From Disruption to Resilience – A New Decade Begins

2019 was marked by global threats that rocked financial markets, only to become pauses between an increasingly persistent upward trend in asset prices for stocks and bonds. In the end, disruptive geopolitical events such as the U.S. - China trade tensions, Brexit, and the impeachment of Donald Trump, have faded into the background noise. Financial markets proved highly resilient in 2019. For the year, the S&P 500 Index gained 31.5%, and the Barclay’s Aggregate Bond Index returned 8.7%. Whither hence for 2020?

Our 2020 outlook calls for slowing economic growth, “flattish” interest rates and a stubborn upward bias to the U.S. stock market. The three primary economic themes we see influencing the course of financial markets for 2020 are fiscal and monetary policy hesitation, modest yet continued economic growth, and a widening gap between the “haves” and the “have-nots” of corporate America (see December 2019 ViewPoints “The Digital Divide Intensifies”).

While not predictable, the elephant in the room is whether a geopolitical event in 2020 could be a tipping
point for financial markets. The recent targeted killing of Iran’s top military leader was disruptive, but not a tipping point to date. Could the volatile geopolitical situations around the world be the “new norm”?  Possibly, but tipping points often are evident in hindsight, not necessarily real-time. As Carmen Reinhart and Kenneth Rogoff commented in their book This Time is Different about the history of financial crises, “financial crises are things that happen to other people in other countries at other times; crises do not happen to us, here and now.”

In 2008, the United States did experience a financial crisis. The Federal Reserve responded with unconventional monetary policy and the U.S. government increased its debt levels. The Federal Reserve balance sheet has expanded to greater than $4.0 trillon from less than $1.0 trillion in 2007. U.S. public debt stands at 105% of gross national product as of 3Q2019 (see Exhibit I above). Unconventional monetary
policy and expansionary fiscal policy has led to a longer-than-average economic cycle.

This extended economic cycle has auspiciously not included a significant uptick in inflation. Wage growth has remained subdued. We attribute this to the changing economic drivers of growth that have left
workers less secure. The Federal Reserve, which began policy normalization in December 2015, reversed course starting in the fourth quarter of 2018. The Federal Reserve returned to expanding its balance sheet and cut interest rates three times in 2019. It is essential to consider that rising interest rates impact mortgage rates, credit card rates, and the cost of financing U.S. public debt. Unconventional monetary policy has led to
a problem for the Federal Reserve: normalize interest rates, which increases debt financing, or maintain lower rates for longer so that debt is less costly to service. Unsustainably low-interest rates in the short term risks the longer-term sustainability of financial asset valuations. Fiscal policy is constrained as well. The Jobs and
Tax Act of 2018 has driven the deficit toward the $1.0 trillion-a-year mark.

We see 2020 as a “not-too-hot, not-too-cold” growth continuum that will be driven by both monetary policy and fiscal policy that is set on maintaining an already longer-than-average economic expansion, yet functionally challenged. We therefore see “policy hesitation” as a response to the unintended consequences of prior policy.

Fiscal policy and monetary policy hesitation is consistent with modest continued economic growth. The unintended guardrails of significant sovereign debt combined with fragile consumer confidence suggest policy will continue to respond to events. Given the Federal Reserve’s difficulty in getting to its 2% inflation target, we may well see a prolonged period in which interest rate levels can remain lower for longer. With
significant public debt, the U.S. government has reduced practical optionality in its policy arsenal.

Slowing potential gross national product growth due to high public and private debt leads to winners and losers given excess supply. Some companies are thriving and growing at superior rates. Others not. Why? We attribute it to the competitive advantage gained through the strategic positioning of a company’s balance sheet, brand equity, and technology.

We believe 2020 will be a crossover year characterized by an acceleration of the digital divide trend so  vividly depicted by the “Amazon Effect” on the retail sector. Productivity and competitive advantage in the digital age accelerate the divide between the companies of today and the companies that will exist by the end of this decade. We call the winners the “resilience leaders” due to their adaptability to varied economic circumstances. While we anticipate muted economic growth and limited upside in financial asset
valuations overall, we see upside potential in earnings and valuation for these “resilience leaders.”

The elongated U.S. economic cycle continues to have growth potential, and financial asset prices could persist higher. The “resilience leaders” of today offer insights into the potential solutions to global issues that affect all of us as part of the world economy. As this decade begins and unfolds, we will continue to look for companies that can profitably solve  economic, social, and political problems impacting our world around us.