Q4 2019 Update: US Equity Markets Finish Strong

US equities ended 2019 near record levels with the S&P 500 Index posting its best overall performance since 2013.

In clear contrast to 2018, the market put in a stellar fourth quarter in spite of continued concerns about the economy, trade wars and tariffs, geopolitical unrest abroad, and political division at home. To wrap up the year, all three major indexes—the S&P 500, Nasdaq, and the Dow Jones Industrial Average—all touched record highs multiple times in December.

Following is an overview of Q4 2019 trends and insights.

Q4 Investment Returns

US equities surged in Q4 as many concerns surrounding the markets abated, such as:

  • The markets welcomed signs of forward motion in the US-China trade dispute.
  • The Federal Reserve (the Fed) moved to a much more accommodative stance on monetary policy.
  • The US economy fared better than feared with strong employment, consumption, and tame inflation.

Top Factors Impacting Markets

Tariffs and Trade Uncertainty

Q4 brought the first major de-escalation of trade tensions since mid-2018.

Early in December 2019, markets breathed a sigh of relief when the United States and China announced they had tentatively agreed on a first phase of a trade deal. As part of the agreement, the United States cancelled tariffs on $160 billion in Chinese imports that were set to take effect within days. 

The United States also agreed to half tariffs previously put in place in September. The deal was vague, but it alluded to structural changes by China that could include new guidelines around the protection of intellectual property, an issue that has been a sticking point for the United States. 

During the quarter, President Trump also allowed a deadline to lapse that would have imposed tariffs on imports of autos and auto parts—tariffs that would have squarely hit European economies.

Impeachment Inquiry

A formal impeachment inquiry against President Trump was launched on September 24, 2019, by Speaker of the House Nancy Pelosi.

The inquiry pertained to interactions between President Trump and Ukrainian President Volodymyr Zelensky, wherein the president allegedly abused his power. In December, the deeply divided House of Representatives voted to impeach the president for two separate articles: abuse of power and obstruction of Congress, sending the case to the Senate for a trial as the next step.

While the process remains ongoing, the market has taken a wait-and-see attitude as the situation unfolds.

Fed Changes

In July of this year, amid signs of a global slowdown, the Fed reduced the benchmark interest rate for the first time in more than a decade. The reduction was intended to help spur spending and support a slowing economy. 

During the fourth quarter, the Fed provided two additional rate cuts. By December, there were indications that this easier monetary policy was having positive effects. In particular, effects were apparent in housing data, where home-builder optimism numbers were robust and growth in housing starts and permits continued to rise while the new supply of homes struggled to keep up with demand. 

Inversion of the Yield Curve

Headlines were buzzing in mid-summer, when an anomaly called the inversion of the yield curve occurred in the US bond market, causing a significant sell-off in stocks. This much-watched recession indicator can spook market participants as it has preceded most recessions since 1955. 

Inversion occurs when the yield on the benchmark 10-year treasury falls below the yield on the two-year treasury, which happened on August 14, 2019, for the first time since December 2005—two years before the recession brought on by the financial crisis.

Since the August inversion, the Fed’s three rate cuts have lowered yields on the short end of the curve, while strong consumer activity and hiring trends have pushed longer-term yields higher, reversing the inversion and staving off fears that the 10-plus-year bull market was coming imminently to its end.

Overnight Money Market

Although it doesn’t receive much attention, the overnight lending market plays a vital role in finance. Overnight lending is facilitated through bank-to-bank lending, which is typically executed near the Federal Reserve Funds Target Rate (Fed Funds Rate), in what’s known as the overnight repurchase markets (repo).

In mid-September, the overnight markets became temporarily distressed with the overnight lending rates more than tripling that of the Fed Funds Rate. The episode reflected what’s known as a liquidity squeeze, meaning there wasn’t enough cash available on that day to finance the daily needs of the financial system. 

The cause of the sudden distress was a bit of a mystery, but it was at least partially due to a large block of US Treasury debt being settled into the marketplace, combined with significant bank withdrawals needed to make quarterly tax payments to the US Treasury.

That said, the overnight markets were stressed enough that the New York Federal Reserve stepped in, injecting hundreds-of-billions of dollars into the system over several days to help return the markets to normal overnight-lending rates.

During Q4, the Federal Reserve Bank of New York boosted its repo operations to ensure that the overnight lending markets continued to function normally, especially through the typically heavy cash requirements that occur at year-end. Despite concerns, the overnight lending markets ran smoothly as the year came to a close. 

Takeaway

In essence, the Fed injected enough liquidity to provide a strong signal that they’re available to provide assistance during tight periods. An often-overlooked byproduct of these operations is that the Fed has added significant excess cash reserves to the banking system, which could add more stimulus to the economy—a positive for riskier assets like stocks.

Geopolitical Unrest

China

While the ebbs and flows of the US-China trade talks have taken center stage all year, China continues to experience its own internal tensions.

Widespread unrest broke out across Hong Kong on October 1, 2019, which marked the 70th anniversary of National Day of the People’s Republic of China. Protesters organized demonstrations they called the National Day of Grief, resulting in some of the worst violence the autonomous territory has seen since protests began months ago. The unrest brought commerce to a near standstill in parts of Hong Kong. While the protests haven’t again reached that level of intensity, the conflict is ongoing.

The Middle East

The Middle East dominated headlines in the first few days of 2020. On Friday January 3, 2020, the United States carried out an airstrike at the Baghdad International Airport, killing Iranian Military Commander Qassem Soleimani, one of the most powerful figures in the Islamic Republic. 

In response, the Iran Parliament voted in favor of expelling US troops from the country and launched a missile strike on two Iraqi military bases that housed US forces. There were no casualties from the attack, and it appears that, for now, the tensions have calmed.

Following the airstrike, President Trump addressed the nation, noting that that neither the United States nor Iran have much appetite for escalating the conflict. The market’s immediate response to the conflict was a sell-off in equities and flight to quality buying in safer assets, like US treasuries, gold, and oil—but this reaction quickly normalized. 

These geopolitical tensions may continue to create uncertainty throughout 2020.

US Economic Activity

In a tale of two economies, employment, consumer confidence, and consumption are reflecting strength in the US economy, while data related to the manufacturing sector continues to decline. The latter phenomenon is largely due to trade-policy uncertainties and tariffs dampening the sector.

Gross Domestic Product

US Gross Domestic Product (GDP) grew 2.1% in Q3, a surprise uptick from the 2% recorded in Q2. An Atlanta Federal Reserve gauge estimates a 2.3% GDP uptick for Q4.

Employment

The jobs market had a stellar performance in November, with nonfarm payrolls surging by 266,000 and the unemployment rate falling to 3.5%, both easily beating expectations.

Confidence Indices

While still quite strong, consumer confidence declined marginally in December after a slight improvement in November. Americans felt largely confident about business conditions in December amid the holiday shopping season, but their confidence wavered somewhat regarding job availability and income growth for the first half of 2020. 

Business confidence rebounded due to optimism about a US–China trade deal.

Manufacturing

The manufacturing sector continues to be the troublesome area of the economy, with the most recent purchasing managers index (PMI) showing additional contraction. The PMI is based on a monthly survey of supply chain managers across multiple industries and is a measurement of the prevailing direction of economic trends in manufacturing.

A reading of under 50 indicates contraction, suggesting expectations for future business conditions are deteriorating. The manufacturing PMI in the United States dropped to 47.2 in December, which is the lowest level since June 2009 when it hit 46.3. Global trade remains the most significant issue impacting the PMI reading.

Housing

The housing market was the high point in Q4 economic data with strong home-builder optimism and continued growth in housing starts and permits, all while new home supply continued to struggle to keep up with demand.

International Market Trends

For the most part, foreign-developed economies, in particular in Europe and Japan, haven’t participated in the upswing seen in the United States and some emerging-market economies.

Japanese data has failed to rebound, and while German business sentiment has picked up, consumer confidence readings across the Eurozone remain weak. At the same time, the United Kingdom’s general election yielded a new conservative majority, potentially offering more clarity around the future of Brexit.

Emerging Markets

While emerging markets bore the brunt of the trade war in early 2019, they posted a solid resurgence into Q4. Flows into emerging markets are highly sensitive to factors, such as geopolitical uncertainty and slowing global growth. However, forecasts by the International Monetary Fund expect emerging-market growth to accelerate into 2020 and remain more than double that of developed markets.

Fixed-Income Markets

US Treasury bonds increased in value during 2019 due to the following factors:

  • Investors turning to safer assets, like treasury bonds, during market uncertainty
  • Heightened expectations for lower global growth and inflation
  • Competitive rates, relative to other parts of the world

While the rate on the US 10-year US Treasury yield dipped below the 1.5% mark in mid-summer—a low that hasn’t occurred since 2016—it closed out the year higher at 1.92% responding to the more-constructive economic view at year-end.

As a note, prices and rates move inversely to each other on bonds; when yields move lower, prices move higher.

Credit Trends

Despite bouts of risk-aversion due to escalating trade conflicts and lingering late-cycle fears, high-yield credit and investment-grade credit have also had strong returns since the beginning of 2019.

The Fed’s willingness to lower interest rates when needed has encouraged investors to reach for yield in lower credit-quality instruments, bolstering demand for these bonds as the global supply of negative-yielding sovereign debt has surged. Some argue this change has taken place even while credit quality has been declining.

In fact, companies around the globe issued a record amount of corporate bonds in 2019.

Looking Ahead

While challenges to global economic expansion have been evident in slowing US earnings growth, the risk of a recession in the United States still appears unlikely in the near term.

There’s reason to remain cautiously optimistic going into 2020, while acknowledging that political risks surrounding an election year, as well as the potential for a re-escalation in trade and geopolitical disputes—have created downside risks that could trigger renewed volatility and further impede economic growth.

Monetary expectations and the Fed’s positioning shifted dramatically at the beginning of 2019. The Fed cut interest rates three times and took a much more accommodative stance, which could be supportive of riskier assets, such as equities, heading into 2020. A reversal of this more-dovish Fed stance, due to inflation or other factors, is a continued risk to the markets.

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For more insight into Q4 activity or how these trends could affect your investments, contact your Moss Adams professional.

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