Q4 Review and Outlook: Have the Clouds Lifted?

Jan 6, 2020

2019 was a whirlwind of a year. 2019 was epitomized by shifting clouds of uncertainty. At times these clouds became darker and recession risks increased while at other moments investors glimpsed the light at the end of the tunnel. This was true in the fourth quarter – recession chatter dominated the start of October until progress on the phase 1 trade deal led to both U.S. and select international equity markets reaching new all-time highs. With a total return of 31.5%, the S&P 500 Index had its strongest annual performance since 2013.

Recapping 2019: Positive, but Costly Returns

Purely from a returns perspective, 2019 appeared to be a banner year. The S&P 500 and other major equity indexes posted double-digit gains and hit new all-time highs in 2019. Investors feasted on easy money from accommodative central banks. U.S. equities set the pace, despite some high-profile wobbles.

With the expected signing of the phase 1 deal now slated for mid-January, Emerging Market (EM) equities led the way in Q4 with the MSCI EM Index having a total return of 11.8% followed by the S&P 500 Index and the MSCI World ex U.S. at 9.1% and 7.9%, respectively. Conversely, on a full year basis the S&P 500 led the pack with a return of 31.5% followed by the MSCI World ex U.S. at 22.5%. Due to the persistent trade uncertainties during 2019, EM underperformed for the year with a return of 18.4%.

Declining yields were a major theme during the first nine months and helped propel performance within fixed income; especially within duration assets. In Q4 the tables turned for this trend as the shape of the yield curve improved. Consequently, the Bloomberg Barclays Aggregate Bond Index was approximately flat for the quarter (+0.2%) while having a robust performance on a full year basis (+8.7%).

But it wasn’t all rosy in 2019. Returns don’t tell the whole story. Much of the returns this year were recapturing losses from Q4 2018. Low (and lower) interest rates helped stimulate asset prices across the board, but they generally failed to boost growth in the real economy. U.S. corporate earnings for the year are likely to turn in flat. And yet, in the face of heightened uncertainty, the consumer kept the economy stable.

Long-dated U.S. Treasury yields may have finally found a floor after the much-publicized—and potentially recession-signaling—inversion of the yield curve. While the Q4 yield curve steepening was a positive for equities, duration-sensitive fixed income assets paid the price.

Uncertainty about the trade war remains one of the biggest issues globally and continues to take its toll. Manufacturing is arguably in a recession already, hurt by the lack of a trade resolution and snail-like global growth. Its plight reflects the questions many investors should be asking as 2019 draws to a close: It’s been a good year, but at what cost? And what does it mean for 2020?

2020 Expectations: Uncertainty is the Only Certainty

To get a read on 2020, a worthy exercise is to follow what market participants expect from central banks. The market expected liquidity in 2019 and central banks obliged. Robust equity and fixed income returns followed. But what happens if central banks turn off the free money spigot?

As the saying goes, there’s no such thing as a free lunch. But markets continue to act as if central bankers will continue to pick up the tab. At some point, somewhere, investors will get a bill. And the price may be steep. The focus should be on sustainable organic growth, not handouts from central banks. More specifically, sustained earnings growth that doesn’t come from tax cuts or share buybacks is what the market really needs. Our best bet is for this growth to come from long term structural trends such as advancements in technology or changing consumer behaviors. The market also needs businesses to invest more, though that requires more policy certainty than we have in the current environment.

Unfortunately, uncertainty is likely to remain front and center in 2020. The major themes to watch in 2020 are nothing new, but as important as ever.

U.S.-China trade war: Prognosticating on a trade resolution is largely a fool’s errand at this point, even though a phase 1 deal is almost signed and there is the potential for continued progress in this negotiation as we head into the 2020 election cycle. While it is unlikely that the full trade deal will be resolved in 2020, continued momentum behind resolving the trade dispute will be essential for market sentiment in 2020.

The damage caused by the trade war is real both in terms of reduced current production as well as reduced investment impacting the future productive capacity of countries. The International Monetary Fund (IMF) estimates the trade conflict could lower global GDP by roughly $700 billion by 2020, which is about 0.8% of global GDP.1 Already, capital expenditure growth for U.S. companies is tepid and overall earnings are declining. And it appears as though a global manufacturing recession may already be underway. The economies that depend the most on trade are suffering.

Recession: We do not expect a recession in the next 12 months. However, a risk in this 24-hour news cycle is that a recession becomes a self-fulfilling prophecy. To this point, consumers have done their part to help the economy and they seem to be continuing to help through the 2019 holiday season. But if people become consumed by the chatter about a slowdown and curb their spending, then the math is simple: firms make less, invest less in their business, hire less or downsize. And, before you know it, we have a recession. In particular, small business sentiment and small business sales expectations, which measures small business confidence and hiring, are two areas likely to shed light on any forthcoming recession.

The election: If anyone has forgotten, there’s a presidential election in 2020. Many Wall Street pundits have touted that the stock market will decline if a Democrat is elected, with the magnitude of decline dependent on the candidate and their policies towards health care reform, tech regulation, or corporate taxes. But with a divided government likely (there is only a small chance Democrats will take the Senate and the Presidency) either way, expect the same gridlock and policy uncertainty.

Iran and the Middle East: Stability in the Middle East has always been a challenge, but now more so. The recent U.S. drone attack that killed Qassem Soleimani, one of Iran’s most powerful generals, will weigh heavily on the region and may have unintended consequences. He was responsible for extending Iran’s influence across the Middle East. There is also the possibility that he helped keep ISIS in check, which was in the interest of both the West and Iran. His death is expected to be a turning point for politics in the Middle East. There is a strong possibility that Iran will retaliate on U.S. interests or Israel, which could lead to an escalation in tensions across the Middle East. This comes on the heels of a recent attack on Saudi oil facilities that were blamed on Iran. These tensions have the potential to drive volatility in the energy markets and beyond.

The bottom line: All indications are that the global economy will remain in a slow growth environment in 2020. Upside from here is possible even as a recession inches closer. On average, a recession typically doesn’t kick in until around 20 months after the 10-year/2-year spread inverts. So, equity and credit markets have time to benefit from potentially better economic data and corporate profits. However, after the spree in 2019, artificial stimulus from central banks and government spending is likely unsustainable.

Quarterly Recap:

U.S. Equities: Growth All the Way

2019 started and ended with strong quarters that were dominated by growth and particularly small cap growth. This was a pleasant change after the economic growth concerns in Q3 that resulted in a temporary shift away from momentum to value.

During Q4, small caps slightly outperformed large caps with the Russell 2000 Index returning 9.9% followed by the Russell 1000 Index at 9.0%. Despite the strong performance of small caps in both the first and last quarters, this could not outweigh their weakness in the middle half of the year as trade concerns flared. For the year, the Russell 1000 Index returned 31.4% followed by the Russell 2000 Index at 25.5%.

Comparing growth and value, growth has been the dominant theme during 2019. This came back to the forefront in Q4. The Russell 2000 Growth Index (+11.4%) followed by the Russell 1000 Growth Index (+10.6%) led markets followed by the Russell 2000 Value Index (+8.5%) and the Russell 1000 Value Index (+7.4%).

On a full year basis, growth maintained its leadership while large caps dominated small caps. During 2019, the Russell 1000 Growth Index (+36.4%) led markets followed by the Russell 2000 Growth Index (+28.5%) and Russell 1000 Value Index (+26.5%) and the Russell 2000 Value Index brought up the rear with a return of (+22.4%).

U.S. Sectors: Trade Detente

Ten of the 11 Global Industry Classification Standard (GICS) sectors had positive returns during Q4. The top performing sectors were Information Technology (+14.4%), Health Care (+14.4%), Financials (+10.4%) and Communication Services (+9.0%). All of these sectors benefited from improving growth expectations and a shift to a more growth-oriented market.

  • Information Technology continued to power ahead. The shift back to the growth rally was beneficial for this sector. The two largest holdings in this sector contributed around 50% to the return while comprising just over 30% of the sector.
  • Health Care has had a challenging year due to concerns about drug pricing and potential political pressure. This cloud lifted slightly in the 4th quarter as expectations for an Elizabeth Warren Democratic Presidential nomination declined.
  • Financials benefited from increasing growth expectations as well as long-term Treasuries finding a slightly higher level.

Real Estate (-0.5%), Utilities (+0.8%) and Consumer Staples (+3.5%) were the weakest sectors. After being the top performing sectors in Q3, these defensive, bond proxy sectors were adversely impacted by the slight increase in long term yields.

Year to date, all 11 GICS sectors notched double digit returns with three sectors having returns in excess of 30%. Information Technology was by far the top performing sector in 2019, with a return of (+50.3%). This was followed by the Communication Services (+32.7%) and Financials (+32.1%) sectors.

The Energy sector lagged during 2019 due to economic growth concerns and excess supply weighing on the price of crude. During 2019, WTI crude was reasonably rangebound between $50 and $60 / barrel. With the improving growth prospects in Q4, we have seen crude prices tick up during Q4 to end the year at $61.06 /barrel. Despite the improvement in crude prices during the quarter, the Energy sector continued to have a subdued performance. On a full year basis, the Energy sector returned (+11.8%) in 2019, making it the only sector with a return below 20% for the year.

Fixed Income: Long Rates Finding a Floor

While the party continued for equity markets, fixed income had a challenging quarter due to long-term Treasuries starting to rise. The 10-year U.S. Treasury started the year at 2.69%, dropped to an all-time low of 1.47% at the end of August and ended the year at 1.92%.

Things would have been far worse for the fixed income market had it not been for tightening corporate spreads helping the performance of risk assets. As such, some of the top performing fixed income segments for the quarter included Local Currency EM Debt, U.S. High Yield Corporate Debt, USD Denominated EM Debt, Preferreds and U.S. Investment Grade Corporate Debt.

During the first nine-months of 2019, the fixed income market benefited from the decline in long-term interest rates. Therefore, while longer duration pulled back in Q4, it has still outperformed short duration over the course of the year. Overall, during 2019, some of the top performing fixed income segments include Preferreds (both fixed and variable rate), Local Currency EM Debt, Long Term Treasuries, U.S. Corporates (Investment Grade and High Yield) and USD Denominated EM Debt.


2019’s strong returns across asset classes defies the broad trends of slowing economic growth and heightened geopolitical risks, but concerns may not translate into declining returns. While the Fed and other major central banks played a major role in driving returns forward in 2019, such support cannot continue indefinitely and will likely taper in 2020. Therefore, positive returns will require a new catalyst, or set of catalysts – a trade resolution, a rebound in manufacturing, or fearless consumers could be the keys. Yet even if some of these catalysts materialize, their impact on various asset classes, regions, sectors, and themes are likely to be felt unequally, resulting in wider return dispersions than witnessed in 2019. Throwing a dart at the dart board worked in 2019, don’t expect a repeat in 2020.  Let’s get back to looking at fundamentals. If the stock market rally is to continue, investors will need to see an acceleration in earnings growth in 2020. We will get a better sense over the next several weeks if this situation will materialize as companies report Q4 earnings.

Category: Commentary

Topics: Macroeconomic

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