As we embark on a new year, there’s no better time to take a step back for some perspective on a few of the major themes and trends that are currently shaping financial markets and should be watched closely in 2020, particularly after having just finished a decade of consistently strong returns across most asset classes.
Slowing Economic Growth – Global GDP growth has been generally soft, as the uncertainty arising from escalating trade skirmishes has weighed on both export volumes and manufacturing output. The United States has delivered relatively stronger growth than other developed countries, as corporate tax reform has driven some repatriation of industrial production and investment capital, while an extremely tight labour market has boosted consumer confidence and retail spending.
However, the US is very much like the rest of the world in that its economic growth has become increasingly reliant on accommodative fiscal and monetary policy. Despite being very late in a historically-long economic expansion, budget deficits across the developed world remain extremely high, and interest rates remain extremely low. It’s difficult to estimate how much the economy has been artificially inflated by the combined impacts of unprecedented fiscal and monetary stimulus, but there is a decent chance that even a normalization of stimulus (without any actual tightening) could result in a significant economic contraction.
Rising Debt Levels – In a textbook world, fiscal stimulus (i.e. budget deficits) could continue indefinitely, but in the real world, over the long run, debt levels accumulate and eventually start to weigh on growth. In the United States, the ratio of Federal debt to GDP hit an all time high of 105% in Q3 of 2019 (up from 64% prior to the 2008 financial crisis)1. If we include household debt, corporate debt, and debt issued by state and municipal governments, the debt burden rises to 346% of GDP2, and that still doesn’t include unfunded liabilities of entitlement programs like Social Security and Medicaid, or underfunded public sector pension and benefit plans.
Nobody knows exactly when the growing societal debt burden might reach a tipping point and potentially result in a contractionary deleveraging, but even just maintaining and servicing the existing debt load is likely to result in dampened economic growth and heightened structural risk. We might look to Japan as an illustrative example of how a highly indebted economy can endure decades of stagnation.
Elevated Market Valuations – In response to historically low interest rates on government bonds, investors have felt forced to move toward riskier assets in order to earn comparable returns. So far, this strategy has been rewarded, and the desired returns have indeed materialized. But this is not because companies are earning significantly more. Prices have appreciated because investors are simply paying significantly more for those earnings.
The Shiller Cyclically-Adjusted Price to Earnings Ratio (or “CAPE Ratio”) of the S&P 500 was at 30.9x as of December 2019. It has hovered around 30x since 2017 but has only exceeded that level twice in the past… in the late 1990s and in the late 1920s.3 We know how badly both those episodes ended.
Looking ahead, further expansion of valuation multiples is unlikely, and contraction remains a possibility, but even if high valuations persist, simple math dictates that because of reduced earnings yield, investors’ expected returns going forward will be lower than they have been in the past, and those returns will come with greater downside risk.
Central Bank Policy Interventions – What happens to market valuations may depend on whether central banks continue to be as accommodative as in the past, and how they might respond in the event of any shock to the system.
Since the global financial crisis, most central banks (with a few exceptions) have limited themselves to lowering the short end of the yield curve with targeted interest rate cuts, and shaping the long end of the curve with open-market government bond purchases (known as “quantitative easing”). Those few exceptions have resorted to either driving interest rates all the way into negative territory (a concept which shouldn’t work in theory, but appears to work in practice!) or extending quantitative easing to financial assets other than government bonds, such as equity index funds.
To date, the US Federal Reserve and the Bank of Canada have firmly resisted those options, but a significant economic crisis and the political pressure which would likely ensue might weaken their resolve and force their hands. Whatever policy actions the central banks choose, we can expect them to have significant impacts on markets.
US Elections – This year, 2020, is yet again an election year in the United States. While most eyes will be glued to the battle for the White House, investors should really be focused on the House of Representatives and the Senate. The current party split between the two houses (with the Democrats controlling the House and the Republicans controlling the Senate) has resulted in two years of legislative gridlock, with few major changes to the statutory status quo despite widening polarization and deeper entrenchment between the two sides.
Should either party break the stalemate by gaining control of both houses, and especially if they can take the Presidency as well, investors can expect a flood of pent-up legislation to be unleashed, for better of for worse. Over the course of 2020, candidates will be nominated, party platforms will be finalized, and a stream of sensational election promises will be put forth, many of which are certain to have profound impacts on investment markets. Markets typically hate uncertainty, and a situation where major parties have diametrically opposite economic policies coupled with tight polling data is a recipe for plenty of uncertainty in the months leading up to Election Day on Tuesday, November 3rd.
Conclusion – It is always possible that markets in 2020 might deliver an encore performance of 2019, with attractive performance despite all the growing concerns. However, this is not the most likely outcome. A more plausible case is that any of the above issues (or some wholly unanticipated event like a viral pandemic!) develops and disrupts the pleasant ride that investment markets have been enjoying.
As always, the sensible approach for long-term investors is to maintain appropriate risk exposure, diversification and liquidity. Doing so allows for adaptability to whatever scenario might arise. To quote London Business School Professor Elroy Dimson: “Risk means more things can happen than will happen”.
1 Federal Reserve Bank of St. Louis and U.S. Office of Management and Budget, Federal Debt: Total Public Debt as Percent of Gross Domestic Product [https://fred.stlouisfed.org/series/GFDEGDQ188S]
2 Board of Governors of the Federal Reserve System (US), All sectors; debt securities and loans, U.S. Bureau of Economic Analysis, Gross Domestic Product [https://fred.stlouisfed.org/graph/?g=WRM]
3 Robert J. Shiller, Yale University [http://www.econ.yale.edu/~shiller/data.htm]