Fourth Quarter 2019 | Issue No. 28An Economic & Market Commentary from Trust Point

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Fourth Quarter 2019Market Point

An Economic and Market

Update from Trust Point

After an unusually weak fourth quarter in 2018, both equity and fixed-

income markets produced strong returns for investors in 2019. While

equity markets were primarily supported by rising investor sentiment,

both markets cheered the actions and words of major central banks

around the world.

U.S. and global economic growth were

positive but weaker in 2019. Not only

were GDP (Gross Domestic Product)

growth rates lower than last year, they

were also lower than what was expected

by economists at the beginning of the

year. While many factors contributed to

the slower pace of growth last year, the

trade war with China certainly played

an important role. As the trade war

unfolded, its impact on confidence,

business confidence in particular,

was of critical importance (Chart 1).

Business confidence has historically

been a very reliable leading indicator

of recessions as it correctly predicted

the past four recessions since the mid-

1970s. Without business confidence,

we know the job market could be at

risk putting the two biggest sectors of

the economy (service and consumer)

in peril. Fortunately, despite weaker

business confidence so far, the

job market has remained resilient.

While we continue to expect sluggish

economic growth in 2020, we remain

on high alert for potential outcomes on

either side of our base case. Whether

the economy surprises on the upside

or downside will be partially dependent

on the ability of the U.S. and China to

seal a comprehensive and sustainable

deal, an outcome that still remains

uncertain despite recent progress on a

“Phase One” deal.

Keeping an Eye on the Dominoes

Dollar Index Level Dec 96.4 99.4 96.2

As of Actual 3 Mos. Ago 1 Year Ago

ISM Manufacturing (>50 = Expansion) Dec 47.2 47.8 54.3

ISM Non-Manufacturing (>50 = Expansion) Nov 53.9 56.4 60.4

Non-Farm Payrolls Nov 266k 219k 196k

Unemployment Rate Nov 3.5% 3.7% 3.7%

CPI Ex-Food & Energy (yoy) Nov 2.3% 2.4% 2.2%

JP Morgan Global Manufacturing Index

(>50 = Expansion) Dec 50.1 49.7 51.4

JP Morgan Global Services Index

(>50 = Expansion) Nov 51.6 51.8 53.7

US Economic Activity

KEY ECONOMIC DATA

Global Economic Activity

Source: Bloomberg

Chart 1: Confidence - An Important Domino That Must Stay

Up Straight

Source: MRB Partners Inc © 06/2019

Trade War

Global Trade

Trade

Note: Dominoes depict trends in the U.S. and aggregate global economy

Sluggish Growth Weak Growth Recessionary

Manufacturing Sector Service Sector Consumer Sector

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Market Point Fourth Quarter 2019

In investing, “picking up pennies in

front of a steamroller” has always been

a dangerous proposition. The term

was coined by journalist Martin Wolf

and economist John Kay years ago to

describe investments with a high prob-

ability of a small gain (pennies) but a

small probability of a very large loss

(steamroller). For investors, recessions

are like steamrollers. They can cre-

ate large losses in portfolios relatively

quickly. As investment managers and

fiduciaries of our clients’ assets, it is

our job to always be on the lookout for

steamrollers and adjust portfolios ac-

cordingly. While we never bought into

the recession story over the late sum-

mer months, we have made it clear to

our clients that we believe we are “late”

in the cycle (Chart 3). While this doesn’t

tell you when the steamroller will ar-

rive, it provides a probability gauge on

the likelihood of one appearing. At this

point, we are not calling for a recession

in 2020, but we remain on the lookout.

Over the past six months we have be-

come more selective in our position-

ings to ensure that we can provide the

best risk-adjusted returns for our cli-

ents without taking unnecessary risks.

Picking Pennies in Front of a Steamroller

Since the trade dispute with China

started to flare in early 2018, policy un-

certainty has been on the rise (Chart

2). Internally, we like to refer to policy

uncertainty as the “rules of the game”.

When the rules are unknown or chang-

ing, fewer people are willing to “play the

game”. In the world of economics, this

means decision makers and business

owners postpone or cancel decisions

to spend and invest, therefore depress-

ing economic activity. Recently, the

announcement of a “Phase One” deal

with China was received with enthu-

siasm. On the surface, it appears like

the “rules of the game” between the

two super-powers are now being de-

fined. However, under the surface, we

question how much has really been

agreed upon. Comparing statements

released from the U.S. and Chinese

administration on the “deal” is quite

telling. While the U.S. statement is full

of “agreed” commitments with specific

dollar amounts and timelines, the Chi-

nese statement is full of generalities

with no dollar amounts or timelines.

Until we get signatures on both sides,

the details of the agreement will proba-

bly remain unclear.

Policy Uncertainty is Not Going AwayChart 2: Policy Uncertainty Remains Elevated and Dependent

on the Ongoing US/China Trade Dispute

Source: Ned Davis Research; Copyright 2019 Ned Davis Research, Inc. Further distribution prohibited without prior permission. All Rights Reserved. See NDR Disclaimer at www.ndr.com/copyright.html.

For data vendor disclaimers refer to www.ndr.com/vendorinfo/.

PPP-GDP Weighted Aggregate of Australia, Brazil, Canada, Chile, France, Germany, India, Italy, Ireland, Japan, Mexico, Russia, South Korea, Spain, UK, and US.

340Global Economic Policy Uncertainty Index (2019-11-30 = 265.8)

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1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Chart 3: Many Signs That The Economic Cycle Is “Late”

Source: Touchstone Investments, Bloomberg

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*Model based on Capacity Utilization, Unemployment Rate, Treasury yield spreads, and Consumer Confidence Indexes

An Equity Market

Update from Trust Point

Market Point

Global equities continued their march higher into year-end as the fourth

quarter was marked by expectations for improving economic growth and

an agreement on a “Phase One” trade deal between the U.S. and China.

Fourth Quarter 2019

S&P 500 3,231 2,977 2,507 2,239 2,059

Dow Jones Industrial Average 28,538 26,917 23,327 19,763 17,823

NASDAQ 8,973 7,999 6,635 5,383 4,736

US Large Cap Growth 10.6% 36.4% 36.4% 20.5% 14.6%

US Large Cap Value 7.4% 26.5% 26.5% 9.7% 8.3%

US Mid Cap Growth 8.2% 35.5% 35.5% 17.4% 11.6%

US Mid Cap Value 6.4% 27.1% 27.1% 8.1% 7.6%

US Small Cap Growth 11.4% 28.5% 28.5% 12.5% 9.3%

US Small Cap Value 8.5% 22.4% 22.4% 4.8% 7.0%

International Large Cap Developed (US Dollar) 8.2% 22.0% 22.0% 9.6% 5.7%

International Small/Mid Cap Developed (US Dollar) 11.5% 25.0% 25.0% 10.9% 8.9%

Emerging Market (US Dollar) 11.8% 18.4% 18.4% 11.6% 5.6%

Quarter-End 3 Mos. Ago 1 Year Ago 3 Years Ago 5 Years Ago

3 Month YTD 1 Year (Ann) (Ann)

3 Year 5 Year

US Economic Activity

EQUITY BENCHMARK TABLE

Equity Returns (%)

Source: Bloomberg, Morningstar

Equities Year in Review

Global stocks had a banner year in 2019

on the heels of major central bank ac-

tions that drove interest rates lower (po-

tentially extending the economic cycle)

and expectations for positive near-term

outcomes in the global trade war. What

the market lacked was a positive con-

tribution from earnings growth as lower

economic activity, particularly in the man-

ufacturing sector, kept global earnings

growth nearly flat for the year. Historically,

we know earnings have been the primary

contributor of rising equity prices. There-

fore, without stronger earnings in 2020,

it is unlikely the stock market could con-

tinue to march higher. A surging stock

market with flat earnings growth last year

lends its influence to very strong investor

sentiment reflected by higher equity valu-

ations in the U.S. and internationally. The

rising bullish sentiment as of late (Chart

4) is a measure of a more positive inves-

tors’ view of recent developments in the

trade war between the U.S. and China

and expectations of a reversal in key eco-

nomic indicators in 2020.

Source: WSJ The Daily Shot

Chart 4 : Investor Optimism Increased Throughout 2019Driving Equity Markets Higher

50

40

30

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AAII US Investor Sentiment Bull - Bear Spread

Market Point Fourth Quarter 2019

As global equity valuations moved high-

er in 2019 on expectations for improved

global growth and positive trade war

outcomes, it leaves doubt to how much

higher global valuations can go without

more support from fundamental stock

drivers such as earnings growth. As

manufacturing activity slowed in 2019,

earnings expectations for the next twelve

months peaked and have since come

down (Chart 5). An improved economic

environment, which already appears to

be priced into stock valuations, leaves

little room for expansion of price-to-earn-

ings multiples. If we assume valuations

remain unchanged throughout the year,

or even give back some of the 2019 in-

crease, particularly in the U.S., any up-

side in stock prices is likely to parallel the

earnings increase in the coming year.

Our base case is for earnings growth

estimates to continue to decline relative

to current expectations suggesting mod-

est global equity returns consistent with

our expectation for sluggish economic

growth in 2020. At this time, valuations

outside the U.S. do not appear to have

discounted much potential improvement

in economic activity and probably rep-

resent the best opportunities for equity

investors in 2020.

Expect Equity Returns to Parallel Earnings Growth

Last year the global stock market and the

global bond market diverged so much

that bonds now appear overvalued rela-

tive to stocks. A regression to the mean

is a reasonable outlook for the coming

year, particularly as major central bank

actions now appear to be on hold in

2020. In a period of rising long-term inter-

est rates, the financial sector could be a

major beneficiary as bank services tend

to see profit margins improve when rates

rise (Chart 6). As such, we continue to

favor this sector of the market relative to

our benchmarks. For many of the same

reasons we prefer the financial services

sector, we have relative underweights to

bond proxy sectors such as utilities and

consumer staples. Each of these sectors

pays relatively high dividend yields that

become less attractive on a risk-reward

basis with improving bond yields. As

yields came down over the past several

months these sectors became more ex-

pensive. On a regional basis, we continue

to overweight the Eurozone area relative

to our benchmarks. The region remains

under the watchful eye of the European

Central Bank, valuations remain relative-

ly attractive, and an expected upturn in

global economic growth is poised to dis-

proportionately benefit the region.

Equity Positioning in 2020

Chart 5 : Global Earnings Growth Expectations Slowing Down

Source: MRB Partners

*U.S. dollars; rebased

Note shaded for NBER-designated U.S. recessions

2006 2008 2010 2012 2014 2016 2018

120120

160160

200200

120120

160160

12-Month Forward Earnings*: Global

Global ex-U.S.U.S.

Chart 6 : Steeper Yield Curve Should Benefit Financials

Source: BCA Research (BCA Analytics)

*Shown rebased to Jan. 2016 = 100. Source: MSCI Inc. (See copyright declaration).

**10-Year Minus 2-Year Government Bond Yield. Germany Used for Euro Area. For Global, G7 10-Year Government

Bond Yield Minus 3-Month Euro Rate is shown.

104

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120

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16 17 18 19

Yield Curve** (RS)

Stocks: Financials Relative to

Broad Market* (LS)

Over the last five years, the Federal

Reserve has driven monetary policy by

raising interest-rates nine times; from

zero-bound to a range of 2.25%-2.5%.

In 2019, it lowered the Fed Funds rate

three times and is now targeting a range

of 1.5%-1.75% (Chart 7). Interestingly,

throughout its journey, the Fed has not

only influenced the direction of the bond

market but the equity market as well.

In late 2018, the Fed contributed to the

equity market correction by hiking rates

too much and too quickly while it also

contributed to the equity market rally in

2019 with their rate cuts. In 2020, we

expect the Fed to take a back seat and

remain on hold the entire year for two

main reasons. First, the independent

Fed will not want to give the impression

of a political bias by impacting markets

during an election year. We have seen

how markets have reacted to changes in

monetary policy in the past and rate cuts

or hikes could give the impression of a

partisan Fed. Second, with core PCE

(personal consumption expenditure)

inflation still well below the Fed’s target,

there is little reason for the Fed to hike

rates. With the Fed taking a back seat,

we expect Fed policy to become less of a

driver of asset prices in 2020.

Federal Reserve - Taking a Back Seat in 2020

A Fixed Income Market

Update from Trust Point

Market Point

During the first three quarters of 2019, the bond market had a tremendous

run in response to weakness stemming from the trade war’s effect on

growth and confidence. The recession fears which drove bond returns

began to unwind in the fourth quarter. Decreasing trade tensions and a

Fed on hold have so far proven that the “worst-case scenario” narrative

implied in the bond market was overdone.

Fourth Quarter 2019

3 Month T-Bill 1.5% 1.8% 2.4% 0.5% 0.0%

2 Yr US Treasury 1.6% 1.6% 2.5% 1.2% 0.7%

10 Yr US Treasury 1.9% 1.7% 2.7% 2.5% 2.2%

US Intermediate Treasuries -0.8% 7.5% 7.5% 3.6% 2.7%

US Treasury Inflation Protected Sec. 0.8% 8.4% 8.4% 3.3% 2.6%

US Mortgages 0.7% 6.4% 6.4% 3.2% 2.6%

US Short-Intermediate T/E Munis 0.9% 5.4% 5.4% 3.3% 2.4%

US Investment Grade Corporates 1.2% 14.5% 14.5% 5.9% 4.6%

US Senior Bank Loans 1.7% 8.6% 8.6% 4.3% 4.4%

US High Yield 2.6% 14.4% 14.4% 6.3% 6.1%

US Convertibles 7.4% 23.2% 23.2% 11.9% 8.5%

Int’l Bonds Ex-US (Hedged) -1.9% 8.0% 8.0% 4.5% 4.1%

Int’l Bonds (Unhedged) 0.5% 6.8% 6.8% 4.3% 2.3%

Emerging Market Debt (US Dollar) 2.1% 14.4% 14.4% 6.1% 5.9%

Quarter-End 3 Mos. Ago 1 Year Ago 3 Years Ago 5 Years Ago

3 Month YTD 1 Year (Ann) (Ann)

3 Year 5 Year

US Yields (%)

FIXED INCOME BENCHMARK TABLE

Global Economic Activity

Source: Bloomberg, Morningstar

Chart 7 : Fed Funds Effective Rate

Source: Bloomberg

1.55

0.00

0.50

1.00

2.00

2.50

2015 2016 2017 2018 2019

Market Point Fourth Quarter 2019

A consistent slowdown in global activity

during 2019 occurred through deteriora-

tion in manufacturing activity stemming

from trade war uncertainty. Growing

recession fears forced investors into

safe-haven bonds and led to some of

the best annual returns from high quality

bonds since the last recession. How-

ever, at the same time investors bought

safe-haven bonds, the stock market rose

to new highs; an unusual and unexpect-

ed divergence. This divergence remains

dramatic today and we believe bond

yields may have fallen too far in 2019. In

fact, during the fourth quarter, we have

started to see bond yields rise well off

the lows from last August. Trade tensions

have eased with the “Phase One” deal,

allowing recession fears in the bond mar-

ket to unwind. Last but not least, the yield

curve—which was possibly sending the

biggest recession signal—is no longer

inverted and has steepened to the high-

est level since November 2018 (Chart

8). These recent positive developments

have all contributed to unwinding reces-

sion fears which were being aggressively

priced into the bond market. We expect

this trend will continue into the first half

of 2020.

Recession Fears Subsiding

The steady rise in corporate borrowing

and leverage has increased concerns

that risks are high in corporate credit. In a

low interest rate world, it is advantageous

for companies to issue debt, so this

development is not surprising. Although

elevated debt and leverage levels have

led to rising defaults historically (Chart

9), the corporate bond market has yet to

show signs of stress. Interest-coverage

and cash flows are the key. Because

interest rates remain low, interest cov-

erage has remained positive and above

historical median levels. Corporations

have been able to generate sufficient

cash flows to service elevated levels of

debt. Lower corporate tax rates resulting

from the Tax Cuts and Jobs Act in late

2017 have also boosted cash flows and

are supportive of interest-coverage.

However, the longer companies increase

leverage, the greater the risk for credit

losses when companies are no longer

able to service debt. Among others, we

continue to monitor profits, lending stan-

dards, and interest coverage as negative

developments in these metrics could

change the outlook. Our positioning in

credit has become more cautious given

elevated risks, but we remain optimistic

that an accommodative Fed and positive

profits will continue to provide a support-

ive environment for corporate credit.

Corporate Leverage Rising

Chart 8 : Yield Curve Climb Accelerates

Source: CNBC

The gap between the 2-year and 10-year Treasury yields is the widest in a year

2019

28

20

10

0

-4

Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec

Chart 9 : High-Yield Leverage Steadily Rising

Source: BCA Analytics

U.S. 12-Month Trailing High-Yield Corporate Bond Default Rate*

U.S. Nonfinancial Corporate Sector Gross Leverage**

15

15

10

10

5

1995 2000 2005 2010 2015 2020

5

% x

Market Point Fourth Quarter 2019

Key Investment Themes

Macroeconomics

Asset Allocation

Fixed Income

Equities

• Structurally, Debt, Demographics, and Deglobalization may influence global growth and inflation for years

• Cyclically, economic growth has been slow but positive, while inflation expectations remain low for now

• Closely monitoring global confidence & the labor market for signs of contagion to services/consumers

• Biggest wild cards for 2020: Trade disputes and fiscal response from China & Germany

• Investment cycle is maturing. The risk/reward outlook no longer favors equities over fixed income

• Low bond yields & pricier equity valuations call for modest returns from financial assets over the next 3-5 yrs

• Global policy uncertainty (including trade disputes) has important implications for various asset classes

• Disconnect between equities/credit and the interest rate market will eventually need to be reconciled

• Longer-maturity bond yields do not currently offer a very attractive risk-reward proposition

• Overweight USD denominated debt over local-currency international bonds

• Low yields on high quality bonds provide little value and cushion against unexpected risk. Stay short duration

• Credit sensitive bonds should still outperform; however, absolute and relative returns will be unexciting

• Global equities have priced in some improvement in economic activity already

• Typical warning signs of an equity bear market are not present

• Corporate earnings are slowing down, recent earnings revisions can’t justify the recent move up in stock prices

• Hedged U.S. equity strategies offer the best value in an increasingly volatile market environment

Market Point Fourth Quarter 2019

Tactical Asset Allocation

Equity

- Underweight + Overweight

Fixed IncomeAsset

Allocation

U.S. Equity

Value

Large Cap

Consumer Staples

International Equity

Growth

Small Cap

Financials

Equity

Interest-rate risk

Government Debt

Foreign Bonds

Short-Term Bonds

Inflation Protection

Corporate Credit

Fixed

Income

We have reduced exposure to equities in portfolios and are now slightly underweight equities vs. fixed income. While we acknowledge

the potential benefits of lower short-term rates on the economy, we must also recognize that “late cycle” signs are accumulating. We

have therefore positioned portfolios to ensure that we can provide the best risk-adjusted returns without taking unnecessary risks. We

are focusing duration in the U.S. on the front end of the curve, as short-term bonds are more attractive relative to longer-maturity term

structures. We are also positioned to capture yield in credit sensitive bonds while being cautious on interest-rate risk. Equity exposure

remains focused on growth and small and mid-cap stocks. Int’l equities are also favored as relative valuations remain attractive.

Profile Summary

Tactical Asset Allocation

Individual client portfolio positioning, performance and transactions therein can vary greatly based on factors including investment strategy, objective, limitations, risk tolerance, time horizon, asset allocation and tax implications.

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