It wasn’t supposed to happen this way. Not with an aging bull market on its last legs, a looming recession, and an ascending China putting the U.S. on the trade ropes. But none of that happened. Instead, we got a record-breaking year of economic growth and stock market gains. Who knew?
I think we can say with near certainty that most investors alive today have never experienced a stock market, or an economy, quite like this. After it was left for dead at the end of 2018, the oldest bull market in history continued to rage on, finishing the year with its best overall gains since 1997. Based on everything we know about the stock market, this one defies logic. It certainly challenged our assumptions about how the market should perform in a year when the aging economic expansion was finally supposed to fizzle amid rising trade tensions, the possibility of higher interest rates, and the likelihood of a wobbly job market. But none of that happened.
Following its near bear market collapse in the last quarter of 2018, the market rebounded with a vengeance that drove it to new record highs throughout the year, leaving everyone smiling but scratching their heads. Now, with the benefit of hindsight, we can posit some ideas as to how and why the stock market managed to fool everyone and perhaps gain some insight into 2020.
A Fluke of the Calendar?
An S&P 500 gain of more than 29% is noteworthy, even remarkable, considering that it has occurred just ten times over the last 90 years. But, what if the near-20 percent decline that occurred from September to Christmas Eve last year occurred from, say, July to September, and the rebound began in October? We might instead be looking at a 2019 gain of just 20 or 22 percent. My point is that a big reason for the humungous gain in the market was due simply to the arbitrary timeframe of a calendar year. The first of the year happened to coincide with the bottoming out of a significant decline from the previous year. That may be a more cynical perspective, but it is no less accurate.
Gasp! The Fed Was Wrong?
That being said, it was also a very good year in which many of the pieces that drive a strong stock market fell neatly into place – starting with the Federal Reserve. You might recall that the Fed embarked on a tight monetary policy starting in 2015. It continued with rate increases through December 2018 with a promise of further rate increases in 2019, despite a weakening global economy and no perceivable increase in inflation. This fear of Fed overreach was a big reason for the stock market decline last year.
Realizing it went too far, the Fed hit the brakes in January 2019, eventually cutting rates three times starting in July and, with no sign on inflation on the immediate horizon, taking a wait-and-see stance in December. There’s nothing the stock market likes more than low and stable rates, which was a driving force in 2019.
Historic Employment Numbers
Although some key economic signals turned mixed over the year, spurring fears of a coming recession, the employment numbers gained surprising strength. The economy added jobs in record numbers while record numbers of Americans joined the workforce. While economists have long held that 4% unemployment was considered a “full employment” threshold with little downside opportunity, the unemployment rate blew through that barrier touching 3.5% at yearend. Employment gains among women and minorities were the strongest in history. When you combine full employment with the fastest middle-income wage increases in more than a decade, the household sector – which represents 70% of GDP — continues to fuel the economy. We don’t hear any more from the Chicken Little media about an imminent recession.
What about the Trade War?
Unquestionably, the on-again-off-again trade talks with China moved the markets this year. The question is how much was driven by the headlines and how much was driven by the actual impact of the tariffs on our economy. Amid trade talk brinksmanship, President Trump threatened to raise tariffs again, sending the U.S. stock market into a $5 trillion conniption for about 30 days. When the two sides agreed to play nice again, the market recovered and, when a “phase one” agreement was announced, the markets rallied to new highs.
In reality, while trade tensions between the U.S. and China have cast a long shadow over the economy for the last two years, they haven’t had the expected impact on price growth. In other words, consumers have yet to feel the brunt of the tariffs because businesses and Chinese manufacturers have been absorbing the higher cost. Should tariffs be expanded to a broader range of consumer products, they may feel the pinch.
The more significant issue for investors is that the real, structural problems of a U.S. – China trade relationship are not going away anytime soon. At the very least, Trump has pulled back the curtain on decades of trade abuse by China. And the so-called phase one agreement barely scratches the surface of what will be a generational struggle to get China to fall in line with the rules and mores of the global trading community. The transient headlines of today may seem mild compared with what we may see in the future.
The Key Takeaway Going into 2020: We Still Don’t Know What We Don’t Know
Going into 2020, investors have every reason to be cautiously optimistic. Rates should remain low, corporate profits are at historically high levels, consumer optimism is rising, the industrial sector is accelerating, and the overall economy is starting to hit its stride. On the other hand, we’re entering a contentious election year amid an impeachment and more investigations. The increase in corporate debt and valuations is accelerating. Another shoe could drop in the trade dispute. And who knows if the Fed will be able to sit on its hands all year.
While we can’t know how the year will unfold, we can still focus on what is knowable and important for positioning our portfolio for possible shocks while capturing whatever returns this market has left to give. That will be the focus of our next blog post.