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ECONOMIC FLASH- A Banner Year As Stocks Climb a Wall of Worry

Without an increase in corporate earnings, the equity markets are now fairly expensive across the board and vulnerable to disappointments. Stll, we don’t find current economic fundamentals disconcerting, and downside risk is most likely less severe than in the last few recessions.

December 2019

US Economy: Better-than-expected but slowing.

The revised reading on US economic growth in the 3rd quarter showed a 2.1% annualized rate of growth, faster than previously estimated. Consumer spending (+0.3% in October) will likely continue to support the expansion but analyst forecasts for 2020 suggest growth is likely to slow.

US Stocks: New highs on trade hopes.

In November, US equities posted their strongest month since June, on optimism that a substantive trade deal with China is on the horizon and 3rd quarter US corporate earnings continued for the most part to beat analysts’ meager expectations. Given this backdrop, growth stocks jumped back in front of value stocks.

Foreign Stocks: Emerging market doldrums.

Non-US stocks did not get a big boost from trade hopes, with EM stocks languishing. EM returns have been increasingly driven by the performance of China as that country’s representation in EM indexes grows. China’s slowing economy, a strong US dollar, and geopolitical tumult in Latin America have all been headwinds year-to-date.

Fixed Income: Rates inch upward.

US long-term interest rates have drifted slightly higher over the past few months, with the yield on 10-Year US Treasury bonds reaching 1.8%. A modest rise in rates fits with investor expectations for limited inflation and the Federal Reserve indicating it will not make additional interest rate cuts for the foreseeable future.

Real Assets: Commodities lag.

Real assets struggled with the risk-on environment, tame inflation and indications of economic weakness. Safe havens such as gold and silver saw lower demand and falling prices, as did most components of the economically sensitive energy and industrial metals categories.

Alternatives: Hedge funds positive.

Hedge funds continued to post incrementally positive returns benefitting from the extended trend of strong equity markets. Managed futures strategies added value through positions that benefited from interest rates going up.

Equities Total Return

U.S. Large Cap 3.6% 27.6% 16.1%
U.S. Small Cap 4.1% 22.0% 7.5%
U.S. Growth 4.5% 31.9% 20.3%
U.S. Value 3.0% 22.8% 10.8%
Int’l Developed 1.1% 18.2% 12.4%
Emerging Markets (0.1%) 10.2% 7.3%

Fixed Income Total Return

U.S. Agg. Bond (0.1%) 8.8% 10.8%
TIPS 0.2% 8.0% 8.6%
U.S. High Yield 0.3% 12.1% 9.6%
Int’l Developed (1.7%) 3.9% 6.9%
Emerging Markets (0.2%) 5.9% 7.7%
Intermediate Munis 0.2% 5.0% 6.0%
Munis Broad Mkt 0.2% 7.4% 8.7%

Non-Traditional Assets Total Return

Commodities (2.6%) 2.5% (4.5%)
REITs (1.5%) 27.9% 17.8%
Infrastructure (0.8%) 21.7% 18.0%
Hedge Funds
Absolute Return 0.4% 3.7% 2.7%
Overall HF Market 1.1% 7.3% 5.3%
Managed Futures 1.1% 7.1% 8.6%

Economic Indicators

NOV-19 MAY-18 NOV-18
Equity Volatility 12.6 18.7 18.1
Implied Inflation 1.6% 1.7% 2.0%
Gold Spot $/OZ $1464 $1306 $1221
Oil ($/BBL) $62 $64 $59
U.S. Dollar Index 92.7 92.3 91.7

Glossary of Indices

Our Take

At the beginning of Dec., the S&P 500 was nearing a year-to-date return of over 29%, which would be the second-best calendar year for large-cap equities in 15 years. Even though US corporate earnings have beaten expectations, it is surprising that equity markets have performed so well given the environment we find ourselves in: Economic fundamentals remain tepid at best and there’s certainly cooling in a number of key areas such as business confidence. Meanwhile, downside risks from Brexit and other geopolitical and economic events haven’t materially decreased. What is the cause of such exuberance?

A rebound from an overly pessimistic 2018, the Fed’s rate cuts and optimism over some type of US-China trade agreement appear to be the biggest drivers of the 2019 rally. But without an increase in corporate earnings alongside that rally, the equity markets are now fairly expensive across the board. What that suggests is that the upside for equity markets from here is growing more limited and could tip negative if a trade deal disappoints or other obstacles arise. Still, as we’ve said in recent months, we don’t find that current economic fundamentals paint a tremendously scary picture, and the downside risk is most likely less severe relative to the last few recessions.

As 2020 approaches, we are taking a close look at our allocations and expect to make some modest changes to further improve the downside characteristics of portfolios. In terms of positioning, fixed income continues to make sense for diversification purposes as do other more defensive areas like infrastructure equities. Meanwhile, international equities may hold a less prominent role given less favorable economic fundamentals abroad. At this point, our adjustments will be measured since we do see further upside in the financial markets.