- The stock market recently broke out of its 21-month trading range, setting the stage for a potentially strong start to 2020.
- Gains in valuation amid a slowdown in earnings growth are consistent with past inflection points.
- Price tends to lead earnings at the turns, so now it’s up to 2020 earnings to grow—and thus justify the P/E expansion.
- This assumes the Federal Reserve has intervened in time to avert recession, but because this is unknowable in real time, I think a 60/40 strategy remains a reasonable approach.
- Protecting against the tails—both deflation and inflation—also remains important.
In my view, the stock market has been following a logical narrative borne out by historical patterns—with one gigantic caveat: Federal Reserve intervention had better have succeeded in averting recession. If the left tail (deflation) takes hold, then all bets are off. But if deflation can be avoided, then I think the recent market rise becomes perfectly rational.
In that case, a diversified asset allocation strategy could make sense for many investors, though protecting against tail risks—both deflation and inflation—seems reasonable to me.
How we got here
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
Following a 21-month-long holding pattern, both the MSCI All Country World Index (ACWI) and the S&P 500® appear to be breaking out to the upside again. This suggests to me that whatever had been ailing the markets over the past couple of years (e.g., the global slowdown, trade war, risk of Fed policy error) has been absorbed or mitigated, and investors are now looking past those perils and out to a more expansive 2020.
Is this optimism justified?
Part of the rationale for a "soft-landing" scenario is that, a year ago, the Fed stepped in just in time with a pivot away from the expected 5 or 6 additional rate hikes (plus balance-sheet reductions) to 3 rate cuts (plus balance-sheet re-expansion). What a difference a year makes! In 2018, we had been looking forward to a 3%-plus federal funds rate and bond yield. A mere year later, the yield curve is registering around 1.40% on the short end and 1.80% on the long.
The point is that the Fed responded quickly to the bond market's flashing red light and is back in line with what the market has been pricing in, i.e., no further rate cuts or rate hikes for the foreseeable future. Thus, if the business cycle indeed revives in the coming year, then—by virtue of the Fed's "promise" to refrain from raising rates until inflation really becomes an issue—the Fed's de facto stance will be more accommodative than economic fundamentals might otherwise call for. This, to me, is clearly a component of the market's presently constructive narrative.
If equities had remained in a robust uptrend despite the falling Purchasing Managers' Index® (PMI®) then one could have argued that the market got ahead of itself in making new highs. But that has not been the case. The fact is that at some point over the past year or 2, in terms of both price and valuation, pretty much every major region of the global stock market suffered a material correction (20% to 30%). In other words, the bear market that everybody fears may already have come and gone.
What about high stock prices?
A bull-market skeptic might point out that the S&P 500's forward price-to-earnings (P/E) ratio zoomed from 13.7x last December to 18.0x this December, while earnings growth slowed from 22% in 2018 to a mere 1.6% more recently. How is this possible? Surely this must be "irrational exuberance" and a sign that the market is delusional in its optimism?
In a word: No. Remember: The market is a discounting mechanism where price leads earnings. Said differently, at major turning points, the change in the P/E ratio typically commands a substantial lead over any associated change in earnings. The message is that a P/E multiple expansion at this stage of the game may be perfectly normal, so long as, over the coming 12 months, earnings come through in some way. Again, it's important that we avoid the left tail risk—deflation.
Of course, by now you're thinking: "How can we know whether we're going to get whipped by a tail? It's unknowable!" My answer: Yes, it is unknowable. The good news, though, is that knowing the which or the whether, tail-wise, is not really required. Our best course of action, in my view, may simply be for investors to maintain a balanced mindset—hewing to a diversified strategy, for instance a 60/40 base-case portfolio (i.e., comprising 60% equity, 40% fixed income)—and thereby accommodate, to some degree, a variety of potential outcomes.
Since 2000 the correlation between equity returns and bond yields has been consistently positive. So while we can tinker around the edges in terms of asset allocation, the basic premise of a 60/40 approach, or otherwise diversified portfolio, suggests that, if history is any guide, we should remain relatively sheltered regardless of whether or not deflation emerges. Past performance is no guarantee of future results, but since the stock market's valuation peak in January 2018, a 60/40 portfolio has delivered essentially all the upside of the S&P 500 with only a portion of the drawdowns. In my book, that's certainly an "acceptable" outcome.
So perhaps we plow ahead with a 60/40 strategy, or a similar diversified strategy, which in theory can ride a cyclical recovery and also may protect against a recession. But what about the right tail—inflation? I think the commodity super-cycle is at a point where we should be on the lookout for a multi-year bottom for inflation. A bottom would suggest that inflation could be the "next big thing" in the years ahead.
Protecting against deflation and inflation
In thinking about portfolio construction, hedging against a deflationary scenario likely would call for lower rates and long-duration bonds. Inflation would demand something like gold or commodity exposure generally or Treasury inflation-protected securities. So, without knowing which tail might prevail, one approach might be to cover both of them, perhaps deploying deflation protection on one side, inflation protection on the other, and playing the middle with some sort of diversified strategy, like a 60/40 asset allocation.
But wait: There's still more! We could possibly even see high inflation and low interest rates—at the same time. How? By the Fed's working more explicitly to repress rates, as it did in the second half of the 1940s. Back then, the US government had run up a huge deficit to pay for World War II, and because the Fed was not fully independent at the time, interest rates were capped at around 2.5% and the budget deficit was monetized. Could it happen again? As crazy as it might seem, I cannot say that it won't. In fact, this past November, US Federal Reserve Governor Lael Brainard suggested capping interest rates the next time short-term rates approach zero.
In conclusion, as I look out over 2020 and beyond, I think that one good approach could be as simple as playing the middle and protecting the tails; in other words, emphasize some form of diversified strategy and think about adding on some inflation/deflation barbells.