Fire Capital’s 2020 Outlook
Are We There Yet?
2019 — A Banner Year
As investors, we are trained to live in the future. That can sometimes leave us susceptible to not appreciating the present. With that said, let’s take a moment to pay homage to 2019 for what it was — a banner year for investing. From bitcoin to gold, and from stocks to bonds, assets outperformed even the loftiest of forecasts due to ideal financial conditions. As we ponder what’s in store for 2020 and beyond, we are compelled to first consider where we are today. To help with this, we often find it helpful to look at how we arrived here to better understand how the various paths forward will reveal themselves. As of late, we are confronted with the fact that, as Mark Twain apparently once said, “History does not repeat itself but, it often rhymes.” In 2019 we saw the milestone surpassed as the longest continued expansion in U.S. history.
Consequently, questions about how and when it will end are natural. We cannot help but be reminded of the classic scene depicted by children insistently asking their parents during a seemingly never-ending car ride, “Are we there yet?” To answer this, we will evaluate the many events that contributed to the current state of the global economy — namely central bank accommodation, record highs in the U.S. equity market, and the ever so unpredictable geopolitical environment.
Don’t Fight the Fed
In a rather abrupt about-face in 2019, the U.S. central bank, the Federal Reserve, cut interest rates once again. Lower interest rates through monetary policy action are intended to spur economic growth by making spending as easy as possible — be it by consumers, businesses, and governments alike. The fundamental premise here is twofold:
- Borrowing is seen as more enticing because the burden (interest payments) to repay is low.
- The prospect of holding cash reserves is less attractive since there is little compensation (interest received) for holding that money in a bank account.
The natural and intended effect is that spending increases and the economy continues growing — at least at first. As time passes, continuously lower interest rates are necessary to entice further spending. With interest rates held low through central bank policy throughout the developed world, additional effort is needed to ensure that low interest rates stay low in the face of mounting debt. To accomplish this, central banks often purchase bonds of various types and maturities from banks. The purchases of these bonds are typically financed by borrowing by the government. This action provides banks with the necessary cash to lend to borrowers while meeting their cash reserve requirements against those outstanding loans. This cycle, which started in the financial crisis, still continues today.
What we have started to see since the beginning of the last quarter of 2019 has piqued our interest. The Federal Reserve has engaged in a sudden large amount of activity through the “Repo” market, to ensure that banks have the funds they need to meet their needs. While this is not a typical tool used for monetary policy as described above, and although the Federal Reserve claims to have everything under control, further intervention should be viewed as potential signs of instability in financial markets. We will be watching this closely.
The Price You Pay
The Federal Reserve has given signals that interest rates will remain low for the foreseeable future, the labor market reflects continued job growth, and home prices remain high. These factors, among others, tend to contribute greatly to a high degree of consumer sentiment towards future prospects. The general outlook of consumers is well illustrated in the so called “Misery Index,” which combines the level of inflation with the unemployment rate to measure how disposable income may contribute to happiness (or lack of misery). The Misery Index has not reflected levels this good in 60 years. And given that the consumer contributes as much as 70% to U.S. economic growth, this lack of misery must manifest into continued spending and therefore economic growth. All of this together has allowed for extremely favorable financial conditions for business activity (tariffs not with-standing), but U.S. corporate earnings growth has yet to materialize. As indicated in the chart below, nearly all of the returns in the S&P 500 for 2019 were driven by multiple expansion, opposed to actual profits. What we are looking for in 2020 is that this environment translates into greater profitability in order to justify the current level of valuations seen in today’s equity market.
The Buffett Indicator
Warren Buffett recently shared his favorite metric for stock market valuation, the so called “Buffett Indicator”, which compares market capitalization to GDP. This infamous gauge recently crossed 150%. The last time this happened was just before the tech bubble popped twenty years ago. We will be receiving initial indications of both fourth quarter GDP and corporate earnings in the coming weeks, and we will be watching closely for indications that this rally has more room to run.
U.S. — China Trade
Geopolitics continue to shape our social and economic landscape and we expect this year to be no different. Late in 2019, China and the U.S. agreed in principal to the “Phase One” trade deal that would begin to bring relief to the billions of dollars in imposed tariffs impeding economic activity through-out the world. While far from a comprehensive free trade agreement between the two sides, markets have welcomed the progress and rewarded the positive sentiment with further gains.
In the wake of a trade war that saw escalating tariffs from both sides, the U.S. emerged with the lowest trade deficit (imports minus exports) in three years. This has been part of President Trump’s initiatives and we expect him to capitalize on the momentum as negotiations progress throughout the balance of the year and beyond.
Within emerging markets, our preference towards Asian geographies remains as we see growth potential to outpace the rest of the developed world. We caveat that further progress in the trade arena will be necessary to achieve full potential.
Geopolitics & Oil
But the intersection of geopolitics and economic forces is not all about trade with China. In 2018, the U.S. emerged as the world’s largest energy producer. As a result, imports of foreign oil are the lowest in nearly three decades. This diminished reliance on foreign sources of energy has provided a welcome insulation from what otherwise would have been a tumultuous time for markets considering recent tension with Iran.
Historically, a spike in oil prices has contributed meaningfully to the onset of a recession in the U.S. Notably these effects reflect a prior regime where the U.S. was far more dependent on foreign supply. Our view is that oil prices are in a secular decline brought on in part by the increased supply of oil delivered from increased U.S. exploration and production. Therefore, tensions in the Middle East are likely to be less of a factor in the end of this business cycle.
Lastly, as we round out our assessment of whether global economic expansion will continue in 2020, our attention returns to the U.S. which will once again be counted on to lead the way. While much of the contribution to the present state of affairs has been a steady dose of favorable conditions provided by the Federal Reserve and positive sentiment on behalf of the consumer, a sudden increase in uncertainty about the future as we enter an election year is a primary risk for the upcoming year.
Another Election Year
While we won’t attempt to predict the outcome of the upcoming election, we are faced with an increasing probability that the democratic nominee will be from the far left. Our point here is not to make a political statement; only to point out that such an outcome would bring about more uncertainty. We cannot help but observe the stark difference in historical returns in years when the incumbent does retain the White House.
Looking ahead, U.S. equity markets have done a remarkable job of indicating who was likely to win the presidency in the months leading up to the election results. If the S&P 500 was higher in the 3-months
before the election, the incumbent party has won and if stocks are lower in the 3-month period, the opposition party has won. This has been true in every presidential election since 1984 and 87 percent of the time since 1928.
So, Are We There Yet?
So, are we there yet? In short, our view is “not quite.”
Due to elevated asset valuations late in the business cycle, the margin for error is very small for central bankers, corporations, and investors alike. Essentially we are operating in an all or nothing world, where caution is warranted.
The markets, in tandem with current economic conditions and policy, are set up for potentially extreme outcomes over the next 12 to 18 months. Global central bank stimulus and a healthy U.S. consumer argue for a world of steadily rising asset prices, while stagnant economic growth and low corporate profits, among other reasons, contend for the opposite.
Historically, corporate earnings have increased in environments such as this, but will need this to come to fruition in order to support current equity prices. The consumer is still strong and confident, but resiliency will be tested in the face of any increased uncertainty. There are signs of growing instability in the financial system, but as of now, seem to be under control.
With that said, now is the time to make sure portfolio allocations are well balanced as we continue to look for pockets of opportunity to allocate client capital. As always, we remain focused on our clients and their unique objectives, while protecting the capital with which we have been entrusted.
Disclaimer
The information in this report was prepared by Fire Capital Management. Any views, ideas or forecasts expressed in this report are solely the opinion of Fire Capital Management, unless specifically stated otherwise. The information, data, and statements of fact as of the date of this report are for general purposes only and are believed to be accurate from reliable sources, but no representation or guarantee is made as to their completeness or accuracy. Market conditions can change very quickly. Fire Capital Management reserves the right to alter opinions and/or forecasts as of the date of this report without notice.
All investments involve risk and possible loss of principal. There is no assurance that any intended results and/or hypothetical projections will be achieved or that any forecasts expressed will be realized. The information in this report does guarantee future performance of any security, product, or market. Fire Capital Management does not accept any liability for any loss arising from the use of information or opinions stated in this report.
The information in this report may not to be suitable or useful to all investors. Every individual has unique circumstances, risk tolerance, financial goals, investment objectives, and investment constraints. This report and its contents should not be used as the sole basis for any investment decision.
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