2020 Themes & Questions

 

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A Discussion with Ms.G., One of Our Most Insightful clients1
“One who, fully prepared, awaits the unprepared, will be victorious.” – Sun Tzu, The Art of War

Executive Summary       

  • While the U.S. impeachment and volatile politics may cause uncertainty, history shows that markets typically react more to economic events than to politics.
  • Although too early to predict, the 2020 Presidential election has the potential to lead to policy changes that could impact corporate profits and stock prices.
  • The risk of recession is expected to remain relatively low for the next 12 months as the trade war impact recedes and monetary easing provides support.
  • Investors should maintain their long-term equity allocations, take steps to manage late-cycle risks and look for opportunities in volatile markets.

Preparing for 2020 with Ms. G.

While investing isn’t the same as war, Sun Tzu’s advice on preparation is still applicable. Many of our meetings with clients are about just this — looking ahead and preparing for what could happen. Sometimes this is personal financial planning. At other times, the discussion centers around the economy and markets, particularly towards year-end. A recent meeting with one of our clients, Ms. G., provided one of these opportunities: She asks the difficult and insightful questions that lead us to some of the most useful insights. 

As is typical of this time of year, the discussion focused on the year ahead and issues that were troubling her. Her three main considerations ranged from fractured politics and the trade war, to the unloved (but ongoing) expansion to concerns that monetary policy may have lost its efficacy, or mojo, as she put it. 

Theme #1: Fractured politics in 2020

Ms. G.: We might as well start with my first concern – politics. Impeachment seems to be in the works and an election is around the corner. How will this impact the economy and markets in 2020?

Glenmede: The inquiry into President Trump’s alleged quid-pro-quo threats to withhold military aid from Ukraine doesn’t appear to be fading away. However, as we have noted before, removal from office is unlikely because this would require a two-thirds vote in the Republican-dominated Senate. As your question implies, it may be more important to understand the market and economic impact of political events.

History doesn’t provide much evidence supporting a direct impact on stocks (Exhibit 1).  During the past two impeachment inquiries in modern history, stocks declined in one and rose in the other. 
The record shows that economic events — not politics — had the most influence on markets. These included the OPEC oil embargo during the Nixon impeachment inquiry in the 1970s, and the Russian ruble collapse and the implosion of hedge fund Long-Term Capital Management during the Clinton impeachment in the 1990s. While impeachment proceedings may contribute to volatility, it’s the economic environment that determines longer-term market performance. 
  

Ms. G.: Ok, you’ve told me before that I should avoid letting my political concerns impact my investment decisions. This may be one of those instances, but I’m still not settled because you haven’t addressed the potential impact of the 2020 election.

Glenmede: Here is where we are going to agree with you in part. While politics, like impeachment, is often surrounded by more noise than economically relevant substance, occasionally politics and economics can intersect. The coming election in the U.S. has the potential to mark another shift in power from Republican to Democratic leadership — and many economically relevant issues are on the table (Exhibit 2).

Potential impact of the 2020 election

The Republican agenda, led by the sitting President, has centered on economic issues, such as tax reform, trade policy and deregulation. His re-election would likely come with a continuation of that agenda. A change in power, however, would likely halt or reverse some of those programs. During the Democratic nomination process, candidates have proposed a relatively wide and comprehensive set of progressive proposals. These include higher income taxes on individuals and corporations, and even wealth taxes, to name a few. Also on the table is more stringent regulation of the economy, including tougher antitrust enforcement and environmental rules. Most of these changes could be made through executive orders, without Congressional approval. The potential for pressure on corporate earnings may be noted by investors and reflected in market performance. 

However, we suspect it may still be too early to predict who will win the Democratic nomination, much less the Presidential election and any shift in the White House policy agenda. We have noted before that despite what we may hear in the media, voters often do not start paying close attention to the election until after the first caucus (Exhibit 3). 

Still too early to predict the outcome 

Many candidates in the past have led in the polls heading into the Iowa caucus, but failed to secure their party’s nomination. At this point in 2003, Wesley Clark led the polls for the Democratic nomination, which he ultimately lost to John Kerry. In 2007, Rudy Giuliani and Hillary Clinton both had big leads, and eventually ceded ground to John McCain and Barack Obama, respectively. In the fall of 2011, Rick Perry led in the polls, yet Mitt Romney emerged from the convention as the Republican nominee. The critical takeaway: None of them went on to win their respective nominations.

Further, policies proposed in the nomination process often are not representative of what is accomplished by a sitting President. After winning the nomination, some candidates veer to the center to better position themselves for the general election. Once in office, others find that commanding from one side proves less effective than finding compromise in the middle. Not much sits in the middle ground, save for desires for broad infrastructure spending and, interestingly, more favorable trade policy between the U.S. and its partners abroad. As a result, with the degree of implementation and economic impact very much uncertain, we see little reason for the investor to do more than continue to monitor the situation for potential policy shifts.

Theme #2: Trade war and the unloved expansion

Ms. G.: We seem to share a worry that our political situation is very much in flux, but I can see your point that it may be a fool’s game to try to predict the outcome at this point. Let’s turn to a more pressing matter that affects our investment decision-making. The expansion has been quite long and has been facing new pressure from the trade war that threatens to slow growth. How worried should I be about recession?  

Glenmede: This is a good question at the heart of discussions with many of our clients. Let’s start with the trade war, most of which has been executed so far through a series of tariffs between the U.S. and China. Tariffs, in effect, are similar to a business tax because businesses directly pay most of the cost. Businesses can choose to either pass the cost along to consumers, or absorb it and reduce their profits. Either way, tariffs pose an economic headwind, reducing income for either consumers or corporations.

The trade war’s economic impact

There are important nuances affecting the likelihood of tariffs causing a recession. The trade war has already been under way for more than a year, with the first tariffs put in place in July 2018 (Exhibit 4). The timing is important because there is a difference between the impact of tariffs on overall economic activity (GDP) and on the rate of economic growth (GDP growth). While tariffs are a cost holding back the level of GDP, their impact on GDP growth has historically lasted for the year following imposition, after which GDP has grown from a lower level that already incorporates the tariff cost. Essentially, the economy has already endured the impact of the first tariffs and future growth faces a headwind only from more recent or future tariffs. As a result, prolonging the trade war has had the beneficial effect of spreading the cost over multiple years, making the economic impact manageable. In addition, the risk of further tariffs has diminished as a result of President Trump’s action in December to put future China tariffs on hold and approve a new trade agreement with Canada and Mexico.

Modest risk of recession

Ms. G.: That is a different way to think about the impact of tariffs and helps soothe me a little, but I still worry about whether the long expansion will soon come to an end. Can you help me with this?

Glenmede: We worry about this as well. While we don’t believe that existing tariffs alone would trigger a recession, we don’t rule out the possibility that companies could slow their spending materially, creating a self-imposed recession. For this reason, we continue to search for indications that the risk of recession is rising. Glenmede’s proprietary recession risk model — a balanced mix of indicators — currently shows only a slight 9% probability of recession in the next 12 months (Exhibit 5). Underlying this modest risk is a lack of built-up excesses in the system and an economy exhibiting enough momentum to continue its slow growth. Importantly, however, we have seen non-zero readings from this model since 2018, suggesting that there are chinks in the armor. While not our base case, a recession is not out of the question.

Growth rebound expected in 2020

While recession risk remains modest, growth has slowed. Global growth declined significantly in 2019 due to the trade war, slowing growth in China and other pressures. The picture appears to be improving as we head into 2020 with projections of a growth rebound (Exhibit 6). The consensus of opinion has begun to recognize that tariffs alone have not been large enough to cripple the global economy and central banks have provided a fresh round of rate cuts and other monetary stimulus to sustain the expansion.

Theme #3: Efficacy of monetary policy and negative rates

Ms. G.: That makes me feel better and brings me to my third question. Does monetary policy work anymore or, to put it my way, has monetary policy lost its mojo? It seems we have had low rates for a long time without much of a boost.

Glenmede: We hear this concern a lot in academic and professional circles as well. Many worry that monetary policy may not be effective anymore. We think the answer is nuanced.  We suspect that monetary policy is simply less effective than it used to be, but remains a necessary tool for managing the economic cycle.

An example of monetary policy’s impact and necessity can be seen in the past year. While many associated the 2019 slowdown with the trade war and tariffs, we believe the Federal Reserve’s rate hikes may have had an equally negative impact. The Fed hiked rates four times in 2018, driving up borrowing costs. The impact was quite noticeable in the housing market, where the interest rate on new mortgages jumped above the average rate on existing mortgages (Exhibit 7). As in the past, this slowed the housing market as buyers shied away from higher borrowing costs. The impact of rising rates in slowing the economy ultimately forced the Fed to reverse course and cut rates three times in 2019.

Limitations of monetary policy

While monetary policy still has an impact and needs to be monitored, there are now limits to what it can do. For example, its effectiveness falls materially when rates are near 0%. Interest rates at such low levels undermine the ability of banks and investors to profit from providing capital to the financial system. Banks, in particular, are heavily impacted. Not only have global rates approached zero in many cases, over $12 trillion in global debt carries a negative yield (Exhibit 8).

Low inflation allows the Fed to keep interest rates low 

Behind these low yields, of course, is an unusually low inflationary environment. Inflation, as measured in the Personal Consumption Expenditures report, has remained stubbornly below the Fed’s 2% target for most of the current economic cycle (Exhibit 9), This is a major change from the majority of modern market history, from the late 1960s through the mid-1990s, when inflation ran over 2%, with peak rates in double digits. Low inflation has permitted the Fed and other central banks to pursue the more aggressive monetary policies that have helped to prolong the expansion. We expect rates to remain relatively low as long as inflation remains in check.

Investment strategy in 2020: What should investors do?

Ms. G.: This has been quite helpful, sorting through the issues and putting them in a larger context. But this does leave one final question: What should I be doing with my investments? 

Glenmede: We believe the economic expansion will continue, despite potential risks. In general, the environment should be good for investors. Valuations for most assets, including equities and fixed income, are high, but markets can remain expensive for a prolonged period, provided the expansion continues (Exhibit 10).

Maintain long-term equity allocations

We should recognize when setting financial plans that above-average valuations imply lower returns over the next ten years. Nonetheless, investors should maintain their equity positioning for now. Equity allocations remain key to meeting longer-term return objectives due to their outsized return potential, compared to low-yielding bonds. However, this does not imply a set it-and-forget it approach.

The importance of risk management

Investors should have in place a risk management game plan. A first step is to include a modest allocation to some defensive strategies. These include exposure to lower-risk and higher-quality equities and alternative investments that can add some asymmetry to portfolio returns by helping to reduce downside risk. Additional risk management steps could include reductions in equity allocations under one of two potential scenarios: higher equity valuations or a sharp increase in expected recession risk.

Potential opportunities in Asian emerging-market, small-cap and value stocks 

Investors should also seek opportunity in the market volatility that we may expect to see amid trade uncertainties. Investment opportunities in the cycle’s late-stage may be found in three areas: Asian emerging-market, smaller capitalization and cheaper, value-oriented stocks. All have been relative laggards over the last year or more.

In conclusion, investors should behave as if the expansion were continuing, but never become complacent. Diligence in both risk management and seeking new investment opportunities should improve the likelihood of success in 2020.

1Ms. G. is a fictional client representing a collection of clients with similar questions and concerns

This 2020 outlook is intended to be an unconstrained review of matters of possible interest to Glenmede Trust Company clients and friends and is not intended as personalized investment advice. Advice is provided in light of a client’s applicable circumstances and may differ substantially from this presentation. Opinions or projections herein are based on information available at the time of publication and may change thereafter. Information gathered from other sources is assumed to be reliable, but accuracy is not guaranteed. Outcomes (including performance) may differ materially from expectations herein due to various risks and uncertainties. Any reference to risk management or risk control does not imply that risk can be eliminated. All investments have risk. Clients are encouraged to discuss the applicability of any matter discussed herein with their Glenmede representative.