Marching Onward and Upward
In 2019, the stock market performed well beyond what most investors would have reasonably anticipated. Powered by a domestic economy that refused to fall into recession and supported by the easing of interest rates and some progress on the trade front, the S&P 500 rose 29% for the year. With those stellar returns now behind us, focus naturally shifts to the outlook for 2020 and the sustainability of the large recent gain. We remain believers that recession is not imminent, we are in a positive environment for stocks, and higher quality companies will continue to perform well. This year we expect equity returns will be in line with their long-term average of high single-digits.
Now in its eleventh year of expansion, our economy remains consumer-driven. Despite weakness in manufacturing, capital investment and trade, 2019 GDP looks to have increased roughly in line with the 2.5% growth achieved in 2018. We expect it to advance at a similar rate in 2020. A large part of the continued growth has to do with a labor market which added over 22 million jobs in the past ten years, resulting in a 50-year low unemployment rate of 3.5%. While wages advanced only 2.9% from a year earlier, that rate is ahead of inflation and has been accelerating, though not in a completely linear fashion. Since it is easier to get a new position than a raise, many workers have taken advantage of that situation and moved to better paying jobs. Importantly, the lowest end of the pay scale will benefit from minimum-wage increases across 21 states and 26 cities and counties this year, a trend which is maintaining momentum.
Meanwhile, inflation remains subdued, running below the Fed’s 2% goal. Technological advancements and modest wage growth combined with weak global economic activity and predominantly stable commodity prices have kept a lid on prices. Given this tame level of inflation, the Fed intends to maintain the currently low interest rate levels throughout 2020 to both support the economy and remain removed from the political process in an election year. Additionally, even if demand were to accelerate and the pace of price increases were to pick up, the Fed has indicated comfort with greater than 2% inflation without immediately resorting to interest rate increases.
Low interest rates are very positive for both the economy and stocks in multiple ways. Last year, large numbers of global central banks lowered rates and implemented other monetary stimulus measures. Historically, there has been lag time between the action of reducing rates and the actual impact. This should provide an economic tailwind for global economies this year and encourage further business investment at reduced costs of capital. Moreover, lower rates allow for comfortably higher stock valuations as current earnings and dividend yields compare very favorably to those of bonds and other alternative investments.
Steady economic growth, modest inflation and low interest rates all bode well for corporate earnings. 2018 saw a surge in earnings growth, in large part due to both the direct and indirect impact of the tax cuts. With those difficult year over year comparisons, earnings growth in 2019 was very modest. Growth is expected to accelerate to a level that we believe will be in the mid to high single-digits this year. Interestingly, if you look at earnings growth over the past two years combined, it closely matches the gains in stock prices during that same period.
While investors will always have something to worry about, there are several factors which may contribute to a favorable environment for stocks. With a President who closely monitors the stock market and often refers to it as a measure of his success, equities could see an election year boost driven by market-friendly policies and initiatives emanating from the White House. Tariff de-escalation with China is dawning with the signing of a formal Phase One trade agreement. In fact, there are early signs that economies worldwide are beginning to benefit from reduced trade friction as well as global monetary and fiscal stimulus.
Finally, it is worth noting that strength in the stock market fuels a better economy and vice versa in a virtuous cycle. History shows that when stocks boom as they did last year, the economy often picks up in the following year. Furthermore, outsized stock market returns one year do not necessarily equate to subpar performance the following year. For example, in each of the six times in the past when the S&P 500 posted annual returns of 29% or more, it also generated a positive return in the following year with an average increase of 19%. We look for that trend to continue this year.
Holger Berndt, CFA Director of Research hberndt@rssic.com
