Pence Perspective | Q1. 2020

Executive Summary:

2019 was one of the greatest years for stocks. The S&P 500 was up 28.9% (or 31.5% including dividends), the second highest return since 1997 or fifth highest return since 1958.

• For 2020, we expect between high single-digit and low double-digit stock returns.
  • We see fewer headwinds in 2020 compared to last year which may favor stocks over bonds.
    • “Phase One” pact between the U.S. and China is done.
    • Brexit is almost over.
    • The global growth slowdown probably bottomed in 2019.
    • The Fed is on hold, meaning we expect mortgage rates to stay below 4%.
  • The market expects 9% earnings growth and 7% sales growth for 2020, according to FactSet.
  • We believe more visibility and less uncertainty ahead can support the current trailing Price-to-Earnings (PE)[1] multiple of 22 as we get closer to the 2020 Presidential elections.
    • If Trump wins a second term, we expect a positive market reaction and support for the current PE multiple – possibly heading towards double-digit stock returns.
    • If Democrats win the White House, we expect a somewhat contracted PE multiple and a mixed reaction with heightened market volatility mostly due to an expectation of a Tax Bill that will increase individual and corporate tax rates.
      • We probably won’t know the most likely Democratic nominee until after the Super Tuesday primaries on March 3, when nearly a third of party delegates pledge.
    • Historically, when the S&P 500 Index returned greater than 30% over a one-year period, 85% of the time the subsequent year also saw positive returns. In fact, the average return was 10.4%.[2]
  • We expect the U.S. economy to grow at or above a 2% rate in 2020 and 2021 given the strength of the household sector and labor market.
    • Consistent with our previous forecasts, we expect no recession[3] in the U.S. in 2020 or 2021.
      • “It’s hard to get the numbers to show a recession unless you assume a massive policy mistake or a very big market accident”, Mohamed El-Erian, chief economic advisor at Allianz
    • Today, there are more people working and making more money than ever before; in 2019, 2.1 million jobs and nearly $130 billion in income were added to the U.S. economy, to be exact.
    • We expect this trend to continue as 21 states are increasing their minimum wage for 2020.
  • We continue to favor and overweight sectors such as information technology, consumer discretionary, communication services and national defense contractors.
    • Today’s tech companies are very different from those a decade earlier. They have become a key part of modern life providing necessary infrastructure for corporations and consumers. We see technology products and services as fixed assets rather than discretionary spending items.
    • The tech sector has revolutionized today’s consumer and corporate behavior. Since the end of the cold war, world economies have moved from being a “command economy” to a “demand economy”. In its simplest form, Say’s Law is frequently understood as “supply creates its own demand”. But today, thanks to technological innovations and targeted advertisements, the reverse seems to be true. Firms have much better insight on what consumers want.

Big Picture

U.S. stocks rose steadily last year despite an uncertain global picture. The S&P 500 Index returned 31.5% on a total return basis in 2019. Going forward, we remain constructive that the market will hold current levels until the U.S. presidential election and perhaps thereafter. This is consistent with analysts’ views that corporate earnings and sales will grow at a mid-single digit range in 2020. The slowdown in global economic growth, predominantly caused by the trade dispute between China and the U.S., is expected to moderately reverse course after both countries agreed to sign a “Phase One” pact and place further escalations on hold. Central banks around the world remain committed to their accommodative low-interest rate policies – removing obstacles for private investment and personal consumption while helping to increase global aggregate demand. A weakening U.S. dollar should ease pressure on internationally focused businesses which were a significant drag on earnings growth last year, while China has announced stimulus measures which should assist lackluster global manufacturing numbers. These are all good signs and tail winds for stocks.

The U.S. economy continues to grow at a stable pace of above 2%, thanks to robust U.S. household spending, which offers optimism for a continued expansion. The labor market remains firm; unemployment rate is at a 50-year low of 3.5% and financial conditions show no sign of stress. Personal finance measured as household debt service payments as a percentage of disposable income stands at 9.7%, down from 13.2% in 2007, a 40-year low[4]. After 10 years of continuous job growth, today there are more job openings than there are applicants, and growth is progressively going to lower skill workers – all with historically muted inflation numbers. While job additions are expected to continue moderating, short of any unforeseen and significant changes in policy, we maintain conviction towards a strong U.S. economy that bucks general weakness abroad.

2019 was also a year of legislative accomplishment, which came as a surprise given the political power shift in 2018 and the stark divisions between both parties. One of the more notable legislative movements of 2019 was the passing of the Setting Every Community Up for Retirement Enhancement (SECURE) Act, signed into law alongside the 2020 NDAA. Having taken effect January 1, the SECURE act makes a couple key changes to retirement savings – one of the more significant is delaying required minimum distributions (RMDs) until age 72 from 70 ½ previously. Retirees who turned 70 ½ in 2019 are not eligible to defer.

This means that in 2020, up to 3.2 million people will be able to delay drawing from their retirement savings compared to prior to the passing of the SECURE act. The bill also eliminates the maximum age for contributions, as long as the individual is working. As a result, nearly 4.8 million people will now be able to continue contributing to their retirement, according to Labor Department data.

Another important inclusion is the increased access to multi-employer plans that allow employers to pool assets for retirement plans without sharing common characteristics such as being in the same industry. The bill offers small employers more scale, lower costs, and tax incentives for automatic enrollment of employees at a higher cap than previously. The Labor Department estimates around 38 million employees at small and midsize companies do not have a workplace retirement plan. The bill also significantly lowers participation requirements for long-term, part-time workers.

The ultimate effect of this is likely more buyers and lower fund outflows, which would help put a floor on the market and support multiples. While we see a number of potential volatility moments over the next year, the increased number of buyers should help dampen volatility in the case of non-geopolitical moments.

2020 Lookahead

The story of 2020 will likely be about a moderate resumption of stable, organic global growth underpinned by a continued U.S. expansion, and it is our opinion that the market will largely be dictated by the calendar. The labor market has continued to show prodigious strength, with the lion’s share of gains now going to employees in the bottom 25% of wage earners. With the “Phase One” China deal, the likelihood of further tariffs is extremely minute, while global interest rates are expected to remain steady with world central banks having a bias towards rate cuts rather than rate hikes. Recent political results in the United Kingdom remove a lot of uncertainty around Brexit, while the United States is expected to ratify the USMCA as a replacement to NAFTA this year.

Markets will largely be discounting results in the 2020 primaries as they come in starting in early February, with the result and policy discussions having more relevance in the back half of the year after each party’s convention. Until then, the focus will be on corporate earnings and geopolitical events as they occur, along with developments in the global growth picture or worldwide manufacturing numbers. After July, politics will reign supreme with policy positions by the nominees being dissected by potential voters. We expect healthcare, student debt, tax policy, China-U.S. and Iran-U.S. relations to be significant topics of focus.

The number one focus of broad markets, politically, will be on tax policy – none of Vice President Joe Biden, Senator Bernie Sanders, Senator Elizabeth Warren, Mayor Michael Bloomberg or Mayor Pete Buttigieg have stated to have wildly differing views on China than the sitting President but all have a bias towards changing or repealing 2017’s Tax Cuts and Jobs Act (TCJA). “Phase Two” of U.S.-China talks will likely be a focus in 2021 and thereafter as China will want to know who the President is before discussing the more sensitive issues like rampant state subsidies.

That’s not to say there aren’t concerns. If the Democratic primary shapes up as Senator Bernie Sanders or Senator Elizabeth Warren looking likely to win the nomination, that may be a negative for markets. Meanwhile a continuation of China’s slowdown would likely exacerbate weakness in manufacturing especially in Europe’s Germany and could do damage to the widely held view of a slight pickup in global growth. And while conflict with Iran seems to have been avoided, further developments in the Middle East are certainly possible.

Any of the above would do damage to the market PE multiple and investor sentiment, but we view the likelihood of a prolonged market selloff as low. Any downward movements in markets are more likely to be a repricing than a meltdown. We hold this view because of just how solid the underlying economic numbers in the United States currently are.

Last year, despite all the negative headlines the general theme was stable. Even in the face of ratcheted trade tensions, higher tariffs, weakness in global manufacturing, slowing global growth, and a lack of stimulus from tax legislation, the United States economy is expected to have grown at a 2.3% rate in 2019. Nearly $500 billion in additional income was created for American workers between 3Q18 and 3Q19. That’s larger than the entire GDP of Ireland, the 32^nd largest economy in the world.

It’s important to note that slower growth is still growth, and with growth comes progress. Over the last 30 years we’ve seen technology go from a transformational development to an overlay over the entirety of world society. This transformation is only accelerating as time goes on. Just over the last decade, the smartphone progressed from a brand-new technology to practically a utility. Today’s tech companies provide “Technology Staples”, services that are key to modern society and for many people are integral to daily life, and the advent of Fifth Generation (5G) networks offers promise for even deeper integration.

The emergence and subsequent ubiquity of technology has had a profound effect on global life and socioeconomics. In 1990, according to World Bank, World GDP sat at $22.6 trillion with 1.9 billion people living in extreme poverty. Today, World GDP is over $85 trillion with an extreme poverty level that is estimated at less than 700 million. In less than 30 years more than 1.2 billion people have been lifted out of poverty and World GDP has grown nearly 4 times over.

Over this time, we’ve seen the U.S. economy become significantly more resistant to external shocks, exhibited no better than its move from incredibly dependent on foreign oil to a net exporter. In September, an attack on a Saudi Arabian oil field knocked 5% of world oil production offline and prices at the pump hardly moved – while recent escalations in Iran only modestly moved global oil prices. That’s a remarkable turnaround from the 1990s and 2000s and a testament to the rise in American energy production.

In a broader perspective, we are firm believers that ‘God and nature are long’ – that in the absence of war or significant natural disasters, growth in productivity and population along with technological innovations will improve people’s standards of living and create more wealth for all habitants of this earth. There’s still plenty of growth opportunities in today’s world for multinational corporations. For example, 21% of India’s 1.35 billion people are estimated by World Bank as living in extreme poverty, while just over half of the world’s population has a connection with the internet.

Investing is about time in the market, not timing the market. Since 1946, the S&P 500 has averaged 11% annually and overcome 11 separate recessions, 5 wars, and 13 presidents. Over the last 2 years, the S&P 500 delivered an annual return of 12%, despite the hysteria and generally overdone selloff in 2018.

Where you stand depends on where you sit, and we encourage an approach that recognizes news has a regional bias but reality has a silver lining. In 2018, if you only watched market moves and media headlines, the entire global economy was on the verge of a collapse. That proved to very much not be the case and the following year was one of the best on record. Investing is a long-term game, and having a rational head and a steady hand helps prevent lackluster decisions driven by emotion. As investors, we should aim to be more confident than those who are fearful, and more nimble than those who are complacent.

We appreciate your trust and the opportunity to be of service.

All the best,