Brian Herscovici, CFA Chief Investment Officer, USAA Managed Portfolios
4th QUARTER MARKET RETURNS
The US stock market ended 2019 near record highs with a 31% return, its best showing since 2013. US and non-US equity returns were somewhat in lockstep this quarter, which is a change from total US domination. Speaking of breaking the trend, Value stocks bested Growth stocks for the quarter according to S&P (S&P Value 11.4% vs S&P Growth 9.5%). The 10-year government bond yield is off the lows, steady at 1.9% with the Federal Reserve signaling no rate changes through 2020. Oil is trending higher into year-end with further pledges of price support by OPEC producers.
US-China Trade Deal is on… Trade Deal is off… It’s back on, sort of. Those were the major news headlines driving daily volatility over the 4th quarter. Despite the confusion, markets grinded higher with US equities hitting fresh all-time highs on the backdrop of steadying fundamentals and higher multiples. Many developed economies flirted with negative GDP prints this year, but the US was able to hold strong above the long-term trend of 2.0%.
Going forward, China holds the key to global growth. Although China is the 2nd largest economy to the US, it is #1 in terms of the marginal contributor (Figure 2). In previous reflationary periods such as 2009, 2013, or 2017, global equity markets experienced significant growth on the back of rising debt levels in China. Today, China is reluctant to stimulate, partly in order to keep pressure on trade negotiations. China is implementing an “as-needed” easing program, providing enough stimulus to hit their target of 6.0% GDP growth. No more, no less. Levers such as lower bank reserve requirements and tax cuts are measurably offsetting stiff regulations in the private banking system (a.k.a. the shadow banking system) and real estate development. China will need to shift to a tailwind in order to get another stellar global equity market in 2020. If we don’t get additional support from China, we will likely see an L-shaped recovery or flatlining global economic growth for a period of time. A trade deal and a reverse of tariffs could be the needed catalyst.
As we close the quarter, we appear to be getting some resolution with the US and China announcing an agreement on phase one trade negotiations, which stopped new tariffs from being enacted in December and offer potential relief in 2020. We remain optimistic the agreement will be signed in mid-January and that phase two negotiations will continue, although they might be protracted due to US elections in November. North American trade and domestic manufacturing are also getting a late-year boost as Congress passed the USMCA, which will replace NAFTA. Progress on the trade front should boost corporate confidence and allow increased capital spending budgets.
A revival of trade globalization should benefit non-US markets more than the US. Europe specifically is a highly cyclical economy with large exposures to manufacturing and exports. They were hit the hardest by the growing trade tensions and stand to benefit the most if it unwinds. Even without a trade deal, the manufacturing cycle may be bottoming as companies eventually need to replenish stockpiles. We are already seeing evidence of this by a pick-up in new orders and auto sales in the fourth quarter. Improving manufacturing, combined with coordinated easing across central banks should, at a minimum, allow the world to avoid a recession for at least 18 months.
Europe has a lot of catching up to do in terms of economic growth and equity market prices. US equity markets are more expensive on any valuation metric you prefer and sit at a historically wide margin compared to Europe (Figure 3). Further, European fundamentals have stabilized, albeit from very depressed levels. Bank balance sheets are improving as non-performing loans fall and interest rates in periphery countries narrow compared to Germany and France. Populism is back in fashion, which should encourage more fiscal spending and favorable business regulations. While central bankers remain accommodative in Europe, fiscal and structural support from European governments will further accelerate growth in that region. Lastly, a No-Deal Brexit has been averted with the latest reelection of Boris Johnson, lifting a large source of uncertainty. For these reasons, we believe European equities make a compelling risk-reward case.
Tactical Positioning in USAA Managed Portfolios at the end of the 2019 was neutral stocks versus bonds, reflecting our view of improving strength of the global economy and tempered concerns on geopolitics. We exited our Treasury position in early December in favor of international developed equities due to their appealing valuation combined with a pick-up in economic data. We maintain our allocation to U.S. large cap, which has been supported by the enduring consumer. The US economy seems set to chug along at its long-term trend of 2.0% GDP growth as long as inflation stays muted. We are still avoiding EM equities as the risk-reward is better in developed markets. The economic growth may come from EM, but the 2013 experience teaches us that EM stocks can still underperform as global growth improves and yields rise.
Within fixed income, we emphasize higher quality bonds with a neutral stance to duration. We continue to hold emerging market debt, specifically high-rated EM government debt, which we believe offers extra yield without stepping down in quality. If rates rise, we expect the higher coupon income from corporate bonds and EM debt to fare better than lower yielding government debt.
As always, our guidance to members is to remain focused on the long-term investment plan that you have put so much thought into. For USAA Managed Portfolio members who may be uneasy about market risk in general or have concerns about current asset-class allocations, we suggest consulting with a USAA advisor.
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Past performance is no guarantee of future results.
Asset allocation does not protect against a loss or guarantee that an investor’s goal will be met.
Fixed income securities are subject to price volatility and a number of risks, including interest rate risk. Interest rates and bond prices move in opposite directions so that as interest rates rise, bond prices usually fall and vice versa. Interest rates are currently at historically low levels. Fixed income securities also carry other risks, such as inflation risk, liquidity risk, call risk, and credit and default risks. Lower-quality fixed income securities involve greater risk of default or price changes. Securities of non-U.S. issuers generally involve greater risks than U.S. investments and can decline significantly in response to adverse issuer, political, regulatory, market and economic risks. Fixed income securities sold or redeemed prior to maturity may be subject to loss. • Investments in foreign securities are subject to additional and more diverse risks, including but not limited to currency fluctuations, market illiquidity, and political and economic instability. Foreign investing may result in more rapid and extreme changes in value than investments made exclusively in the securities of U.S. companies. There may be less publicly available information relating to foreign companies than those in the U.S. Foreign securities may also be subject to foreign taxes. Investments made in emerging market countries may be particularly volatile. Economies of emerging market countries are generally less diverse and mature than more developed countries and may have less stable political systems.
The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets. • The MSCI EAFE Index covers 21 developed markets outside of North America: Europe, Australasia and the Far East. It aims to include in its international indices 85% of the free float-adjusted market capitalization in each industry group within each country. • The MSCI USA Index is designed to measure the performance of the large- and mid-cap segments of the U.S. equity market. The index covers approximately 85% of the free float-adjusted market capitalization in the U.S. • The MSCI World ex USA Index measure large- and mid-cap stock performance in 22 developed markets (U.S. excluded). The index covers approximately 85% of the free float-adjusted market capitalization in each country. • The Bloomberg Barclays U.S. Municipal Index covers the U.S. dollar-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds and pre-refunded bonds. • The Bloomberg Barclays US Corporate High Yield Bond Index measures the U.S. dollar-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody’s, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded. • The Standard & Poor’s 500 Index is an unmanaged index of 500 stocks representing the large cap segment of the market, covering 75% of the U.S. equities market. • The S&P SmallCap 600 Index measures the small-cap segment of the U.S. equity market. The index is designed to track companies that meet specific inclusion criteria to ensure that they are liquid and financially viable. • The Russell 2000 Index is an unmanaged index that consists of the 2,000 smallest companies in the Russell 3000 Index. It is a widely recognized small cap index. • The Bloomberg Barclays U.S. Aggregate Bond Index is a widely recognized index used to track the performance of investment grade bonds in the U.S. • The Bloomberg Barclays U.S. Credit Index measures the performance of the investment-grade, taxable corporate and government-related bond market. It is composed of the Bloomberg Barclays U.S. Corporate Index and a non-corporate component that includes non-U.S. agency, sovereign, supranational and local authority bonds. • The JP Morgan Emerging Markets Bond Index Plus (EMBI+) tracks total returns for foreign currency-denominated, fixed-income securities issued in emerging markets.
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