Modest equity encore in 2020
Bottom Line The S&P 500 surged 29% over the course of calendar 2019 (up 31.5% on a total-return basis) to a closing price of 3,231, surpassing our high-on-the-street, full-year forecast of 3,100. That’s the stock market’s best price-only performance in six years. Even more impressive is the equity market’s powerful 40% total-return rebound from its Christmas Eve Armageddon trough in 2018 at 2,347.
After a sensational 2019, what will stocks do for an encore in 2020? Macroeconomic fundamentals remain relatively solid, and in our view will lead to a modest 8-10% upside rally to about 3,500 at year-end, but with bouts of increased volatility. As a result, the equity and fixed-income professionals who comprise Federated’s investment policy committee met over the holidays to opportunistically increase our exposure to risk assets.
Here are the key fundamental drivers on which investors should focus their attention in 2020:
No recession in 2020 Our proprietary dashboard has remained consistent for the past few years on this point. Judging from the status of several of our critical inputs, such as the strong labor market, benign inflation, a resurgent housing market and a steepening yield curve, we do not expect any recession risk before mid-2021 at the earliest.
Federal Reserve on hold After three quarter-point interest rate cuts over the past six months, which reversed the Fed’s mistaken hike in December 2018, we believe it is on hold for all of this year, with the upper band of the fed funds rate at 1.75%, absent an exogenous shock.
Inflation and interest rates remain benign The core year-over-year PCE and CPI inflation indexes were at 1.6% and 2.3%, respectively, in November. We expect they’ll grind higher over the next year or so, perhaps up to the Fed’s PCE target of 2%, which would imply a 2.5% goal for CPI. Benchmark 10-year Treasury yields, under pressure at 1.8% today (up from a low of 1.45% last September) because of the turmoil in Iran, may grind toward 2.35% over the course of 2020.
Skinny ‘Phase One’ deal with China The trade and tariff war with China has been dragging on for nearly two years, and this uncertainty has had a negative impact on CEO confidence, corporate spending, productivity, and economic and corporate-profit growth. But on Jan. 15 in Washington, D.C., China and the U.S. are scheduled to sign their skinny “Phase One” agreement. Crucial elements include a reduction in U.S. tariffs and an increase in China's imports of our pork, soy beans, corn and natural gas.
Better-than-expected GDP growth First-quarter GDP growth will be under pressure, due to the temporary Boeing production shutdown, the lagged effect from the Chinese trade dispute and seasonal winter issues. Today’s December ISM reading at only 47.2, for example, is the weakest in more than a decade. But these issues will begin to fade as we approach mid-year, which we believe will support a re-acceleration of economic growth and our full-year 2.4% GDP estimate for 2020, compared with the Blue Chip consensus estimate at only 1.8%.
Market-friendly election results We believe that the controversial presidential election on Nov. 3 will boil down to a contest of character versus the economy in the minds of voters. Our proprietary re-election dashboard suggests that at its current pace, the strength of the U.S. economy positions the incumbent well. That said, we are bracing for election-related market volatility due to the primaries starting in February, polls, the Democratic convention in Milwaukee in July, the Republican convention in North Carolina in August, the debates in the fall and ultimately the election itself. We would not be surprised by a mid-year air pocket, followed by a strong rally starting in August through year-end.
Here are the recent rebalancing asset-allocation changes we made to our PRISM moderate-growth model:
Equity: moved from a 3% overweight to a 5% overweight at 59%:
- Domestic large cap growth We lowered our allocation to it by 1 tick to neutral at 13%. This was largely for profit taking, as richly valued growth driven by the powerful technology upgrade cycle has significantly outperformed value over the past year. We could see a long-overdue rotation from growth to value during 2020.
- Domestic large cap value We increased this asset class by 2 ticks to a 2% overweight at 17%. Value has underperformed growth by more than 11% over the past year. We think the U.S. economy will re-accelerate later this year after a difficult first quarter, so we expect that undervalued cyclical stocks (especially financials and industrials) will lead the way higher.
- Emerging markets We increased this category by 1 tick to a 1% overweight at 5%. The Phase One trade deal with the U.S. should help lift Chinese economic growth, and that’s the largest piece of the EM benchmark. Stronger global growth out of China and the current turmoil in Iran will help to lift energy prices. This should benefit the economies of Russia and Brazil, two BRIC countries heavily dependent on commodities. So undervalued emerging markets, which have lagged the S&P by more than 12% over the past year, should outperform over the course of 2020.
Fixed income: moved from a 9% underweight to a 7% underweight at 25%:
- Treasuries/agencies We increased our allocation to this group by 2 ticks to a 3% underweight at 7%. While yields have risen off late-summer's lows, economic softness and massive amounts of negative-yielding global debt are limiting upward moves, creating a relatively narrow trading range.
- Mortgage-backed securities (MBS) We raised this asset class by 1 tick to a 2% underweight at 5%. We are neutral on MBS within fixed income but underweight the asset class in PRISM due to fixed income’s large underweight in the stock-bond allocation model.
- Investment-grade corporates We increase this category by 1 tick to a 1% underweight at 4%. This asset class is neutral within fixed-income portfolio models on tight spreads relative to Treasuries. But it is underweight in the PRISM model given fixed-income's overall large underweight.
- High yield We decreased it by 1 tick to neutral at 2% for reasons similar to investment grade: spreads are tight, limiting appreciation.
- Emerging markets We lowered this group by 1 tick to neutral at 2%. Uncertainties over trade, range-bound oil and a Fed on hold argue for neutral for now.
Alternatives: moved from neutral to a 1% overweight at 13%:
- Treasury inflation-protected securities (TIPS) We increased allocation to TIPS by 1 tick to a 1% overweight at 4%. With core PCE inflation expected to rise from 1.6% year-over-year in November towards the 2% level over the next year or so, TIPS look attractive at current levels and should rally along with a gradual rise in inflation, aided by a Fed that seems unconcerned about rising prices.
Cash: lowered from a 6% overweight to a 1% overweight at 3%:
- We used this easy-to-deploy asset class to help fund these additions totaling 5% to our model allocations. But we are still are keeping a little dry powder in case further opportunities arise.