The path of 2019 economic growth was largely characterized by a tug-of-war between geopolitical drags offset by global monetary policy easing. Tariff and trade uncertainty weighed heavily on business sentiment, producing a sharp deceleration in global capital spending and manufacturing output.
Recent hiring data in the U.S. however, has been an encouraging sign that the U.S. economy could be withstanding the global slowdown and continued trade-related uncertainty. The U.S. economy has performed very close to expectations in 2019. GDP growth was forecast to slow from 2.9% in 2018 to somewhere between 2.0%-2.6%. With three-quarters of actual data reported, 2019 has been on track to hit a growth rate of 2.3%.
Even as growth has shifted to a lower gear, the economy appears to be advancing at a fairly solid pace. This resiliency is perhaps best reflected in the labor market, which has continued to defy expectations and generate sturdy payroll growth, record low unemployment, and steadily improving wages.
Consumers have remained the linchpin of U.S. growth. The solid job, wage and income gains have accounted for the persistence in elevated consumer confidence. Household spending has also received a notable boost from one factor that was not anticipated at the beginning of 2019 – lower interest rates.
The Federal Reserve cut interest rates three times in 2019 on worries that weakness in trade, business investment, and manufacturing could derail U.S. growth by triggering cutbacks in spending and hiring.
Uncertainty related to the U.S.-China trade war has held back investment spending in the United States in recent quarters, and sluggish growth in capital spending has acted as a constraint on overall GDP growth in the U.S. economy. There has been little sign of recent weakness abating as the forward-looking new orders component has continued to slip.
The much larger service sector, however, has held up fairly well, as hiring has shown few signs of spillovers from the weakness in manufacturing. Notably, the ISM non-manufacturing index has remained in expansionary territory, and new orders have pointed to continued growth in the sector.
Trade policy uncertainties are not likely to dissipate anytime soon. Although the United States and China could very well agree to a Phase I trade deal, it has appeared unlikely the two sides will come to an agreement on a comprehensive deal that would return tariffs to their pre-trade war levels, at least not in the foreseeable future. Consequently, growth in investment spending in the United States will likely remain weak.
Home sales and new home construction are poised to end 2019 on a strong note. Sales of new homes have risen in two of the past three months marking the strongest pace since August 2007. Sales of existing homes have also improved during the last three months, with single-family homes accounting for practically all of the increase. The improvement in home sales has bolstered homebuilder confidence and led to a steady increase in single-family starts, which have risen for six months in a row.
With mortgage rates below 4% and the Fed likely on hold for the foreseeable future, housing has the wind at its back. Residential investment should contribute positively to GDP growth in 2020.
U.S. business investment remained sluggish late in 2019 and was a drag on U.S. economic growth in the second and third quarters and is likely to do little to support growth in the fourth quarter.
There are prospects for an improvement in business investment in 2020. A string of recent developments have been seen as positive for manufacturers. Included in that progress have been trade talks between the U.S. and China, the completion of a new trade deal with Canada and Mexico, and Federal Reserve policymakers’ intentions to maintain the current low level of interest rates. The easing of trade tension between the U.S. and China might ease some of the uncertainty, and lead to an increase in business investment.
Fed’s Interest Rate Policy
The Federal Reserve has cut interest rates three times in 2019 on worries that weakness in trade, business investment and manufacturing, and slowing global growth could derail U.S. growth by triggering cutbacks in spending and hiring. The Fed’s benchmark interest rate—currently in a range between 1.5% and 1.75%—has provided less support to the economy in 2019 than policymakers thought. Annual U.S. inflation has been running below 2% for most of the past decade. With inflation weak and economic growth slowed in 2019 than 2018, the Fed could likely be on hold for the foreseeable future.
The trade-weighted value of the U.S. dollar has more or less been unchanged on balance relative to a year ago. Although the Federal Reserve has cut rates by 75 bps since July, most major central banks have continued to maintain extraordinarily accommodative policy stances. With interest rates expected to remain historically low for the foreseeable future, foreign exchange market participants may well look toward economic growth differentials for insight into currency market moves. With U.S. economic growth expected to slow further, at least in the near term, and with foreign economic growth showing some signs of bottoming out, the U.S. dollar may depreciate modestly throughout 2020.
The U.K. Conservative Party’s victory in the December general election has paved the way for approval of the withdrawal agreement allowing the U.K. to leave the E.U. with a deal in place by January 31, 2020. This would merely mark the end of Brexit phase one, as attention will now likely shift to E.U.-U.K. trade talks which should begin in late Q1-2020 or Q2. The current withdrawal agreement has provided a “transition period” of only 11 months, which may not be enough time to finalize a deal. Therefore, it would seem likely both sides would agree to extend deadlines to continue conducting trade talks, which could be a downside risk for the U.K. economy. The 2020 Brexit environment should be similar to the 2019 backdrop, with hand-wringing over deadlines and multiple rounds of negotiations. Consequently, U.K. economic growth is likely to remain subdued in 2020.
The Global Economy
It was a challenging year for the global economy in 2019, and 2020 is not shaping up to be much easier. Several factors have combined to restrain the performance of the global economy. The most pronounced area of weakness has been the industrial sector, with industrial output in contraction territory for many key economies during recent months, including Canada, the Eurozone, Japan, and the United Kingdom.
One of the key factors contributing to the industrial downturn has been the extended and persistent escalation of trade tensions between China and the United States. The longer the industrial sector remains under pressure, the greater the risk of a spillover of weakness into the consumer and services sectors.
Although the industrial sector has been a cause of concern, the consumer and services sector has, so far, generally been a source of confidence. Job growth has been relatively solid and, with unemployment rates low by recent standards, wage growth has picked up across many countries and regions. Moreover, the modest rate of CPI inflation across many economies has added to the real purchasing power of consumer incomes.
With monetary policy settings in most major economies already aggressively easy and fiscal policy unlikely to loosen much, the outlook has remained for steady and subdued economic growth. Economic growth in most foreign economies will remain modest over the next two years. Global GDP growth will be 3.0% in 2019, which would be the slowest pace of growth since the global recession of 2008 and 2009. Global GDP is also expected to be about 3.0% in 2020.
Eurozone GDP growth is expected to be at 1.0% in 2020, down slightly from 1.1% in 2019. Meanwhile, despite the recent rise in underlying inflation, inflation expectations remain subdued and the ECB’s inflation target remains a long way off at this point. Accordingly, the ECB is expected to cut its deposit rate an additional 10 bps to -0.60% in Q1-2020.
For Japan, GDP growth of only 0.5% in 2020 is expected compared to 1.0% in 2019. The consumption tax increase that went into effect in October in Japan will likely further lower GDP growth in 2020. Growth in investment spending in many foreign economies in 2020 will also remain sluggish as long as trade tensions between the United States and China continue to linger.
Major emerging markets like China and India will likely also see a drop in GDP growth rate in 2020. China’s export and industrial sector have been hard hit by trade tensions with the United States, with the growth of industrial output registering its slowest increase since the early 1990s. While Real GDP Growth adjustments to monetary and liquidity policy in Euro Area (19 Countries) Japan response to subdued economic performance are expected, those policy adjustments willlikely be calibrated to achieve an orderly growth slowdown. As a result, China’s GDP growth should slow to 5.8% in 2020 from 6.1% in 2019.
The U.S. economy has continued to plug along, but has pulled back from the robust pace of 2018. Consumer spending on goods and services plus housing growth has formed the key pillars of a U.S. outlook that foresees the economy expanding 2.0% in 2020, a slight cooldown from 2.3% in 2019. Underlying this view is the strength of the labor market, absorbing more and more workers, while wage growth should hold at fairly robust levels. And, with low-interest rates, the ingredients are present for household spending to rise at a sustainable rate in 2020.
In contrast, business investment will be less supportive of the outlook. Manufacturing output has been in a slump globally in 2019, and recently in the U.S. Despite a phase one trade deal with China, trade policy uncertainty will not likely diminish enough to see a big resurgence in private investment. Outstanding trade disagreements remain with China, the EU, and other nations. What’s more, political uncertainty associated with the November 2020 election is likely to hamper plans by businesses to expand capacity until further clarity on the likely direction of future policies.
The plunge in mortgage rates is already supporting stronger housing activity, with residential investment rebounding in the third quarter and housing starts continuing to trend higher. That boost should soon feed through to other rate-sensitive sectors like household durables consumption and, with trade uncertainty starting to ease, lower corporate bond yields are expected to eventually drive a recovery in business investment too. With inflation likely to remain subdued, the Fed will reinforce that supportive backdrop by keeping interest rates on hold for the foreseeable future.
Weak foreign demand combined with elevated economic uncertainty does not bode well for a quick recovery in global industrial production. Instead, it raises concerns about whether consumers worldwide will remain stalwart in the face of persistent uncertainty. The global economy has regained some of its footing, with recent economic and trade developments in the U.S. and China offering some comfort that the slowdown has eased. In 2020, global GDP growth should be around 3% largely due to supportive government policies. Recent progress on Brexit and U.S.-China trade relations are signs that headwinds to growth may diminish somewhat in 2020.
Economic Downside Risks
In 2019, the tariff pass-through impact for consumers was limited in the U.S., by design. Initially, consumers were shielded, but the effects on prices have been surfacing. Any further re-escalation of the ongoing trade conflict between the U.S. and its major trading partners, including China and the EU, would risk more damage to confidence and goods inflation. Higher prices for consumer goods would likely erode growth in real income that could exert headwinds on growth in consumer spending. The largest macro concern as we head into 2020 is the current U.S.-Iran stand-off. Beyond yet more geopolitical uncertainty, it is the potential lasting impact on oil prices it might have if and in what ways the conflict escalates.
There are also uncertainties related to the November 2020 U.S. election to consider. Could the polarized nature of American politics today and the wide range of potential policy outcomes cause consumers and businesses to take a cautious approach to spending in 2020?
The outlook in most foreign economies would brighten if trade tensions between the United States and China should subside and, conversely, the outlook would darken if tensions increased further. The Brexit process has continued to cast a cloud of uncertainty over the U.K. economy as well as the European Union. A Chinese crackdown in Hong Kong, should one occur, could also impart a negative shock to global growth prospects.
To summarize, in the United States, no economic recession is expected, but the signs of an aging economic cycle are increasing. The most likely scenario is that the economic expansion that has been underway in the United States will continue for the foreseeable future, although at a subdued pace. Likewise, economic growth in most foreign economies will remain modest in 2020. However, the unsettled political and geopolitical environment at present imparts more uncertainty than usual into this economic outlook.
Geopolitical risks that dominated the news cycle for much of 2019 subsided a bit during the year’s final quarter. Trade policy uncertainty, in particular, faded with the announced “phase one” trade deal between the U.S. and China. And in the UK, near-term political uncertainty fell following the Conservative Party’s landslide general election victory. The fourth quarter also saw the Federal Reserve’s third rate cut of 2019 followed by a statement indicating that “the current stance of monetary policy is appropriate.” No further rate cuts are expected in 2020. Given this backdrop, U.S. equity markets produced strong gains and ended the year near all-time highs. The U.S. benchmark S&P 500 rose by 9.1% during the quarter. Results overseas were also strongly positive as the MSCI EAFE index gained 8.2%, and the MSCI Emerging Markets Index jumped 11.8%. Fixed income markets produced modest quarterly gains. The Barclays U.S. Aggregate Bond Index rose 0.2%, while the Barclays Global Aggregate ex. USD Bond index was up 0.7%.
U.S. equities generated strong gains in the fourth quarter driven by an improved economic picture, alleviated trade tensions, and a dovish Fed. The U.S.-China trade deal eliminates planned new tariffs, while U.S. tariffs imposed in September are to be reduced by half. Other U.S. tariffs on Chinese goods remain unchanged. In turn, China has agreed to increase purchases of U.S. goods, particularly agricultural products. The deal is scheduled to be signed in mid-January. The technology sector responded positively to the easing of trade tensions, rising more than 14% during the quarter. Growth stocks continued to best value names, but for a change of pace, small companies outperformed larger ones. Overall, it was generally a “risk-on” quarter where bond proxy sectors, including real estate and utilities, significantly lagged as yields rose and investors sought risk.
Developed international equity returns for the quarter were strong, but trailed those generated in the U.S while emerging markets produced a gain of nearly 12%. European equities, as measured by the MSCI Europe index, gained nearly 9% during the period. European stocks were supported by the previously mentioned phase one trade deal between the U.S. and China as well as better economic data from Germany. Christine Lagarde took over as president of the European Central Bank on November 1st, and, in her first major speech, encouraged governments to boost public investment. The MSCI UK index gained nearly 10% during the quarter as markets responded to the reduction in near-term political uncertainty following December’s landslide general election victory for the incumbent Conservative Party. In Japan, equity markets lagged broader international indexes but still produced a solid gain of more than 7%. Significant Japanese economic developments included the consumption tax increase on October 1st and announced greater planned fiscal stimulus. Emerging markets showed strength during the quarter as geopolitical risks eased. China, the index’s largest constituent, rose nearly 15% as markets reacted positively to the U.S.-China trade agreement. The other BRICs, Brazil, Russia, and India, also produced gains during the quarter. Brazil gained more than 14%, aided by a stronger currency. Russia, benefitting from crude oil strength, rose almost 17%. And India gained a more modest 5.3% as the country faced economic and political turmoil.
Government bond yields rose during the quarter as sentiment improved and investors sought risk. The U.S. 10-year Treasury yield increased 26 bps while the two-year yield dropped five bps. The steepening yield curve reflected a more optimistic view of the economy. Overseas, the 10-year German bund jumped 38 bps and finished the quarter at a negative 0.19%. The 10-year UK gilt yield increased 33 bps amid optimism surrounding Brexit. U.S. corporate bonds outperformed government issues, and high yield bonds continued to produce strong results. U.S. high yield bonds generated a return of more than 14% for the year. Finally, emerging markets delivered solid fixed income results. Local currency emerging market bonds did especially well as EM currencies showed strength in December.
A year ago, markets were nervous amid concerns about U.S.-China trade policy, a less accommodative Federal Reserve, continued Brexit delays, and numerous other geopolitical issues. Throughout the year, a recession seemed possible as global manufacturing contracted and the U.S. yield curve inverted. Today, central bank easing, the apparent de-escalation of trade disputes, and generally encouraging economic data have pushed global stock markets higher, with U.S. equities reaching new all-time highs by the end of 2019. Significant uncertainties remain, however, including the potential re-escalation of trade conflicts, a shift in central bank policies, the agenda of the next occupant of the White House, and other geopolitical risks including unrest in Hong Kong and actions by Iran. All things considered, the outlook for 2020 is cautiously but return expectations should be lowered.
In the U.S., volatility is expected to persist in 2020. Markets should enjoy tailwinds in the form of 2019’s three Fed rate cuts and improving business sentiment driven by recent progress on a U.S.-China trade deal. The fading effect of the 2017 tax cuts and uncertainty about future tariff policy, however, offer potential headwinds. The upcoming presidential election cycle has the potential to generate additional volatility given the wide range of possible policy outcomes, particularly in the areas of taxation, regulation, and trade policy. The wide gap between stock market performance and corporate earnings suggests equity returns may be only modest in 2020. A reacceleration of global growth and a weakening dollar have the potential to drive better than expected corporate earnings. Weaker than expected earnings will likely pressure multiples. Given the maturing economic cycle, many geopolitical uncertainties, and richer current valuations, an emphasis on quality holdings with durable profit streams and reliable dividends may prove propitious.
International developed equity markets sharply lagged their U.S. counterparts in 2019. Going forward, international stocks are expected to produce returns more in line with U.S. stocks, thanks to more reasonable valuations. Notably, international stocks tend to be more economically sensitive than U.S. stocks. Therefore, should global growth reaccelerate, international stocks may offer greater upside potential. An easing of geopolitical tensions and a corresponding rise in business confidence have the potential to drive valuations higher and produce a stronger result for the asset class. Compared to twenty years ago, global stock markets are currently less synchronized with each other. This suggests that a globally diversified portfolio may help effectively manage risk. To take advantage of this diversification benefit as well as currently attractive valuations, investors with a significant below benchmark allocation to international equities may want to consider increasing their exposure.
Emerging markets continue to have uncertainties stemming from the U.S.-China trade conflict, softening economic growth in China, and other global challenges that are likely to persist. Emerging market economic growth is expected to be strong but muted by ongoing difficulties for companies and economies sensitive to weakness in global manufacturing. On a positive note, valuations are attractive, with the MSCI Emerging Market index trading at a year-end forward price-to-earnings ratio just south of thirteen. Additionally, central bank policies outside of China are likely to remain supportive, and an increase in global economic growth would certainly boost this asset class. Finally, moderate U.S. dollar weakness wouldn’t be unexpected, and emerging market stocks should benefit from relative local currency appreciation. In short, some exposure to this asset class is certainly appropriate, but the shorter-term risks suggest that caution is prudent.
Rates across the yield curve that remain near historically low levels and are supported by subdued inflation, modest economic growth, and central bank liquidity. These circumstances are likely to drive U.S. fixed income markets soon. However, with greater rate stability expected from the Fed, investors are unlikely to benefit from falling yields to the same degree they did in 2019. Within credit markets, investment-grade bonds appear attractive relative to high yield where valuations appear stretched. Investors should be cautious reaching for yield in this exceptionally low-yield environment. Returns for international bonds to be marginally lower than those for U.S. bonds given the relatively lower yields offered in non-U.S. developed markets. Municipal securities remain a viable option for investors in higher tax brackets. Selectivity is key, however, as limited supply and strong demand have pushed valuations higher. While fixed income returns in the near-term are generally expected to be low, their fundamental role in client portfolios remains unchanged. High-quality bonds should continue to play a key role in managing portfolio risk.
Sources: Department of Commerce, Department of Labor, Morningstar, Bloomberg, Institute for Supply Management, the Conference Board, Eurostat
This article was produced for Middleburg Financial by Capital Market Consultants, Inc.
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