The Dawn of a New Decade

Context

In almost diametric opposition to 2018’s difficult market environment, 2019 will likely go down as one of the best calendar years in history for both bond and stock market returns. It puts a capstone on a remarkable decade for capital markets, which featured several unusual characteristics compared to the longer historical context:

• Bond markets only experienced one down year (2013).
• Stock markets ascended with very low volatility. In fact, the stock market did not once experience a bear market (typically defined as a 20% drawdown from the previous market high). In the previous decade, the stock market fell significantly for a sustained period on two occasions: 1) when the technology stock bubble burst in 2000, and 2) when the Global Financial Crisis hit in 2008.
• U.S. stocks rose a cumulative 250%, trouncing international stocks by an unprecedented margin (International Developed and Emerging Markets rose a comparatively meager 79% and 49%, respectively).
• Despite more than 100 years of evidence that value (i.e., inexpensive) stocks outperform growth stocks over the long run, U.S. large cap growth stocks outpaced value stocks by more than 100%, a trend which accelerated after 2014. In fact, U.S. large cap growth stocks far outperformed any mainstream investable asset class.
• Also in contrast to the long-run data, large cap stocks outperformed small cap stocks by roughly 1.7% per year.

No wonder an entire generation of investors is questioning whether a proactive approach to risk management and portfolio diversification is worth the time and effort! After all, a simple strategy of buying and holding a domestically oriented portfolio of 60% large cap stocks and 40% bonds would have more than accomplished most objectives over the last ten years.

Yet, extrapolating the recent past too far into the future is usually fraught with danger.

What has underwritten this uncommon period in markets has been very low and stable levels of interest rates.[1] In fact, the 10-year Treasury bond—long serving as the best proxy for the “risk free” rate of investing and on which the prices of so many financial assets cue—actually ended the decade under 2%, half of what it was in January 2010. This, as the economy set a record for the longest period of uninterrupted economic growth since records began! Despite textbook warnings to the contrary, the emergency and unconventional measures the Federal Reserve (Fed) and global central banks undertook (moving short-term interest rates to zero, coupled with successive rounds of balance sheet expansion[2]) to revive the economy after 2009 did not lead to inflation or debasement of the U.S. dollar’s status as the world’s only reserve currency. In fact, inflation has persistently undershot the Fed’s target of 2%, allowing it to promise to provide liquidity to calm capital markets whenever it sniffed the chance of an imminent recession (notably in late 2015 and late 2018).

It was exactly this dynamic which propelled last year into the record books. 2018 culminated with market expectations of two further interest rate increases in 2019. Instead, the Fed cut interest rates three times as the deteriorating trade war threatened the economic outlook, while also curtailing its commitment to reducing its balance sheet to ensure the smooth functioning of overnight lending markets.

2019 In Review

By the end of 2019, the Fed had undergone an about-face from its hawkish stance in 2018, leading the market to expect downward revisions to the Fed Funds rate throughout the year. As a limited “Phase One” trade deal was announced by the U.S. and China in December, signaling a distinct thaw in tensions, the yield curve began to re-steepen after threatening a sustained inversion over the summer.[3] Fixed income markets rallied, leading bond prices to rise by 8.7%. Against this more benign interest rate environment, corporate profits did not contract as many had feared, propelling global stocks to a 27.3% gain—the U.S. lead the way with ascension in excess of 30%. Our strategies were positioned to benefit from these tailwinds, as we reestablished an overweight exposure to stock markets in early spring after our discipline confirmed the concerns of late 2018 had abated.

Outlook

Balentine’s 2020 Capital Markets Forecast, “Steady at the Helm: Maintaining Investment Discipline While Navigating the Currents,”[6] updates our longer-run views of the opportunity set and addresses three key themes:

• The need to maintain the principles of investment discipline centered around diversification and proactive tactical rebalancing in the years ahead, especially after such a long and unusual period of below-average volatility.
• The fact that private capital markets are at a crossroads, demanding patience and a steady commitment from investors to active management in niche areas to be successful.
• Where to find sustainable cash flow from investments with fixed income yields at such a low level.

It also flags how international equities are priced for above-average returns over the next market cycle after severely lagging the gains of U.S. equities during the past ten years.

With sustained historically low levels of interest rates, it is understandable to worry about whether excess leverage and speculation will lead to instability. Over the near-term, although investors are decidedly less anxious than a year ago, we still do not yet see evidence of widespread euphoria. While the year and decade ending in 2019 proved to be productive for investors, many are not participating fully as this bull market continues. Assets held in money market funds remain near a decade high at over $3 trillion[7] as investors remain far from exuberant about the outlook. Additionally, according to our discipline, stocks are not expensive relative to bonds. Irrational exuberance and overpriced stocks are the two main characteristics which will lead us to reduce our allocation to stocks to adopt a more defensive stance against a major bear market.

With media attention turning to the 2020 presidential election cycle, geopolitical concerns escalating in the Middle East, and an enduring trade deal with China still a long way off, markets are likely to be more volatile in 2020.

The chances of a significant, but temporary, correction along the way should be expected and taken as an opportunity to put capital to work until such time as our models unemotionally signal a sustained bear market may be imminent.

For now, the U.S. economy continues to grow. The labor market remains robust with unemployment at its lowest rate since the 1960s, and although wage growth has picked up, inflation remains well contained. Productivity growth, a key ingredient for this virtuous cycle of improving fundamentals to continue, has ticked up. Internationally, the long-declining European economy has perked up as an orderly “Brexit” is now anticipated after general elections in the United Kingdom provided Prime Minister Boris Johnson with a clear mandate. Stress in the emerging world emanating from China has also dissipated as a détente (for now) in the trade war has been declared. This backdrop should set the stage for corporate earnings to continue to grow and stock prices to continue to appreciate, although likely not at 2019’s blistering pace.

While the elevated risks of recession gripping markets a year ago have receded, perhaps 2019’s enduring message for investors is that the economy has not been able to escape an environment of persistently low interest rates. If rates remain constant[8], the Fed and other central banks will have a much more limited playbook to combat the next downturn when it eventually arrives. There are limitations to the assumption that interest rates can fall further to support economic activity from today’s levels. The negative interest rates which still consume over $14 trillion of debt abroad have not helped to stoke economic performance, meaning the next recession may be longer and deeper than average. For investors, a process which stays true to offering multiple lines of defense through cash management, intelligent, forward-looking diversification, and a proactive approach to risk management may be even more valuable than the last decade’s experience may suggest.

[1] Outside of capital markets, who would have thought in 2010 that over the next decade the United Kingdom would vote to leave the European Union, the U.S. would become the world’s leading energy producer, U.S. unemployment would hit a 50-year low at 3.5% after peaking at over 10% in 2009, reality TV show star Donald Trump would be elected president, and the Chicago Cubs would finally win the World Series?
[2] Many have referred to these techniques more pejoratively as “printing money.”
[3] See our blog post “Are Recession Red Lights Flashing?” for more information about the significance of a sustained inversion of the yield curve as a leading indicator of the future economic environment.
[4] For taxable investors, we realized very few gains in 2019 after generating as many tax losses as we could during 2018’s volatile fourth quarter.
[5] All but one are on course to outperform their public market equivalents with a margin commensurate to compensate investors for locking up capital for a longer period of time.
[6] Balentine’s 2020 Capital Markets Forecast will be released later this month. It is a useful reference point for reconfirming the appropriateness of the strategy you are invested in to reach your goals.
[7] Per Lipper and Thomson Reuters, as reported by the Wall Street Journal.
[8] Policymakers both here and abroad are turning their attention to fiscal policy (i.e., tax cuts and government spending) to help the economy continue to grow without the continued reliance on low interest rates.