What’s in store for financial markets in 2020? After a year of trade tensions, modest economic growth and rock-bottom interest rates, the final Market Voice of 2019 asks if the equity market party will continue ahead of November’s U.S. Presidential election.
- With stocks still cheap relative to bonds and the U.S. Federal Reserve primed to cut rates on any signs of slowing, it seems that 2020 should be pretty benign for global markets.
- The adverse reaction of financial markets to U.S.-China trade developments will continue to represent a buying opportunity in 2020.
- U.S. payroll gains are moderating, making it unlikely that inflationary pressures will divert the U.S. Federal Reserve from its current economic support.
As we head into the end of the year, it is time to think about the big themes for markets in 2020.
In so many ways, the New Year issues are likely to be continuations of the old. The two big themes of 2019 — U.S. trade tensions with China and a no-deal Brexit — are still on the horizon, and likely to remain there well into 2020.
Indeed, President Trump has said there may not be a China deal before the November White House election. But before addressing these issues, a more immediate question is whether the turn of the year will see a repeat of the 2018 year-end spasms in the stock market.
Anecdotally, hedge fund redemptions were the primary source of the 2018 year-end selling as fund managers had to liquidate holdings to have cash to repay investor redemptions.
Reportedly, the sell-off was exaggerated by several funds exploiting the forced selling at a time of seasonally thin trading, pushing prices to extreme lows to scoop up the cheap shares — hence the sharp rebound.
While the continued shift out of alternative investments in 2019 seems to bode ill for a repeat of the year-end dive, the chart below from the Eikon polling app demonstrating investor positioning suggests conditions are not so dire.
Figure 1: Hedge fund redemptions and the SPX
The red line in the prior chart shows the decline in institutional investor allocations to alternative investments – e.g., hedge funds. While allocations continued to fall in 2019, the decline was roughly half the pace of 2018, implying more modest needs for year-end liquidations.
As also shown, the stock market went into decline at the start of the fourth quarter, creating a bearish bias lessening risk tolerance making the market prone to sell. The late-year heightened nervousness is apparent (see below) in the VIX hitting year-plus highs at the start of October 2018 and remaining bid into the middle of December.
By contrast, both implied and realized volatility have trended lower in the fourth quarter this year, suggesting a much more complacent outlook on equities. However, the situation has been clouded slightly by the negative reaction to dimmed prospects for a China trade deal.
Pending hedge fund redemptions cannot be totally dismissed as creating a year-end sell-off risk, especially if the market remains soft going into year-end. However, lower redemptions and better awareness should keep any weakness more modest than last year’s rollercoaster.
Figure 2: SPX realized and implied (VIX) three-month volatility
Not so terrifying tariffs
As noted above, there has been a negative market reaction to Trump throwing cold water on hopes for a near-term resolution of the Chinese trade issues.
One of the key themes we consistently pushed in 2019 was that the market was substantially exaggerating the importance of the trade tensions with China for U.S. economic performance.
Our general bias was that market sell-offs in response to adverse Chinese trade news was a buying opportunity.
While tariffs clearly harmed certain sectors — especially farming — the market is underestimating the positive impacts for other sectors like steel, and has missed how small the traded goods sector is relative to the broad economy.
Figure 3 shows the year-over-year absolute change in the U.S. current account. There was some deterioration in the current account balance this year, although not materially worse than what occurred in 2014 to 2015.
More important, the magnitude of the current account changes is tiny when compared to GDP, so the direct impact is necessarily modest.
While it is possible that the current account deterioration contributed to moderating GDP gains over the past year, we believe other factors are mainly to blame — especially, the fading impact of tax cuts and slower global growth.
We continue to contend that tariffs are a minor issue, and weakness associated with trade announcements remain buying opportunities.
Figure 3: U.S. current account and nominal GDP – Y/Y absolute change
The curve inverted, but stocks are cheap
The markets became fixated with the bearish implications of the interest rate curve inversion that emerged in the middle of 2019. As shown in Figure 4, the 3-Month vs 10-Year Treasury curve inverted in the middle of the second quarter and did not normalize until early in the fourth quarter.
But the 3-Month rate is tightly linked to the Federal Reserve’s target funds rate, and while its inversion universally precedes recessions it is also prone to generating false signals.
Using the 2-Year rate as the front anchor provides more reliable recession signals with almost no false positives. This part of the curve marginally inverted for only one week of August, so it is not clear this was adequate to signal a recession ahead.
In any event, curve inversions generally lead recessions — and the onset of a bear stock market — by at least one year so this is at worst a story for 2021, not for markets in 2020.
With the Federal Reserve seemingly on hold well into 2020 and biased to cut rates, the prospects are slender for a re-inversion of the 2-Year vs 10-Year curve at least until the second half of 2020.
Figure 4: Inversions of the U.S. Treasury Bond Yield Curve
A major driver of the yield curve inversion was a decline in the 10-Year rate from a peak of around 3.2 percent at the end of 2018 to a low of around 1.5 percent — the lowest levels since 2016.
All-else-equal, lower bond yields make equities more attractive. They have firmed in the fourth quarter to around 1.75 percent, putting them at rough par with dividend yields for the S&P 500.
But even with dividend levels low by historical standards, stocks are relatively good value given the current yield on bonds. As shown below, bond yields have recently gained versus equities, but the ratio remains below the average for the past ten years.
Notably, the ratio of bond to equity yields historically needs to get to a range of 1.5 to 2.0 — i.e. double equity dividend yield — before stock uptrends run into resistance. Unless bond yields skyrocket, 2020 is shaping up as a year for an ongoing equity market party.
Figure 5: Equity dividend yields vs 10-Year Treasury yields
2020 is an election year – and maybe impeachment?
The November Market Voice outlined the impeachment process and the potential implications for the market — and it seems likely that the House will vote for impeachment late this year or early in 2020.
There is some evidence that a Congressional vote for impeachment has a temporary negative impact on the market but the final resolution — regardless of the result — is followed by an extended equity rally. But given the small sample size, it is difficult to have confidence of how the market will react.
Impeachment or not, there will still be a Presidential election in November 2020.
The table in Figure 6 shows how the stock market has performed in the context of Presidential elections since 1950. Red lines indicate a Republican victory and blue denotes Democrat wins. Bold lines indicate the incumbent president was re-elected — including President Johnson.
Figure 6: U.S. elections and SPX performance
There is no evidence that there is a direction in market bias in either the month before or after the election. It is also not apparent that an incumbent win versus a new president has any notable impact either over the next month or year of trading.
The only clear differential is that the market performs better over the subsequent year with a Democrat win. In 71 percent of the Democrat victories, the market did better in the subsequent year than in the year prior to the election.
For Republicans the market outperformed in only 41 percent of their wins. And in outright terms, the market gains 15 percent on average in years following Democrat gains and only one percent in years following Republican victories.
While the sample size is considerably bigger than for impeachments, it is still not big enough to be confident of the seeming favorable outcome from Democrat victories.
Moreover, it seems likely that whoever becomes the Democrat candidate, the platform will contain a mix of tax and regulatory changes that will not be market friendly. Despite the historical bias, we suspect the market will at least initially sell-off on a Democrat victory and especially if they also carry both houses of Congress.
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Payrolls and inflation impact
If we are right that there is little risk that trade disputes will seriously derail the economy, then with stocks still cheap relative to bonds and the Fed primed to cut rates on any signs of slowing, it seems that 2020 should be pretty benign for the U.S. economy — notwithstanding the pending impeachment and Presidential election.
But the Fed support for the economy hinges on inflation remaining well behaved. Any signs that a significant inflation pick-up is emerging could force the Fed to take away the proverbial punchbowl. Fortunately, as shown in Figure 7, the pace of job creation in the U.S. suggests inflation will remain low.
Figure 7: Monthly Non-Farm Payrolls and CPI inflation
The historical relationship between the unemployment rate and inflation — the Philips Curve model — has broken down since the financial crisis; inflation remains low and stable even with the unemployment rate testing historical lows. But the chart above suggests there is still a link with the pace of employment and inflation.
In particular, both before and after the crisis, an acceleration in employment — increasing monthly payroll gains — has led to a firming in the inflation rate. In addition, there is some evidence that monthly gains in excess of 200,000 create some upward pressure on inflation.
In any event, payroll gains are moderating and well below the 200,000-threshold, so inflation is not likely to get ugly in 2020.
There is perhaps no way to sensibly predict the Brexit outcome at this juncture. The good news is that the coming election should provide some clarification; a Conservative pro-Brexit victory will give Boris Johnson a stronger mandate to negotiate an exit package with the European Union.
An upset loss could create momentum for a second referendum and reversal of the decision to leave the EU. That said, there are still a lot of unknowns before this is resolved and the implications of a no-deal Brexit remain murky. Given this, it is somewhat surprising that the market has become seemingly indifferent.
Figure 8 below, shows that both one-year GBP implied volatility and the 5-year UK sovereign credit default swap rate have been good barometers of market sentiment related to Brexit issues.
Both surged in 2016 in the wake of the ‘yes’ vote on Brexit and a year ago when the prospect of a no-deal Brexit became a likely outcome.
In recent months both indicators are headed back to five-year plus lows. So, while it remains unclear where the Brexit process is headed, it is clear the market is no longer primed for adverse news.
Figure 8: 1-year GBP implied volatility and the 5-year UK sovereign credit default swap rate
Financial markets in 2020: The bottom line
It looks likely the year ahead will be much like the year just gone; modest but positive growth, low inflation and rock-bottom interest rates. Neither the pending impeachment proceedings nor the coming election are likely to seriously impact the economy or markets.
Chinese trade relations will remain a factor that will periodically roil the market, but we continue to believe the implications for general economic activity are modest. Brexit remains a serious unknown and the fact the market seems to no longer be worried about it may in itself be cause for concern.
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