From an economic and capital market standpoint, 2019 might best be remembered as a year where the trade war dealt some light blows to business investment and overall growth, while dovish monetary policy supported a surge in stock prices. Investors who kept their cool at the turn of last year – when downside volatility ripped through the equity markets – were rewarded for their patience.
So, what’s ahead for 2020? Below, I offer four forecasts I think could play out in the new year.
Volatility and Correction Coming
If you look at the S&P 500 over the last 38 years (1980-2018), you’ll find that not only are corrections frequent, they have been the norm. The average intra-year correction for the S&P 500 since 1980 is -13.9%! In fact, it has been very rare to get a year where the S&P 500 doesn’t fall at least -5% at some point within the twelve-month period. It’s only happened twice in the last 38 years (1995 and 2017), when the S&P 500 declined just -3% intra-year.
In 2019, the biggest drawdown we saw was -7%, making it a below-average year for equity market volatility.1 In 2020, I think we’re going to see a correction more in-tune with the longer-term average, and I think it would be wise for investors to mentally prepare for it.
History, and the normal and natural nature of stock market corrections, compel my view. But there is also strong evidence that investors are becoming more optimistic and confident, which in my view tends to make the market more vulnerable to selling pressure. The American Association of Individual Investors (AAII) found in its most recent survey that “optimism rose to its highest level in a year, while pessimism fell to an unusually low level.”2 CNN also publishes a Fear & Greed index showing that ‘greed’ is on the rise. The more that confidence and optimism build, the higher the probability of a correction, in my view.
Further Isolation from China
Markets cheered the most recent truce reached between the U.S. and China, and it feels for now like the world’s two biggest economies have hit the pause button on tit-for-tat tariff levying. But recent history suggests, in my view, that China is likely to fail to follow through on some of its promises, or renege on the agreement altogether.
For example, according to U.S. negotiators, China has committed to agricultural purchases to the tune of at least $40 billion for the next two years, an exorbitant amount by historical standards. In fact, $40 billion of agricultural purchases would amount to almost double the record for what China has purchased from American farmers in previous years.3 China has growing demand for soybeans and pork, sure, but are they really going to double spending to reach the target? China has done enough overpromising and under-delivering over the years for me to remain skeptical.
I wrote a Mitch on the Markets column in October 2019 where I pointed out that I’d been “observing a notable rotation away from cyclical sectors and towards defensive sectors.” I also noted in the column that there were nearly “2.5 times the amount of put options on the S&P 500 Index as there [were] call options, and the cost of hedging [had] soared to one-year highs across several equity benchmarks.”4
My conclusion: investors were getting too defensive and that opened the door for cyclicals to outperform looking ahead.
Cyclicals have rebounded since, and in 2020 if we have a global economic recovery, we may see corporate earnings growth that spurs this rotation even further. With optimism on the rise and the Fed likely remaining on the sidelines with no plans to tighten, I think cyclical, “growthy” categories will continue to do well and have the possibility to surprise to the upside. However, an investor always has to be somewhat cautious about buying stocks where the earnings growth is anticipated by the market but not yet reflected in earnings estimate revisions.
Income that Isn’t Risk-Free
As mentioned above, the Federal Reserve is likely to remain on the sidelines for much of 2020, in my view, unless there is some unforeseen crisis or negative surprise on growth and employment. On a global level, major central banks appear committed to continued easing, which should keep a ceiling on interest rates and risk-free bond yields. For the millions of retirees out there, and for those planning to retire in 2020, that may mean having to look outside of risk-free Treasuries to generate income in your portfolio.
Fortunately, I believe investors can generate yield in other ways without substantially increasing your portfolio’s risk profile. For example, you could explore the municipal bond market, investment grade corporate bonds, and even dividend stocks as alternatives to create cash flow in your investment portfolio while controlling for risk.
Bottom Line for Investors
Looking back at the last two decades, we find that equities have returned just higher than +10% in years when real GDP and inflation (as measured by CPI) were both in the range of 1.5% to 2.5%. In my view, the U.S. economy should generate real GDP right in the 2% range for 2020, and I believe inflation should at least notch 1.5%.5 In other words, I believe conditions should be good for solid, perhaps high mid-single digit growth in the new year.