January 18, 2020
A review of the recent economic history that was 2019 and thoughts as to where the opportunities and risks may lie in 2020.
To set the stage, you may recall 2018 was filled with political and economic uncertainty. The trade war was launched, China and the world economies began to retract, Brexit got going, and mid-terms resulted in a change in power in Congress. In 2018, after what has been a very long, slow recovery since the Financial Crisis, the stock market responded with very volatile prices and ended with the worst performance in a decade. To the surprise of many, in 2019, after taking a lot of time to "climb the wall of worry", the stock market made new highs and has continued on its bullish path to this day. This contrasts with the real economy which grew only modestly last year. The one big positive was the addition of many more new jobs, but the rate of economic growth slowed all year and corporate profits completely stalled. These weak trends appear to be continuing into 2020 with U.S. data suggests the economy will slow or stagnate this year. This seemingly conflicting set of conditions comes at the end of more than 10 years of the world's central banks adding oodles of money to the system which surely has contributed to asset price inflation and is at least partially the source of this disconnect. Let's look at three pieces of the current puzzle to try and make some sense of it all: (1) the economic data, (2) the flood of new money printed by the Fed, and (3) the steady uptrend in the stock market. I will conclude with my suggestions on how to invest in this environment.
Even though the data is not very positive, the larger narrative at the moment is that the economy is doing very well and will grow faster this year. Low unemployment levels and a bullish stock market are likely reinforcing this rosy thinking. Here are some of the reasons to be suspect:
U.S. leading economic indicators have begun to flatline in recent months, breaking a steady uptrend.
Manufacturing has been slowing since 2018 and shows no sign of reversing, even with a détente in the China trade war.
Services have been getting weaker too, but not as much.
Some regional employment models expect some job losses in the near future.
The number of published job openings are decreasing and stated hiring plans of companies are down.
In recent interviews, 97% of CFO's expect the economy to slow this year or next and 82% of those are taking defensive actions.
The pace of growth of the U.S. economy (GDP) is generally expected to continue at around 2%. This level is good but not booming. What might change the bullish popular narrative? It will probably take newly reported employment data significantly weaker and/or substantially lower GDP numbers. Some reliable forecasts expect GDP growth percentage for the fourth quarter of 2019 to be released in late January to be sub 1.0%. If this is correct, it will be a jolt to the psychology of the markets. If this is followed by weaker employment data on a national level, the bullish narrative will be put to the test further.
It is impossible to look at the economy and asset prices without considering the changes in the financial system since the Financial Crisis. Because of leverage and psychology, if a bear market starts to build momentum over a short period of time there is always the potential for it to snowball into something much worse. This is mainly because lower prices themselves create even more selling - without much regard for value. Left unchecked, it could have devastating effects on the economy. The U.S. Fed and other central banks of developed markets were able to backstop this type of selling spiral that was building at a rapid pace in 2008. They did this by various measures to support asset prices that all hinged on their ability to create vast amounts of new money and keep interest rates very low. Putting aside the argument that central bank manipulation beforehand was probably key in setting the stage for the crisis, there is little doubt that central bank efforts during the crisis ultimately saved things from spiraling further downward and set the stage for recovery. (A side note, if the Fed and other central banks had not done something substantial, it is highly likely that asset prices and economic conditions would have worsened much more and driven many companies, banks, and households into bankruptcy. This is important to keep in mind when people say the stock market will always recover, it does not have to if events play out differently. Just because the risk of something bad does not happen does mean the risk was not real.)
Now after over a decade of steady growth in the economy and near or complete recovery in most stock and real estate prices, it would seem logical that central banks should have been able to declare victory a number of years ago; thereby cease adding excess money to the system and end the suppression of interest rates. They have chosen not to, so real estate, bond prices, and stock prices continue to be greatly affected by the overabundance of easy money. Medical and education costs have also sored over the recent years which at least partially can be blamed on too much easy money. Why continue juicing the system? The wider thinking seems to have embraced the idea that easy money can be permanent without ill effects (no significant inflation). Most likely because recent policies have not caused runaway inflation like in the 1970's. This confidence has led to political movements from both parties (and around the world) that are willing to borrow and/or fund with printed money various political agendas. Will this create fast-rising inflation? If pursued to a great enough degree, highly likely - it is hard to say where that tipping point is. Right now, investing in stocks and real estate is rewarding and inflation is not worrying to the general public. The only prudent thing to do though is to tread carefully moving forward. The further they rise the harder they fall - as the saying goes.
The rate of growth of corporate earnings was actually flat last year but stock prices rose significantly. This disconnect has not lasted in the past. What companies chose to do with what money they did make was not to invest in their businesses because they expect more demand in the future, but they chose to spend huge amounts on buying back their stock. Fewer shares available with the same or more money that want to buy those shares, all else being equal, will result in higher prices. There is a real issue with this practice being legal in the U.S., it was not for most of corporate history. The obvious reason that it permits manipulation of their stock price by the company.
So cheap money and corporations' preference for buying back shares are major contributors to the rally in the markets - but if stocks go up for any reason, does it really matter why? Not today at least, but higher prices generated not by company growth but by technical factors are probably not as solid. As this picture unfolded in 2019, bond prices rose substantially reflecting the fact that the growth in the economy and corporate earnings were slowing and could slow more in the future. A combination of stocks and certain government bonds performed well without the one-sided exposure of a portfolio heavy in stocks.
Economic conditions are vulnerable. If growth data materializes weaker and employment levels begin to trend lower, expectations and psychology will likely shift much to be much more bearish. This would then imply lower interest expectations translating to higher bond prices - at least probably shorter-dated Treasury bonds, if inflation is a concern, longer-dated bonds will probably not do well.
Easy money policies are likely to continue and become more entrenched. The Fed gives all indications they are fully committed to keeping interest rates down and increasing the money supply if any trouble crops up. Politicians in power and those seeking power are focused on some combination of borrowing and printing money to spend at the government level or let the people spend. There are many ideas floating around: infrastructure rebuild, more defense, school loan forgiveness, free college, government medical care and so on. The tipping point is getting closer. Inflation caused by depreciating the value of the currency will continue gradually and could accelerate. If this is the case, investing in commodity-related companies, commodities themselves, precious metals and raw materials related assets should benefit from this trend. Gold most likely would be a good hedge against more serious inflation developing. There are various ways to make this investment or hedge, direct ownership, physical gold funds, mining companies, and various option strategies.
The stock market could continue to thrust higher as stock counts keep getting reduced and cheap money continues to be available. Recently the gains have been focused on the largest few U.S. company stocks but this trend could infect more parts of the market if nothing changes. Because of the growing risks highlighted, it would be prudent to limit exposure outright and use hedges when possible.
The markets continue to be an exciting and challenging arena more than ever. Even though these days they may seem very precarious, there are ways to navigate through it all with an eye to the future.
Notaro Wealth Advisory is a registered investment advisor. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this blog post are as of the date of the posting, are subject to change based on market and other conditions. This blog contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this blog post should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax or legal advice. If you would like accounting, tax or legal advice, you should consult with your own accountants, or attorneys regarding your individual circumstances and needs. No advice may be rendered by Notaro Wealth Advisory unless a client service agreement is in place.