As confidence in an (eventual) economic recovery continues to spread through financial markets, several of the biggest beneficiaries have been some emerging market currencies. Among those that have spurted higher lately include Brazil and Mexico, although still far down year to date. And important to note that although financial conditions have strengthened for Latin America, the economic conditions on the ground have yet to show any improvement and remain dismal.
New reports from the IMF makes for grim reading.
The global economy is expected to contract by 3% in 2020.
Perhaps even scarier is the accumulation of unprecedented debts. The world's fiscal debt level will climb from 83% of GDP to 96%. The situation is even worse for developed countries as governmental debt will reach 122% of GDP.
Year in Review – Twelve Months ended March 31st, 2020
Given the monumental impact of the coronavirus disease (COVID-19), it is virtually impossible to discuss the twelve-month period as a continuous period. It’s more sensible to think about the world before COVID-19 (to be referred herein as BCV) and after (ACV). For our purposes here, we will define that demarcation point as the middle of February, when investors woke up to the cataclysmic impact the disease would have on the economy. There is little one could say about BCV that would be applicable to ACV.
BCV the focus was on issues such as: impeachment, Brexit, presidential primaries, and trade wars and truces. In the world of ACV, the issues are starker: 1) individual health and 2) national and global economic survival.
The BCV economy was positive for the American economy and consumer, although growth slowed noticeably as the year wore on. Purchasing power gathered strength due to low inflation, and wages rose a bit faster than in previous years as unemployment fell to levels considered impossible just a few years ago. Federal Reserve rate cuts buoyed investor confidence.
ACV the economy is at a standstill. Official statistics are lagging indicators, but we know that perhaps 20 million Americans lost their jobs before the end of March. Many others face an uncertain future. It is certain that the global economy entered a deep recession and the timing and strength of the recovery remain unknown.
Major Economic Events
No nation was able to escape the impact of the COVID-19 disease. Hardest hit have been the US, Italy, Spain and China. Commodity producers have also suffered as demand vanished overnight.
The Federal Reserve, the US government, and governments worldwide have scrambled to deploy every tool at their disposal to keep economies afloat until the disease becomes better understood, better managed, and perhaps preventable via development of a vaccine. Levels of borrowing have already reached levels not seen since World War II and seem likely to rise from here. At this point (end of March), it’s much too early to assess the impact and effectiveness of the governmental responses.
As if things weren’t bad enough for the energy sector due to the collapse in demand, Saudi Arabia, Russia, and the US decided this would be a good time to fight for market share. Prices plummeted, and although this can be good news for consumers and resource-poor nations, it was devastating to oil-dependent economies such as parts of the US and energy producers globally.
The Equity Markets
Global stocks plunged in the first quarter of 2020, erasing all gains from 2019. An index of global stocks fell by -22%. This drop occurred within a span of just four weeks and includes the sharp upward move during the last week of March. For the year global stocks fell -12%.
Stock markets were particularly susceptible going into 2020. Profits had stagnated throughout 2019 and the stock market gains of 2019 could be categorized as a triumph of hope over reality. ACV, profits have diminished drastically. At this point, there is no clarity as to what investors can or should expect in terms of corporate profits or dividends.
The American stock market performed better than its international counterparts. Part of this reflects a flight to the perceived safety and quality of the US dollar, which rose against counterparts. International markets fell by -16%, while the US markets fell by high single digits.
Although long-term investors in small and mid-cap stocks have been rewarded for the elevated risk of these firms, there is no doubt this has been an extremely difficult period. In 2019, rising labor costs and a slowing economy hampered smaller firms. The COVID-19 induced economic collapse impacts smaller firms more severely as they have less ability to weather a deep downturn. It is still unclear if governmental policies and interventions will suffice, or if they will largely be directed to the larger and better- connected firms. A good case can be made that given the magnitude of the declines that small cap investors have already endured (-32% in Q1-2020), investors can be reasonably optimistic about this asset class going forward.
China’s markets were significantly impacted by the ebb and flow of the trade war. The news of a truce spurred a rally towards the end of 2019. Interestingly the Chinese market has fared relatively well in 2020 vs. the US and other major economies.
Natural resource stocks tracked the price of oil and collapsed in 2020 when demand vanished, and suppliers flooded the market. REITs were very hard hit in 2020 as the future value of much commercial real estate has come into question.
Overall, the effects of diversification from the traditional S&P 500 index were extremely negative. Every major asset class fell significantly short of the S&P 500.
The Fixed Income Markets
It was a strong year for US bonds, particularly government offerings. Prices rallied as the Fed cut rates during 2019 and then slashed rates to zero percent in response to the crisis. The broadest index of US investment-grade bonds rose by 9%. Corporate bonds fell in 2020 but ended the twelve-month period with gains. Municipal bonds experienced similar price movements. The collapse of tax revenues plus the strains of coping with the health crisis are placing major strains on state and local budgets. The federal government has declared its intent to support the finances of states and local governments, although as with much, the breadth and effectiveness of these interventions is unclear.
International bonds were basically flat, as price gains were offset by the impact of the rising dollar. Cash and similar investments had benefited from the Federal Reserve’s increases in rates, and will now continue to drop in alignment with Fed policy.
The dominance of the stock market by a handful of companies continues. The 5 largest firms now comprise 18% of the capitalization of the market, far in excess of anything seen over at least the past 25 years.
Year in Review – 2019
The world endured an uncomfortable degree of political uncertainty, much revolving around US efforts to remake the world trading/economic order. Despite the apparent momentum behind populist leaders in several countries, corporate influence and profits remain at astounding levels. Despite much turmoil, conditions favor investors and the stock market’s strong result in 2019 evidences this.
The year was positive for the American economy and consumer, although growth slowed noticeably as the year wore on. Purchasing power gathered strength due to low inflation, and wages rose a bit faster than in previous years as unemployment fell to levels considered impossible just a few years ago.
The Federal Reserve responded to the market plunges in late 2018 and weakened business confidence with three rate cuts during 2019. The absence of inflation has prompted a re-think at the Fed and official optimism on this front has increased.
Major Economic Events
Growth in the US was tepid, continuing the extended expansion. The effects of the Trump corporate tax cut waned and growth slowed accordingly. Despite trade tensions and business uncertainty, employment expanded steadily, inflation remained under control, and housing prices rose. Consumer confidence remained very high, as evidenced by high spending. Profit growth stagnated, but margins remain at extremely high levels.
The global economy expanded but growth faded. Europe’s economic recovery stalled as several countries fell into recession and Germany’s growth ground to a halt. The British economy underperformed. Contrary to what most expected however, the interminable Brexit saga has not had a drastic effect on British and European economies. China’s growth continues apace but is far below the rate achieved during the past decade. The Chinese government has struggled to develop policies to manage the trade war’s impacts.
Commodity prices rose, although not nearly enough to kindle a widespread inflation. Military exchanges in the Middle East had little impact on prices, except for some ephemeral spikes.
The Equity Markets
Global stocks surged higher with a gain of 27%. Prices rose in every quarter. Investors shrugged off the trade conflict between the world’s two largest economies. As 2019 came to an end, both the US and China appeared exhausted from the conflict and news of a “cease fire” further catalyzed the markets. The other US-induced trade conflicts also failed to dent stock prices. Interestingly, the 2019 gains could be categorized as a triumph of hope over reality: Profits themselves were flat, albeit at extremely high levels.
The American stock market performed better than its international counterparts. International markets had a strong year, with gains of nearly 22%. That robust result fell short, however, of the astounding 31% from the US markets. Technology stocks were the standouts among sectors and growth stocks continued to outpace value. Despite what appear to be ideal conditions (low interest rates, supportive government policies), small cap stocks lagged. Many firms reported that the twin effects of tariffs and rising labor costs are hampering their business.
China’s markets were significantly impacted by the ebb and flow of the trade war. The news of a truce spurred a rally towards the end of 2019.
Natural resource stocks tracked the price of oil and ended 2019 with a positive result. REIT investors celebrated the cessation of Fed tightening and the fall in interest rates.
Overall, the effects of diversification from the traditional S&P 500 index were quite negative. Every major asset class fell significantly short of the S&P 500.
The Fixed Income Markets
It was a strong year for bonds. Prices rallied as the Fed signaled an end to tightening and interest rates for most bonds tumbled. The Fed followed through with three rate cuts and left little doubt rates will stay low for the foreseeable future. International bonds also rose, although at a more moderate pace. Cash and similar investments had benefited from the Federal Reserve’s increases in rates, and will now continue to drop in accord with Fed policy.
Stagnation in American manufacturing continues. ISM index falls to 48.1, below the "neutral" level of 50. Despite the resolution of the UAW strike, there was no improvement in November. I suppose when Boeing resumes shipping the 737 Max, the overall numbers will improve. But nevertheless, the effects of the trade wars and poor business confidence continue to manifest themselves in data.
Should we be alarmed that the Fed is cutting rates at a time when core inflation has accelerated? Core = inflation excluding food and energy. Although the inflation rate for September itself was quite low, I note that core inflation has increased steadily in recent months and is now at 2.4% year over year. It appears the Fed will remain singularly focused on combating the effects of the Trump trade war. We can only hope that inflation will remain well contained even with the return of (very) easy money.