Investment Strategy Overview

The year ahead in 2020 represents another milestone in the post-credit crisis era. This expansion is the longest on record in the U.S. at over 127 months and has included numerous volatile episodes just about every year of that period. The post-crisis decade has included new monetary policy experiments, a double oil price collapse, central bank balance sheet expansion and contraction, negative interest rate debt totaling over $17 trillion at one point, unexpected world leadership changes, a Brexit vote, and a U.S. and China trade war, just to name a few.

Heading into 2020 we maintain our bullish stance given our view that monetary policy remains accommodative, global growth bottoms in Q1, election uncertainty ultimately fades, and the trade negotiations with China continue to move further into de-escalation mode in general. In addition to our more balanced view and accompanying portfolio strategy we expect two other scenarios to be debated throughout most of 2020. The three scenarios, which we outline on the following pages, are:

• a melt-up scenario in which sentiment turns from bearish or more defensive to significantly more positive, benefiting risk assets significantly;
• a balanced view (our base case) that mixes growth optimism with election uncertainty over the summer;
• a shallow negative performance in which growth falters and geopolitical risks rise.

Three primary areas in 2020 should help determine the magnitude and direction of capital market activity and whether scenario one, two, or three prevails by the time 2021 arrives. The three areas, which include Trade, Politics (namely U.S. elections), and the level of Inflation are all in some form of transition. How surprising they become relative to consensus beliefs should ultimately determine the level of interest rates, the appetite for risk assets, the direction of the U.S. dollar, the degree of below- or above-trend economic growth in key countries, and the direction/communication of monetary policy (most importantly from the Federal Reserve [Fed]). Throughout 2020 all three scenarios may appear, at different times during the year, to be developing, but we still land on the balanced view unfolding in the end. In our view, it is less important to determine the return for equities for the calendar year. Rather, we prefer to provide an assessment on the business cycle, how capital markets might react, and whether the widely discussed concerns are just headlines or actually materialized. Returns based on calendar year are generally for year to year investors not necessarily for longer-term investors looking to achieve specific goals.

Although we continue to envision a World in Transition, we expect the bull to trot onward in a positive direction. More importantly, our view for the long term is further cemented by the growing positive force of demographics and innovation. We expect these two dominant forces to gather momentum in the next decade and beyond, which should induce the second major wave of an equity culture, in our opinion. Lower overall total returns in fixed income, predominantly due to yields that are higher albeit still low compared to recent history, could force a larger than expected rotation of capital into equities as millennial and Gen Z investors enter their prime investment years. The need to maintain a specific level of total portfolio return should likely induce a higher equity allocation.

After a period of initial disruption, this should be supported by a backdrop of surprising growth and higher productivity led by the second wave of innovation encompassing automation, robotics, on-shoring and the development of local supply chains, 5G, perhaps a new utility grid system and personalized medicine, not to mention the rising potential for significant investment in global infrastructure, the advancement of trends in sustainability and impact, and solutions to combat the negative impact of climate change. All elements of a World in Transition.

As we experience an entire new movement of globalization toward localization, the areas of the world with greatest access to natural resources, education, healthcare, skilled labor, and innovation should dominate, which is likely to break the U.S. further away from the rest of the world. The powerful demographics of close to 150 million millennial and Gen Z consumers mixed with an unprecedented potential transfer of wealth from the Boomer generation to Gen X ($32 trillion according to Cerulli Associates) should help subsidize “the aging of adjacent generations” and strengthen many of the trends mentioned below including housing and experiential services industries. In addition, new opportunities should continue to develop around sustainability and impact strategies.

The core U.S. consumers should receive help from the rising income of the growing youthful population in the emerging markets (EMs), which should further transition these economies toward service-led industry build-outs relative to manufacturing. On-shoring in the U.S. through high-end, more automated manufacturing is likely to create rising opportunities for new jobs that mix engineering with technology and factory servicing.

Moreover, while the ultimate long-term bull market and more positive economic cycle unfolds, it is important to understand that debt around the world continues to grow at a level that could prove to be unsustainable. As long as interest rates remain low (even if they back up slightly in the years ahead) with a shallow ceiling, debt service should remain around current levels, thereby keeping this expansion on the tracks. However, small bouts of cyclical inflation, periods of significant over valuation (bubbles), or structural policy errors could upset the business cycle and help create recessions from time to time. Given our view that we expect the mini-expansion, mini-recession type business cycle dynamic to remain in the years ahead, we believe recessions (when they materialize) are more likely to be short and shallow with a cub-like equity market drawdown rather than a nasty grizzly bear.

While some are likely to “wait” for the “cubs” (small bear markets) or some exogenous shock, we continue to use periods of weakness as portfolio rebalancing opportunities across allocation profiles and align with the long-term bull. We maintain our strong preference for equities relative to fixed income.

Scenario Analysis

These scenarios reflect our view of the likely range of economic, geopolitical and market outcomes for 2020. As noted, whether scenario one, two, or three prevails in 2020 should be determined by developments in three areas—trade, politics, and inflation—and all three scenarios may appear, at different times during the year, to be developing.

I. Melt Up Scenario in which growth is better than expected and geopolitical risks fade

• U.S. equities rise 14% or higher as measured by the S&P 500
• S&P 500 earnings of $183 (estimated 10%-12% plus growth)
• Price/Earnings (P/E) multiple of 19-20
• 2019 S&P 500 base of approximately 3125
• 2020 S&P 500 level of 3575 or higher achievable

Components:
Further Policy Easing

• Easier monetary policy that includes further expansion of the Fed’s balance sheet, as growth surprises and inflation contained
• Further non-U.S. central bank policy accommodation
• Fiscal policy discussions in Europe led by Germany and France; the likely fiscal stimulus could be infrastructure-related
• Significant wave of automation and innovation takes over, driving corporate margins and profitability higher
• U.S. consumer and housing picks up steam as job growth and personal net income remain healthy

Trade Risks Fade Significantly

• Phase 1 trade deal with China signed which rolls back tariffs and includes significant agricultural purchases
• Phase 2 of the trade deal discussions begin and ultimately include greater domestic market access for U.S. firms, intellectual property and technology transfer rights relaxation

Election Risks Removed

• The scenario of highest uncertainty (higher regulation, higher taxes, resumption of trade uncertainty) is taken off the table after the primaries
• Impeachment uncertainty removed

Growth Better Than Expected

• Global and U.S. economic growth better than expected and rise above trend
• S&P 500 earnings growth of 10%-12% driven by the consumer (housing, jobs), substantially improved industrial activity (autos surprise) and higher capital investment (another major leg in innovation)

Investor Sentiment

• Bears turn to bulls as investor cash levels fall, some fixed income rotation moves to equities
• P/E multiple expansion (1-2 points) occurs as investor enthusiasm takes hold
• Defensive positioning is unwound

Portfolio Implications

• Equities significantly outperform fixed income as yields back up; curve steepening supports rising growth, reflation and equities
• Weaker dollar, low oil prices, low volatility and improved global growth supports non-U.S. equities, which rally in line or above the U.S.
• Cyclicals continue to outperform defensives and financials take over full market leadership as yield curve steepens
• Momentum and value-oriented investments gather strength throughout 2020
• Credit and structured product in fixed income outperforms Treasurys and munis
• High yield spreads narrow further and total return in lower-quality credits reaches mid-high single-digit percentages

II. Balanced Scenario that mixes growth optimism with election uncertainty over the summer (base case)

• U.S. equities rise around 8% as measured by the S&P 500
• S&P 500 earnings of $177 (estimated earnings growth of 8%)
• P/E multiple of around 18.5 (valuation neutral)
• 2019 S&P 500 base of approximately 3125
• 2020 S&P 500 level of 3300 plus achievable

Components:
Maintain Current Monetary Policy and Fiscal Policy

• Monetary policy that includes current pace of expansion of the Fed’s balance sheet, inflation remains consistent with the Fed’s target of 2% prompting no change to current Fed policy
• Non U.S. current central bank policy maintained
• Fiscal policy discussions in Europe led by Germany and France but not likely to be approved in 2020
• China growth stabilizes
• Clarity on the implications of Brexit improves
• U.S. consumer and housing remain engines of growth for the U.S.
• Automation and innovation enter second gear; on-shoring begins as automation helps keep operating leverage and margins stable

Trade Risks Continue To Fade but Concerns over Phase 2

• Phase 1 trade deal with China signed eventually which rolls back tariffs and includes agricultural purchases
• Phase 2 of the trade deal discussions become on-again off-again but ultimately begin with greater domestic market access as a core element but no movement on intellectual property and/or technology transfer rights

Election Uncertainty Drops but Remains Ambiguous

• The scenario of highest uncertainty (higher regulation, higher taxes, resumption of trade uncertainty) fades over the summer months but not completely removed
• Uncertainty remains into the November presidential election keeping equity valuation from rising too high
• Impeachment uncertainty removed

Growth Bottoms

• Mini-expansion type phase re-gathers its footing as global economic growth bottoms in Q1 and rises to trend levels
• S&P 500 earnings growth of around 8% driven by the consumer (housing), slightly improved industrial activity (autos pick up) and capital investment (continued innovation)

Investor Sentiment Improves But Still Cautious

• Bears remain given election risk and concerns over global trade but investor cash levels decline somewhat and equity exposure rises
• P/E multiple remains around 2019 levels and earnings growth drives the total return for equities
• Defensive positioning is lower but still not completely removed

Portfolio Implications

• Equities outperform fixed income handily; small curve steepening supports equities
• Stable to slight weakness in the dollar, low oil prices, and slightly improved global growth provides some support to non-U.S. equities, which perform in line with U.S. but solid performance could remain fragile if dollar strengthening resumes
• Solid dividend-paying and growing companies perform well across a number of sectors
• Industry groups in sectors that benefit from healthy consumer spending and housing (Consumer Discretionary and Financials) mixed with improved industrial activity (Industrials) and specific technology themes should perform well
• Large cap preference remains given balanced scenario
• A diversified mix of growth and value performs well across sectors
• Investment grade corporate credit outperforms; high yield spreads remain narrow but low yields remain relatively unattractive; longer-dated Treasurys and munis still represent a hedge on equity risk

* In this base case scenario we believe most of the equity performance occurs earlier in the year as the global economy bottoms while monetary policy remains accommodative. We expect election and geopolitical uncertainty to potentially pressure risk assets through the summer, which would represent a buying opportunity in our view, before closing the year back toward 2020 highs in December.

III. Uncertain Scenario in which growth falters and geopolitical risks rise

• U.S. equities down around 5%
• S&P 500 earnings of $164.50-$165 estimate (earnings growth of 0%)
• P/E multiple fades 1 point to 17-17.5
• 2019 S&P 500 base of approximately 3125
• 2020 S&P 500 level of around 2875 or slightly below

Components:
Monetary and Fiscal Policy

• Fed becomes too patient as growth falters later in year and inflation drops; Fed rates stay at current levels too long and parts of the yield curve invert again
• Non U.S. current central bank policy becomes less accommodative as signs of an economic pick-up in overseas economies emerge
  
• Fiscal policy discussions in Europe led by Germany begin but do not materialize

Trade Risks Rise

• Phase 1 trade deal with China is delayed into Q1 but ultimately signed with limited tariff concessions and agricultural purchases
•  Phase 2 of the talks breakdown over the spring/summer as election uncertainty takes hold
• The United States-Mexico-Canada Agreement (USMCA) trade deal remains unsigned and trade in the North American block becomes less certain

Election Uncertainty Rises

• The scenario of highest uncertainty (higher regulation, higher taxes, resumption of trade uncertainty) rises over the summer months as campaign season heats up
• High level of uncertainty remains into November presidential election with slower growth and trade uncertainty which could push equity valuation lower
• Impeachment uncertainty lingers though end of Q1

Economic Growth Bottoms Initially Then Slows Down Below Trend

• Global economic growth bottoms in Q1 but falters again in the middle of the year as a tired consumer mixes with weak industrial activity
• S&P 500 earnings growth of 0% or slightly lower driven by lower consumer confidence and spending, lower capital investment given election and trade uncertainty
  
• Weaker growth prompts risk aversion and a general flight to safety which could trengthen the dollar and pressure overseas growth

Investor Sentiment Improves In Q1 but Then Takes Its Cue From Election, Trade, and Growth Uncertainty

• After initial respite the bear camp gathers momentum as recession risk rises just prior to election
• P/E multiple drops below 2019 levels; this mixed with 0% earnings growth could create negative return environment in equities
  
• Defensive positioning rises; flows increase into more conservative investments such as Treasurys, higher-yielding equities, and gold

Portfolio Implications

• Fixed income outperforms equities as volatility picks up and risk aversion rises
• U.S. and higher-quality, defensive growth sectors (Consumer Staples, Utilities) and
• Stronger dollar and slower growth pressure overseas markets which leads to underperformance
  
• Higher-yielding companies (Real Estate Investment Trusts [REITs], Utilities) with solid balance sheets outperform
• Commodity-related sectors (Materials, Energy) underperform
• Momentum (high P/E multiples) and value-oriented cyclicals (Industrials) underperform
• Treasurys and munis outperform credit; high yield spreads widen out and lower quality
• credits underperform as defaults rise

For in-depth commentary on our views on specific asset classes and discussion of timely investment topics, see the full-length version of this edition of Investment Strategy Overview.