Published January 17, 2020
Below we reprint a recent article from Charles Schwab analyst Jeffrey Kleintop outlining the possible risks to the current market uptrend. While the comments focus on the risks, we can also read between the lines and understand what the market’s expectations are – which creates the risks, of course. Herewith is Mr. Kleintop’s article:
“History shows us that the biggest risks in any year aren’t usually from out of left field (although that sometimes happens). Rather, they are often hiding in plain sight. As goes one of my favorite quotes: “It ain’t what you don’t know that gets you in trouble, it’s what you know for sure that just ain’t so.” Risk appears when there is a very high degree of confidence among market participants in a particular outcome that doesn’t pan out. So, by identifying the unexpected, here are the top ten global downside risks for investors in 2020, in no particular order:
1. Return of inflation. Central bank policy is a persistent risk to the market. Yet for 2020, few expect any material uptick in inflation that would prompt central banks to raise interest rates. The current economist and market consensus is that inflation will remain muted, much the same as in 2019. To use the U.S. as an example, only a quarter of the 70 economists tracked by Bloomberg expect U.S. inflation to rise by half of a percentage point or more in 2020. Historically, inflation usually moves by more than a percentage point in any given year and has moved by at least a half a percentage point in 15 of the past 20 years. The risk is that inflation surprises to the upside and forces central bankers to raise interest rates more than expected. This outcome has ended many past economic and market cycles.
2. Trade tensions don’t fade. Markets have responded positively to the “Phase One” deal between the U.S. and China, seeming to believe 2019 was the peak in trade tensions and that 2020 will see them fade. However, while the “Phase One” trade deal stops the escalation of tariffs (at least temporarily), it does nothing to restrict use of other legal and political tools to try to constrain technological advances. As the U.S.-China strategic conflict becomes more focused on technological leadership, it may impact stocks in the technology sector which led the global stock market higher in 2019.
While the U.S.-China trade conflict has garnered much of the world’s attention, the largest trading relationship in the world is between the U.S. and European Union. Trade tensions between these two parties could heat up following WTO-approved tariffs in response to illegal support for airplane makers and France’s new digital services tax on U.S. tech companies.
3. Brexit ends badly. Both the British pound and U.K. stocks rallied in response to Prime Minister Johnson’s Brexit deal being passed by Parliament. This deal helps sets the stage for the U.K. to leave the European Union (EU) on January 31, 2020. However, this isn’t the end of Brexit. During the transition period that runs until the end of 2020, the U.K. and the EU will need to negotiate a new trading agreement. As the year goes on, there should be indications as to the success of these negotiations. If evidence points to no agreement, the year-end split with the EU could have similar economic impacts to a no deal Brexit. The markets may begin to price in the risk of disruptive economic consequences.
4. Rising costs prevent earnings rebound. Despite a weak revenue picture, analysts expect a 9-10% rebound in earnings per share in 2020 for the global companies in the MSCI World Index, which saw no growth in 2019. This expectation could be threatened by a rise in costs. Labor is the biggest cost for most companies and record low unemployment rates combined with weak productivity could mean pressure on wages to rise, squeezing corporate profit margins and resulting in weaker than anticipated earnings. After a rise in valuations lifted stocks around the world in 2019, an earnings recovery may be needed to cement or build on last year’s gains.
5. Manufacturing recovery fail. After a 15-month long global manufacturing downturn, a four-month rebound began in August 2019. However, December registered a decline to 50.1, a hair’s breadth above the dividing line between expansion and contraction of 50.0, as you can see in the chart below. The leading component of the index, new orders also weakened, suggesting manufacturing might be running out of steam just as it was about to start growing again.
6. Geopolitical conflict. The markets have been largely immune to geopolitical incidents of the past two years. It showed little response to terrorist attacks in the Strait of Hormuz, Turkey’s invasion of Syria after the U.S. withdrawal of support for the Kurds, Iran shooting down a U.S. surveillance drone, the attack of Saudi oil processing facilities which temporarily cut Saudi oil production in half, the protests in Hong Kong ignited by a controversial extradition bill, or the murder of Jamal Khashoggi, a Saudi dissident and journalist with the Washington Post. A number of geopolitical concerns for 2020, including those with North Korea and Iran, may interrupt the market’s calm.
7. Surprise election outcome. The biggest global political event in 2020 is the U.S. election. For now, markets seem to be unresponsive to the candidates’ rise and fall in the polls. But, as the election draws closer, the markets may start to price in the potential for sweeping changes with uncertain impacts for legislation-sensitive sectors like financials, health care, and energy.
8. Job cuts. In 2019, as unemployment rates fell to multi-decade lows, most employers seemed focused on finding more workers—rather than laying them off. Although trade deals are being completed, they have not yet stimulated demand growth or global trade. Unsold inventories are piling up. After cutting spending on equipment in 2019, business leaders might begin to cut jobs if demand doesn’t improve. Signs of weakness in the global labor market may undermine consumers’ high confidence leading to a pullback in spending and a possible recession.
9. Increased regulation. Regardless of the U.S. election outcome, a movement toward increased regulation has taken hold among legislators in countries around the world, focusing on a range of issues from data privacy to climate change. Increased operating costs, litigation, lobbying and other expenses could result in lower expected earnings.
10. Ineffective monetary policy. Market participants exhibited a high degree of confidence in central bankers’ powers to manage the global economy in 2019. Yet, many people believe that monetary policy may be nearing the end of its usefulness in stimulating global economic growth.
Upside surprises
Of course, it’s not all negative. There may be upside surprises in 2020 as well, such as: meaningful fiscal stimulus by world governments, a rebound in business spending, and a reacceleration in China’s economy. With the latest reading for the OECD’s global composite leading indicator ticking up for the first time in two years, perhaps global growth may pickup in 2020, rather than merely stabilize.
As we consider unexpected positive impacts, it’s worth noting that European economic data has been surprising on the upside in recent weeks, after disappointing economists in both 2018 and 2019.
Market Update
Stock investors continued to find nothing to worry about as earnings season kicked off. Monday brought another +0.7% gain as investors extended Friday’s rally. The prior Friday’s employment report showed employment strength with only modest wage gains; a report which keeps interest rates low. Tuesday delivered the first earnings with big banks offering solid reports. Investors reacted with a quiet day of -0.2%. Wednesday saw stocks add +0.2% with earnings reports mixed and the signing of the “phase one” trade deal with China occurring. Weakness came from retailer Target (TGT) whose report suggested softer holiday sales than expected. However, a broader report on retail sales showed strength in Thursday’s session, a more bullish reading which led stocks to a strong +0.8% gain. Of note that day was the milestone achievement of Alphabet (GOOG) which became the fourth company to cross a $1 Trillion valuation, joining fellow tech/consumer heavyweights Apple (AAPL), Microsoft (MSFT), and Amazon (AMZN). Solid data on consumer sentiment, housing starts, and Chinese industrial production all supported stocks Friday. Investors appeared ready to book the week’s solid rise though with Friday’s session posting a modest +0.3% lift.
For the week the S&P 500 (SPY) rose +1.93% to continue its rally from October. The S&P has risen 13 of the past 15 weeks with the two losing weeks being only fractional losses. In other words, the market has seen no selling of any real consequence in 15 weeks now, quite a long stretch. The market-leading Nasdaq 100 (QQQ) added +2.28% this week. Those four trillion dollar stocks mentioned above account for 40% of the QQQ, powering the advance of that index. The small-cap Russell 2000 (IWM) saw some rare outperformance this week, rising +2.50% to match its prior high from September 2018. It is the only major domestic index to still have not quite reached record highs.
Warm wishes and until next week.