What a difference a year makes.
Worries about rising interest rates, slowing economic growth, an escalating trade war, and an aging bull market abounded a year ago. Yet, with the Fed cutting rates, investors—as our panel of market strategists predicted last December—largely focused on the positives, and stocks climbed to record highs in the bull market’s 11th year.
There are old and new risks on the horizon, however, and stock valuations are challenging. That portends a more muted outlook for 2020, according to the 10 strategists Barron’s recently surveyed. They see an average rise of 4% for the S&P 500 (.SPX) in 2020. Layer on a roughly 2% dividend yield, and stocks could deliver a total return of about 6% next year.
The coming year raises questions about more than just fundamental asset allocations. Shocks from trade war talks and elections could lead to a range of outcomes. This suggests that turbulence may be in store. This week saw the market surge as a preliminary trade deal took shape.
“A key for next year is that the stuff that will probably move markets is very hard to predict because it’s geopolitical issues, it’s political issues—rather than fundamentals,” says Saira Malik, head of equities at Nuveen, TIAA’s investment unit.
So far this year, the S&P 500 has climbed 26.4%, to 3168.57 at Thursday’s close. Bond yields have slumped, as prices have surged: The 10-year Treasury’s yield dropped to 1.90% from 2.68% at the start of 2019. U.S. assets have generally outperformed their overseas counterparts, thanks to a relatively stronger economy and bond yields that may be slim, but that are at least positive.
The economy: Slowing but growing
Our panel sees real U.S. gross domestic product growth slowing to an average of 1.9% in 2020, from its current estimate of 2.3% for this year. That compares with growth rates of 2.9% in 2018 and 2.4% in 2017, and it’s still far from the recession that has been loudly and often predicted to have arrived by now.
Rick Rieder, chief investment officer of global fixed income at BlackRock, sees the consumer remaining the driving force of the U.S. economy in 2020. Unemployment is at 3.5%, and wage gains accelerated in the back half of 2019, surpassing inflation. That means consumers have seen their spending power increase—good news for the economy, since consumer spending accounts for about 70% of it. And households have remained optimistic, with measures of consumer confidence remaining near their highs of the cycle.
“We think consumption stays really solid, residential construction stays in good shape, and consumers’ employment and wage levels remain strong,” says Rieder, who expects 1.8% U.S. GDP growth in 2020. “So we think that keeps the economy in good shape.”
There is broad agreement on that point, and some strategists see signs of a manufacturing rebound on the horizon as well. Citigroup’s chief U.S. equity strategist, Tobias Levkovich, cites a quarterly Federal Reserve Board survey of senior loan officers as a leading indicator for industrial activity. The measure of commercial and industrial loan standards showed easing conditions in the spring and summer of 2019, suggesting an increase in industrial activity to come in the first and second quarters of 2020.
Levkovich expects 2% real U.S. GDP growth in 2020, with the first half of the year stronger than the back half. The same quarterly survey of lending standards suggests a deceleration by the third quarter. T. Rowe Price Group’s head of investments Rob Sharps also sees a manufacturing rebound boosting economic growth next year.
Monetary policy: Open the taps
The Federal Reserve’s about-face from raising interest rates in 2018 to lowering them three times in 2019 played a major role in stocks’ march to record highs this year. Lower rates support higher stock valuations by making future earnings worth more when discounted back to the present at a lower rate. Dividend-paying companies also see greater demand from yield-seeking investors, and lower borrowing costs make share buybacks more affordable for companies.
The S&P 500’s price-to-earnings multiple—how much investors are willing to pay for each dollar of earnings—has expanded to 19.3 at Thursday’s close from 15.4 at the end of last year. That has fueled stocks’ rise, despite slow economic and earnings growth.
“This year we’re looking at relatively flat earnings—slightly negative earnings without buybacks—and all of the returns have come from multiple” expansion, says Savita Subramanian, head of equity and quantitative strategy at Bank of America Securities. “The idea is that low rates breed higher multiples, but we haven’t necessarily seen that when growth is slowing to levels where we are today.”
Central banks around the world have been even more accommodative, with the European Central Bank and Bank of Japan each targeting negative interest rates. That has made the objectively meager U.S. yields relative giants in comparison, and demand from foreign investors will likely keep a lid on Treasury yields next year. None of our panelists see the 10-year Treasury climbing above 2.20% in 2020.
Federal Reserve Chairman Jerome Powell signaled an on-hold stance for the Fed going forward, unless economic data meaningfully change the outlook. Investors probably can’t count on further rounds of interest-rate cuts to boost stock multiples further in 2020, but central banks remain supportive in other ways.
“The ECB, Bank of Japan, and the Fed are all expanding their balance sheets now pretty aggressively, to the tune of about $100 billion a month,” says Mike Wilson, chief U.S. equity strategist at Morgan Stanley. That dampens volatility, he says, which “leads to higher asset prices for virtually everything.’’
Credit: Focus on quality
Like stocks, corporate credit has rallied across the quality spectrum in 2019. The coordinated decline in interest rates across the globe has spurred a search for income from investors who have piled into bonds and pushed down yields. That has made it harder to find attractive opportunities in credit going into 2020.
“Because spreads have tightened so much and yields have come down so much, I think credit is fair at best,” BlackRock’s Rieder says. “If you want to own some credit in the portfolio, we like higher-quality parts of high-yield and some midlevel quality in investment-grade credit. But going into 2020, our desire to own credit is much lower than it was last year, because valuations just aren’t that great.”
Beyond pushing spreads tighter, the central bank asset-buying programs that are pumping up liquidity have made it possible for companies to secure financing that otherwise might get a more skeptical look from investors. Economist Edward Yardeni, president of Yardeni Research, notes that half of investment-grade bonds are now rated BBB or the equivalent. He warns investors to focus on quality companies with solid balance sheets and cash flows.
“One of the consequences of the Fed easing again...is that they’re feeding the zombies, the walking-dead businesses that would be out of business by now if it wasn’t so cheap and easy to get credit,” Yardeni says. “With interest rates so low around the world, investors are reaching for yield, and that means they’ve been buying junk.”
But as long as the U.S. avoids recession and funding remains easy, the zombies can likely keep marching along. Richard Lacaille, global chief investment officer of State Street Global Advisors, sees a moderately positive year for investment-grade credit and some parts of high yield in 2020.
“The credit-expansion machine continues to roll on,” Lacaille says. “At the moment, that’s working pretty well. There is a lot of demand for spread, and I don’t see a sharp pickup in defaults in 2020.” He prefers short-dated credit, with long-dated bonds squeezed by heavy demand from pension funds and other long-term investors.
The shocks: Election and trade
The two wild cards for 2020 are what happens with U.S.-China trade and who wins the U.S. presidential election. Each has the potential to have a major influence on markets next year, and each is hard to predict.
The world’s two largest economies have been embroiled in a trade war for more than a year, with multiple rounds of tariffs and counter-tariffs affecting nearly all goods traded between the two. The impact of those levies isn’t large for an economy of the U.S.’s size, but the damping effect on corporate confidence and investment has been much greater. This fall, U.S. stocks have ridden a wave of optimism for a preliminary deal.
In the third quarter, the Conference Board’s measure of CEO confidence fell to its lowest level since the financial crisis in early 2009, and capital spending remains relatively low.
For 2020, J.P. Morgan’s earnings-per-share estimates are sensitive to how things shake out on the trade front: Dubravko Lakos-Bujas, chief U.S. equity strategist, offers a base case that a partial resolution helps push earnings 10% higher, to $180, next year. A full tariff rollback could lift that to $184, while an escalation and adoption of additional tariffs could keep earnings at $171, up just 4%. The $13 spread illustrates the divergent outcomes possible.
Morgan Stanley’s call for an economic rebound early in 2020 also depends on an improving trade environment. “Our economists have been very explicit about this,” Wilson says. “If we don’t get some sort of progress, then their call for a bottom in the first quarter would probably be too optimistic.”
Another wild card is the U.S. presidential election, with strategists most concerned about the wide gap between proposed policies on the left and right of the political spectrum. Investors and companies might hold back in the months before the election until there is more clarity.
Several members of our panel see President Trump being re-elected as the most bullish outcome. “My working assumption is that Trump will win and that the market will view that favorably, to the extent that he’s favored deregulation and been generally very pro-business,” Yardeni says.
RBC Capital Markets’ head of U.S. equity strategy, Lori Calvasina, notes that two-thirds of RBC’s equity analysts see a win by such progressive Democratic candidates as Sen. Elizabeth Warren or Sen. Bernie Sanders as bearish for their covered industries.
Sharps of T. Rowe Price sees the impact as negative more broadly than on the targeted companies in areas like health care or energy. “The policies that some of the more progressive candidates are promoting could be really challenging for sectors like energy and financial services, and those are sectors that have multiplier impacts on the economy,” he says.
Stocks: Stay long, but don’t be greedy
A return to earnings growth will be the force that drives the S&P 500 higher in 2020, with valuation multiples already toward the high ends of their historical ranges.
The general view among our panel is that stocks should more or less remain at their current valuations, and rise slightly or hold their level through year end, along with profit growth. Their average estimate is for about $174 in earnings per share next year, which would be up 6% from 2019’s $164 consensus forecast.
“Earnings drive bull markets higher,” says Nuveen’s Malik, who has a 2020 year-end target of 3100 for the S&P 500, about equal to the index’s current level. “And we’re not going to have much earnings growth when it comes down to it for this year or next year...and we actually expect multiples to contract a bit.”
Yardeni, our panel’s most bullish member, sees the S&P 500 rising to 3500 by year end, powered by an accommodative Fed, progress on trade negotiations, and a reach for yield that pushes investors into dividend-paying stocks.
The path there may be bumpier, however. Headlines on the trade, economy, or election fronts all threaten to drive a reactive market higher or lower for extended periods.
“The odds that we get a correction between now and the end of 2020 are pretty meaningful,” says Sharps, who sees the S&P 500 rising next year to 3250. “Where we stand today might not ultimately end up being your best entry point.”
Wilson’s year-end target for the S&P 500 is 3000, below its current level. But he sees a possibility of the market going higher in the early part of 2020. “The liquidity picture is quite robust and will stay that way for at least the first quarter of the year,” he says. “There is little risk of a recession near-term and people are feeling a bit more optimistic, so we could see valuations overshoot to the upside in the next three or four months.”
Sectors: Buy what’s on sale
Financials, health care, and industrials are all popular sector picks among our panelists for 2020. More attractive valuations than the rest of the market play a big role in each of those calls. The sectors trade for 13.3, 15.8, and 16.5 times their 2020 earnings estimates, respectively, versus 17.6 for the broader S&P 500.
Bank of America’s Subramanian’s favorite sector for 2020 is financials. She notes that it is out of favor, with declining sell-side coverage and below-average fund ownership, but boasts the highest shareholder yield of all sectors in terms of dividends and share buybacks. Subramanian isn’t as worried about election risk for financials, given bigger targets in health care and energy and the regulatory burden that is already on Wall Street.
Health care may be the sector with the greatest election-related risk, with proposed Medicare for All and drug-pricing legislation representing an existential threat to large parts of the industry. But that’s a well-understood and discounted prospect, say several of our panelists, who believe it is unlikely that a single-payer system actually makes it through Congress and into law.
Demographic trends, meanwhile, are supportive of health-care-exposed businesses in the long term and valuations are attractive relative to the rest of the market. “A lot of the fear is priced in, and that should abate and the health-care sector should benefit,” J.P. Morgan’s Lakos-Bujas says.
RBC Capital Markets’ Calvasina says the time to buy industrials is when manufacturing indicators like purchasing-managers’ indexes are improving. “In a few years, we’re all going to look back and wish we’d loaded up on machinery stocks in the middle of the trade war,” Calvasina says.
Sharps also sees a pickup in the industrial economy next year. He recommends United Parcel Service (UPS) as one quality name to play a potential rebound. For investors with a greater risk appetite, more cyclically exposed firms like Texas Instruments (TXN) and United Airlines Holdings (UAL) deserve a look. He also sees an opportunity to pick up some dividend yield in industrials at a more attractive entry point than those in bond-proxy sectors, such as real estate or utilities.
“There are lots of different places where you can find dividends,” Sharps says. “I think I would look less at the resilient, less economically sensitive names and maybe more at some of the stuff that has a little bit of cyclicality if I were trying to get exposure to dividends.” Such stocks include Union Pacific (UNP), with a 2.2% yield, and Alaska Air Group (ALK), which currently pays 2.1%. Both can benefit from an upturn in the U.S. economy next year.
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