January 14, 2020
Global markets rallied in the fourth quarter of 2019 with the year ending on a positive note. Trade tensions eased during the quarter, highlighted by an apparent détente between the U.S. and China reflected in a so-called “Phase One” trade agreement. This reduction, combined with a reinforcement of accommodative monetary policy in the U.S. and globally, led to increased optimism over the global economic outlook for 2020. 2019 capped off a strong decade for U.S. stocks relative to historical returns and international stocks. The last decade’s outperformance in the U.S. market was driven by the recovery from the financial crisis, favorable economic policy, and the U.S. market’s overweight to growth-orientated industries:
However, this frame of reference can be misleading as the U.S. stock market’s 11% annualized return over the previous five quarters is less impressive, and over the prior 20 years, global market returns have been well below longer-term historical returns. Depending on perspective, one could argue stock returns are extended or recovering from a period of poor performance. Future returns are always unpredictable, and our highest priority remains to build resilient portfolios that achieve healthy investment returns over multiple decades.
In early 2020, global markets were unsettled by the assassination by the U.S. of Qassem Soleimani, head of the Iranian Revolutionary Guard’s overseas forces. As of this writing, the U.S. and Iran appear to be backing off from open confrontation. The main risk to the global economy and equity markets would emanate from any disruption in the global oil supply. However, the reality is that the makeup of the global oil supply is substantially different than was the case during the crises of 1973-74 and 1979. Due to the unconventional oil extraction, U.S. oil production is now at a record level of nearly 13 million barrels per day as compared with a low point of under 4 million in 2008. Combined with increased use of alternative energy, the world and the U.S. are much better able to withstand the impact of any supply disruption in the Middle East than was the case during the 1970s.
Aside from the uncertainty created by events in the Middle East, the global economic background early in 2020 appears supportive of higher equity prices worldwide during this year. During 2019, the U.S. economy was characterized by strong consumer spending, which more than offset the negative impact of weakening manufacturing activity. A reduction of trade tensions reflected in an initial trade agreement between the U.S. and China and an agreement between Congress and the Executive branch on a revised NAFTA agreement increases our confidence that manufacturing activity can recover from depressed levels during this year and recession odds over the next 12 months are limited.
A favorable monetary policy environment is also supportive of the U.S. economy and equity market. The Federal Reserve reversed policy early last year and initiated multiple reductions in short-term interest rates for a cumulative cut of 75 basis points. Late in 2019, the Federal Reserve gave strong indications that rates would remain stable throughout 2020. The injection of reserves into the repo market is likely to continue, which is, in effect, quantitative easing. On the fiscal front, the budget agreement reached late last year will result in record-high deficits, which will have a simulative impact on the U.S. economy.
According to data from Oxford Economics combining economy momentum and interest rate spreads, the probability of a U.S. recession six-months ahead has declined to a “more comfortable” 20% level:
Outside the U.S., China is undertaking stimulative policies, including the injection of more cash into its financial system and a move away from reducing leverage. The impact of increased accommodation combined with an easing of trade tensions with the U.S. gives cause for optimism over economic prospects for this year. An improvement in the Chinese economy would have a positive impact on European exports as well as the economic outlook for the remainder of Asia. In Europe, the victory of the Conservatives led by Boris Johnson in the U.K. December election reduces uncertainty, as the exit of the U.K. from the European Union will now take place by the end of January and the process of achieving new agreement on trade can begin.
Princeton Global’s equity strategies fully participated with the strong global equity market returns in the fourth quarter. Our equity turnover was low while we maintained our sector preferences for Information Technology, Health Care, Financials, and Communications Services. Our equity purchases in 2019 focused on companies with attractive secular themes we forecast will deliver solid earnings growth in various macroeconomic environments.
We have reviewed many equity strategist outlooks for 2020, and one of the consensus views is for Value stocks to outperform Growth stocks due to their attractive relative valuations. We believe on the surface Value stocks’ valuations look enticing, and there are select opportunities; however we continue to maintain diversified exposure across major investment styles with a focus on free cash flow generation and free cash flow growth (free cash flow is the discretionary cash left over after a company pays for its expenses and capital expenditures). Many companies in growth industries are generating unprecedented amounts of free cash flow. New technology, including cloud computing and faster internet speeds, has enabled research & development (R&D) intensive companies to grow more efficiently compared to historical growth driven by large capital investments (which pressures free cash flow). Due to these shifts, the traditional price to earnings (P/E) and price to book (P/B) ratios have become less useful over time predicting future stock returns, so our focus has shifted to free cash flow yield (free cash flow per share divided by the share price).
U.S. stock market valuations appear stretched on earnings multiples. On a free cash flow basis, the S&P 500 remains in the middle of its long-term range. The stock market valuations look attractive on the Fed Model, which compares stock earnings to bond yields:
We have been keenly focused on investor sentiment and its signals for future returns. Investor sentiment has recovered from a year ago and a quarter ago from historically low levels. We believe investor sentiment is becoming more positive after the strong returns in the fourth quarter. However, enthusiasm remains mixed and nowhere close to euphoric levels. Investors continue to look at equities with suspicion due to severe corrections in the prior decade (Tech Bubble and Financial Crisis) and the volatility experienced in 2018:
The recovery in sentiment has boosted stock market multiples, so that earnings growth will be more critical over the coming years. Current estimates for 8-9% earnings growth for the S&P look reasonable due to the supportive global economic backdrop. We believe earnings growth for Emerging Markets stocks should exceed U.S. stocks due to pent-up demand from the trade uncertainty and accommodative government policies. We maintain our exposure to the Emerging Markets region.
Fixed Income Strategy
During the fourth quarter, short-term rates declined in tandem with the rate reductions undertaken by the Federal Reserve, while longer-term rates rose as a result of increased optimism over U.S. economic prospects. Yields on two-year Treasuries declined from 1.62% to 1.57% during the quarter. In contrast, the yield on five-year Treasuries rose from 1.54% to 1.67%. On ten-year obligations, the yield rose from 1.66% to 1.92%.
We expect the differential between short and longer-term U.S. rates to continue to widen. The Federal Reserve has indicated that it is willing to allow U.S. inflation rates to rise above the 2% target for an extended period before considering a tightening of policy. A tight labor market is causing wages to increase at an accelerating rate, which should eventually be reflected in higher inflation overall. At the same time, the increased deficits and resultant financing cannot help to place upside pressure on U.S. interest rates over time. Given this outlook, we adhere to a strategy of maintaining shorter than average durations in our taxable and tax-exempt portfolios. We continue to place the majority of funds resulting from maturing or called bonds into short term instruments with the purchase of somewhat longer duration instruments being undertaken on a highly selective basis.
Princeton Global Asset Management, LLC
This report is for informational purposes only, and contains data based on information Princeton Global Asset Management (PGAM) believed to be accurate. However, PGAM cannot assure the accuracy of the data.
Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security.
It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.