Top surprises of 2020
Downside risks we don't anticipate that would
cause a long-term change in our view on stocks
Of late, we are often asked, “What if anything would change our view.” Frankly, we just don’t place a high probability on a major downside event that would stop the current secular bull in its tracks. Sure, as we’ve seen this week with Iran, there will be temporary crises and headlines that cause setbacks. But we have and will continue to view these as buying opportunities, not times to panic. As we’ve written before (see " 'Boo!' It's the secular bull, still running over the bears ...", link at bottom) this secular bull has very strong foundations—a “third industrial revolution” in the digitization of the U.S. economy, nearly permanent low bond yields due partly to global demographics, and a base level of caution among all economic players, investors and regulators rooted in the 2008-09 financial crisis. This foundation is very hard to shake.
However, in the spirit of answering the question, what would change “permanently” (nothing is truly permanent but let’s say “for at least a year”) our optimistic stance on stocks, below are four tail risk possibilities that would. We ascribe no greater than a 5% chance of any of these events. That’s why even as it’s been bullish, the PRISM® Committee always has recommended clients maintain at least minimal positions in bonds, cash and uncorrelated “alternative” assets against their equity overweight. Now, the four remote downside risks that could happen, though are very unlikely in our view:
- Democrats nominate a Socialist-oriented candidate, win the election and sweep Congress.
- The China trade war reignites, leading to a termination of trade and cross-border investment in both countries.
- The Iranian conflict evolves into a large-scale “shooting war” that takes out, semi-permanently, up to half of Saudi 0il production.
- Inflation suddenly reignites and the Fed changes course, hiking rates aggressively and producing an economic recession.
At the start of each year, we’ve gotten into the habit of publishing our top 5 surprises for the coming 12 months. Unlike some other lists, these surprises aren’t meant to suggest “tail risk” possibilities that are inconsistent with our market view, but rather five key foundations for our view that we see as likely and the market consensus does not. So in this list are events that we believe are in fact likely and would be not be a surprise at all to us, but would surprise most market participants.
First, let’s summarize our 2020 outlook. We remain bullish, though our year-end S&P 500 target, 3,500, would reflect a more “normal” return for equities of about 8%, not the bounce-back 31% of 2019 and even less than the average market return of 15% over the last five years. We do think the risk to our forecast is skewed to the upside, particularly if we “run the table” on the five surprises listed herein. Our outlook’s foundation lies heavily in our 2020 economic forecast, which at 2.6% U.S. GDP growth is almost a full percentage point above consensus.
As we enter the year, our PRISM® committee’s moderate stock-bond allocation model is recommending a 59% position in equities, a 50% overweight from our neutral position, with that overweight tilted largely toward stocks that should benefit from the economic re-acceleration we expect—large-cap value stocks, small-cap stocks and emerging-market equities. As we did last year when we started 2019 with an 80% overweight to equities, we anticipate peeling back our 2020 overweight into strength through the year. Conversely, should we get a major correction along the way—always a possibility—we plan to add further to equities.
Top 5 surprises of 2020 we view as likely and consensus does not
No. 1: The China “deal” gets better, not worse. Though Phase One is on schedule to be signed next week, most investors expect the China “Cold War” to more or less continue to plague us for the next several years. We see this as unlikely. As we’ve said before, China’s and the U.S.’s economies are complementary, and strong performances by one helps the other and vice versa. The issue historically has been a tilted playing field, set up intentionally that way 30 years ago when China’s income per capita was just below $1,000 and it was in everyone’s interest for it to be given an opportunity to embrace capitalism and mature into an economy of middle class consumers. This has come to pass. Now the entire world, including the Chinese, understand President Trump’s point that China is big enough to compete on its own, without economic training wheels. Even President Xi, I expect, knows this ultimately is better for his country. Following Phase One, China’s economy is likely to pick up as its export industries come back on line. With it, President Xi himself will be anxious to continue his own domestic transformation of China’s economy, which will require substantial foreign investment and a continued flow of ever-improving U.S. technology and software into China. To achieve this, the remainder of President Trump’s un-addressed agenda (further intellectual property [IP] protections, for instance) will be needed—by China. Xi just can’t admit publicly this was Trump’s idea, and he won’t. That’s why we don’t expect much of a Phase Two, in a formal sense. Rather, we expect over the course of 2020 through 2022, a gradual further opening of China’s capital markets, a further shift towards rule of law and IP protections, and a more freely floating Chinese renminbi. All of it will be introduced as President Xi’s independent decision, not Trump’s idea. And the net result will be positive for Chinese and global GDP growth, and positive for risk assets.
No. 2: The U.S. and U.K. negotiate a new trade deal before either completes deals with Europe. U.K. Prime Minister Boris Johnson has won a commanding majority in the Parliament, giving him maximum flexibility to negotiate new trade deals he will need with countries all over the world now that the old European Union-based trade deal is no longer applicable to non-EU member Britain. So what will be his next move? Yes, some sort of temporary truce and short-term extension of the existing trade arrangement with the EU might be possible, but negotiating an entirely new set of trading arrangements across all U.K. products exported into Europe and European products imported from Europe will be very difficult. The EU has 22 member countries to appease, and is still upset about Britain’s surprise escape from the union. Our guess is that he turns to a natural political ally, President Trump. Johnson needs a deal with the U.S., as well, not to mention China. With Trump, he knows he can get something done quickly and fairly. And having a U.S. trade agreement in his back pocket would help a lot when he sits down with Brussels. The president, on the other hand, also is in the midst of negotiating a new deal with Europe, which has been dragging on, again primarily due to differences within the EU itself. A deal with the U.K. would be another great election-year win, following the deals he’s put in place with Canada, Mexico and China. We think we’ll see such a deal by early fall. While a U.K. pact would not be big enough to have a major impact on the U.S. economy, it would certainly be market supportive from a confidence perspective. And we think it’s one that few people are currently talking about.
No. 3: U.S. manufacturing begins to experience a renaissance. Most investors and commentators with whom we speak, and most of the media, don’t expect much real, long-term economic impact from Trump’s trade deals—just a lot of noise. Most also think the corporate tax cuts, which raised after-tax returns on corporate investment by roughly 20%, had no impact because they there was not much of an investment pickup in the ensuing 12 months. Most of this analysis misunderstands the role of confidence in investment decisions, as well as the very long-term nature of, and slow-moving process for, corporate investments. With the tax cut done, and the terms of trade with our top three trading partners (Mexico, Canada and China) now settled, we expect corporate investment to begin to accelerate off the already slow pickup underway. “Made in the USA” is already back, as customers demand ever-shorter supply chain lead times. And now with key trade deals in place, foreign firms, even European ones that can see where things are heading, are more and more convinced the easy answer is to locate manufacturing closer to or in the very key U.S. market. We think this acceleration in capital expenditures, alongside a reignition of foreign trade thanks to the trade deals and the normal ebb and flow of the industrial sector of which we’ve written (See "The pain trade is higher" and "What if we are not ‘late cycle’ but actually ‘early cycle?’ "), will see a recovery by midyear in a U.S. industrial economy that has been hovering near recession levels. This largely is what is behind our above-consensus 2020 GDP forecast, and as markets sniff it out (they are already beginning to), we expect the rebound in cyclical names that began in the fourth quarter to continue, fueling the market’s rise.
No. 4: From the market’s perspective, the U.S. election is over by March. This surprise, if we are right, will be another big confidence-boosting outcome for the economy and financial markets. Playing off the last election’s playbook, most investors expect a close election that won’t be decided until Nov. 3. While we actually anticipate an Electoral College landslide for the president, the market in 2020 only really cares that the next president is not so radically left of center, and/or that a radically left candidate wins by such a margin that he/she sweeps the Congress with her/him, making a dramatic change of direction in tax or regulatory enforcement a reality. For example, a nomination win by Sens. Warren or Sanders would spook investors, for sure. However, the new Democratic primary system makes the likelihood of a Warren or Sanders victory relatively low. With no “early lead” built in for any candidate now that the super delegates are prevented from voting in the first round, the proportional method of allocating state electors will ensure that everyone walks away with a votes of some kind from every state, making the opportunity to score a knockout punch difficult. This, combined with the new rule preventing candidates from transferring their votes to others, will probably result in a multiple-lane freeze-up by the end of winter. By then, the market will discover that the moderate “Super Delegates,” who swung the nomination to Hillary last time, are actually still in play—but only on the second ballot of a brokered convention. With those delegates mostly party establishment, and political realists—in effect, the swing vote—concerns about a radical leftist nomination will ebb. And with this, the fear of a dramatic reversal of current economic policies should fade. For sure, the election will still matter for our longer-term outlook, which is currently bullish but would likely shift down with a win by the opposition party of any stripe as we’d have to pare our longer-term GDP growth expectations. On the other hand, if President Trump is re-elected and with him, four more years of the growth-stimulating policies we’ve already experienced, the market would likely rally well beyond our current 3,500 target in last months of the year. We’ll hold that analysis for later.
No. 5: The market multiple, generally perceived as “rich” by consensus, rises higher through the year. The bears have been crying of late about the market’s rich P/E, given the rise in the S&P in the face of what has been a very sluggish year for corporate earnings. No doubt, this will continue, as even we expect only modest growth this year of corporate earnings to $176 per share—approximately 8% growth off 2019’s estimated outcome. And we expect an 11% gain in 2021 to $195 per share. So our 3,500 S&P forecast currently assumes the market gets priced a tad higher than its current “high” level of 17.9x forward earnings. However, our own analysis of market multiples in similar low-inflation environments suggest a more fair multiple on earnings would be closer to 19x. As the year rolls on and inflation remains tepid despite the economic recovery, the long bond yield remains capped due to global pressures and the Fed remains on the sideline, we think perceptions about a fair multiple on the S&P will change. This last surprise, frankly, is not in our 3,500 year-end forecast, and if it happens (actually, it’s not really “if” but “when”), the market should move higher still. Yes, 19 x 195 is 3,700. And that would be a nice post-election 2020 Christmas present for all of us.
October 29 2019