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As we look back at some of the headlines that were responsible for sizeable bouts of volatility in 2019 (a choice between “inverted US yield curves”, “worsening China-US trade war”, “hard Brexit”, “Hong Kong riots”, “spiking overnight cash rates” and “pending weak US earnings”), there is no doubt that markets had ample reason to be nervous. Now heading to the end of the year, markets have mostly recovered from these anxieties, as economic data seems to be bottoming in many places around the world. Recent data points in the US have modestly surprised to the upside, and the consensus outlook for 2020 seems to be that economic activity will remain in positive territory. The feedback from most companies coming out of the recent US earnings season is that growth will likely continue to slow but remain in positive territory, and then improve towards the latter half of 2020.
Against the backdrop of better data, the negotiations between the US and China to reach a preliminary deal to start the process of defusing the trade war inches forward. While this is not the first time markets have believed both sides to be close to a deal, there does seem to be more willingness to find some common ground during this round of negotiations. An interim resolution to the current trade impasse would probably remove the threat of further US tariffs being levied on Chinese imports, and potentially also include some bilateral roll-back of the existing tariffs already in play. Both steps would be positive for US consumers and businesses, but particularly for the latter: any increase in policy certainty will provide a boost to business confidence and be supportive of extending the cycle.
The fact that the Fed has become more accommodative since July is also positive. The chart below shows the US ISM Manufacturing New Order index against the Fed Funds rate (with the latter inverted) over the past 20 years. Worth noting is the lagged effect tightening policy has on the direction of the manufacturing survey. With hindsight, it’s not difficult to make the case that the Fed’s ‘autopilot’ policy of rate hikes in 2018 was too aggressive; at least the Fed has already changed course this cycle.
Despite the improvement in data, we think that the global economy remains in a low growth, low inflation paradigm. To us, that equates to rates staying lower for longer. The Fed at the December 2019 FOMC meeting held rates steady, as expected. There were few changes to the policy statement, although the prior mention of "uncertainties" about the outlook was removed. Chairman Powell said he wants to see a "significant and persistent move up" in inflation before the Fed moves to raise rates from here, which serves to provide some clarity around the future rate trajectory and likely anchors inflation expectations around current levels. Given this combination of factors (low growth, low inflation, low rates) we still prefer companies that can generate internal growth, but we are vigilant about the margin of safety we pay for them.
Throughout the volatility of 2019, the US consumer has remained a bright spot of the ongoing economic expansion– not a huge surprise, given that nearly 70% of US GDP is exposed to consumer spending. US consumers have experienced solid tailwinds over the last few years: unemployment sits at multi-decade lows, real wage growth has picked up and household balance sheets have been substantially improved from levels seen prior to the Global Financial Crisis. Combined with very low inflation and some tax relief, the average American consumer is feeling wealthier, and has therefore been inclined to continue spending. The chart below demonstrates this: US household debt as a percentage of disposable income has declined from its’ pre GFC peak, whilst the savings rate has improved.
Consumer spending is ultimately highly correlated with confidence in the future of the economy, both at a household and business level. The weak economic data seen in the second half of 2019 has been largely at the business level, and the main cause seems to be the confidence- and certainty-sapping effects of the ongoing trade war.
US consumers, on the other hand, have mostly shrugged off the uncertainty. The decline in 30-year fixed mortgage rates has positively impacted housing activity, and refinancing volumes have increased significantly over the last year as rates have come down. Household durable purchases have remained solid.
Given that 2020 is also a Presidential election year in the States, it would seem obvious that the White House understands it cannot afford consumers to feel the pinch if President Trump wants to see a second term. Pleasingly, the latest data point on the US labour market was positive with November nonfarm payrolls of 266K (against 184K expected) dropping the US unemployment rate by 0.1% to 3.5%. At this stage, we are reasonably comfortable that the US consumer remains in a position to support economic expansion in 2020.
When we look at the key risks for 2020, obviously a trade war escalation remains near the top of the list, given that an economy growing around 2% is simply more vulnerable to such an external shock than one growing at a higher rate.
The main left-field risk we see on the horizon is a sustained pick-up in inflation, though it’s difficult to see where the inflation really comes from. Fiscal stimulus – particular as an outcome of increasingly populist politics – is one potential source, though we are hesitant to construct portfolios based on political outcomes. Our only comment on this matter would be that in many cases, governments who can afford to spend seem unwilling, whilst those are willing to spend can least afford it. Economic conditions would have to worsen materially before governments finally shoulder some of the burden they have asked central banks to carry for the last decade.
The other potential source of inflationary pressure could be a combination of a tightening US labour market alongside too-easy monetary and fiscal policy, leading to an overheating US economy. This would force the Fed to put up rates and given that this is not an income currently priced in by markets, it would likely have a sharply negative effect on sentiment. We don’t think this is a likely outcome in the very near term – there are more concerns about deflation than inflation – but we do think this is a long-term risk worth keeping an eye on.
On the whole, we believe market volatility will remain elevated, particularly in a US election year, but we think equities can still offer reasonable returns in 2020. We continue to back businesses with economic moats that we believe can compound over time.