All is calm, all is bright—markets are strangely quiet as we head into year end, with the S&P 500 Index sitting near all-time highs.
In fact, volatility has been remarkably low throughout 2019; the maximum drawdown this year was less than 6% compared with the 14% average that we’ve had in the last 15 years.¹ Several positive catalysts have contributed to this environment, including an accommodative U.S. Federal Reserve (Fed), improving global economic data, and positive news flow on the U.S.-China trade front. Looking into the horizon, here are the three key risks we see for 2020 that could disrupt the calm seas.
Risk 1: the end of not "QE"
After expanding its balance sheet to $4.5 trillion with QE2 and QE3, the Fed started to shrink its balance sheet in 2018. However, when the repo market started to act up in mid-September, the Fed started to use its balance sheet to hose down the liquidity dry-up that was driving short-term borrowing costs higher. More than a year later, the central bank has kept the tap running, and the hose remains in use—and what was termed “not QE” (although the bill-buying exercise adds to the Fed’s balance sheet, the central bank took pains to stress that it isn’t quantitative easing). In fact, the Fed’s balance sheet has grown by $300 billion in the space of a few months. The current rate of balance sheet expansion is faster than past QE programs, regardless of what the central bank chose to call it. How much is this affecting the market? The current upside move in the S&P 500 Index coincided with the balance sheet expansion in mid-September into October, but we won’t really get a sense of its impact to financial assets until “not QE” comes to an end.
Risk 2: earnings engine fails to restart
Recent gains from the market have all come from earnings multiple expansion, and today, the forward price-to-earnings ratio (P/E) stands at 17.7x. Over the last decade, the highest P/E ratio we reached was 18.5x. Although earnings estimates are now down to a meager +0.1% for 2019, corporate earnings are still expected to drive market performance in the year ahead—the street’s still expecting +9.7% earnings per share (EPS) growth for the S&P 500 Index in 2020.¹ In our view, a lot will need to go right on the macro front for that amount of growth to be achieved. This includes a sustained move higher in the U.S. Leading Economic Indicators Index and a confirmed bottoming of Purchasing Managers’ Index data globally. We’re not ready to call the “all clear” on this front—yet.
Risk 3: investors overthink the 2020 U.S. presidential election
It’s easy for investors to let their emotions get in the way of making sound investment decisions, and it’s even easier when politics are involved. Different administrations can have different priorities, which can influence short-to-intermediate investment returns and risk; however, giving too much weight to political developments in the decision-making process has historically led to suboptimum portfolio decisions. Although we’re roughly a year away from the next election, we’ve already seen examples of how politics can influence investor behavior. For instance, we’ve observed an inverse correlation between the performance of the U.S. healthcare sector and the betting odds of Elizabeth Warren winning the Democratic nomination. Investors essentially sold healthcare when they thought Medicare for All was a strong possibility. Ultimately, the selling pressure helped to unlock value in a sector with strong fundamentals. If investors were to choose to anchor their political views to their investment decisions, they’re likely to end up making missteps along the way. In our view, that’s a big risk going into 2020.
What to do now
As John F. Kennedy famously said, “the time to repair the roof is when the sun is shining.” In our view, investors should adjust their portfolios now, rather than waiting until volatility picks up and emotions can get in the way. What should they do?
While we might be on the cusp of a whole new decade, what remains unchanged is the fact that we’re still in the late cycle. As we’ve mentioned previously, one way to approach late-cycle investing is to move up the quality spectrum in bond portfolios. Higher quality debt typically holds up much better in times of slowing growth and market stress.
Investors might also want to consider moving out of cash holdings and move into core bonds. This could make sense in the current environment given that the Fed has stated that interest rates aren’t likely to rise for some time.
Alternatively, the traditional 60/40 allocation between stocks and bonds could also be an option—balanced portfolios can be a simple way to capture returns when stocks move higher, while the bond allocation can provide some shelter in times of volatility.
For more on these concepts, please visit our flagship market outlook publication, Market Intelligence.
1 FactSet, as of 12/11/19.