As we say goodbye to 2019 and the decade of the 2010s, we thought it would be helpful to take a look at the forces appearing to exert influence over the investing world at this time. While we embark upon this overview with a look toward the future, we also bear in mind the difficulty of making too many predictions about the next decade.
“The only function of economic forecasting is to make astrology look respectable.”
— John Kenneth Galbraith
The one prediction that seems safe to make is that the new decade will not look like the last, just as last year’s winners may not repeat as this year’s winners. The 2010s were the first decade in United States history that did not see a recession. The decade was born with high unemployment, low stock valuations, and an economic recovery underway from the Great Financial Crisis of 2008. It was a great environment to be an investor. The 2020s are starting with low unemployment, high stock valuations, and expectations of a recession sooner rather than later — so this decade could be more challenging for investors.
After the large gains in stock and bond portfolios last year, does it makes sense to lock in those gains and move to cash? History would suggest the answer to this question is a resounding NO. As seen in the chart below, since 1950, in any year when stocks have been up more than 25%, the following year provided positive returns 81% of the time with an average return of 13%.
Source: Stocks are represented by the Ibbotson® Large Company Stock Index, which is represented by the S&P 500 Composite Index (S&P 500) from 1957 to present, and the S&P 90 from 1926 to 1956.
The performance of long-term Treasuries after years of strong growth is more mixed. During the same time period, in any year when U.S. Treasury Bonds have been up more than 10%, returns the following year were positive only 65% of the time. As seen below, long Treasury bonds have followed strong years with generally positive years as well.
Source: Bonds are represented by the Ibbotson® Long-term Government Bond Index (~20-year Maturity).
Additionally, recessions typically have not followed years with exceptionally strong equity and bond performance.
Globalization & Trade
Beginning in the 1990s, globalization was embraced fully and even accelerated from the trend of the post-WWII era with multilateral trade agreements, such as NAFTA and creation of the European Union, that propelled an interdependence of the world economy as never before. Falling trade barriers, outsourcing of manufacturing and technological advances all led to a virtuous cycle of economic growth without the ravages of inflation. Many expensive jobs were sent offshore, and the internet created pricing transparency that changed shopping forever, keeping inflationary forces at bay for the last decade. Toward the end of the 2010s, we saw a backlash against these forces of globalization with a spike in uncertainty surrounding the continued strength of these trade alliances. While we experienced periodic drops in the stock market over concerns regarding trade, there has been no significant lasting market impact.
Source: Baker, Nick Bloom and Steven J. Davis. It reflects the frequency of articles in American newspapers that discuss policy-related economic uncertainty and also contain one or more references to trade policy
Though there have been negative repercussions, the benefits of open trade have been felt worldwide. For example, globalization has been a contributing factor to the reduction in poverty around the world as can be seen in the chart below.
However, starting in the 1980s, the growth of middle-class incomes in the U.S. began to lag economic growth as measured by traditional GDP. This gap has continued to widen with each succeeding decade as can be seen in the chart below. Like a frog placed in a pot and brought to a slow boil, the real or perceived inequalities took years to manifest into discontent. The Great Financial Crisis widened the divide further, creating much of the financial insecurity people genuinely feel today and fueling desires for a rejection of the old trade order.
These forces will impact the world at large in the new decade of the 2020s. Solutions to problems will not be simple — and certainly will not be agreed on uniformly. Will globalization fall apart? Will there be regional agreements? Will this process slow or speed growth? Will inflation finally come back to haunt central bankers? As investors, we must continue looking past the politics and focus on the trends that follow to provide proper positioning of portfolios into the future.
As shown in the first chart below, job growth overall has been strong, and unemployment has fallen for 10 straight years. That said, the types of jobs in demand have been changing, as can be seen in the second chart. For example, job creation has occurred in the technology sector, while job destruction has happened in the retail sector. Job creation is likely to continue in the areas of computer systems design and home health care, but retail and department store employment likely will continue to struggle.
The offshoring of jobs has helped developing countries pull their populations out of poverty, but possibly has created a hole in the middle class of the West. A big initiative around the issue of middle-class employment has focused on manufacturing jobs. However, the push to bring high-paying manufacturing jobs back to the U.S. has had minimal impact, and manufacturing jobs growth is still mostly on the same weak trend of the past decade.
Source: Bureau of Labor Statistics
The 2010s were the first decade not to have a recession. However, there were a few near misses:
- Early 2010s: U.S. debt downgrade, Eurozone recession, Greek Crisis
- Mid-2010s: Taper Tantrum, U.S. Budget Sequestration
- Late 2010s: Chinese economic slowdown and, most recently, Brexit and the trade war
None of these events knocked the economy off course. Robust jobs gains and an accommodative Federal Reserve kept the economy’s wheels in motion.
However, the 2020s probably will not be so lucky to escape a recession. Signs of stress started to show last year as negative rates became commonplace globally, and the yield curves in the U.S. and in many places around the world inverted. The bond market was registering its concern for growth prospects in every possible way. The inversion of the yield curve in the U.S. prompted the Federal Reserve to act quickly to head off a slowdown, cutting rates by 25bps three times in 2019. So far, the economy has responded well to this injection of stimulus.
However, as previously noted, if the trend in jobs growth continues to slow, the yield curve again may be correct in its track record of recession forecasting. For now, Cardan is positioning portfolios for continued growth into 2020.
Market & Rates
As previously stated, if history provides any context, next year may bring reasonable returns for stock investors. Many Wall Street strategists also are projecting modest gains for the year.
However, as time passes, many of the asset classes change leadership by decade, as can be seen in the chart below. And before jumping to the conclusion that REITS and bonds will continue to stand out in providing consistently positive returns, bear in mind that interest rates have fallen for the last three decades. The falling rate environment benefited both of these yield-oriented asset classes, but rates are unlikely to continue to fall for the next 10 years. Yet at this point, we are not fearful of rising rates as we discuss later in this report.
The lackluster performance of international markets in the last decade may make them interesting candidates for ownership into the years ahead. U.S. stocks are historically expensive, while emerging-markets stocks are relatively inexpensive. U.S. companies are the most profitable and innovative in the world, and at this point, who doesn’t agree with that statement? U.S. stocks are now probably priced with that sentiment in mind — while issues surrounding emerging-market stocks are well known, making them deservedly cheap. Nevertheless, we may be approaching the point where valuations have fallen too low, and the geopolitical changes taking place may be the catalyst for those markets to outperform over the next 10 years. The S&P 500 has a price-to-sales ratio that is now above the level set in 1999 during the internet bubble, while emerging markets have a ratio that is right in the middle of their normal range.
Source: Bloomberg LP
Source: Bloomberg LP
Additionally, Apple and Microsoft are today worth more than the entire Russell 2000, as can be seen in the chart below. There is no doubt these are two of the best companies in the world and will continue to be. However, there are questions one must begin asking:
– At more than $1 trillion in market capitalization for each company, is all of the goodness priced into each stock?
– Is there a possibility that the 2,000 companies in the Russell have a chance to outperform Apple and Microsoft? And what about their FAANG brethren: Facebook; Amazon; Netflix; and Alphabet, parent of Google?
Source: Bloomberg LP
What about Gold? Will lackluster performance of the last decade be reversed? Gold generally performs well in periods when real interest rates (nominal interest rates less inflation) are less than 1 percent. We sit well below that level today, and so we expect gold to be a more productive asset into the future.
Source: Bloomberg LP
As for interest rates, we believe the multi-decade downtrend is not over given that the demographic and market forces in place for years likely will continue to anchor rates at low levels.
Events that may cause rates to go lower:
- A recession may cause U.S. rates to head towards 0%, according to a paper by the Federal Reserve Board’s financial stability unit.
- Geopolitical shock = flight to safety
What may cause rates to go higher:
- The possibility of stagflation, not unlike that observed in the 1970s, due to supply-chain disruption (slowing growth) from realignment of trade interests in combination of tariffs (increasing prices/inflation).
- Oil price shock due to continued tensions in the gulf.
- Demographic shift from the impact of the last of the Millennials’ entrance into the labor force. Total labor force appears to lead the inflation rate and interest rates by about three years with the implication being that rates may start to move higher in the middle of the decade.
Absent a geopolitical shock or a recession, 2020 should shape up to be a reasonable year for investors as an accommodative Federal Reserve policy and corporate earnings provide an underpinning to asset prices. A watchful eye needs to be maintained on the behavior of the bond market and the labor market for further signs of economic weakness. Last year’s yield curve inversion and continued slowing of payroll growth serve as a reminder that the economy is just above stall speed.
As the decade progresses, losers of the past, such as gold and international markets, finally may come into their own and compete with the powerhouses of the U.S. International markets actually could go from being a drag on performance to becoming a benefit to it.
With all of the issues we seem to need to tackle today, optimism always is warranted. A great quote from Warren Buffet from 2015 sums up why:
“I think if I’m sort of neutral about optimism or pessimism, and I look at the facts around me, I look at what has happened in my lifetime … put three of me end-to-end, and you’re back before the Declaration of Independence was written. That progress, in three lifetimes like mine, is mind-blowing. Indeed, who has ever benefited during the past 238 years by betting against America?”