2019 has been a very good year for investors, with the S&P 500 on pace for its strongest year since 2013. Total returns including dividends through November stood at more than 27%. The headline number is aided by 2018’s lackluster performance, which was the S&P’s first decline in a decade despite posting 20% earnings growth. Earnings in 2019 appear headed for low single-digit growth, and early projections for 2020 are for a near double-digit advance. The forward P/E multiple is approximately 17.5x, above the 5-year average though lower interest rates support the case for a higher-than-average multiple. Yields on 10-year Treasury bonds started the year at 2.6% but more recently were closer to 1.8%.
Despite concerns about slowing global growth, which have been reflected in modest business investment and a contraction in manufacturing activity, the economic backdrop looks generally favorable. GDP growth in 2019 should be in the neighborhood of 2%, consistent with expectations for 2020. This isn’t particularly inspiring, but it could certainly be worse.
The U.S. consumer has been a key contributor to growth, and the November jobs report suggests this will continue to be the case. Employers added 266,000 jobs in November, bringing the three-month average to 205,000, the highest since January. The headline number was boosted by the return of approximately 40,000 General Motors workers, who were on strike in October but was still well ahead of expectations. Furthermore, payrolls for October and September were revised higher by 41,000 and the unemployment rate dropped to a 50-year low of 3.5%.
Evidence of a strong U.S. consumer is apparent in other data as well. The recent University of Michigan consumer sentiment reading improved significantly, rising to the upper end of the range it has been in since the start of 2017. This is good news heading into the important holiday season, where according to the National Retail Federation, retail sales are expected to grow approximately 4% this year despite one fewer week between Thanksgiving and Christmas. Spending has been supported by average hourly earnings rising at an approximate 3% rate annually. As long as the U.S. consumer continues to demonstrate resilience, it is hard to see a meaningful deterioration in the economy.
Rising wages and lower unemployment naturally lead to concerns regarding inflation, but so far these concerns appear unfounded. Inflation continues to be subdued and in the 12 months through October core PCE inflation reflected a 1.6% increase, below the Federal Reserve’s 2% target. The core PCE index is the Fed’s preferred measure of inflation and has consistently run below target. Implied expected inflation over the next five years is only 1.6%, indicating the market remains unconvinced inflation will rise to meet the Fed’s objective. This expectation is something that has drawn increasing focus by members of the Fed.
The Fed’s 2% inflation target is “symmetrical,” meaning theoretically it should be as comfortable running slightly over 2% as it is slightly below. In late November Fed Chairman Jerome Powell indicated the central bank is “strongly committed” to maintaining 2% inflation, stating “it is essential we at the Fed use our tools to make sure we do not permit an unhealthy downward drift in inflation expectations.” Furthermore, at the October press conference Powell stated, “We would need to see a really significant move up in inflation that’s persistent before we would consider raising rates.” This was well received by the market as it seemingly has put the Fed in a position where the bar to raising rates is reasonably high.
After raising rates in 2018, the Fed abruptly shifted to cutting rates in 2019 in response to fears about a slowdown in global growth partially attributable to the U.S.-China trade war. Following three rate cuts this year the Fed now appears to be content to stand pat. This wait-and-see mode looks likely to hold over the next few Fed meetings, with the threshold for further cuts seemingly lower than it is for rate increases.
Trade remains an important factor that continues to move markets. The stock market’s most recent move higher started after President Trump said in mid-October that the U.S. and China had reached a “substantial phase one deal,” yet two months later a deal has not been finalized. How close we really are to an agreement is anyone’s guess, but there is a chance an agreement could take substantially longer. Reaching an agreement was potentially complicated by President Trump signing into law a bill showing solidarity with Hong Kong protestors. Trump also recently indicated he was willing to wait until after the presidential election to reach a limited trade deal with China, which caused stocks to dip modestly. His comments could be viewed as an attempt to gain leverage in the discussions and the market essentially shrugged them off as the selloff didn’t last.
Agreement or not, trade negotiations between the U.S. and China will be a point of focus. U.S tariffs on $156 billion of annual imports from China covering a range of consumer goods including laptop computers, toys, and clothing are currently scheduled to go into effect on December 15th. If talks continue down a constructive path, it is expected the U.S. is likely to delay the implementation of new tariffs, but the situation is certainly fluid. China is not the only front in the trade war. President Trump recently said he would raise tariffs on steel and aluminum imports from Brazil and Argentina. The administration also proposed tariffs against some French imports in retaliation for a new tax France has imposed targeting U.S. technology companies.
Big picture, the economy appears to be growing at a reasonable pace on the back of the U.S. consumer, the Federal Reserve is likely to maintain rates where they are with a bias towards accommodation, and we are entering an election year, when stocks have historically performed well. Trade remains an issue to monitor but any deal with China is likely to be an incremental positive for growth. All things considered, the backdrop entering 2020 appears okay for investors.
From the January 2020 issue of the Investor Advisory Service.