Perspective - Markets
Outlook 2020: US equities
The ongoing squeeze on profit margins will continue, with higher labour costs and the ongoing US-China trade war the main economic headwinds in 2020.
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US small and mid-cap equities
Robert Kaynor, Head of US Small and Mid Cap Equities
The market volatility experienced in 2019 can be mostly attributed to the ups and downs of the US-China trade dispute and the expected accommodation from the Federal Reserve (Fed). Regarding the latter, monetary policy (which includes the setting of interest rates) has slowly transitioned from the driver of risk appetite, to the stabiliser of risk appetite. After a muddled communication at the start to the year (also known as “the pivot”), the Fed’s path has been fairly stable throughout 2019. In fact, with market expectations of Fed Funds Futures now more aligned with the Fed’s expectations, we believe the opportunity for the Fed to disappoint the market in 2020 is greatly diminished.
That said, the market should still be on the lookout for disappointment, especially in relation to any potential resolution of the US-China trade dispute. However, it is unlikely that there will be any meaningful agreement on the trade front. While the politics may be entertaining, one side of the negotiating team is positioning for the presidential election in November 2020, while the other is positioning for the next 25 years. How the equity market will absorb this inevitable disappointment largely depends on the economic growth developments over the next few quarters.
A year ago we said that the US economy would avoid a recession in 2020 and that market participants would continue to favour larger companies, secular growers and bond proxies. The extremes of the latter reached a breaking point in early September. The significance of that shift should not be underestimated, as the market has been reminded of the excruciating pain that occurs when everyone tries to exit the “popular” trade at once.
This leads us to the precarious questions of where are we now and what to expect in 2020. In a period of political and economic uncertainty, fixed capital investment is clearly being stifled. Regardless, the market is currently discounting a bottom in the manufacturing economy as cyclical companies look past bad news in anticipation of a recovery ahead. Given that central bank easing actions typically take a few quarters to impact the economy, some of this optimism seems warranted. However, we remain surprised how quickly the market rotated back into “ugly cyclicals” despite any evidence of improving fundamentals.
What has not surprised us is the health of the US consumer. An extended period of improving employment, modest wage increases, and healthy balance sheets, coupled with declining interest rates has provided a very favourable backdrop for the US consumer (who still represents about 70% of the domestic economy, according to data from 2019 provided by the US Bureau of Economic Analysis ). To ensure that the economy remains on a solid footing, it is critical that consumer confidence remains unwavering.
The small and mid cap segment of the market is poised to achieve superior earnings growth in 2020, the seventh time in nine years that small cap earnings have outperformed their larger cap brethren. However, for seven of the last nine years small cap stocks have underperformed. This conundrum has left us with some of the most attractive valuations in small cap vs large cap since the financial crisis. We are excited about the prospects that lie ahead. In terms of what could turn that excitement into fear? That’s easy… a polarising presidential election that puts capitalism on trial.
US large cap equities
Frank Thormann, Portfolio Manager, US Large Cap Equities
With the S&P 500 reaching record highs, US stock markets are on track to close a very positive year (up +25% at the time of writing). This exuberance surprised us, particularly as the economy has been expanding for more than 10 years, corporate profitability is stagnating (it even went backwards slightly in Q3 compared to the previous year), trade frictions remain unresolved and many macro-indictors are pointing to weakening growth. However, the market has clearly taken a more positive view that renewed monetary stimulus and the upcoming presidential election can breathe fresh life into the economic cycle.
However, higher labour costs are likely to be a significant contributor to the ongoing squeeze on corporate profits in 2020. The US labour market continues to be exceptionally tight, with lower skilled jobs in particular seeing above average pay rises. Companies operating in the service industry, particularly retailers and restaurants, will arguably be most negatively affected. Conversely, companies with high levels of automation, or with very high added value, such as software, will be the least impacted. While lower interest rates (following three rate cuts in 2019) will translate into lower interest payments, the trend is almost certainly in the direction of lower operating margins for many US companies in 2020.
Revenue will also likely remain muted given a soft growth environment, weakening confidence and subdued capital investment. Uncertainty regarding US-China trade has already contributed to slower growth and this is likely to continue to rumble on in 2020. A full resolution to the issue (in the form of a comprehensive new trade deal) is unlikely to be achieved before the presidential election in November 2020.
Stock market returns may be limited in 2020 due to a weaker growth environment, lower profit margins and unrealistic earnings expectations (S&P 500 earnings growth expectations are currently +10% for 2020). Companies which are able to demonstrate the ability to grow could be increasingly rewarded by the market. This is underpinned by ongoing innovation in the sector, although sentiment towards the sector is also dependent on a benign outcome in the presidential election. The ongoing trend towards digitisation could also benefit large technology companies.
- You can read and watch more from our 2020 outlook series here