Weekly Markets Review – 12/12/2019
We’re heading into the close of 2019, where it was a somewhat tumultuous year for equity investors, but for those who have maintained a long bias, it has been one of the best years in quite a while. With the S&P 500 advancing 25% YTD, which compares to 2017 performance of +19.4%. The market has had a fairly strong year, though the beginning of 2019 was filled with questions and uncertainty. The bar is set high for a repeat of those types of gains in 2020, although we anticipate that a reversion to the mean scenario where the S&P 500 advances in a range of 10%-12% is highly doable given the fundamental backdrop of lower interest rates, and diminished earnings comps heading into 2020.
We continue to maintain our optimism on equity prices, though we echo some of the sentiments tied to diminished equity momentum heading into 2020, though with the caveat that comps are reduced to a level where outperformance among lagging sectors should lead to earnings growth, which should then extend the equity markets momentum in 2020. This is driven by weak comps due to the weak earnings environment through the course of FY’19 with S&P 500 earnings persistently flat or negative through the course of the year, which should translate to stronger earnings performance on stronger y/y comps due to some macro strength as a tailwind, and some FX impact as well.
Also, some of this optimism seems to be priced-in towards the tail-end of the year. When it pertains to Federal Reserve policy, we’re not anticipating much in the way of interest rate cuts in 2020. Though, there’s a possibility of one additional interest rate cut assuming US-China trade tensions continue, and inflation persistently remains below the 2% target set by the Federal Reserve. To drive inflation we anticipate that wage growth will be a big factor, price of commodities could contribute to inflation, but with the price of crude oil persistently in the doldrums we anticipate that driving inflation will be difficult absent of some added interest rate cuts, so the Federal Reserve can keep pace with the ZLB (Zero Lower Bound) or NIRP (Negative Interest Rate Policy) that’s being set by rest of world Central Banks.
FOMC Statement Dominates Market Headlines
For the most part, interest rate policy remained unchanged with most market participants shrugging at the non-event, as we had discussed in our numerous publications leading to the FOMC meeting in December, we anticipated that there wouldn’t be an additional interest rate cut following the spate of strong economic news heading into the event, and the heightened expectations of at least a phase-1 implementation of the US-China trade deal.
When pertaining to the dot matrix plot, we tend to disregard the long-run projections of the Federal Reserve, as we’ve never seen the policy path fully implemented as described in all our years of following the Federal Reserve. As such, we’re going to dedicate the discussion strictly to the 2020 dot matrix plot where they’re signaling the slight yet extremely low possibility of a +25 bp interest rate hike.
While the decision was unanimous among all voting members when pertaining to the present policy level of 1.5%-1.75%. We saw something else that was interesting from the projection materials, and so we compare the prior projection materials that was published on September 18, 2019 where voting members projected an interest rate of 2.5%-1.5% for 2020. When counting the votes carefully from the September, 2019 meeting with regards to 2020 there was 1 vote in favor of 2.25%-2.5% interest rates, 6 votes in favor of 2%-2.25%, 2 votes in favor of 1.75%-2%, and 8 votes in favor of 1.5%-1.75% (the present policy level).
We then compare the 2020 sentiment from the September 2019 forecast to the December 2019 forecast, and we think the dovishness is still here, as opposed to the headline fake of various news outlets that suggest otherwise.
Source: Federal Reserve
As you can tell by the above dot matrix, there are now only 4 votes in favor of 1.75%-2.00%, and there are 13 votes in favor of keeping interest rates at 1.5%-1.75%. What this suggests is that we’re still on a monetary easing path, because the prior forecast was more hawkish in nature when compared to the current forecast, and the Federal Reserve still voted to cut interest rates by another -25bp in October’s meeting anyway. This suggests that we’re still facing the distinct possibility of an additional rate cut or two in FY’20, which should provide added relief to markets next year, and it’s why we’re anticipating some of the market gains to be driven by a lower-interest rate environment, and it’s why we think investors should continue to position at the long-end of the bond yield curve across US-Treasuries and Corporate Bonds, because interest rates are likely to continue trending lower, which should lead to mark-to-market gains on term premia in the interim.
We also anticipate that underwriting in fixed income, and bond issuances will increase in 2020 given the more favorable interest rate environment. The predictable environment in fixed income will also provide somewhat of a tailwind for investment banks that trade fixed income, and additional underwriting fees than usual. This will be driven by new debt issuance, debt restructuring, or debt rollover for both consumer/commercial banking. We also anticipate that M&A activity will increase among larger corporations, and private equity firms looking for LBOs (leveraged buyouts) will execute more transaction in 2020, so we anticipate private market activity to increase, and also large corporate transaction to pick-up momentum due to the favorable interest rate environment.
Financial Select Sector (XLF) SPDR Fund from Google Finance
This might help compensate the banks who are likely to experience some net interest margin deterioration in the more dovish environment, though I don’t imagine the big banks complaining given the favorable impact on trading, and heightened consumer/commercial banking activity. Though, when interest rates trend lower, markets volatility tends to dissipate, which leads to less brokerage commission given diminished trading volumes, which is why the macro narrative while somewhat easy to follow, it’s difficult to articulate the impact when pertaining to financial sector stocks. This is why Financial stocks are performing in-line with the S&P 500 this year, as it’s difficult to anticipate how well the banks will perform with interest rates trending lower after an abrupt reversal in Hawkish Powell’s policy approach. We think the financials will likely perform in-line with the broader markets next year given the five-year mean, so investors would have to be highly selective on fundamentals to look for distinctive opportunities among financial services firms in 2020.
Political & Economic themes for the week
USMCA ratification or US-Mexico-Canada trade deal being brought forth for a vote by the lower-house or Congress next week. We anticipate that Congress will pass the USMCA, which should have a positive impact on North America trade this upcoming year, which should lead to some positive impact on US trade flows with both Canada and Mexico, though the sentiment from various political analysts has been that of modest adjustments to NAFTA (North America Free Trade Agreement). The legislature is likely to pass the bill mainly because of the congressional districts where swing voters are more present, and with Democratic moderates needing to demonstrate some pro-economic policies given 2020 is a re-election year for all congressional districts.
The impact might add some momentum to US GDP next year, although the Federal Reserve’s forecast suggests 2% GDP growth vs. their forecast of 2.2% GDP growth in 2019. So, the impact from this trade agreement is likely to be modest, but could perhaps the needle by 20-35 bps, which could provide enough uplift to GDP to bring us above the Fed’s forecast, which is why we reference the impact from the revised trade deal.
Source: Real Clear Politics
In terms of pure politics, we saw some of the trends we outlined in our prior market edition report, where we anticipate the Buttigieg would lose some of his momentum on the polls dropping from 11.4% to 9%. The remaining field weakened considerably when compared to their prior polling figures with the exception of Andrew Yang holding on, and Michael Bloomberg gaining momentum (as we had already anticipated) with Michael Bloomberg gaining 5.5% approval making him the 5th most popular candidate based on recent polling data. We anticipate that Michael Bloomberg will move to the 4th spot in short order given his stellar track record in both politics and business, and his centrist/moderate stance on politics that will make him a clear favorite heading into 2020 to go toe-to-toe with Joe Biden. Also, we anticipate that while Joe Biden has maintained his edge against his opponents there’s no denying that he’s in a bit of a holding pattern with his poll figures in a range of 25%-30% with Donald Trump frequently smearing Biden at various political rallies (as of late). This doesn’t have much impact on the Democratic leaning base, but it does have a significant impact on undecided voters, or independents in various swing-districts.
When pertaining to Elizabeth Warren and Bernie Sanders, it’s becoming obvious that Sanders is building up some momentum ahead of Elizabeth Warren. This is mainly because he’s been a favorite in Democratic election cycles for quite a while now, and a fan favorite among millennials, though we doubt moderate Democrats that fall into an older age cohort find his far-left views that appealing.
In terms of Elizabeth Warren, her poling figures continue to slip, as we believe the rationale outlined in some of her policies sound dangerous enough to make even the most loyal Democrats question her 2% wealth tax, and also her views on Medicare for All. Though, to be fair both Bernie and Warren split the far-left base between each other, and it’s why they’re kind of competing with each other neck-and-neck to win the far-left, whereas Michael Bloomberg and Joe Biden are playing a sort of tug-of-war to win the moderate Democratic base.
We don’t anticipate any of the other candidates currently in the field to stand much of a chance at a Democratic Nomination, as of present. For example, Buttigieg looks like a Geometry Teacher in a High School district, as opposed to a Presidential candidate. Also, Buttigieg’s debate tactic is kind of irritating to listen to, and this is mainly because he reminds you of the brats that always raise their hands in the middle of class to throw in their two cents while snickering to their friends as they make their High School English teacher howl with frustration in the middle of class. He’s just that irritating to watch, and we can’t imagine him winning a nomination much less a presidency.
The other candidates while having interesting political commentary like Amy Klobuchar (for example) she also tends to ramble on in a format that’s very logical, and it’s kind of reticent to listening to Rand Paul on the Republican side when he tried to run against Donald Trump back in 2016. The two mirror each other while they sit on opposite sides of the political aisle, and their debate strategy is also reticent if not similar to each other, which means neither of them are likely to win a presidency anytime soon though both come across as great intellectuals and legal scholars.
Donald Trump impeachment heading to the Senate floor…
Yes, Donald Trump is arguably the least happy man… when it pertains to the impeachment process. Now, this doesn’t mean we anticipate him to actually get impeached, but he sure knows how to talk himself into a corner when it pertains to wooing any Democratic support on this matter.
We don’t anticipate the Republican Senate to vote in favor or impeachment, so the impeachment is unlikely to happen. What’s more likely to happen is as we had already described, and what has already happened is political leverage for pro-Democratic policies. The way it’s described in the mainstream media isn’t what’s actually happening behind the scenes, as this has less to do with diminishing Trump’s favorability with his base, but rather putting a stick in the sand to buy Democrats more time, and more political currency as a means of negotiating progressive policies with the threat of articles of impeachment looming right over Donald Trump assuming the Democrats win more districts in the 2020 cycle in both the lower and upper house.
Congress is set to vote on the Article of Impeachment starting Thursday, i.e. today as of date of publication. We anticipate that the vote will pass the lower house (next week), and then the Senate will be convened to vote on the matter in January. During this timeframe there will be a lot of negotiating by Democrats to convince some Republican Senators to vote in favor of Impeachment, but we don’t anticipate any of the Republicans even the most spiteful towards Donald Trump, i.e. Mitt Romney to vote in favor of impeachment.
So, instead we anticipate that various legislative deals will be worked out to either diminish Donald’s favorability by voting against hard-right leaning policies, or the Democrats will work to advance progressive legislation. The confusion tied to the impeachment process helps Democrats in various backroom deals to improve the number of votes tied to left-leaning legislation that could garner some bipartisan support while legislators also leverage the opportunity to rile up both party bases. Textbook politics where nobody really gets what they want, but at least Democrats will have an opportunity to negotiate various chits as a means of advancing some progressive legislation in January.
We anticipate some momentum to close out December with sideways consolidation in the first couple of weeks of December already baked in. The impact from political headlines while hardly surprising has already been absorbed, and it’s unlikely that the status quo scenario involving Donald Trump is unlikely to change anytime soon. However, it’s worth noting that during all this confusion a number of pro-Democratic legislation is likely to pass the house and senate in the coming months as a means to pander to the Democratic base following a failed impeachment on Donald Trump as a means of some compromise.
When pertaining to the somewhat neutral Fed policy stance we don’t really buy it, we think the Federal Reserve’s latest policy path forecast is more dovish in nature than historically, and it’s likely that we’re in for a couple rate cuts in 2020 contingent on economic data. That being said, there will be plenty of reasons for markets to panic sell in an election year, so it wouldn’t be surprising if a number of geopolitical events force the Fed’s hands next year.
In terms of positioning we continue to emphasize equities, particularly the cyclical-types that have diminished comps from 2019 to carry-over more strongly in a 2020 earnings growth year. We also prefer longer-duration bonds over shorter-duration mainly because of the added term premia appreciation at the long-end of the curve and the predictable policy path.
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