What a difference a year makes. While in 2018, it was very difficult to make money in financial markets, in 2019 pretty much everything went up. Our portfolios meaningfully participated in the global equity rally. And portfolios with fixed-income allocations benefited from the fall in interest rates/rise in bond prices last year that surprised most Wall Street strategists.
You might be wondering why both stocks (risky assets) and bonds (defensive assets) appreciated sharply in 2019? They tend to move in opposite directions. The last time bonds had a similarly great year, the stock market fell in the last-leg of an extended bear market. The reason for the atypical pattern this time was the Federal Reserve’s sharp U-turn in monetary policy. The Fed had been raising interest rates in 2018, but in the face of a weakening global economy, they switched gears and actually cut rates three times in 2019. Late in the year, the Fed also began injecting liquidity into the short-term lending markets.
U.S. equity investors responded to Fed easing much as they have during the past decade—by bidding up stock prices regardless of already high valuations and a lack of earnings growth. The completion of a “phase one” U.S.-China trade deal further boosted sentiment.
Major central banks in Europe, China, and elsewhere also cut rates or provided additional monetary stimulus. This and an increased probability of an orderly Brexit helped European stocks gain 9.9% in the fourth quarter and 24.9% for the year. Emerging-market stocks shot up almost 12% in the fourth quarter and returned 20.8% for the year.
Meanwhile, inflation and inflation expectations remained at or below central bank targets. This lifted concerns that interest rates would be hiked anytime soon, and the bond market rallied as well.
Tactical positions in foreign stocks, flexible bond funds, and selected alternative strategies all made money in 2019. But they couldn’t keep up with the mix of U.S. stocks and core bonds from which they were funded. As a reminder, tactical positions are asset classes or strategies we believe have superior expected returns versus risk compared to U.S. stocks and core bonds, and are used more as a defensive tilt to our portfolios.
A Balanced Mindset
There are reasons to be cautiously optimistic for financial markets in 2020:
• Easy monetary policy should soon trickle down to boost the global economy. Global manufacturing is already starting to turn up and expand again.
• Stock markets tend to rise when central banks are in easing mode.
• Inflation is benign so central banks are unlikely to raise rates in 2020. Along with strong U.S. households, continued low interest rates should support consumer spending and the housing market.
• The U.S.-China trade war has de-escalated and Brexit fears have abated for now.
• And financial market imbalances, which triggered the past two U.S. recessions and bear markets, are not yet at the breaking point as long as the economy grows at a decent pace.
However, to some extent this outlook is already reflected in current market prices—at least for U.S. stocks—especially after the sharp year-end rally. CNN calculates a Fear/Greed meter based on internal dynamics in the U.S. stock market. Sentiment swung 180 degrees to Extreme Greed at the end of 2019 from Extreme Fear a year earlier. High valuations and excessive optimism make asset prices more susceptible to negative surprises. We think the wisest course for balanced investors continues to be a broadly diversified, moderately defensive posture.
We are closely watching and weighing the ramifications of several potential short-term risks beyond high U.S. stock valuations. These include a reigniting of the U.S.-China trade war, the risk of recession, volatility around the U.S. presidential election, a hard Brexit with no new trade agreement between the United Kingdom and the European Union, and as always, the chance of an unexpected geopolitical shock. (Iran tensions are one example.)
In the meantime, clients are invested in portfolios built to be resilient across a range of market/economic scenarios. They are positioned to withstand a market downturn, consistent with each portfolio’s specific risk objective. Yet they also provide tactical exposure to asset classes, strategies, and managers we believe currently offer attractive total-return potential over the medium and longer term.
The last few years’ investment experience has been a roller-coaster ride. Globally diversified balanced portfolios of stocks and bonds generated strong returns in 2017, weak returns in 2018, and strong returns in 2019. The market consensus will likely be surprised again in 2020. The only certainty is the lack of certainty. This is why we focus on the long term and don’t make 12-month forecasts. But through all the ups and downs of the last three years, investors have made a strong average return. The wild ride at times is the cost of doing business in investing. Discipline and patience pay off over the long run—something to remember as the unknowns of 2020 unfold.