2019 was very good for investors. Stocks, as measured by the S&P 500 Index, returned 31.5 percent for the year, making it only the 18th calendar year since 1930 that the index showed a total return greater than 30 percent. And, unlike most equity rallies, bond investors weren’t left out of the fun, as a potent combination of accommodative monetary policy and a strong appetite from investors drove total returns of nearly 9 percent for the Bloomberg Barclays U.S. Aggregate Bond Index. Because investors often rush exuberantly into risky assets like stocks at the end of a market cycle, some pundits see continued investor demand for bonds—despite low yields—as a sign that this 11-year bull market may still have some room to run.
What was perhaps most striking about the capital markets in 2019 is the magnitude of returns relative to nearly everyone’s very low expectations at the start of the year. As is often the case, great returns often occur when you least expect them—as do large declines. This is why market timing is so dangerous.
In fact, the presence of a troublesome list of worries at the beginning of 2019 may have helped propel markets to new highs, a phenomenon described by the financial media as “climbing a wall of worry.” This means that reluctant investors become more and more willing to buy risky assets at higher prices as they tick off worry-list items, one by one.
In December 2018, investors stared up at such a wall. After experiencing the worst year for stocks since the financial crisis—with the S&P 500 Index down nearly 20 percent from its high point—investors faced a troubling list of worries. The list included concerns over escalating U.S.-China trade tensions, worries that the Federal Reserve was not positioned for slowing global growth, and anxiety that a divisive political environment could lead to government shutdowns and gridlock. On top of that, investors and policymakers alike worried that the global economy was heading toward recession.
Over the course of 2019, as these worries resolved or diminished in investors’ minds, markets rallied. As doubts decreased, stock prices increased, and credit spreads—a measure of bond investors’ risk perceptions—shrank to within striking distance of all-time lows.
The Federal Reserve resolved a major market worry when it reversed course, making three interest rate cuts. Against concerns over escalating trade tensions, markets celebrated progress toward the United States-Mexico-Canada Agreement (USMCA) as a replacement for the North American Free Trade Agreement (NAFTA) and, late in the year, the announcement of a phase one deal between the U.S. and China. Lastly, despite much rancor, the current political divide did not translate into stock market volatility or another government shutdown.
As we look ahead to 2020, investors are again sizing up their worry list, including some new worries and some resolved worries from 2019 that could resurface.
Middle East Tensions
Tensions simmered throughout much of 2019, including attacks on oil tankers in the Persian Gulf, attacks on critical oil production infrastructure in Saudi Arabia, and the downing of a U.S. drone. As we start the year, Middle East tensions risk boiling over through a rapid-fire series of escalating tit-for-tat events.
In late December, a rocket attack by a group believed to be linked to Iranian forces killed a U.S. contractor in Iraq. The U.S. retaliated with airstrikes at five facilities in Iraq believed to have ties to the Iran-backed militia, causing a backlash within Iraq and demonstrations at the U.S. Embassy in Baghdad.
On January 3, the U.S. conducted a precision drone strike near the Baghdad airport that killed a top Iranian general, Qasem Soleimani and announced the deployment of approximately 3,000 soldiers to the region. Iran announced it was ending its commitment to the Iran nuclear deal, and the Iraqi parliament voted to expel U.S. troops. Then, on January 7, Iran responded with missile attacks on Iraqi bases housing U.S. troops, after which President Trump announced new economic sanctions on Iran.
The market’s initial response to these events was significant, with overnight stock market futures falling and crude oil prices rising on fears of global oil supply disruption. However, fears abated by the opening bell, leading to more muted price moves. The magnitude of the U.S. energy renaissance, which has dramatically reduced U.S. reliance on foreign oil imports, is one likely mitigator to the market impact of escalating tensions. As shown in Figure One, U.S. oil production rose 96 percent from 2009 to 2018, making the U.S. the world’s largest energy producer and reducing the risk of supply shocks driving prices higher, with a corresponding hit to consumer confidence and spending.
Figure One: Top Three Global Petroleum Producers
Source: CAPTRUST Research
Corporate Earnings Growth
Although you wouldn’t think it given soaring stock prices, U.S. corporate earnings growth was paltry in 2019. As shown in Figure Two, S&P 500 earnings per share grew only 2 percent year-over-year in 2019, compared to an 18 percent advance in 2018.
Figure Two: Year-over-Year Earnings per Share Growth vs. S&P 500 Calendar Year Price Return
Source: Bloomberg, CAPTRUST Research
The earnings pop in 2018 was fueled by the significant reduction in the corporate tax rate from the Tax Cuts and Jobs Act of 2017. This tax cut led to a surge in business spending and investment as well as an increase in stock buybacks that served to elevate earnings on a per-share basis.
It is not uncommon to see S&P 500 earnings growth and price returns move out of sync, and there have been many instances over the past decade when price returns eclipsed earnings growth, or vice versa. But with prices at all-time highs and price-to-earnings ratios indicating that stocks are fully valued at current earnings levels, much of the support for future price appreciation must come from growth in corporate profits. Earnings expectations for 2020 reflect improvement from 2019’s low levels toward mid- to high-single-digit levels. However, it is important to remember that annual earnings estimates have a tendency to start high and trail down as the future becomes clearer.
The State of Global Economic Growth
Global economic growth is a critical precondition for rising corporate earnings. One of investors’ largest concerns in 2019 was the decline of gross domestic product (GDP) growth across the globe, particularly in parts of the world more sensitive to trade conditions, including China, Germany, and emerging market economies. Recently, we have seen signals that global growth conditions may be finding a bottom, including a steepening of the yield curve and improving economic conditions in Europe.
When the Treasury yield curve flattened and briefly inverted in late summer, many interpreted this event as a prediction of recession. The Fed seemed to take notice and introduced its first rate cut since the financial crisis. More recently, the yield curve has steepened, a healthy sign. In fact, the yield differential between 10-year and 2-year Treasurys recently topped 0.3 percent, the measure’s highest point in more than a year.
Global economic activity seems to be on the mend, thanks to growth-supporting global monetary policy moves that have helped keep interest rates low and a better outlook for a U.S.-China trade truce. Over the past two years, trade uncertainty has been a major headwind to global growth. But with U.S.-China tensions waning and the anticipatory export pull-forward behind us, there has been an improvement in global manufacturing activity, as reflected in the global Manufacturing Purchasing Managers’ Index (PMI) data shown in Figure Three. Looking ahead, we believe that the policy backdrop supports further upside.
Figure Three: Markit Manufacturing Purchasing Manager Index (PMI)
Source: CAPTRUST Research
Durability of Trade Truce
The phase one trade deal announced in December between the U.S. and China suggests progress toward resolving a major obstacle for the global economy and provides a positive sign for trade-sensitive economies and companies, business confidence, and profits. The announced truce suspended the tariffs on $160 billion of Chinese imports that had been scheduled to begin on December 15 and rolled back some tariffs imposed earlier in the year, in exchange for Chinese purchases of U.S. agriculture products and other concessions that have not yet been detailed.
Both sides of the trade dispute have strong incentives to de-escalate, even if the chances for a more comprehensive trade deal before the elections are small. And with the 2020 U.S. presidential election in sight, there is some concern that a de-escalation with China could merely shift the trade war to other parts of the world.
Following its series of three interest rate cuts in 2019, the Federal Reserve has clearly signaled a pause in further actions as it watches incoming economic data. After the last of these cuts, the minutes of the October Fed meeting explained that policymakers viewed the cuts as sufficient to support growth conditions, a healthy job market, and inflation moving toward its 2 percent target.
At the same time, Chairman Powell’s comments also served to quell the potential worry of negative interest rates—despite pressure from the White House to move in that direction—stating that it did not see negative interest rates as an attractive policy tool for the U.S..
Despite its pause, the Fed has other ways to supply economic fuel—namely through open-market operations to buy securities and increase the size of its balance sheet. The Fed has pursued such purchases to the tune of $60 billion per month since mid-October, causing the Fed’s balance sheet to swell to $4.2 trillion by year-end, as shown in Figure Four.
Figure Four: The U.S. Federal Reserve’s Balance Sheet Assets
Sources: Bloomberg, Federal Reserve, CAPTRUST Research
When it last employed quantitative easingoperations in the aftermath of the global financial crisis, the Fed was clear that such measures were intended to stimulate lending and investment. This time, it has struck a different tone. In an October speech, Chairman Powell stated that these security purchases were intended as structural measures to “maintain an appropriate level of reserves.” Call it what you will, the market reaction has been the same: a green light to lend and invest. If an injection of liquidity increases risk taking and dampens volatility, it has a stimulative effect on markets.
Political stability provides a foundation for global economic growth. But as we enter the 2020 election year, a great deal of uncertainty remains and is likely to increase from here. Although it may be too early for the U.S. presidential election to impact the stock market, by the end of March, more than two-thirds of delegates will have been determined, and we should have a Democratic front-runner for the presidential election. As shown in Figure Five, stocks have historically performed reasonably well during presidential reelection years, with average returns of 6.3 percent since 1948, and with less volatility than open presidential election years, reflecting investors’ expectations that incumbents tend to win reelection.
Figure Five: S&P 500 Index Average Performance in Presidential Reelection Years vs. Open Election Years (1936–2016)
Industry surveys suggest that most institutional investors believe that President Trump will be reelected. An RBC Capital Markets survey of nearly 120 institutional investors released in December reported that 76 percent of respondents thought he would win. However, one indication that this outcome may not be assured is the size of the gap between market expectations for his reelection and the president’s approval ratings. The reelection chances cited above would be more understandable if President Trump’s approval ratings were similarly high—not sub-50 percent, while in the midst of impeachment proceedings and Middle East crises. This disconnect could be a significant risk, or at a minimum, a source of increased market volatility if the political environment changes in a way that markets don’t expect.
After enjoying a blockbuster 2019, investors in 2020 should be mindful of potential obstacles to a repeat performance in 2020. Valuations across asset classes are higher, making it more difficult—although not impossible—to reach similarly outsized gains in the future without strong fundamental growth. Unlike last year, we have a Fed that seems more content to watch from the sidelines. With jobless claims at historically low levels, we’re unlikely to get an additional boost from the labor market, without commensurate pressure on corporate profit margins. And we face growing concerns around a growing U.S. budget deficit, which is expanding at a pace normally only seen during recessions.
But if last year taught us anything, it’s the reminder of
the perils of market timing. Few years have boasted near-30 percent returns
from the S&P 500 Index, along with high-single-digit returns for core U.S.
bonds. Long-term investors simply can’t afford to observe these kinds of
returns from the sidelines.
 Powell, Jerome, “Data-Dependent Monetary Policy in an Evolving Economy,” federalreserve.gov
 Maranz, Felice, “More Investors Expect Trump to Win in 2020: RBC Survey,” Bloomberg.com