2020: Cash is King
I forecast because it forces me to look at the numbers. It forces me to consider what the numbers do not tell me. It forces me to look at the flaws of my models. It forces me to forget about who is the President of the USA. It forces me to think. It forces me to remain humble. I then arrogantly write about what remains, as if it was for me to know the future.
Last year at this time I called for the S&P 500 to appreciate by 20% from 2485 to 2972 (actual 3230) over the course of 2019, the US 10-year Treasury yield to fall from 2.69% to 0.77% (actual 1.90%), US Real GDP to grow from the then 3.1% four-quarter rate observed in Q3 2018 by 2.4% (actual likely 2.2%), and PCE-PI inflation to moderate from the then last-observed November 1.9% rate to 1.8% (actual likely about 1.5%). In general getting the direction right on all measures is satisfactory, as one at least set the sails right. I do not believe in the invest and forget strategies, but monthly and quarterly position reviews are useful for assessing adjustments to investor holdings or your enterprise budgeting. I adjusted my models in several areas over the course of the year to moderate momentum effects having an excessive impact on forecasts, especially in interest rates and inflation forecasts. Foreign exchange forecasts are in rework stage as an entire section was missing in the model.
2020 is an Election Year in the US, and the propaganda machines will - as always - work hard to tweak reality in favor of the incumbent. I thought it would be interesting to see how much better or worse off the electorate, and investors have been after four years under Trump, compared with the Obama second term. I have the US economy growing by 1.8% during 2020, which is the same as Morgan Stanley and pretty much a vanilla outlook in the middle of the pile. I am just noting that there is nothing in my outlook that changes the Trump Administration performance over the full term by adding in negativity in the coming year.
At the end of 2020, US Real GDP will have grown by 10% over the 4-year term of President Trump. That is the same 10% growth rate delivered by the Obama Administration. Roughly speaking, this is just riding trend growth over the last 30 years. The people work. Presidents rule. So what makes a difference?
Not surprisingly, Real Personal Consumption Expenditures grew the same 12% over the terms of the two Presidents. People are better off, but the rate of change did not budge. People worked, innovated and multiplied at pretty much the same rates. People power.
Obama must have been running some form of socialist economy, while Trump obviously is a hard core capitalist, a modern-day Scrooge. Interestingly, Real Government Expenditure and Capital Formation under Obama only grew by 2% over four years, while Trump will have delivered 8% total growth.
Real Gross Private Domestic Investment under Trump will have expanded 8%, while Obama scared investors into growing their investments in the USA at a 19% rate.
The trade deficit is where Trump has gone to war, and while President Obama saw that grow by 52% in real terms - by 237.2B USD - President Trump has Made America Great Again by reducing the growth over his term to 28%, although that corresponds to an increase in the trade deficit in real dollars of 284.9B USD. Still, we are talking rates of change, so Trump just needs re-election to get the deficit under control. Hint: Real Exports grew by 3% under Trump, and a mere 9% under Obama. Obama squandered America's Greatness by growing Real Imports by 14%, while Trump slapped the rest of the world in the face by cutting back to a 12% rate of growth.
In real terms, the S&P 500 will have grown by 29% during the Trump Presidency, while investors drove up equity values by 50% under Obama. Here I am getting into subjective assessments, as I see nowhere to hide for investors during 2020, except for going to cash. The runup in valuations could well continue, but two important factors will put a damper on the US stock market during 2020. First, inflation will finally respond to a tight labor market and we will see firms passing on labor costs to consumers, as corporate earnings growth is slowing. Second, the Fed will likely remain on hold in the first quarter of 2020, as labor markets will see some deterioration on a seasonal basis. Then we will see continuing labor market strength for the remainder of the year, and the Fed hawks will drive the FOMC to hike to a 2.50% - 2.75% rate band by the end of the year. A full percentage point of hikes will necessarily work on valuations through discount rates. We will likely see a peak in the S&P 500 in February at around 3280, and a slow grind down to about 3150 by year-end, for a -2.4% loss on the year. Boring and unattractive. Current momentum would suggest upside to equities. MENA political unrest, including the US killing of Iranian General Soleimani, the underlying issues leading to Fed intervention in the repo market, trade wars, and China unknowns keep us from seeing S&P 500 at 4000 as a reality in 2020, although that is how strong momentum was up to the end of 2019.
US 10-year Treasury bonds will likely yield 2.9% on average in Q4 2020, rising from the 1.8% Q4 2019 rate, as PCE-PI inflation rises from 1.5% to 2.3%. This increase in real bond yields on a current realized basis could be viewed as an increase in investor requirements, and not so much in inflation expectations rising. The FOMC hawks will differ, and so reward new buyers of US paper while causing bond valuations overall to fall. This drives investors to cash - taking T-bills at decreasing rates, while long rates are rising. There is no way to tell whether this widening of yield spreads from 2019 is a healthy sign, or something that deteriorates into a recession warning. UST10s yielded 2.2% on average during Obama's second term in office, and 2.4% over the Trump Presidency through 2020 - not much of a difference, although the net is a loss for bond holders. We saw a recovery in the direction of normalcy, but both yields are outside the normal range on the low side.
The Trump Legacy
Trump's bragging rights will rest with his electorate in general - the American Worker - when the voting booths open in November. Whereas the non-institutional civilian population expanded by 10.4M people under Obama, this was restricted to 7.6M under Trump, possibly because of immigration restrictions. Yet, the Labor Force will under Trump have expanded by 9.5M workers, while his predecessor only brought 4.2M workers into the Labor Force. Labor Force Participation will have risen to a 63.2% average during the Trump years from the Obama second term 62.9% - and I predict that we will see Participation rising from 63.2% in Q4 2019 to 64.5% in Q4 2020, for the first time since Q3 2011 re-entering the long term normal range in Q2 2020. Participation rate adjusted unemployment will then have been reduced by -8.1M citizens during the Trump reign, while Obama only achieved a -1.7M improvement. One could debate the contributions of monetary policy to this, but the FOMC has almost a complete bias in supporting price stability in its decisions, despite its Dual Mandate. Consistent increases in Real Government Expenditure and Capital Formation and other (enterprise) fiscal incentives are likely more important drivers of Civilian Employment than monetary policy considering the 2017 - 2020 Presidential Term.
Trump has brought the US economy to Full Employment in the narrow sense - disregarding labor force participation rates - for the first time since Q4 2006, while broad unemployment still has room for improvement. In Q4 2020 we will likely average 5.8% broad unemployment, well under the 8.0% long term average rate while 5.3% would be considered Full Employment. The US economy was last seen at 5.8% broad unemployment in Q2 2007.
Monetary stimulus averaged -2.6% (minus sign indicating stimulus) during the second term of President Obama, while this reduces to -1.2% during the Trump Presidency, which was somewhat offset by increases in Government Expenditure and Capital Formation and fiscal stimulus through lower tax rates. Monetary stimulus came down from -2.7% in Q1 2017 to -0.1% in the first half of 2019, currently in expansion to -1.4% this quarter and finishing the year around -0.7%, even as Fed Funds rates increases by a full percentage point. Most Wall Street houses seem to think the Fed will be on hold during 2020. Yet, I just report the numbers story, recognizing that the Street violently disagrees with my outlook on Fed Funds.
Back to Normal?
The long expansionary cycle keeps us waiting for a new recession, a crash or some freak event, like war, driving us back into a cyclical downturn. Definitions of "normal" have moved, and so our way of looking at the US economy, and assessing its future developments. In the previous paragraph I give Trump bragging rights on Labor Force Participation, while 2019 closed at a 63.2% average quarterly rate, outside the normal band on the low side. It is not a given that the improvement under way will continue. Q4 2019 saw participation adjusted unemployment at 8.8%, well above the long term 8.0% average. I forecast a major improvement in this measure during 2020. Meanwhile, we are far from Full Employment in the broad sense.
US 10-year Treasury yields are below the long term normal range on the low side, reflecting low inflation and corresponding low monetary policy rates as economic stimulus continues. I forecast a return to normal in Q4 2020, but until we do, the government bond market is in an exceptional state.
US 10-year Treasury Yield (market pricing) to Fed Funds (policy rate) spreads averaged in recession warning territory (less than 0.3%) for the fourth quarter in a row in Q4 2019. I expect this to normalize in Q1 2020, but until we do, there is a recession indicator flashing red lights.
The US real neutral Fed Funds policy rate (r*) averaged some 1.1% during 2019 and is still falling to 0.9% in 2020, a full percentage point outside the long term normal range on the low side. In nominal terms, r* was 2.5% throughout 2019, while we will see this rise to 2.9% this quarter and to 3.2% in Q4 2020. This framework is perhaps on the decline in terms of popularity in central banks, at the cost of not knowing what level of stimulus one is adding to the economy. Economic theory drives a lot of empirical work based on rather complex estimation-techniques. One could speculate that the issue is with the credibility of the results of these complex model estimates, as they have not necessarily been converging. Since the neutral rate is not observable in markets, one would be tempted to treat monetary policy as the sport of sailing. You look to the sails to define your position relative to winds and currents and look at your dual target response rates overall. Sailing is a particularly relevant sports analogy as the response to action is delayed and overshoots and undershoots are inevitable, especially when commanding major vessels (although look at the world largest yacht, the 88m Perini Yachts (https://www.perininavi.it/ ) built Maltese Falcon of VC billionaire Tom Perkins for tech sailing! ( https://youtu.be/lcvEJD87uY4 ) After Powell, I would propose to appoint Tom Perkins to Fed Chairman to take the institution into the 21st century).
Policy becomes highly undefined if there is no point of quantitative reference, and therefore I would argue for maintaining a Neutral Rate concept, working on the premise for sustained economic growth by eliminating policy errors. Our increased data sets and analytical capabilities (AI) and the emerging Quantum Computing capabilities, would speak for working on the dynamics of the economy, allowing theory to borrow more from physics than static models of the past. For market operators it is important to be able to share in the understanding of where we are and likely going in economic activity, It is much more interesting for enterprises to have an idea about the direction of monetary and fiscal stimulus than absolute rate levels, when developing operating budgets, including workforce considerations, and when developing investment strategies. Once your point of reference is a dynamic Neutral Rate, operators will find comfort in seeing how rising policy rates may not necessarily mean a reduction in net stimulus. The US Fed is operating in the normal range of monetary stimulus, getting close to the long term average stimulus of -1.5% in Q1 2020, without touching rates.
US Fed Funds are currently below the normal rate determined by looking to policy goal parameters only (2.5% - 2.75%). There are other fenomena influencing central bank actions, and these currently depress rates, raising stimulus. In part, these are domestic phenomena reflected in repo market illiquidity (but not handled through Fed Funds rate setting) and the factors behind this. Long term Treasury yield spread to Policy Rate constrain the space for rate hikes and set a line in the sand that keeps the central bank from committing obvious policy errors. The implication of our forecast for Fed Funds is that these constraining factors abate during the year. Yet, they will not be completely eliminated and this causes concern as one needs to see through the collective eyes of market operators to assess where we are and where we are going. Most market operators and the FOMC itself sees Fed Funds holding at current levels, possibly with further cuts this year. This was also my view until the last inflation and GDP data was published. A shift occurred in the data that suggests an important policy rate move in the US.
Implications for enterprises and private investors
IPO markets have been good, Venture Capital and Private Equity has more money at its disposal than ever before going into 2020, so the world is flush with money. Still, agendas shift and people look at the world with fresh eyes.
Market moves following the events in Iran show how events can drive markets to forget fundamentals and go to perceived safe havens. World PMIs are still at 47, meaning activity as seen by purchasing managers globally is contracting, albeit at a modest rate compared to where we were in August 2019. If global PMI does not grow into positive territory by Q2 2020, we may not see much inflation pressures, nor Fed Funds hikes.
At the macro level, the runup to 2020 November elections will likely be characterized by the US government driving momentum in the labor markets and keeping monetary and fiscal stimulus at levels that will maintain growth at healthy levels through the year, despite the unusually long duration of the economic expansion following the Great Recession. We are seeing banks cutting staff at elevated levels, and trucking industry failures, indicating the presence of emerging sector specific pain points and subsequent adjustments. Repo market operations by the Fed is a reminder of the tools of central banks extending to open market operations and reserve requirements, albeit most focus have been on policy rates. If specific, important institutions have issues related to liquidity and its business model as a result of mortgages crisis fallout and the resulting monetary policy, are we sure that providing liquidity will resolve the fundamental issues relating to specific institutions? Will the Fed Balance Sheet remain elevated forever?
Q1 of 2020 will reveal if we are just to emerge from a 2015 - 2016 type of slowdown and adjustment, or if there is trouble ahead. I would be alarmed if the UST10 to Fed Funds spread remained below 0.3% also in Q1, which would build confidence in a recession forecast. A setback in labor markets in Q1 2020 is to be expected, and my advice is to ignore it, unless accompanied by negative macro news in other sectors.
As an investor in public markets, this is the time to go to cash, as there is a good chance equity and bond markets will go south this quarter, most likely after a February peak. In other words, 4Q 2019 earnings will likely be as expected plus something, but the outlook will be so-so. Ride the next wave of AI and Electrification in venture capital through venture investing, and leave it to your pension fund managers to worry about Wall Street.