- The global economy remains sluggish but is showing signs that conditions are no longer deteriorating.
- Uncertainty may prove less of a headwind for business confidence in 2020 due to monetary easing from central banks and the de-escalation of the US-China trade conflict.
- Forward estimates point to market expectations for a significant recovery in earnings growth in 2020, which may be difficult to achieve without a sustained reacceleration of global growth.
- For investors, the late cycle historically delivered mixed results and limited upside for a diversified portfolio—though average results for most asset classes have been positive.
During Q4, favorable policy developments—including further monetary easing by the Federal Reserve and de-escalation of the US-China trade confrontation—provided additional fuel to power stock markets to a strong finish in 2019. The global business cycle registered evidence of improvement in some areas, but it remains relatively mature and, against the late-cycle US backdrop, continues to warrant smaller asset allocation tilts compared with earlier in the cycle.
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The emerging-market (EM) and non-US small-cap equity segments led the widespread Q4 gains that put an exclamation point on the best returns for global stocks in several years. For full-year 2019, all major asset categories posted strong results. Monetary easing and lower interest rates boosted returns to bonds, and US large-cap equities led the outperformance of US versus non-US stocks.
Economy/macro backdrop: Mature US and global business cycles
The global economy remains sluggish but is showing signs that conditions are no longer deteriorating. The US is firmly in the late cycle, while recessionary conditions in major European countries such as Germany and Italy may be poised for improvement. Overall, the global cycle remains in a mature expansion, but with hints of improvement in some areas, and of a bottoming in global trade and industrial activity.
The near-term risk of US recession remains relatively low, with declining interest rates boosting housing activity and keeping consumers’ debt service at manageable levels. Tight employment conditions continue to support consumer spending. However, some leading indicators suggest the labor market may be nearing peak levels.
Capital spending slumped in 2019 amid weak growth and trade-policy disruption, although recent sentiment indicators suggest business confidence may no longer be weakening. With companies facing an extremely tight labor market, it may be difficult for earnings growth to accelerate meaningfully without material improvement in the global economic environment. Thus, we expect profit growth to face a difficult expectations hurdle in 2020.
Major central banks re-engaged in extraordinary monetary policy this past year. Government bond yields declined around the world, with US 10-year Treasury bonds dropping roughly 80 basis points. The European Central Bank (ECB) restarted quantitative easing (QE) with 20 billion euros of monthly security purchases, and the Fed began buying $60 billion of Treasury bills monthly and expanded its repo operations to relieve money market stress. These actions drove down real US yields, helped boost asset prices, and provided a positive liquidity environment to start 2020.
Core inflation has remained generally stable at around 2% in recent years, with near-term expectations holding firm. The outlook for oil also is supportive, as prices have generally trended higher in recent months amid inventory declines. Compared to history, the Fed is likely to be more permissive of inflationary pressure, implying an inclination to keep rates at current levels barring a major inflection in growth or inflation.
Global economic policy uncertainty rose to unprecedented levels in recent years amid an unclear outlook for monetary policy, international trade tension, Brexit, and a host of other issues. However, world central banks’ shift to monetary easing and the de-escalation of the US-China trade conflict late in 2019 offered hope that uncertainty may prove less of a headwind for business confidence in 2020.
Asset markets: Strong quarter for risk assets, strong year for everything
Global stocks finished strong in Q4, led by emerging markets (EM) equity. For 2019 overall, almost all asset classes logged sizable absolute gains, with US growth stocks and the tech sector the top performers. In fixed income, long-duration debt proved the worst-performing sector in Q4 but gained nearly 20% for the year. Riskier credit categories such as high-yield and EM bonds led in Q4 and posted strong full-year results as well.
Earnings growth across all regions finished the year on a weak note. US profit growth continued to slow subsequent to the tax-reform boost in 2018, while non-US earnings growth spent all of 2019 in negative territory. Forward estimates point to market expectations for a significant recovery in earnings growth in 2020, which may be difficult to achieve without a sustained reacceleration of global growth.
Cyclically adjusted price-to-earnings (CAPE) ratios for non-US developed and EM equities remained below those for the US, providing a relatively favorable long-term valuation backdrop for non-US stocks. In Q4, the US dollar generally depreciated against many of the world’s major currencies. Nevertheless, US dollar valuations still remain relatively expensive overall.
In fixed income, inflation expectations rose modestly in Q4, boosting yields amid signs of global economic improvement. In the US, risk-on sentiment contributed to modestly higher Treasury rates and even tighter credit spreads across most bond categories. As a result of accommodative global central banks and benign credit conditions, bond yields generally remain in their lowest decile relative to history, and credit spreads in most categories are generally well below their long-term averages.
Late cycle has often involved rising inflation pressure, which has tended to enhance the attractiveness of inflation-sensitive assets such as Treasury Inflation-Protected Securities (TIPS), commodities, and energy and materials sector equities. Our near-term outlook for core inflation is relatively range-bound, but the market’s expectations (represented by TIPS’ breakeven rates) are at the lower end of their decade-long range, suggesting to us that inflation protection is relatively inexpensive.
Historically, the mid-cycle phase tends to favor riskier asset classes and produce broad-based gains across most asset categories. Meanwhile, of all the business cycle phases, late cycle has delivered the most mixed performance results. Another frequent feature of late cycle has been overall more limited upside for a diversified portfolio, though results for most asset classes have, on average, been positive.
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