2019 Positive Equity Markets – Negative Corporate Earnings

The S&P 500 has risen over 26% so far in 2019. Despite that strong performance, each quarter this year will likely show a decline in S&P earnings. More specifically, earnings-per-share through the third quarter declined 3.4% at the same time corporate earnings declined over 4%. The difference between the two reflects corporate stock buybacks. Figure 1 shows that buybacks and dividends played a more important role in corporate spending this year than in the past.

Figure 1

2020—the Four Questions

The upcoming year should supply answers to some of the following economic and political questions: First, will strong consumer spending continue to influence corporate investment, or will the more cautious corporate outlook prevail over consumers? Then, will the Sino/American trade battle continue to overhang both the global economy and financial markets despite the phase 1 limited agreement? Of course, no one can forget the presidential election battle in 2020 and, most important, will control of the House and Senate split, or will both fall into the hands of one party? Finally, with increasing federal government debt, low domestic interest rates, and negative nominal rates globally, what direction will monetary policy take in the U.S. and worldwide?

Let’s begin.

Question 1: Consumer Optimism vs. Business Pessimism — Who Wins?

Based on most recent surveys of consumer sentiment, U.S. consumers kept a high level of economic confidence (see Figure 2). In comparison to consumers, the 2019 trade war led to lagging business confidence creating a gap with consumers (see Figure 3).  As a sign of business caution, recent Fed surveys of U.S. manufacturers show their capital investment plans continue to fall.

Figure 2

Consumer Confidence

Figure 3

Difference between U.S. CEO and Consumer Economic Confidence

(The Conference Board Indices, Q2 1976 to Q3 2019)

Source: The Conference Board, DB Securities; Axios Visuals

Expect Consumer Confidence to Lead to Business Investment Recovery

A Merrill Lynch graph shows that at the same time small business optimism improved large business optimism continued its downward track (see Figure 4). That track could potentially turn up with the partial trade agreement in place supported by continued consumer optimism. By the second half of 2020, business could take advantage of low interest rates and 2017 tax bill provisions to step up their investment spending. In addition, strong new housing starts may also supply stimulus to 2020 economic growth as Fed easing sparks housing demand. Interestingly, despite most economists labeling the current economic cycle as late, a stronger housing market usually occurs early in an economic cycle rather than later.

Figure 4

Small Business vs. Large Business Optimism

GDP Outlook For 2020

Recognizing the many ifs, accommodative monetary policies and less trade war overhang should enable the economy to recover from any near-term slowdown to reach its potential growth of 2% in 2020. Ultimately, it remains more likely difficulties in financial markets rather than those in the real economy would lead to an economic downturn. In the real economy, we do not see excesses that normally would lead to a recession.

Question 2: The Trade Agreement – the Potential for a Follow-up? —Global Trade Shifts? – the Outlook for the U.S. Dollar?

Follow-Up Sino/American Trade Agreement Will Not Come Easily—If at All

The recently announced limited trade agreement should put that issue on the back burner in the 2020 election year. At the same time, any further Sino/American trade agreement, beyond this initial limited agreement, will not come easily — if at all — no matter who sits in the oval office. As evidence, both the Senate and House passed bi-partisan sanctions against Chinese officials for their actions in both Hong Kong and Uighur. Further, the south china morning post recently quoted the former U.S. Assistant Secretary of State for East Asian and Pacific Affairs that China’s U.S. policies are uniting a broad range of American interests against the world’s second largest economy.

Global Supply Chains— Will the Trade Dispute Change Globalization.

Since China joined the World Trade Organization (WTO) in 2001, global supply chains took advantage of lower trade barriers to move various production steps to their most cost-effective locations. In doing so, goods typically moved across borders more than once. Figure 5, from an IMF working paper on global value chains, shows how the growth of global supply chains altered global trade. To avoid the trade war and still benefit from lower wages, labor intense manufacturers will likely move their supply chains from China to other emerging market countries.

Figure 5

Traditional and Global Value Trade (GVT)

(Percent of Nominal World GDP)

Source: IMF Working Paper — Global Value Chains: What Are the Benefits and Why Do Countries Participate?  Traditional Trade Comprises Exports of Goods and Services Produced in One Country and Absorbed in the Destination.

Global Supply Chains Could Also Shift Closer to End Markets

One added influence on global supply chains may come from the growing demand for rapid delivery of internet orders – same or next day. That influence could lead to manufacturers moving their supply chains closer to consumers. This change would likely increase the role of production in Mexico (see Figure 6). Same/next day delivery may also result in higher overall inventories necessary to meet that commitment. These various forces will result in changes to the locations of global trade and production but not an end to efficient global supply chains.

Figure 6

Percentage of Goods Import Value by Year

Source: Wall Street Journal/Daily Shot — Census Bureau 2019 Data Through October

Lessened Global Trade Disputes Could Result in a Weaker Dollar

Trade disputes, including Brexit, caused global economic growth to slow. With trade disputes now less an issue, global growth should broadly improve.  The International Monetary Fund (IMF) looks for 2020 global growth to increase from 3.0% this year to 3.4% in 2020. For emerging market and developing economies, the IMF looks for growth to accelerate from 3.9% this year to 4.6% in 2020.

With that, investors and businesses will likely take advantage and increase their investments in markets outside the United States. A greater flow of dollars leaving the U.S. could weaken the U.S. dollar. The currency translation of a weaker dollar would benefit domestic holders of non-U.S. investments and the incomes of global U.S. companies. A weakening dollar might also lead to higher fixed income rates as unhedged global investors reduce their holdings of U.S. fixed income securities. If that occurs, a steeper U.S. yield curve may also result.

Question 3: The Elections: The Effect on Taxes? The Key Election Outcome for Investors?

U.S. Presidential Elections – Key Democratic Primaries Over by Early March

The Democratic race faces key primary outcomes by early March. By then, voters will choose 70% of the 3,979 delegates. The key change this year came when California, which accounts for 20% of the delegates, moved its primary up three months to early March.

Potential for a Brokered Convention

With the number of candidates running in the Democratic primaries, the result may be a brokered convention. The last brokered democratic convention occurred in 1952. Without getting into the weeds, if the convention moves to a second ballot, the party’s 765 super delegates, the party leaders, then can vote. At that point, the convention could turn wide open.

Democratic Candidates Tax Policies Reverse 2017 Tax Cuts

The presidential and congressional elections this year could add to greater financial market volatility as we move into the second half of the year. Voters could elect a Democratic presidential candidate whose policies could substantially reverse provisions of the 2017 tax legislation (see Figure 7 — TCJA refers to The Tax Cuts and Jobs Act of 2017). Therefore, a split in party control between the House and Senate could prove important to calming investors concerned about proposed tax law changes shown in Figure 7. Because market history suggests that financial markets prefer such a split, this will likely prove to be a key outcome from the election.

Figure 7

2020 Democratic Presidential Candidates’ Positions On Tax & Investments — 11/14/2019

Source: Americans For Tax Fairness

Question 4: Increasing Federal Debt and the Use of Negative Interest Rates—Can Monetary Policies Return to Normal?

Substantial Federal Debt Levels—Difficult to Return to Normal Monetary Policies

To recover from the Great Financial Crisis (GFC), the Fed, in effect, substituted Federal debt for troubled individual and business debt (see Figure 8). The inability, so far, for the Fed and other central banks to return to a more normal monetary policy reflects the continuing impact from the unconventional monetary policies and the high level of debt created following the GFC. It also likely results from diminishing returns from growing levels of debt.  The resulting global repression of interest rates shows up in historically low fixed income yields. At this point, both rebuilding the Fed’s balance sheet and three rate cuts this year puts off any effort to return to a more normal monetary policy.

Figure 8

Source: Econimica

Negative Nominal Interest Rates – the Impact? – A Return to Normal?

Major central banks lowered interest rates this year, including the European Central Bank, which further lowered nominal negative rates (see Figure 9). In the short-term, negative rates may produce positive expansionary results. Longer-term negative rates likely depress bank returns and profits, makes it difficult for insurance companies and pension funds to meet long-term obligations, and encourages individuals to save more to the detriment of consumption. For young generations, negative rates limit their opportunity to invest in less risky debt for their retirement. 

Figure 9

Central Bank Rate Changes – 2019

Source: Bloomberg, WSJ/Daily Shot

Greater Eurozone Fiscal Stimulus Needed for a Return to More Normal Interest Rates

To return to “normal,” Eurozone countries will need to use greater fiscal stimulus to offset the diminishing power of monetary policies. This difficult shift requires an important economic and political focus by the European Central Bank under its new leadership. If that shift occurs, the Eurozone economy should benefit from fiscal stimulus.

Investment Conclusions

Portfolio Mix

Looking into 2020, the global economy will likely show improved growth as negative trade war pressures subside. Our past portfolio recommendation mix called for an equal balance (one-third each) among equites, fixed income, and alternatives. Despite the possibility financial markets already discount a positive economic outlook; our portfolio mix recommendation increases equities to forty-percent and alternatives, modestly, to 35%. Our weighting decreases to twenty-five percent for fixed income investments. This lower recommendation reflects current low interest rates for debt and lesser overall concerns about the risk for a recession.

Equities

For equities, we continue to recommend stocks of companies that can demonstrate stable growth in an era marked by its shortage. These companies should also demonstrate high returns on investment, growing dividends, along with their stocks selling at fair prices.

With the likelihood of increasing global growth and potential dollar weakness, earnings of global U.S. companies should benefit. Of course, managements will never spotlight translation benefits on their quarterly earnings calls. For the same reasons, selective non-U.S. markets should show improved returns. For those investors with higher risk tolerances, emerging markets should also react positively.

Fixed income

In the case of fixed income, we continue to favor short-term duration debt. If global economic growth shows improvement, longer duration debt might prove vulnerable to a sell off as interest rates increase.