Part I: Record Economic Expansion and Reduced Recession Indicators Drive Consensus Views for 2020
One of my favorite New Year’s rituals is to review Blackstone Vice Chair Byron Wien’s annual list of Ten Surprises. Byron has been publishing the list and supporting rationale since 1986, dating back to the early days of his long tenure as Morgan Stanley’s Chief US Strategist. Byron, one of my closest mentors at Morgan Stanley, has always emphasized that the best way to generate above average returns is to identify high conviction, counter-consensus ideas. The logical starting point is therefore to identify exactly where the consensus is—understanding that the consensus often turns out to be right.
Along those lines, I thought it would be helpful to begin the year summarizing what I believe are the ten most pertinent consensus views for 2020. I have also incorporated some risks to those consensus views. The first five consensus views can be read in Part I, while the remaining consensus views can be read in Part II. In rough order of importance:
1) The US avoids recession with moderate 2-2.5% growth, as does Europe (more like 1-1.5%) and China (approximately 6%, at least officially). The widespread fears of a US recession that emerged toward the middle of last year, punctuated by the inverted yield curve, have largely disappeared. As such, the consensus increasingly believes that the longest US economic expansion on record is poised to extend into its 12th year with an assist from the recent US-China trade détente and continued deficit spending. Virtually every key US consumer recession indicator we monitor (e.g., housing permits, retail sales, jobless claims, job sentiment) indicates that a recession is not imminent. The outlook is more mixed in terms of business activity, particularly as it pertains to new manufacturing orders, profit margins, and business confidence (CEO confidence recently fell to its lowest levels since 2009).
Meanwhile, additional fiscal stimulus is expected in Europe with even traditionally austere Germany increasingly willing to jumpstart its stagnant economy. That likely won’t be enough to offset the continent’s long-standing growth woes that include weak demographic trends, inflexible labor markets, and the kind of increasingly low inflation expectations that contributed to Japan’s anemic growth rates for the better part of the last 30 years. Pervasive negative interest rates may help to ward off a near-term recession but their deleterious impact on the European banking system and lending activity are widely seen by investors as longer-term impediments to growth.
Finally, China remains the world’s key growth engine, albeit with steadily declining growth rates over the past several years that were all but inevitable simply due to the law of large numbers. The US trade tensions have exacerbated the major long-term challenges associated with transitioning from an export-dominated manufacturing-led economy to a more balanced consumer-led economy, ringfencing the country’s massive shadow banking system and combating a sizable increase in private sector corporate bond defaults. However, investors widely expect the Chinese government to provide fiscal stimulus where necessary to avoid a largescale economic downturn that could trigger the kind of social instability that would be of great concern to the Chinese government.
2) The Federal Reserve remains on hold throughout the year and the US 10-Year Treasury yield remains largely rangebound (say 1.7-2.5%). It’s a safe bet that the Fed’s strong preference is to stay on the sidelines during what promises to be a particularly contentious election year. While they may clearly feel compelled to tighten if the economy appears to be running too hot, or cut if recession fears re-emerge, inflation remains the key wildcard.
Inflation’s inability to breach the Fed’s 2% target—the great “mystery” of the post-crisis era as former Fed Chair Janet Yellen described it—remains the single greatest potential macro game changer, in my view. As discussed previously, the Phillips Curve’s positive correlation between employment and inflation is now widely seen as dead. Rather, a combination of technological change (e.g., automation and the “Amazon effect”), weakening demographics, and surging public debt are widely seen as powerful secular disinflationary forces. Still, rising wages, an oil price shock and (arguably) deglobalization/trade wars are among the factors that could trigger an inflation surprise—with potentially significant ramifications for Fed policy, credit risks, and equity valuations. Simply put, a more hawkish Fed in response to a sustained uptick in inflation is an almost sure bet to trigger an equity sell-off given current premium valuation levels.
3) Credit conditions remain relatively stable. The time-tested pattern is that a significant deterioration in credit conditions triggers recessions, which in turn trigger bear markets. The clear consensus is that despite potential pockets of instability such as in leveraged loans and parts of the energy sector, there is nothing systemic on the horizon even remotely analogous to the 2008/2009 credit crisis. Aggregate corporate debt levels are high with a near-record portion of that debt in the lowest (BBB) designation. However, debt service costs appear highly manageable thanks to low interest rates and the extent to which companies have extended maturities several years into the future. The same is true for US consumers with household debt service (debt payments as a percentage of disposable personal income) which peaked at 13% in 4Q07 but has since fallen to 9.7%. Still, at prevailing equity market valuations, it is not difficult to see any potential credit unrest having a meaningful impact on stocks simply due to the amount of debt outstanding and the extent to which many pension funds remain underfunded.
4) Trump wins (and Congress remains divided). Although the “official” betting odds view the election as essentially a toss-up (Trump is a slight favorite on most legal betting sites), virtually every survey we have seen of investors and Wall Street types indicates that they expect Trump to win. For example, Barron’s recently summarized the consensus of its ten annual Roundtable panelists as an “almost certain” Trump victory. We delved into politics in last month’s market update and won’t rehash the discussion here. Suffice it to say, for all the strong emotions that President Trump engenders, the equity market would likely view a Trump victory as a net positive given the extent to which it has embraced his tax cuts and broad deregulation. Conversely, the market fears a highly progressive administration that would likely raise taxes dramatically, increase regulation, and potentially allow deficits to surge even higher. The combination of a more centrist Democratic President and a split Congress would likely be far more palatable to investors.
5) There will be at least one 10-20% correction, but no 20%+ technical bear market. 2019 was an anomaly in that the S&P 500’s largest intra-year drawdown was just 5%. Even during the generally benign equity markets of the last decade, 2013 and 2014 were the only two successive years without a 10%-plus correction (2014 came quite close at 9.8%). Indeed, there have been forty-seven 10% corrections since 1928, including twenty bona fide 20%-plus bear markets. Given the wide array of prevailing uncertainties, including the 2020 election, as well as historically rich valuations, we cannot imagine that many folks would be surprised if the market has at least one 10-20% downdraft this year. That said, most investor sentiment indicators have recently moved to extreme bullish levels while the options markets, including the oft-cited VIX fear gauge, imply little apparent concern regarding a near-term pullback. Corrections are never pleasant when they are taking place but given the very powerful rally over the past four months, an oxymoronic “healthy correction” may be in order.
For Part II of the consensus series, click here.