As we begin our 2019 review, we want to look at the style performance over the course of the year.
In 2019, growth outperformed value once again over the course of the year, continuing the longest run the investors have favored growth in history. Outperformance also skewed toward large caps, with the only exception to that being Mid-Cap Value marginally outperforming Large-Cap Value.
The outperformance in large caps isn’t, historically speaking, normal. Over the long-term, small-caps and mid-caps tend to be riskier, but they also outperform large caps. The switch in 2019 is significant.
Over the last two decades, the two largest companies in the US market averaged roughly 57% of the total market cap of small-cap stocks. At the end of Q3, that rose to 92%, per Royce and Associates. That is more than three standard deviations greater than the long-term historical average, per 13D Strategy & Research.
Beyond styles, we also want to look at stock sector performance during 2019.
Information Technology outperformed the pack by a wide margin, as investors continue to pour into stocks that typically have the highest growth potential in the market. With technology becoming such an important aspect of contemporary life, it’s no surprise that investors would pay, in some cases, a large premium on earnings to invest in the companies of the future.
The laggards, health care, and energy each had their own overhangs throughout the year. With health care, it centered primarily on legislation risk. Health care is one of the most talked about points in US politics and with the presidential election quickly approaching, various policies have been thrown around to adjust the system. The uncertainty that creates hurt the sector in 2019.
For energy, global energy prices stalling and over-production hurt performance in 2019. There continues to be a shift into more renewable energy across the world. According to Bloomberg, China will add 129,000 megawatts of energy capacity in 2020; 43,000MW will be in solar. Despite the shift, fossil fuels haven’t been completely abandoned. Of their energy capacity expansion in 2020, China will also add 33,000MW of coal, per Bloomberg. Despite this, issues like climate change have made energy a spurned sector in 2019.
The consumer continued to push the economy along in 2019, continually expanding over the course of the year and allowing recession fears to cede for the year once again as the longest expansion in US history continued. In December of 2019, personal income grew above expectations at 0.5% vs. the Bloomberg survey of economists that forecasted 0.3% growth. In the same month, personal spending grew at 0.4%, the amount of growth forecasted by economists.
Consumer spending makes up almost 70% of the US GDP, which is a higher percentage than almost every other country in the world. For comparison, China’s consumers only make up 40% of their economy, per Bloomberg. As we look forward to 2020, an important factor in avoiding a recession will be continued strength with the US consumer. As manufacturing loses steam and companies continue to pull back on investment, the consumer will be more important than ever in continuing the record US expansion. Overseas economic numbers haven’t been up to the level that US numbers have been over the course of 2019, so the impetus to spur economic growth will fall on our shoulders as we move into 2020.
Bloomberg notes that the consumer has powered the US economy through a tough period in 2015-16 when the manufacturing and energy sectors were going through a rough patch. They also make the point that household consumption grew at an annualized rate of 4.6% from April to June, the fastest pace since the last quarter of 2017. Consumers’ keeping the economy afloat is feasible and can continue into 2020, but we will watch the numbers closely.
But, as a point of caution, Dallas Fed chief Rob Kaplan made a good point concerning the consumer and overall economy when talking with the Financial Times. “If you wait to see weakness in the consumer, you’ve likely waited too long.” A cautionary message as we move into 2020 relying on the consumer to continue to carry the economy. The hope is that consumers won’t have to carry the economy through the year again and there will be a bounce back in the manufacturing sector and abroad.
2020 Look Ahead
Looking ahead to 2020, we want to highlight key issues investors we’ll grapple with as well as make a few predictions of our own about the coming year.
One unexpected event that has become the center of the geopolitical world to start the year is a real threat of conflict between the US and Iran. President Donald Trump ordered the assassination of Iran’s top general, Qasem Soleimani at the beginning of the year, potentially setting off a chain of events that could end in a full-out conflict between the two nations, among others. On Sunday, January 5th, the Iraqi Parliament voted to oust US troops from the country in backlash of the strike on the Iranian general. China, Russia and a string of other European countries, including Britain, France, and Germany, have either condemned the attack or urged for stability in the region.
Iranian’s did not take well to the attack, to say the least. So far, they have pulled out of the nuclear deal signed in 2015 and strongly condemned the attack. Disturbingly, a video surfaced of their Parliament chanting ‘Death to America’ on Sunday.
The full extent of the fallout from the attack surely hasn’t come to fruition and investors will be watching closely to see how the Iranians and other countries like Russia and China react to it. A full-out conflict would likely involve countries other than Iran and will be one of the main issues that investors focus on throughout the year.
A large part of the 2019 rally was predicated on P/E expansion, meaning investors were paying more per dollar of earnings a company was outputting. The reasoning behind this varies from undervaluation at the beginning of 2019 and the reality that investors were starved for yield and return as bond yields decreased throughout the course of the year. Investors will be focused on a bounce back in earnings throughout 2020 to spur equity markets forward in the new year. If earnings can grow, along with a bounce back in manufacturing and international economic data, equity markets could continue to perform in 2020.
Trade War progression
On January 15th, US President Donald Trump is poised to sign a ‘Phase 1’ trade deal with China that will mark the beginning of the end of a year’s long conflict between the two superpowers. Trump has indicated that he will travel to Beijing later in 2020 where “talks will begin on Phase Two!” Here are the known details of the Phase 1 deal between the two countries, per Politico:
- China has pledged to increase its purchases of US farm goods, energy, manufactured products and services by around $200bn over the next two years (unconfirmed by China publicly, but stated by US officials)
- The US will cancel plans for an additional 15% tariff on $160bn of Chinese goods
- The US reduced tariffs on $120bn worth of goods to 7.5%, from 15%
The big positive if the deal gets signed is that China and the US have reached an agreement on some things and past behavior is a good predictor of future behavior. If they can agree on this, maybe they can agree on more and end the whole spat. The big question investors have is what’s next? When will talks for a ‘Phase 2’ deal begin? Will that be the end, or will this continue to drag out? Will the aggression in Iran provoke the Chinese into stalling on another deal?
These are questions that will be a large determining factor in how markets perform over the course of 2020.
The Federal Reserve switched course during 2019, from raising interest rates in 2018 to lowering them last year. How will they behave during 2020? Consensus says interest rates will likely stay the same and if they do change, they’re likely going higher rather than lower.
The Fed began purchasing T-bill’s, an action they announced would continue at least through the second quarter of 2020. That program was supposed to be $60bn in monthly purchases but has been substantially larger. 13D Strategy & Research believes the implication of this will be a steeper yield curve as the Fed puts downward pressure on short-term rates.
How the Federal Reserve behaves in 2020, not just regarding interest rates, but also in the repo market, will be a large determinant in market behavior over the coming year and likely beyond.
Finally, we want to make some predictions about how we think markets will act during 2020.
No 2020 Recession
Recessions are almost impossible to predict, but I don’t think 2020 is the year we fall into one. Bloomberg believes that avoiding a recession relies on consumer spending, global trade war concerns waning and investors not getting spooked by the US presidential election or anything else. Unlike them, I think the market is pricing out too much of the geopolitical risk with China, Iran, etc. but I don’t think that’s enough to push us into a recession. They warn of the risks that surround that prediction, but I still believe the economy will continue to chug along in 2020, even if it’s not at the pace that we’re used to seeing.
Growth or Value?
Investors have been trying to make this call for years, but at the risk of sounding redundant, I believe value will make a comeback in 2020. 13D Strategy & Research makes four good points on this subject that I think are worth noting:
- Value-investing performs well when the market recognizes the risk of overpaying for superior fundamentals.
- As the US economy slows, valuation will matter a good deal.
A note on this, we saw the beginning of this in 2019. Investors were not in the mood to pay the high valuations of tech companies going public without either positive earnings or, at least, a clear path to profitability. That could be a precipitator in how investors go about picking companies in 2020.
- A steepening yield curve has historically favored value overgrowth.
- Mean reversion is a powerful force in financial markets.
For all these reasons, I think value has a good chance at outperformance in 2020.
Small/Mid-Caps to Outperform Large Caps in 2020
We talked earlier about how the two largest companies’ market cap has risen to 92% of the total market cap of small-caps in 2020. Seeing as that’s over 3 standard deviations higher than the historical norm, I think small- and mid-caps outperform during 2020. As stated previously, on a historical basis, small-caps outperform over the long run. On top of that, historically, small-caps have outperformed the S&P 500 for several years after the Fed began new rate-cutting cycles, as they have done in 2019, according to 13D Strategy & Research.
In 2020, I think we’ll return to the historical norm and small-caps will again have their day in the sun.
Surprise Asset Class: Gold
Geopolitical risks remain important in markets, as we’ve recently seen with the Iran-US conflict. For that reason, I think gold could outperform in 2020. Safe haven assets like gold tend to outperform when those geopolitical risks exist, and we’ve got them in abundance this year with the continued soft conflict with China and the fresh conflict with Iran. I don’t believe investors looking to de-risk will look to the bond market in 2020 as they did in 2019. The yields aren’t nearly as attractive as they were and there’s some risk there, especially in the corporate bond market. For those reasons, I believe gold could be the safe haven asset that investors are looking for in 2020, spurring growth in the asset.
To wrap up our 2019 review and 2020 outlook, I want to emphasize that this is a great time to be rebalancing the portfolio. With a great year in equity markets behind us, it’s time to take stock of what did and didn’t perform well and rebalance portfolios accordingly. Taking gains off the table at opportune times allows investors to protect from riding assets like a roller coaster, up and down. 2019 was a great year in the market, but now it’s time to prepare for the year ahead.
58 Words and Phrases that Got Us Through a Crazy Decade in Business by Peter Coy, Bloomberg Businessweek
Peter Coy takes us through the words and phrases that defined the 2010’s. It’s interesting to see them and remember that time in history when that’s what occupied our brains. Does anyone remember Grexit (the Greek exit from the eurozone that never happened)?
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