December 2019

The bullish stock market that generated such outsized returns last year continues its upward trajectory in the opening days of 2020. Undeterred by a supposed Iranian plot to kill Americans, the United States’ removal of the supposed plot mastermind, the Iranian missile attack response, including the Iranian attack of a Ukrainian passenger aircraft, the various stock indices have reached new all-time highs.

The bond market, on the other hand, has traded in a lackluster fashion.  Despite our forecast for continued economic strength, we doubt that interest rates will move materially higher this year.  The Federal Reserve’s continued buying of Treasury notes and bonds in the secondary market is suppressing interest rates.  With the consumer price index rising 2.2% year-over-year, the fair value for the 10-year Treasury note is approximately 3.10%, 120 basis points above the current level.  However, if that were to happen, equity and credit investors would panic and dump stocks and other risk assets, and for good reason.  The S&P 500 index, at its current valuation is trading at nearly 19 times forward earnings.  The catalyst behind the continued rise in stock prices is threefold.  First, corporations continue to sell debt to buy-back shares in their own companies, thereby shrinking the float of outstanding stock and driving the price higher.  Second, investors have been emboldened by the low-volatility, low interest rate environment and have an appetite for assets with the highest return potential.  Lastly, investors have been rewarded repeatedly over the years for “buying the dip” whenever stock prices have corrected, and have adopted that as a strategy.  The effect is a seemingly perpetual virtuous cycle.  No one at the Fed has an appetite to do anything other than what they’ve been doing for the past ten years, knowing that the consequences would likely result in a recession at best, or a complete meltdown of asset prices similar to what occurred in 2008.  Moreover, because the United States government is able to generate yearly spending deficits in excess of one Trillion dollars, the Fed needs to buy in the secondary market to sop up the excess Treasury supply that now appears to exceed demand.

With that backdrop we expect 2020 to be a low volatility, low return year for the bond market, especially given the Federal Reserve’s history of avoiding intervention during an election year.  That’s not to say that we expect the same from the stock market.  Should economic activity accelerate and drag profits higher, it’s possible that stock prices reach even higher highs. 

A wild card is what will happen in Europe.  The European Central Bank is now Chaired by Christine Lagarde, the former head of the International Monetary Fund.  The expectation is that the ECB will become a more democratic institution than was witnessed under former Chairman Mario Draghi. As with the Federal Reserve, we suspect that the ECB will want to avoid disrupting economic growth by raising rates but Chair Lagarde has not publicly stated the direction she intends to lead the Central Bank.  For sure, the European banks would love for the ECB to abandon the negative interest rate policy that’s been in place since 2014. But Madame Lagarde may be hesitant to label herself as a “hawk” so early in her tenure.

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