BY: JIM McELROY, CFA
The word “halcyon” has an interesting derivation. According to Greek myth, two married lovers compare themselves in their happiness to Zeus and Hera. For their hubris, Zeus kills the husband by thunderbolt and the grieving widow (Alcyone) drowns herself in the sea. The other gods take pity on the couple and change them into kingfishers, which, again according to myth, make their nests on the surface of the sea during the seven days before and after the winter solstice. The gods further assured the couple and their descendants that the seas would be calm and the winds mild during this period of incubation.
Halcyon (from Alcyone), the Greek word for kingfisher, describes a period of calm, peace and elation, an apt adjective for the holiday season, and not a bad descriptor of the current state of the financial markets.
2019 is ending with a lot of good cheer: the S&P 500 is up 28% for the year; the much feared inverted yield curve has returned to a healthy and positive slope at rates attractive to borrowers; the U.S. unemployment rate continues to set record post WWII lows; the fully employed domestic consumer remains a strongly additive force to the seventy or so percent of the economy it controls; the Fed has signaled that barring a dramatic increase in unemployment or inflation, changes in interest rates are on hold; and both sides in the Sino-American trade war have declared a cease-fire, pending further negotiations.
With the stock market hitting new highs on an almost daily basis and the economy posting ever more positive results — now the longest uninterrupted expansion in the post WWII era — one might be tempted to declare the end of cycles and bear markets and to accept the arrival of a New Millennium. Our experience with the fatal phrase, “it’s different this time,” is enough to keep such temptations at bay. But we must admit, from the vantage point of late December 2019, the portents for 2020 appear to be good.
Before we sink too far into the eggnog, however, we should acknowledge that there are several potential troubles on the horizon. The year 2020 is an election year and, based on the partisanship of recent days — the President has been impeached for only the third time in history — the body politic of the nation will be subjected to an extremely divisive year. For now, the partisanship has had little impact on the world beyond the city limits of Washington D.C., but as the year progresses and the campaigns of each party promote their differences in predictably intemperate language, we should expect that Wall Street, as well as Main Street, will be shaken by the prospect of either party winning.
The world economy, outside of the U.S., seems to be mired in recessions, near-recessions or “growth recessions.” A good bit of the blame for this weakness overseas is due to the assertiveness of the Trump administration in using tariffs to protect U.S. industry and laborers. The U.S. tariffs have begotten foreign tariffs and, in the case of China, a true trade war. For now, the trade war with China appears to be on hold, but if the past is any kind of guide to the future, negotiations will likely break down several times during 2020 and trade wars will return.
Eventually, high tariffs and trade wars beggar everyone, including the U.S. On this subject, it’s certainly good news that the USMCA (the successor to NAFTA) has been ratified and signed. We can hope that this is a harbinger of better trade relations in the coming year.
The turmoil in global trade has a direct impact on U.S. manufacturing. The Institute for Supply Management in its most recent Purchasing Managers’ Index shows a reading of 48.1, the lowest reading since the end of the Great Recession. It’s often suggested by Wall Street analysts that since consumer spending represents anywhere from 60% to 70% of domestic GDP, the other components of GDP — government spending, net exports and investment — are of secondary importance; as long as the consumer is experiencing low unemployment, rising wages and high confidence, the economy should be healthy. Since manufacturing only employs about 17% of the workforce (services employ 81% and agriculture 2%), it’s assumed by many that slowdowns in manufacturing are of minor importance the economy. And this is largely true in the short term.
In the long term, however, the manufacturing sector is critical to continued growth: it produces 92% of the nation’s exports, 65% of research and development spending and 42% of growth in productivity. In a global economy, where all developed nations and many developing nations are experiencing zero or negative population growth, an extended decline in manufacturing, with related shortfalls in R&D spending and productivity, will put a significant “crimp” on long term growth. For now, however, focusing on the near term, the prospects for the economy in 2020 appear positive.
A positive economy suggests a positive stock market, and we’ve certainly seen that in the closing days of 2019. And yet, despite the new records being set on an almost daily basis, the current level of the U.S. equity market does not suggest irrational exuberance in earnings expectations for 2020. The P/E multiple on future earnings is 19.7 and on trailing earnings is 21.5, suggesting an earnings growth rate of 9.1% (some brokerage firms place the earnings growth expectation even lower, at 6%) well below the average and median rates of earnings growth since 2008 (33.2% and 12.4%, respectively) and over the last 30 years (14.8% and 12.1%, respectively).
It’s true, that the absolute level of P/E multiples is above average, but this may reflect more the absence of competition for returns from fixed income and other markets than an overabundance of optimism about growth. The second longest bull market since 1928 (the longest, from December 1987 through March 2000, lasted 12 years and about 3 months) may very well continue into the new year.
In the fixed income markets, the concerns over the last year that the Fed would incite a recession by raising rates too far and too fast, have so far proved to be overly pessimistic. After holding short term rates near 0% during the Great Recession and for the six years which followed, the Fed began lifting rates from 2016 through 2018, ultimately reaching a target range between 2.25% and 2.50%. But, because of concerns about a stubbornly inverted yield curve (short rates higher than long rates) and a global slowdown due to tariffs and trade hostilities, the Fed this past summer embarked on a mid-cycle adjustment: in three steps, it lowered the rate to a range between 1.5% and 1.75%. The latest from the Fed is that they consider this current range enough for now to meet the twin goals of full employment and price stability.
The market expressed its confidence in the Fed by delivering a positively sloped yield curve: as the upper range of the overnight rate dropped from 2.5% to 1.75%, the ten-year yield on the U.S. Treasury rose from 1.47% to the current 1.92%. We expect the ten-year rate to increase gradually and for the yield curve to remain positive and moderately steepen over the coming year. Critical to these expectations is the belief that inflation will be held in check — near 2% — and that employment levels will remain high. If these assumptions are shaken or overturned, 2020 could provide a very bumpy ride, both for bond and stock investors.
We began this commentary with a Greek myth about lovers, hubris, divine wrath, transformations and peace. After exhibiting much hubris trying to forecast the future, we confess that we’re bracing ourselves, if not for thunderbolts, then at least for condemnation for our bad guesses. But we must say that at this time of year, with the kind of returns we’ve experienced, it’s hard not to be positive about the future. And we have seen several kingfishers flashing over the lake where we live.
About the author: Over an investment management career covering nearly forty years, Jim McElroy has served as portfolio manager, partner, mutual fund manager, Chief Investment Officer, President, consultant and writer of commentary for several financial institutions and private firms. In addition to a Ph.D. and an MBA, he is the proud holder of a Chartered Financial Analyst designation.