Published on Jan. 28, 2020
Fourth Quarter 2019 | Equity Commentary
Stocks closed out 2019 in robust fashion with the S&P 500 gaining 8.5% for the fourth quarter. We believe that investors were encouraged by the fact the US and China announced that they have reached a phase I trade deal, as well as indications from the Federal Reserve that monetary policy will likely remain accommodative for some time. Positive economic data also helped to support stocks, and eased investor concerns that a recession may be on the horizon.
In December, the US and China announced that they appear to have reached an agreement on a phase I trade deal. While the deal has yet to be signed, expectations are that a signing will take place this month. Highlights of the agreement include increased Chinese purchases of US agricultural products. We also believe this deal requires China to end its practice of requiring foreign companies to transfer their technologies to domestic businesses in order to gain local market access. In return, the US will halve the current 15% tariff rate on about $120 billion of Chinese imported goods. We think that this is particularly noteworthy, as this would be the first time since the trade war began that the Trump administrationhas rescinded any tariffs. Also of significance, the key tranche of tariffs that were set to go into effect on December 15thwere not implemented. This would have included duties on consumer products such as cell phones and laptops which in our view could have negatively impacted US holiday sales.
While we see this initial agreement as positive for capital markets, we believe that it only reduces rather than eliminates trade-related uncertainties. There are still many unknowns regarding how and when the next phase of negotiations will play out. Moreover, certain thornier issues such as industrial subsidies remain unsettled. We would not be surprised if more tariffs are threatened during the subsequent round of talks, which could trigger further volatility for capital markets.Therefore, while we are encouraged that some progress has been made, we still think that there is plenty of work to be done before a comprehensive, lasting solution is reached.
The Federal Reserve helped to support stocks during the quarter with a rate cut in October and subsequent messaging that interest rates are unlikely to move higher any time soon. Following the Federal Open Market Committee’s (FOMC) December meeting, Chairman Powell noted that he would only support a rate hike after inflation had moved persistently and significantly higher. Similarly, the Fed’s closely watched dot plot, which depicts committee members’ interest rate projections, indicates that the FOMC does not currently anticipate raising rates at all this year. A prolonged pause would be significant, and stimulative for equities, in our view, given that the fed funds rate currently sits below core inflation. Put another way, real interest rates are negative and could remain so for some time. The Fed has also materially expanded the size of its balance sheet in recent months, which also tends to be positive for equities. With negative real rates likely to persist for an extended period and a growing Federal Reserve balance sheet, we view the current state of monetary policy as being quite accommodative.
Recent economic data have been encouraging, particularly regarding the consumer. The November employment report came in ahead of expectations with 266,000 jobs added, and estimates were revised upwards for both September and October. Moreover, the unemployment rate dropped to 3.5% which marked a low for the current economic cycle. The housing market continues to strengthen, with the preponderance of industry data coming in ahead of economist’s projections, and there are reasons to believe that the momentum will continue into the new year. Changes in mortgage rates typically impact housing with a lag, and we therefore expect that the approximate 100 basis point reduction in rates over the past year could bode well for continued strength in housing activity during 2020. Consumer sentiment also appears healthy. The University of Michigan’s latest reading topped expectations and remained near the best levels in a year.
The manufacturing sector, however, has been challenged as it has struggled with trade related uncertainties and a strong dollar. The ISM’s December manufacturing survey was weak and consistent with a contracting growth environment, though other indicators, such as Markit’s manufacturing PMI fared better. Despite this disconnect, we are encouraged that the yield curve has steepened meaningfully of late, and credit spreads have contracted. These market indicators, along with the healthy state of the consumer, suggest to us that overall the economy is in good shape. A near-term recession, which had seemed plausible up until just a few months ago, now seems less likely. We think that this perception has been a key factor in driving stocks higher.
Over the course of the 4th quarter we gradually adjusted some of our portfolio weightings to reduce the risk that a factor rotation towards more value and cyclically-oriented shares and away from higher quality and growth companies might pressure our investment performance. We incrementally reduced exposure to growth, momentum, and defensive holdings in favor of stocks with characteristics of greater cyclicality and value. Given some of the positive economic data noted above along with an accommodative Fed, we believe that the shares of companies with these characteristics may continue to perform well, particularly given that value stocks have been trading at extreme valuation discounts. We are not making a strong relative call on value and cyclicals over high quality and growth stocks, but we see the former as being valued attractively enough that given the current fundamental landscape, we wanted to reduce our underweighting in these areas.