30 Dec 2019
Investors Should Stay at Their Long-term Strategic Allocation to the U.S. Equities
As we enter 2020, we remain tactically neutral on U.S. equities—which means we continue to recommend investors stay at their long-term strategic allocation to equities, while using volatility to rebalance back to those long-term targets. Within U.S. equities, we remain biased toward large cap stocks at the expense of small cap stocks given the latter’s weaker profitability path and higher debt ratios; although small caps’ valuation discount should continue to provide some relative support.
Manufacturing weightier than its economic weight
In the coming year, we will likely continue to focus on what to-date has been a fairly firm dividing line between the manufacturing/business investment side of the economy and the services/consumer spending side. The divide in confidence has been stark and could persist at least at the outset of 2020. CEOs’ forward-looking confidence is currently at levels last seen during the global financial crisis; while consumers’ expectations remain near historic highs.
Both manufacturing and business investment tend to punch above their weights in the economy as they are more cyclical and leading in nature. Historically, it’s via the labor market that the morphing of manufacturing/business investment into the broader economy has occurred. On that note, heading into 2020, so far so good.
The labor market has significant momentum heading into the new year; with the unemployment rate at a 50-year low; payrolls growing at a robust pace; but unemployment claims recently ticking higher—albeit still at historically-low levels. Unemployment claims bear close scrutiny heading into 2020, as they typically carry signals for the future health of the labor market. In fact, they are one of the 10 components of The Conference Board’s Leading Economic Index (LEI), on which we keep a close eye.
The level of the LEI has been flattening over the past year; while the year-over-year rate of change has yet again dipped to the zero line. For now, this recent weakness is reminiscent of the two prior intra-cycle slowdowns—both of which had a manufacturing bent to them. But further weakness from here would likely elevate the risk of a broader contraction in the economy. Some good news may be coming from the rest of the world. Global LEIs have been leading U.S. LEIs since the eruption of the trade war in 2018; and they have recently stabilized. Further improvement outside the United States could lead—with a lag—to a stabilization in U.S. LEIs.
Deal lite or real deal?
Although a “Phase One” trade deal has been agreed to by the United States and China; it falls quite short of the initial U.S. goals of forcing China to morph its state-driven economy to a more open/fair economy. It does, for now, defer the tariffs that were set to go in effect on December 15, 2019. That’s good news as they targeted a mass of consumer-oriented goods. In addition, there was a partial roll-back of prior tariffs—with those having been imposed last September getting cut from 15% to 7.5%.
However, the “original” 25% tariffs on $250 billion of Chinese goods remain in place. China also agreed to increase its purchases of agricultural products to $40 billion, up from its current annual run rate of less than $10 billion (and the all-time peak of $29 billion). However, the product lists will not be publicly disclosed; meaning monitoring capabilities will be limited.
The “deal” also doesn’t mean the Trump administration won’t continue to use tariffs and other trade barriers as a tool to coerce various concessions from, or to punish, other countries. This ongoing uncertainty is likely to keep a lid on corporate confidence—and in turn capital spending. Even with trade tensions somewhat reduced, corporate confidence will also likely remain muted in what is likely to be a very contentious election year. In fact, for the first time in 11 years, as per the ISM Manufacturing survey, U.S. manufacturers are expecting to reduce capital spending in 2020. The expected 2.1% decline follows a 6.4% increase in 2019.
Fed to the rescue?
The Federal Reserve’s three interest rate cuts in 2019 clearly supported asset markets, as well as interest-sensitive areas of the economy. The Fed currently expects to stay “on hold” in 2020; recently declaring that they have essentially set the bar higher for inflation to lead to rate increases; even if the tight labor market causes wage gains to accelerate. We do believe inflation could surprise marginally on the upside this year; which could be a cause of some market volatility.
History shows that during cycles when the Fed continued to cut aggressively (two or more additional times after the third cut), the stock market suffered relative to times when the Fed continued to cut less than two additional times. This should be intuitive given that a Fed that continued to cut rates aggressively was likely combating recessions.
Earnings need to step up
So for now, the Fed’s position supports the intra-cycle slowdown thesis as well as the equity market. However, the tailwind behind P/E multiples may have run (most of) its course. Most valuation metrics—including P/Es—are stretched relative to history; and now likely require earnings growth to begin to do some of the market’s heavy-lifting. According to Refinitiv, S&P 500 earnings growth is expected to rebound back into double-digit territory by the second half of 2020; but estimates have been trending down for several months, and are likely to continue to do so.
In particular, profit margins are under pressure courtesy of both tariffs as well as rising unit labor costs; not to mention the more secular weight of de-globalization. The historically-wide spread suggests either profits will eventually need to catch up to the market; or stocks may have to correct to move more in line with profits. At this point, we expect a combination of both for the coming year.
New heroes are needed in 2020 for global markets
Unless global growth reaccelerates, international stocks may remain stuck within the volatile range of the past two years, given their high sensitivity to economic conditions. In 2020, growth may depend on comprehensive trade deals and fiscal stimulus to reverse the 2019 slowdown in manufacturing and business investment. If tariffs are not lifted before businesses cut jobs, it may undermine the consumer spending that is supporting the world’s economy.
Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.
The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.
All expressions of opinion are subject to change without notice in reaction to shifting market, economic or political conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.
Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.
The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.
Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.
The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc, and the source of comments provided here.
About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist