2019 – The year that was, but perhaps should not have been

One year ago, we were happily kissing good-bye to a disheartening year in financial markets and casting cautious expectations for a better year in 2019.  On paper, 2019 was a roaring year, with both the S&P/TSX Composite Index and the S&P500 returning in excess of 20%.  Even the more sedate Canadian bond market gained almost 7.0%.  It is hard to dispute the roaring performance of the S&P500 over the past two years, generating approximately 10.0% average annual returns (in Canadian dollars), with the 2018 dip being fully compensated for by 2019’s strong return.  In contrast, the 2019 return for the S&P/TSX Composite Index was primarily a recovery from last year’s downturn and, in fact, it ended the year only a few percentage points above its 2018 high.  Similarly, the Canadian bond market has been rocked by the rapidly shifting policy stances taken by central banks around the world (led by the U.S. Federal Reserve) and, over two years, the returns have been about what you would expect, gaining a little over 4.0% annualized.  In other words, we have taken a bumpy path to end up somewhere in the neighborhood of average returns.

Three main economic themes dominated financial markets during the year:  trade, central bank policy and the dearth in earnings growth. Although it would be easy to get distracted by the many political side-shows for the year (impeachment, the bitter Canadian election, ongoing Brexit drama) the impact on investment portfolios for these events has been nominal.

Trade Wars are Easy to Win
 
Following the trade dispute between China and the U.S. has been somewhat like watching a bouncing ball……. we have a trade deal……. we don’t have a trade deal……. more tariffs on China!…….. no more tariffs on China……. retaliatory tariffs on the U.S……… we have a trade deal!………. we don’t have a trade deal…. maybe we will reduce tariffs on China……. Throw in an occasional threat against Mexico or the EU and it suddenly becomes almost predictable in its unpredictability. 
 
Although the process may be comical, the consequences of so much uncertainty are not.  Around the world manufacturing PMI (purchasing manager’s indices) plunged, suggesting a recession in the manufacturing sector.  Investment in capital expenditures stagnated, global trade volumes notched three consecutive quarters of decline and the global economy slowed to the brink of recession. 

Through this period (please enjoy the irony), based on estimates generated by the French bank BNP Paribas, U.S. exports to China declined by approximately twice the value of Chinese exports to the U.S.  So, Donald, are trade wars really that easy to win?
 
As we wrap up 2019, there are indications that a “phase one” trade deal between the U.S. and China can be accomplished and may result in the rollback of some tariffs. Having travelled this path a few times in the last twelve months, we are loathed to put a probability on the success of this deal.  Equity markets have taken relief in the prospect of such an event, which of course leaves the risk of disappointment. 
As the proposed trade deal is expected to leave the most difficult issues unresolved, if a phase one deal does get completed, does it really mean anything or is it primarily political posturing?

A U-Turn by Global Central Banks

The trade war was not the only cause of a slowing economy.  Throughout 2018 the U.S. Federal Reserve and the Bank of Canada were pushing interest rates higher, supported by strong economies, full employment and a desire to create some cushion in the monetary system in recognition that a low interest rate environment would leave little flexibility should another recession occur.  Higher interest rates are designed to slow growth by making it more difficult to borrow.
 
The process of raising rates came to a sudden halt in January, as the U.S. together with almost 20 other central banks around the world (albeit with some grumbling about how the central bank shouldn’t have to bail the country out of a decline triggered by a trade war) began the process of cutting their respective benchmark interest rates with the goal of stimulating the economy, creating essentially a full reversal in short term interest rates.
 
This raised some alarm bells.  As of August, it was estimated that there was $17 trillion of debt trading at negative yields (yes, that means you get paid to borrow money).  With so many central banks cutting interest rates, that number was destined to spiral higher, wasn’t it?  Once more, expectations and reality diverged and by year end the amount of negative-yielding bonds outstanding had dipped to around $11 trillion.

The Bank of Canada was not amongst the group shifting to monetary stimulus.  The main reason is likely that Canadian real interest rates remained negative even as interest rates moved higher.  (The real interest rate is the nominal interest rate less inflation).  Meanwhile, U.S. real interest rates reached a peak of approximately 0.5%, providing more flexibility to cut.  It must be noted that the reduction in nominal interest rates has now pushed the real rate back into negative territory.

Despite the non-action by the Bank of Canada, investors have pushed market interest rates lower throughout the year.  This has led to lower mortgage and lending rates and should provide the Canadian economy with some of the benefits of a rate cut without the Bank of Canada doing anything.  Given the lagged impact of monetary policy on the economy and since lower rates began to move into the market around mid-year, we would expect to start to feel the impacts on the economy sometime in the first quarter.

The Case of the Disappearing Earnings Growth
In the midst of all this uncertainty, corporate earnings growth did a strange thing – it evaporated.  The S&P500 index in the U.S. provides the most detailed data on corporate earnings growth and, for the first three quarters of 2019, earnings per share growth has been non-existent.  The data can also be used to give a hint of the global trends as, in Q3, companies that generated greater than 50% of their revenue outside of the U.S. experienced a dramatic 9.1% decline in earnings, in comparison to companies that operate primarily in the U.S., which experienced a more modest 0.8% decline.

This leads to two obvious questions.  1) If share prices and earnings are highly correlated, why were equity markets so strong in a year in which earnings declined and 2) What is likely to happen to earnings growth next year?  Let’s tackle them in that order.

First, earnings growth and share prices have a very strong correlation over the long term.  But equity markets tend to be forward looking.  Therefore, equity markets fell in the last half of 2018, despite the strong earnings, as the market began to expect a weaker 2019 performance.  The rise in share prices in the first part of 2019 was primarily a recovery of the decline of 2018.  The Canadian index didn’t reach a new high until the end of October while the S&P500 breached its 2018 peak earlier in the year.  Therefore, you could argue that the majority of the gains this year were really still based on the strong 2018 earnings performance.  New gains weren’t reached until the market began to look with some optimism towards 2020 and subsequent earnings growth.

This leads us directly into the second question: what is anticipated for 2020 earnings?  Although we state this with some trepidation since we are making a forecast based on such an uncertain event, it seems there will be some de-escalation of the trade war (or at least no further escalation) and the global economy should begin to benefit from lower interest rates which would suggest a better operating environment for companies.  Central bank policy is likely to be more stable and is unlikely to make another rapid change in directions.  This opens the door for a better 2020.
 
How much better remains the unanswered question.  Current consensus estimates suggest close to 10% earnings per share growth in the coming year.  In our opinion that number seems aggressive, but feasible, if trade tensions ease more than we currently anticipate or if governments provide some fiscal stimulus to the global economy.  Without those benefits we would expect to see some moderation in the estimates for the year. 

Market performance, are sitting at relatively high, although not extreme, levels.  This suggests the easiest path to higher returns is through earnings growth, not through further valuation increases.

So, if 2019 was a year of excellent performance, without any real rationale, then 2020 is looking like a year where further gains must be earned.

January 2, 2020 Logan Wealth Management

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