A Look Back and Forward by Guest Blogger Buck Klemkosky

What a difference a year makes. At the end of 2018, the Fed had just raised interest rates for the fourth time that year and was forecasting three more in 2019. Stocks were plummeting and trade tensions rising. At the end of 2019, things don’t seem nearly as bad, even somewhat normal. The economy in 2019 did revert to the “new normal,” the 2% GDP growth rate of prior years. The year started out with first-quarter annualized GDP growth of 3.1% but it reverted to 2.0% in the second quarter and 2.1% for the third quarter. If GDP growth is close to 2.0% in the fourth quarter, growth for 2019 will be 2.3%, down from 2.9% in 2018.

The economy has faced several crosswinds in 2019. Certainly, the trade tensions have been one of the biggest headwinds in 2019. Even though a “Phase 1” trade agreement with China was reached in December, trade tensions are expected to continue not only with China, but Europe and Latin America. Trade tensions and policy uncertainties are the primary reasons that CEO confidence is at the lowest level in a decade. This corporate gloom has resulted in negative corporate investment in the second and third quarters of 2019. Other CEO concerns are slower synchronized global growth and a manufacturing recession in most developed countries plus China. In the U.S., manufacturing has contracted for six consecutive months. While manufacturing doesn’t play as prominent a role in today’s economy, 11% of GDP and 8.5% of employment, it is still considered an economic bellwether.

There are economic tailwinds. The biggest is probably the state of the consumer. Unlike the CEOs, consumer confidence is close to an all-time high. Unemployment of 3.5% is at a 50-year low, wages are growing at a 3% annual rate and jobs are still plentiful; there are still more job openings than people looking for jobs. Household balance sheets are in good shape and household net worth (assets minus liabilities) is at an all-time high. The consumer has been the pillar for the economy in 2019.

Other tailwinds in 2019 have been monetary and fiscal policy. After raising interest rates four times in 2018, the Fed did an about-face and cut rates three times in 2019. These were “insurance cuts” because of trade tensions, slowing global growth and the manufacturing recession. Even though the unemployment rate is at a historic low, inflation appears moderate as the Fed’s preferred measure of inflation continues to be below its 2% target. Monetary easing and subdued inflation have resulted in the bellwether 10-year Treasury bond yield falling from 2.68% at the beginning of 2019 to 1.92% at year end. This has been good for consumers, homeowners and corporate borrowers but financial repression for savers. The biggest benefactor of lower interest rates has been the U.S. government. As the effects of the 2018 tax cuts waned, the government attempted to stimulate the economy via spending and fiscal deficits; the deficit surpassed $1 trillion for the 12 months ending in October 2019 for the first time since the Great Recession of 2007-2009. These $1 trillion fiscal deficits are projected into the foreseeable future.

The stock and bond markets reacted favorably to the economic crosswinds in 2019. The S&P 500 appreciated 28.9% in 2019, the best year since 2013. To keep this in perspective, some of the 2019 stock market appreciation was in reaction to the dismal performance in the fourth quarter of 2018; the S&P 500 peaked at 2930 in September and fell to 2351 by Christmas Eve day, a decline of 19.7%, excluding dividends. A decline of 20% would have been classified as a bear market, so it was close to being the first since 2007-2009. Since earnings growth was slightly negative in 2019, the stock market’s appreciation was all due to higher valuation metrics. Given the stock market performance, individual investors don’t seem to be enthused about the longest-running bull market in history. In 2019, investors have withdrawn more than $156 billion from equity mutual funds and exchange-traded funds – the largest withdrawals since they began tracking flows in 1992. There were record inflows into money market and bond funds in 2019. Going back 35 years, 2019 was the first time the S&P 500, crude oil and gold all appreciated at least 10%, and the 10-year Treasury yield fell .75%. Gold had its best year since 2010 and the S&P 500 since 2013. As both short-term and long-term interest rates fell in 2019, bond markets also performed well – the longer the maturity, the better the performance. It certainly paid to follow the Wall Street adage – Don’t Fight the Fed – in 2019.

Recessions tend to catch economists unaware, and the ones they do see coming often don’t happen. In 2018, many of the economic pundits were predicting a U.S. economic recession in 2020. But recession fears have been dialed back. One of the red flags of 2019 was an inverted yield curve – short-term interest rates higher than long-term rates; it has since uninverted. The other red flag was manufacturing; while still contracting, it is doing so at a decelerating rate and stabilizing. The outlook for the global economy is improving; the economies of the U.S., China and Japan have improved but not the Eurozone.

2020 economic growth hangs on the consumer; consumption is more than two-thirds of overall GDP. The household sector is in good shape; while debt is at an all-time high of $16.2 trillion at the end of the second quarter of 2019, it represents 76% of GDP versus 100% in 2008. Household net worth was $114.9 trillion at the end of the second quarter of 2019, a record high, and debt payments as a percentage of disposable personal income were 9.7% versus 13.2% in 2007. Shoppers have been the heroes of this record-setting economic expansion, 10.5 years and counting. Consumer spending will continue to be the primary force driving the U.S. economy in 2020 given the strength of the job market, wage increases and moderate inflation. Corporate investment is usually one of the driving forces in the later part of economic expansions and this has been missing in 2019. It would help if this could get back on track in 2020 to alleviate some of the burden on the consumer.

Monetary and fiscal policy will continue to be economic stimulants in 2020. But headwinds still exist; trade tensions with China and the rest of the world will not abate, and election worries will probably trump everything. There are wide differences among potential president candidates, and the primary process and election may affect consumer confidence and already deflated CEO confidence. Less trade and policy uncertainty would certainly help the latter.

One macro factor to watch carefully in 2020 is inflation. Many believe inflation is permanently muted because of globalization, demographics and price transparency at the consumer level. Thus far, the historical relationship between a record-low unemployment rate and inflation has not held up. If wage inflation picks up and the U.S. dollar weakens, overall inflation could perk up. If this happens, the Fed will be slow to counteract it by raising interest rates because it has adopted a symmetrical inflation policy whereby their inflation target will be an average of 2%. Since the inflation rate has consistently been below 2%, the Fed plans to let it run above 2% for some time before tightening monetary policy. Higher inflation would translate quickly into higher interest rates, certainly not good for the bond and stock markets.

Investors should not expect 2019’s stock market performance in 2020. In 2018, S&P 500 earnings increased more than 22% for the year and the S&P 500 fell 6% due to the bad fourth quarter. In 2019, S&P earnings declined and the S&P 500 increased 29% due to price-earnings multiple expansions, leaving valuations above historical levels. This could be justified based upon lower-for-longer interest rates. So interest rates will be a critical factor in how the stock markets perform in 2020. Another factor may be FOMO, fear of missing out. There are record amounts of money in money market and bond funds that could navigate into stocks. With bond yields at extraordinarily low levels, there are few alternatives to stocks. Real yields on bonds – the after-inflation return – is barely above zero and stocks do offer the possibility of capital appreciation and dividend growth. Plus stock buybacks offer some support for stock prices. S&P 500 earnings are expected to increase in 2020 relative to 2019 adding more support for the stock market. The consensus of stock market prognosticators is for market returns of around 5% in 2020 with 1.8% coming from dividends. Historically, election years have been good for the stock market with only two down years since 1948.

The consensus for U.S. economic growth in 2020 is the “new normal” of 2%. GDP is a function of the number of hours worked times output for worker. The number of hours worked has been increasing about 0.8% annually and productivity has also been increasing about 1.3% although it was negative in the third quarter of 2019. Given the low unemployment rate, the growth in the number of hours worked is expected to fall below 0.5% going forward. That leaves the heavy lifting to productivity and that has been trending down for several decades – 2.77% in the 2000s and 1.3% since 2010. It will take a dramatic increase in productivity to get GDP growth out of its 2% rut. This is a global as well as a U.S. problem.