As we look into 2020, we see the possibilities of the following:
- Slowing economic growth in a mature global business cycle expansion
- U.S. central bank monetary policy headwinds (but more sensible support in Europe and Japan)
- Stable inflation
- Geopolitical and pandemic threats
Our portfolio positioning now favors a slightly more conservative asset allocation approach to global equities and fixed income with the following expectations:
- Long-term expected returns for all asset classes may be below returns experienced over the last ten years; however, returns for equities could be well above those for fixed income for some time, but with higher volatility.
- Several outside threats (the biggest of which include a Federal Reserve Bank monetary policy misstep, tariff policy changes/trade wars, possible pandemic, geopolitical turbulence, and a rising risk of a global economic slowdown) may continue to unsettle capital markets in the form of higher-than-normal market volatility.
- Global equity valuations are above long-term averages and may exhibit lower-than-average returns going forward.
- Real asset equity alternatives should offer low-correlation inflation protection and differentiated returns compared to traditional equity and fixed income.
Fixed income investments remain prudent, given potentially rising bouts of volatility.
Assuming your plan, risk tolerance, and investment policy are aligned, long-term investors need not take drastic action, but should continue to manage their plan.
What is a year?
A ‘year’ is nothing more than an arbitrary measurement of the time it takes our planet to rotate around the sun. Market participants have a tendency to focus on a year as the ultimate unit for investment performance measurement. We, ourselves, can be guilty of this misstep as well. Recall, we labeled the great investment performance during 2017 as "The Year That Made Asset Allocation Great Again." We followed that up by characterizing the awful investment performance in 2018 as the exact opposite! We will not make that mistake again, even though 2019 - again an arbitrary measurement of time - was fantastic:
A year is merely a moment in the longer and larger, tapestry of the average person's investment story. The inherent “recency bias” of most investors only recalls what the market has done lately and usually forgets that it’s really about the long-term path forward. The great year of 2019 stands out now, but may be forgotten as the ups and downs of the investment path forward set in. It’s the forward path that we should spend our time thinking about. While we don't like to forecast what will happen in any year or years ahead – because forecasting the future is not a recognized scientific possibility - we need to consider potential and probable outcomes in order to position our clients' portfolios accordingly.
Considering the investment future is only advisable if viewed as a part of the broader 10-year business cycle: The current business cycle expansion is the longest on record. Long-time readers may recall that the biggest risk to any business cycle expansion is the Federal Reserve Bank. There have been 14 business-cycle expansions (including the current expansion) and 13 recessions — and all except one were associated with the Fed raising short-term interest rates. In this instance, for us, correlation is, in fact, causation. It should be noted that, since the mid-1960s, the Fed has only been able to deliver three "soft landings," or periods where raising short-term interest rates slowed down the economy and inflationary pressure enough without triggering a recession.
There are two probable reasons the Fed policies are unable to keeping business cycle expansions going: (1) their tools to figure out where we are in the business cycle are rudimentary and imperfect (oh yeah, just like ours!); and (2) their control of short-term interest rates operates with a long lag, i.e., interest rates changes in the present don't fully permeate throughout the economy until 9-15 months later.
It is the second reason that keeps us cautious about the investment path forward and prescribing conservative positioning for client portfolios. The chart below shows the short-term interest rate that the Fed controls.
From the chart, the Fed kept interest rates at close to 0% between 2009 and 2015. From 2015 until the end of 2018 the Fed embarked on an interest rate hiking campaign and then subsequently lowered them later in 2019. It is the hikes in 2018, and their inherent lag that worry us today.
If it takes 9-15 months for us to see the ultimate results of those hikes, then it is possible that we have not yet felt the full effect of those changes. In other words, financial conditions may be poised to tighten up and constrict economic activity. Today there is no doubt the U.S. economy is slowing down from its most recent peak in mid-2018:
We believe this is due to the lagging effects of the Fed’s recent interest rate hiking campaign. The question is, how much further will the economy slow from here?
Virtually no one seems to expect recession in the near future; everyone seems to believe the Fed has delivered another soft landing. Although we seem to be alone on an island with our concerns about lingering business cycle risks, we believe it is too early to be in the "no recession" camp. If we can get through the summer without our business cycle leading indicators raising red flags, we would be more confident in joining the more optimistic camp. By the way, that camp's rationale centers on the very strong equity market we are currently enjoying. However, there is a precedent for equity markets to rise meaningfully late in a business cycle expansion. This was the case prior to the last three recessions! As an example, in 2006-2007, the S&P 500 Index soared 23% over a period of 14 months right before the Great Recession of 2008. The last six months have been unique in that the speed of the advance has been so intense with U.S. equities up about 40% from the lows in late 2018.
As we have mentioned before, there are a number of not so pleasant macroeconomic realities that continue to complicate our worries about the business cycle, including:
- The weakest economic expansion on record since 1948 when looking at overall GDP growth
- Slowing global economic growth - most notably China
- A protracted trade war that is creating uncertainty across global manufacturing supply chains
- The potential of a coronavirus pandemic
- The upcoming 2020 political election season
As responsible financial advisors, we have the humility to know we cannot predict the future with precision and know when a recession will be upon us. With sound financial plans in place, as mentioned above, we believe a slightly more conservative client portfolio asset allocation is prudent, given the intermediate-term environment we expect. The future direction of macroeconomics and, more importantly, capital markets in 2020 is still anyone’s guess. Questions regarding the timing of this cycle’s inevitable turn for the worse are certainly worth thinking about. As always, we focus on conducting ourselves as long-term investors delivering investment outcomes that help our clients meet their wealth-planning objectives.