January 7, 2020 In the fourth quarter of 2019 a good year got better in the equity markets. The bond market experienced a robust return as interest rates fell. Investors fear of risky investments during the third quarter disappeared with virtually all asset classes gaining ground. The strongest move came from Emerging Markets, which jumped 10% in the fourth quarter. A report from Schwab market analyst, Jeffery Kleintop said that all major asset classes did better in 2019 than their ten-year average return which he thought had never happened before. It was a rare year. So perhaps we should look at the consequences of these great returns to see what they have done to valuations.
The gains in US equities came mainly from PE expansion which in plain English means investors were willing to pay more to buy a dollar of earnings at the end of the year than at the beginning of the year. This means investors are optimistic and believe that the economy is going to continue growing and most of our problems are being resolved. The Fed’s decision to cut rates last year was a clear contributor along with the feeling that the trade war with China is being resolved removed another layer of fear. That probably added some FOMO (fear of missing out) motivation to buy equities since the yield on bonds is not inspiring anyone.
International equity returns jumped as well, just not as high as those in the US. These asset classes have been considered cheap for years and remain cheap despite the double digit returns in 2019. The Emerging Markets whose economies heavily rely on trade were probably the main beneficiary of the reduction in trade tension. China after all is the largest of the Emerging Markets. Their Shanghai market index did not participate in the rally. It struggled and fell about 6% last year which is no doubt partially due to the tariffs.
In 2019 US Aggregate Bond Index’s yield fell about 1% to a yield of 2.3%, a rate of return that does not pay many bills.
This decline in rates caused bond prices to rise 5.4% which together with the starting interest rate gave a total return of 8.7%. A sizeable portion of that move followed the Fed’s three rate cuts during 2019 which are unlikely to be repeated in 2020 so one should expect a more modest return this year in the bond market.
Overall one should expect lower returns in 2020, while the economy catches up to the PE expansion in the markets. We are through 126 months of expansion and it seem to be on track to continue albeit at a slower pace here in the US. Interest rates are low, and the negative effect of the trade war could rapidly fade if the disputes are settled. Fortunately, there is progress on that front with the Chinese. On the other hand, the situation with the Europeans appears to be worsening and warrants some concern. It appears that Germany is entering a recession while the rest of Europe is at stall speed. Many point to the negative interest rate policy as a potential cause. Most economists outside of Europe think it is a failed policy and doing more of it is contributing to their deteriorating economic condition. Afterall negative interest rates hurt banks and insurance companies’ earnings and they make it impossible for pensions to earn enough return to fulfill their obligations to retirees. Hopefully the EU leaders will find a way to restart their economies and reach a sensible agreement with the UK on Brexit. If so, the global economy could continue growing.