Setting Our Sights on 2020

The market backdrop in 2020 will be colored by election uncertainty, thorny trade negotiations and heightened geopolitical risks such as Brexit. And the macroeconomic picture is unclear as we’re seeing mixed signals in different parts of the world. We have already witnessed an unprecedented period of growth for U.S. equities with a 14% average annualized return for the S&P 500 over the last 10 years. Investors are now wondering if 2020 will be another leg in the longest bull market in history or a broad-based correction.

To protect capital and provide diversified returns, we look for strategies that will be versatile in either market scenario. In 2020, we favor active managers that are able to reduce exposure, reallocate capital, capture alpha and generate uncorrelated returns through active management. During periods of market strength or sudden volatility, we believe it is prudent for clients to allocate to long/short equity, event-driven and private-market strategies that balance capital appreciation with structural and tactical downside protection. These strategies should prevail as sustainable investment strategies relative to the broader market and comparable asset classes.

We continue to evaluate how managers could manage through distant or seemingly unlikely, but potentially highly impactful, trends and events including growing government debt levels, inflation or deflation surprises, the rise of global populism and increasing political polarization. Our goal with Multi-Asset Strategy Viewpoints is not to try to predict what will happen over the next year, but instead discuss what we believe are the most influential market dynamics and possible scenarios that can play out. In addition, we take a look at our defined asset categories and make a determination as to whether or not they look attractive relative to one another. We see three key themes worth watching in 2020:

• Central bank policy
• Trade tensions
• Politics

Handicapping Central Banks

The Federal Reserve cut interest rates three times in 2019, bringing the federal funds rate to a 1.5% to 1.75% range. The European Central Bank and the Bank of Japan continued to provide stimulus to their respective economies in 2019 through continued asset purchases. The result has been low- to negative-yielding sovereign debt, tight spreads in credit markets and low equity returns. Many U.S. companies are using debt to buy back stock, which is helping drive stock prices higher. The intended effect of low borrowing costs is to entice investment that can spark economic growth. The unintended effect is that it has driven investors to chase yield in riskier segments of the market.

Now, 10 years after the global financial crisis, even higher-yielding segments of the market are at or near record-low yield levels. While the major central banks are looking to exit their accommodative monetary policies, we feel it’s unlikely to happen in 2020. Despite higheryielding segments providing low yields relative to their own history, they’re still attracting assets because of low absolute yields globally. This is likely to continue in 2020 as investors clamor for yield and take it where they can get it, regardless of whether they’re paying a premium for it and taking more risk to get it.

It’s also worth noting that the overnight lending market has been under pressure. In September, overnight lending rates spiked, prompting the Fed to inject liquidity to bring rates down. While the market has downplayed the significance of this liquidity crunch, it should serve as a sign that an allocation to defensive assets has become more critical.

Are Trade Tensions the New Normal?

While trade tensions between the United States and China dominate the headlines, the Trump administration is also dealing with trade tensions with other countries. Even if a deal with China was struck, it doesn’t mean that these conflicts will be resolved. Recently, the Trump administration threatened to raise tariffs on aluminum and steel imports coming from Brazil and Argentina citing unfair competition that is costing American jobs. Additionally, President Trump proposed tariffs of up to 100% on France’s imports as a result of the “digital service” tax France imposed, which impacts a number of U.S. technology companies. In our view, trade tensions will likely continue to stir volatility.

The U.S. manufacturing sector has borne the brunt of these ongoing trade tensions, having experienced three consecutive quarters of contraction. This decline is likely due to the slowdown in trade. If the “phase 1” deal with China is finalized, then it will most likely be modest in nature and unlikely to silence the noise surrounding a U.S. partnership with China. In this scenario, ongoing negotiations will continue with the same pattern of conflicting news stories of “deal on” and “deal off,” which confuses markets and, more importantly, U.S. corporate management and their capital expenditure decisions. The uncertainty surrounding trade will most likely continue to weigh on the manufacturing sector throughout the 2020 election cycle.

Meanwhile, the service sector is still expanding and the U.S. consumer remains strong due to a healthy job market and moderate wage gains. Note that the consumer represents approximately two-thirds of the nation’s GDP. Even if trade tensions persist throughout 2020, it doesn’t necessarily mean that the U.S. economy is going into a recession.

Election-Fueled Volatility

In our view, the 2020 U.S. election cycle will be headline news throughout the year. The three likely outcomes are Trump’s reelection, the election of a centrist Democrat or the election of a progressive Democrat. Regardless of who wins, market reactions to the voter polls and comments by candidates will fuel volatility. Two of the three outcomes would likely be a positive development for markets—Trump getting reelected or the election of a centrist Democrat. A progressive Democrat winning the presidency would likely be a negative development for the markets. Even if a progressive Democrat is elected, it’s unlikely that extreme legislation would be passed unless Democrats control the House of Representatives and the Senate. Even then, the passage of extreme legislation wouldn’t be a given. Plus, these laws wouldn’t take effect until 2021 at the earliest. Therefore, the two scenarios with the highest probability of occurring would be good news for the markets. Still, anything can happen in an election and it’s possible that the least favorable scenario for markets could come to pass.

Political strife globally can have a significant influence on financial markets. Aside from U.S. impeachment proceedings, inequality and populism are themes that resonate from South America to Europe to Hong Kong. These volatile political issues could spur meaningful drawdowns in the financial markets. However, we don’t advocate avoiding markets outside the United States. Instead, we advocate the use of active management that can successfully navigate the markets to find opportunities within their areas of expertise. We favor international and emerging markets, both equity and debt. However, we stress the use of active managers to avoid trouble spots and, based on their expertise and discipline, take advantage of opportunities as they arise.

Our Views

We believe the risk of recession has subsided, at least for now, and that economic expansion will continue in 2020. This means, in our opinion, that risk assets will provide a modest real rate of return while defensive assets could also provide modest returns given investor concerns about lofty valuations at this stage of the cycle. Investors must be vigilant as there are significant risks that can stoke volatility. Our overall asset class views have remained fairly consistent. We believe that inflation is at bay, fundamentals remain intact and economic growth continues, albeit at a slower rate.

Given these factors, we believe that recession risk is not a near-term concern, but it’s worth monitoring as some recession indicators are beginning to flash red. For example, the manufacturing sector is contracting and profit margins seem to have peaked. We remain committed to current positioning and continue to emphasize portfolio diversification. Now could be an ideal opportunity to allocate excess cash and realized gains from overvalued investments to segments of the market we find most attractive.

Reach out to an Oppenheimer Financial Advisor to learn more.