming into 2019, however, positive equity market returns were far from certain in the minds of many investors as the S&P 500 flirted with bear market territory on Christmas Eve 2018.

Santa Delivers

Fears of a global recession brought on by a hawkish Fed policy mixed with escalating trade tensions between the U.S. and China swelled in 2019. The Fed’s dovish pivot provided some relief in the form of a “mid-cycle adjustment” that ultimately included three rate cuts along with an end to balance sheet run-off (or Quantitative Tightening). Prospects of a “phase one” trade deal between the U.S. and China added to global liquidity-driven positive sentiments that further dampened recession risks. Tacking on the improving prospects of an orderly Brexit following December’s UK elections, investors received just about everything they had hoped for last year.

The 27% rally in global stocks in 2019, as measured by MSCI ACWI, capped a decade of significantly improved performance of 9% annualized for the 2010s. Much of the strong performance was attributable to the largest equity market, the U.S., where the S&P 500 compounded at 13.6% for the past 10 years.

In spite of the equity market’s renewed mojo this year, clouds on the economic horizon remain. While leading economic indicators have ticked up, manufacturing activity remains a glaring weak spot globally. Only time will tell if thawing tensions between China and the U.S., combined with loosened monetary policy, will reinvigorate the beleaguered manufacturing sector. If unsuccessful, the risk of contagion into the consumer sector will be a concern to monitor closely.

Investors will also be closely watching the domestic political landscape for signs of change. With political polarity spiking in recent years, outcomes have become more difficult to handicap. A change in the business-friendly climate in Washington may sour the optimistic mood of the markets.

Keeping these risks in mind, our base case economic backdrop for equities—one that includes a carryforward assumption of low inflation and low, yet stable growth—remains positive. However, valuations appear to be fully reflecting this positive outlook and will limit the potential for outsized returns in the years to come. A similar conclusion can be drawn for fixed income, where interest rates remain low and credit spreads are tight. Amid such conditions while looking ahead to the 2020s, investors should expect lower returns across most asset classes, while maintaining durable diversified portfolios that can withstand episodic spikes in volatility.

On to November: Visions of 2020

With the Fed expected to take a pause from making rate adjustments and unlikely to provide excitement in 2020, investors are beginning to pay attention to politics and the impact of the election on markets and the economy.

On the slate for November is the presidential election, as well as congressional elections for all 435 seats in the U.S. House of Representatives and 35 of the 100 senatorial seats. While the last few years have seen headlines about U.S.-China trade relations, Democratic party candidate reveals and impeachment proceedings, 2020 may be a year when voters demand that the candidates offer specific policies rather than vague wish lists.

While it is early in the election cycle, and voters may already be fatigued, most observers anticipate that if the Republican party maintains the presidency, the administration would continue to seek increased defense spending, possibly act on prior infrastructure plans, and most likely continue aggressive trade policies with China and, potentially, Europe.

If current trade policies continue with President Trump’s re-election, capital expenditure and business investment spending could suffer as a result of a spike in trade tensions. As shown in the chart below, the administration’s trade policies have led to significant uncertainty that is unlikely to recede.

Trade Policy Uncertainty Reaches Record Levels
Source: "Measuring Economic Policy Uncertainty" by Scott Baker, Nicholas Bloom and Steven J. Davis at Data charts the frequency of articles in U.S. newspapers that discuss policy-related economic uncertainty and also contain one or more references to trade policy.

The possibility of a Democratic administration also concerns investors because of the widely varying proposals of the Democratic hopefuls and little clarity on who the final candidate will be. The differences between tax changes proposed by, for example, candidates Sanders and Biden are dramatic, as are defense spending goals with Buttigieg planning to raise and Warren seeking to cut. That said, there are several areas where the Democratic candidates broadly agree while differing in the details:

  • roll back some or all of the 2017 Tax Cut and Jobs Act;
  • increase tax rates for wealthy individuals; and
  • change current banking and energy policies.

Banking and energy appear at this stage of the campaign to offer the clearest expectations of the potential impact of a Democratic presidency on specific market sectors.

Glass-Steagall Redux?

Two of the candidates, Sanders and Warren, would bring back the 1933 Glass-Steagall Act which separated retail banking and investment banking. While Glass-Steagall was repealed by Democratic President Bill Clinton in 1999, lack of Glass-Steagall protection has often been cited by Democratic politicians as one cause of the Great Recession.

Forcing banks to unwind the changes they have made to balance sheets and operations over the last 20 years would almost certainly result in lower profitability for the financial sector.

The Democratic candidates also have plans for the oil patch, including ending new oil and gas leases on Federal lands, ending offshore drilling, enacting carbon taxes and, for Warren and Sanders, banning oil and gas extraction through fracking. These proposals could exacerbate current slowdowns in an energy sector already suffering from stubbornly low oil prices and a significant debt overhang.

According to Moody’s Investor Services, the exploration and production sector holds some $93 billion in debt—nearly all of it below-investment grade—that will be coming due next year. If a fracking ban is implemented, the cash flow needed to service or refinance this debt, in addition to the already daunting task of refinancing below-investment grade paper, will be even more onerous. A fracking ban could also lead to layoffs and lost employment in the gas and oil sector.

Beyond banking and energy, the technology sector might also see increased regulatory oversight in a Democratic administration. While past administrations, in particular President Obama’s, welcomed the expertise—and lobbying—of tech heavyweight companies, a Democratic winner in November may want to follow the lead of several European nations which are pursuing legislative changes, antitrust enforcement, data privacy rules, and regulatory scrutiny of multinational technology and social media firms. These tech companies, which dramatically outperformed the U.S. stock market in 2019, may see new and unwelcome domestic pressures.

Prospects for Legislative Success

Perhaps heartening to investors is the likelihood that many of the more progressive Democratic proposals would face little chance of passage in a post-election Senate with a Republican majority. Even in the unlikely event of a Democratic takeover of the Senate majority, many of the Warren-Sanders initiatives might struggle to achieve the majority of votes needed to pass.

If the Democratic party selects a moderate candidate and is successful in gaining the Presidency, a Democrat-led House of Representatives and a Republican Senate may find areas where compromise is achievable. Infrastructure spending and a solution to health care costs that continue to soar as the U.S. population ages may be two of the challenges that a divided Congress could successfully tackle.

As the decade ended, a divided and rancorous Congress found ways to work together. Even in the midst of impeachment vitriol, Republicans and Democrats were able to pass important legislation that included a North American trade agreement (USMCA), prescription drug pricing, government funding, and defense spending.

This Is Now... That Was Then

Asset classes across the spectrum recorded positive returns in 2019 with nearly every asset class finishing in the green. From stocks to Treasuries, corporate bonds to REITs, investors of all persuasions recorded gains. Even Treasuries—which typically decline when risk assets such as stocks rally—ended the year with a gain of 6.8%. What is surprising about the bumper crop of winners last year is the contrast, from a fundamentals perspective, between 2018 and 2019.

In 2018, investors should have been encouraged by corporate earnings up 20%; inflation-adjusted GDP growth above long-term averages at 3%; and the stimulative impacts of corporate tax cuts and deregulation of multiple industries and sectors. Yet in the midst of these buy-side signals, the S&P 500 lost 4.4% for the year. Among the suspects cited for lackluster market returns were trade tensions and Fed rate hikes.

Fast forward to 2019, where corporate earnings flatlined at 0.3% according to FactSet; GDP growth fell to long-term averages of around 2%; and some progress, but no resolution was made to trade disputes with China and Europe. In the midst of these sell-side signals, the S&P 500 rallied to fresh highs—seemingly daily as the year drew to a close—and finished 2019 up 31.5%. The Fed’s dovish about-face, resulting in three rate cuts in 2019, have been key to understanding untethered animal spirits in the market. But it should be noted that the S&P 500 had already jumped nearly 20% even before the first rate cut following the Fed’s July 30-31 meeting.

If there is one lesson to take away from the divergences of 2018/2019, it is that short-term market timing based on forecasting returns is a mug’s game where players may regret asset allocation shifts when market returns have proven to be irregular and lumpy.

Looking Ahead

The second half of 2019 saw data releases that helped assuage investor concerns over the summer that economic recession might be on the horizon. These included a Treasury yield curve returning from the inversion brink; a pickup in residential housing starts; and consumer sentiment that, while down from earlier peaks, had yet to hit levels consistent with predicting an upcoming recession. Investors also cheered the USMCA which could add as much as 35 basis points to future GDP growth.

The “phase one” deal with China was also welcomed, but more as a promising start of a period of risk reduction and a sign of a renewed willingness on both sides to work together than as a resolution of numerous outstanding issues. Hopefully, “phase two” will supply more details that investors can use to determine the impact of a trade thaw. For now, “phase one” does little to resolve ongoing corporate concerns over global supply chain management and whether to increase capital expenditures on plants and equipment.

There were a few lumps of coal left in Santa’s bag this past holiday season, including rising overseas tensions as North Korea—the Hermit Kingdom—resumes nuclear testing; potential market volatility as the impeachment process moves from the House to the Senate; and continuing recession in the U.S. manufacturing sector. As the year ended, Iran was added to the list of geopolitical hot spots.

As shown in the chart below, the ISM Manufacturing Index dipped below 50 in August and has remained in contraction territory ever since. Meanwhile, the equivalent service sector gauge of growth dropped recently but continues to plot firmly in expansion. The PMI gauge shows manufacturing sector health is at its lowest point since the Great Recession a decade ago. A significant area of concern for 2020 and beyond is whether the growing service sector and robust consumer spending can continue to offset manufacturing weakness.

US Manufacturing Declines to Lowest Level
Source: FaceSet, ISM - Institute for Supply Management

The Fed Coasts: The Rise of Big Data

The Fed’s Federal Open Market Committee (FOMC) final meeting of 2019 in December was a rather dull affair that left rates unchanged at the current range of 1.5% to 1.75%. The Committee also signaled that after a busy 2019 that saw three rate cuts, 2020 is expected to be a quiet year with no changes to rates expected and, possibly, one hike in 2021 and a second in 2022, although Fed Chair Powell admitted after the meeting that “none of us have much of a sense of what the economy will look like in 2021.”

This quietude comes after a torrent of nine rate hikes over the last several years and might allow investors to shift their focus from Fed navel-gazing to other economic developments that impact bond and equity markets as the economy enters its 11th year of expansion and many of the summer’s recessionary warning signals fade.

After the meeting, the Fed repeated its mantra that the FOMC will remain highly data-dependent before considering any moves, specifically noting that “The Committee will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”

A key data point in support of the FOMC’s decision to pause adjusting rates was robust jobs creation. The November jobs report released by the U.S. Bureau of Labor Statistics (BLS) saw nonfarm payrolls surging by gains of 266,000 spread across most sectors and a revision that boosted the prior two months total by a further 41,000 jobs, the largest increases since the beginning of 2019. The unemployment rate, meanwhile, dropped to 3.5%, matching its lowest level since 1969.

Through the end of November, according to the BLS, 2.2 million nonfarm jobs were added this year with the majority of the new jobs coming in services-providing sectors such as education/health services; leisure/hospitality; and professional/business services which each added an average of 500,000 jobs. The goods producing sector added a net 217,000 jobs with manufacturing employment growing by only 76,000 jobs.

Nationwide, tepid employment growth in manufacturing reflects the ongoing recession in manufacturing as, after peaking in early 2018, manufacturing job growth has fallen back to its level just after the 2016 election.

Beggar Thy Neighbor?

Over the last three years, job growth and unemployment declines have seen dramatic, if uneven, data releases. Behind the overall numbers the benefits have been lumpy across the 50 states.

Total employment since the 2016 election grew by an average of nearly 8% in the top five states of Arizona, Florida, Idaho, Nevada and Utah.

Other states, including Texas, California, the Carolinas and Georgia, averaged around 5% growth. But Midwestern states—heavily reliant on manufacturing and agriculture—saw tepid job growth averaging under 2% in Minnesota, Wisconsin, Michigan and Ohio.

Job growth since the election in the manufacturing sector, while weak overall, was also strongest in other states, with 12 states recording growth in excess of 5%. Over the same period, the Midwestern swing states that were decisive in the 2016 election outcome and are likely to be just as critical in the next one, saw growth in the 1% to 2% range, with Michigan actually losing manufacturing jobs.

As shown in the chart below, over the last several months both the overall Midwestern economy and manufacturing declined to negative growth rates from their peaks in early 2018.

Midwest Contractions Graph
Source: Federal Reserve Bank of St. Louis, Federal Reserve Bank of Chicago

Charles Evans is the Chicago Federal Reserve Governor whose territory covers five midwestern states. The combined economy of these states is over 50% more concentrated in manufacturing than the nation. The five states also produce 40% of U.S. corn, soybeans and hogs.

In an October speech, Governor Evans told the Peoria Economic Development Council,

An increasing number of my business contacts—particularly those in manufacturing or ones with a large international footprint—are telling me about delayed or canceled investment projects, and a few have mentioned downsizing workforce plans. And, of course, tariffs and other possible trade disruptions pose a threat to supply chains and business relationships, prompting some firms to reevaluate these elements of their business models.

Governor Evans, Speech to Peoria Economic Development Council

The recent “phase one” trade announcement could help shore up farmer support for the president next year given China’s vow to purchase more agricultural products. But the manufacturing sector continues to be challenged and will prove difficult to boost through bilateral managed trade agreements. With manufacturing providing 13 million workers nationwide, many heavily concentrated in the Midwest, the president might need to convince swing state voters that he deserves another shot at delivering on his 2016 promise to reinvigorate manufacturing in the heartland.


Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.

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Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations. HighMark, an SEC-registered investment adviser, is a wholly owned subsidiary of MUFG Union Bank, N.A. (MUFG Union Bank). HighMark manages institutional separate account portfolios for a wide variety of for-profit and nonprofit organizations, public agencies, and public and private retirement plans. MUFG Union Bank, a subsidiary of MUFG Americas Holdings Corporation, provides certain services to HighMark and is compensated for these services. Past performance does not guarantee future results. Individual account management and construction will vary depending on each client’s investment needs and objectives. The benchmarks referenced in this piece are used for comparative purposes only and are provided to represent the market conditions during the period(s) shown. Benchmark returns do not reflect the deduction of advisory fees, custody fees, transaction costs, or other investment expenses, but the returns assume the reinvestment of dividends and other earnings. An investor cannot invest directly in unmanaged indices. Investments employing HighMark strategies: • Are NOT deposits or other obligations of, or guaranteed by, the Bank or any Bank affiliate • Are NOT insured by the FDIC or any other federal government agency • Are subject to investment risks, including the possible loss of principal invested.

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