It may be Valentine’s Day, but there’s not much love to be found in recent economic data from the long-suffering Eurozone. Worse still may be in store given the importance of exports to China for Europe’s biggest economies, and the still-unquantifiable toll the coronavirus may have on growth prospects in that country. Yet investors seem perfectly content to keep on keeping on. The chart below presents three key economic indicators for the region along with the performance for the last twelve months of the German DAX equity index and Greece’s 15-year sovereign bond yield.

Stuck In the Mud

Back in 2017 it seemed like Europe was finally shaking off the last of the crisis that threatened the very integrity of the single currency region from 2010 to 2012. “Synchronized growth” was the phrase of the day among the financial chattering class, with the EU joining the US, Japan (remember Abe-nomics?) and emerging markets on a coordinated upswing.

That was then. Since the first half of 2018 Europe has slowly made its way back to the plodding, barely-there growth trends characteristic of the earlier part of the 2010s. Industrial production (the upper right quadrant of the above chart) has plummeted since then. Economic sentiment – a blend of business and consumer confidence – has fallen steadily (lower left chart). A brief uptick in sentiment at the end of last year is unlikely to last given the latest hard data points.

Perhaps the bleakest of those data points is Germany, where GDP growth (upper left chart) is a hair’s breadth away from tipping into recession. The Eurozone’s largest economy derives a significant amount of its overall output from exports of high-value goods to China. Whatever the impact of the coronavirus winds up being on the Chinese economy, that impact will resonate in Germany and quite possibly drag the entire region (France and Italy are also struggling) into recession by the middle of this year.

Bad Is Good

If all that sounds dire, then why have investors pushed Greek sovereign bond yields down to laughably low levels? The lower right chart above shows the 15-year bond currently trading at a 1.5 percent yield. Yields on the 10-year bond fell below 1 percent this week (which would seem to make 10-year US Treasuries, trading around 1.6 percent currently, awfully appetizing). And EU equity markets are blithely powering along in tandem with risk assets in most of the world. Isn’t the prospect of a looming recession supposed to cast a negative pall on markets? In this case apparently not, potentially for two reasons.

The first of those reasons is the euro, which has lost more than 3 percent against the dollar in the year to date and is at its weakest level in three years. A weak euro, all else being equal, should make European exports more attractive on world markets, thus potentially offsetting weaker demand from China and other key export markets.

The second reason, which should come as no surprise to anyone who has tried to follow the logic of market sentiment since the beginning of the 2010s, is the European Central Bank. The ECB has been in full-on dovish mode since 2012, when then-chief Mario Draghi pledged to do “whatever it takes” to save the single currency region. The current chatter centers around a further cut in the discount rate (which is already in negative territory) and an increase in the monthly bond-buying program, currently in the amount of €20 billion per month.

The market may have it right, and another tidal wave of easy money could head off a further downturn in the macro numbers. But it may also be wrong. The ECB’s next meeting is in March, and Mario Draghi will not be there. It remains to be seen whether new ECB head Christine Lagarde will be able to work the same magic as her predecessor. Moreover, the tensions between the austerity-loving “north” bloc of the ECB and the more dovish “south” members have not gone away at all.

Finally, there remains the unanswered question about just how far below zero interest rates can go before the unintended consequences turn ghoulish. In that respect the US Fed has much more runway for taking further policy action than does the ECB. And if Europe does fall into recession, the likely hit to investor sentiment may have Fed bankers hastily updating their own arsenal of money-printing tools.

All happy families are alike, said the great Russian author Tolstoy in the opening lines of “Anna Karenina,” but the same does not apply to happy stock market rallies. The bulls are as different from each other as their unhappy ursine counterparts. The Great Bull of the 2010s will – in the absence of an unseen X-factor blowing things up in the meantime (reminder: this is a non-zero probability) – reach its eleventh anniversary in March of this year (that will still not match the all-time record of December 1987 – March 2000). It’s a good time to step back and take a broader look at the story of this decade, a story made unique by the starring role of one protagonist: the Federal Reserve.

From Unconventional To Ho-Hum Normal

In the chart below we have divided the story of the 2010s bull into seven chapters, each with its own heading and its own particular story.

The 2010s bull story began, as most do, with a trough recovery. The Fed had brought the target Fed funds rate (green line) down to a range of zero – 0.25 percent. At the same time the central bank was experimenting with the unconventional policy of purchasing longer-dated fixed income securities that would come to be known as QE. But world events intruded in 2010 and 2011 as a nasty backlash from the financial crisis hit the Eurozone. For most of this time markets were highly volatile. The bull market came very close to running out of steam in August 2011 when it ran into a vortex of the Eurozone, Congressional fumbling of debt ceiling negotiations and a downgrade by Standard & Poors of US Treasury securities.

The Eurozone crisis peaked in June 2012 when European Central Bank chief Mario Draghi talked down jittery markets with his “whatever it takes” speech. Shortly thereafter US Fed chair Bernanke signaled a new wave of easy money that would become known as QE3. Markets rallied strongly with the S&P 500 soaring to its best year since the Roaring Nineties in 2013.

Economy, What Economy?

What has been missing from this narrative so far is any kind of a leading role for the actual economy of real goods and services. Year-on-year GDP growth throughout this period meandered along in the range of two percent, while inflation remained below central bank targets and jobs came back steadily and without interruption, month after month. Outside the US, though, economic trends were not particularly comforting. Europe stabilized but at barely-positive growth levels. China went through a bout of uncertainty that popped a bubble in its own domestic stock market and forced a currency revaluation that caught global markets by surprise in 2015. Meanwhile the Fed had wound down QE3 by the end of 2014 and was signaling its intention to start raising interest rates. US equities seemed to be going nowhere from late 2014 through the contentious election season of summer and fall 2016.

The Reflation That Never Was

That election brought with it the beginning of Chapter 5 in our bull saga. Almost immediately after the Republicans’ seizure of executive and legislative branch control a conviction set in that a massive public infrastructure program was going to send inflation and interest rates soaring. The infrastructure program never happened, as anyone passingly familiar with the priorities of Republican policymaking could have foreseen. But the reflation trade moved ahead on its own momentum for more than a year.

The Stand-Alone Economy That Never Was

Now, though, economic data came back into sharper focus. The Fed was trying to get rates back to some semblance of “normal,” but was a low-growth economy ready to take off the training wheels for once and all? It seemed that in September 2018 markets finally got the memo that the Fed was serious in its quest for an economy able to resemble something close to the norms of the past 50-odd years. Risk assets went into a tailspin, and once again US stocks threatened to bring the bull story to an abrupt end, coming within a hair’s breadth in December of that year. That would also mark the last time there would be serious talk in mainstream financial circles about a self-sufficient economy able to function without the narcotic of easy money.

You Just Keep Me Hanging On

And that brings us to chapter seven. It is admittedly a bit arbitrary to pin a specific date on the beginnings and ends of these chapters, but a likely one for this current installment is September of last year. Late that month the interest rate for overnight repurchase agreements (the brown dotted line in the above chart) suddenly spiked up out of nowhere, setting off alarms about unusually low levels of reserves in the central bank accounts of US banks.

Up to that point, 2019 had been a fairly volatile year for equities. The big rally early in the year was less impressive when seen in juxtaposition to the big correction of late 2018. Several times during the year we witnessed pullbacks of more than five percent. Yes, the Fed was guiding towards a resumption of interest rate cuts, but was that going to be enough? Meanwhile the financial chattering class seemed to be talking itself into a recession, perhaps brought about by the US-China trade war or perhaps just an organic end to what was already the longest growth cycle on record.

The hiccup in the repo market on September 26 caused a few days of jittery trading. But on October 11 the Fed announced that it would step in with a new program of monthly purchases of short-dated Treasury bills in quantities of $60 billion per month. Markets immediately jumped on the news, visions of recession disappeared from investors’ eyes and the S&P 500 threw a bang-up holiday party. The index has registered gains of 13.8 percent since that Fed announcement, just four short months ago.

The Fed took pains at the time of this announcement to emphasize it was not starting another QE program. Fed officials have continued to push this line ever since. But the reason it keeps trying to hammer home the point that this is not QE4 is because the market keeps insisting that it is, in fact, QE4. Looks like QE, quacks like QE, must be QE. The Fed’s balance sheet is expanding by $60 billion a month, after never having gotten back down to anywhere near its modest pre-2008 levels. QE by any name, right?

Now, this QE-not-QE policy is not the only plot line to our chapter seven. US economic numbers continue to suggest more of the same modest growth trends, while remaining solidly ahead of the plodding Eurozone and never-quite-healthy Japan. China’s growth headwinds got much stiffer in the past couple weeks with the coronavirus outbreak. There are plausibly enough reasons out there to keep investors from massively selling off. But the pace of this phase of the bull run is torrid – if it were to last for the duration of the year then it would outpace even last year’s gains. For the record, we do not think that is a likely outcome. But momentum can be a tough nut to dislodge, particularly if a melt-up mentality if fully baked into the cake.

The Fed has said it plans to keep its “not-QE” policy in place at least through April, with plans to unwind it as soon as practicable thereafter. But Fed officials should know by now how hard it is to get the market off the morphine of easy money. It will be interesting to see how this dialogue plays out between the doctors and their very needy patients.

Back in August of 2014 the World Health Organization issued a Public Health Emergency of International Concern statement in relation to a viral disease that had been spreading among the populations of a number of West African nations for the past several months. The disease was called Ebola. Apart from the affected areas and the international health organizations involved in trying to stop its spread, Ebola garnered little attention from the world at large. Then, in late September, a US citizen returning from Liberia to Dallas, Texas contracted the disease and, after some misdiagnosis from the local hospital, was eventually quarantined and died in the first week of October. US stock markets wobbled a bit. Then, two nurses who had attended the deceased patient were also diagnosed with the disease and quarantined. Markets went from wobbly to full panic mode in the space of a day or two. The chart below shows the S&P 500 during this period.

The market panic over Ebola was swift and, for a one-off event, relatively deep: the S&P 500 was down more than 7 percent from its previous peak when it just as abruptly bottomed out and staged an impressive recovery, setting one record high after another through early December (notably, the two nurses who were quarantined both survived as did one further US-based Ebola patient). The emergency edict issued by the WHO was still in effect, but the health risk to people (or business enterprises) outside the West African nations at the center of the outbreak was judged to be relatively limited.

A Different Virus in a Different World

In the early weeks of 2020 we are in the throes of another international health scare. This week the World Health Organization issued another Public Health Emergency of International Concern in regard to the coronavirus that has spread from its origination point in Wuhan, China to more than 10,000 cases worldwide (including the US). Clear evidence of person-to-person transmission has been recorded. China has responded with an effective quarantine of the city of Wuhan, travel in and out of China more broadly has been severely restricted, and the Chinese economy – the world’s second largest – is clearly feeling the impact. Starbucks, which has a huge operation in China, has closed half its stores there. Other US and global firms with significant Chinese assets have also taken direct action. Given the economic size of this disease’s epicenter, it would seem like cause for greater concern among global markets.

And yet, the reaction thus far has been relatively muted. At its lowest point since the coronavirus first became news the S&P 500 was down just 2.5 percent from its recent high (and since last fall the US blue chip index has set one record high after another). Even Hong Kong’s Hang Seng index, right in the thick of exposure to mainland China and still burdened with its own problems of domestic unrest, has lost less in percentage terms thus far than US markets did during that brief Ebola panic. In general, world markets seem less prone to sudden panics than they were six years ago. Is that a sign of maturity, or a misreading of the risks at play?

Not Default to Worst

The market’s spasm of panic during the Ebola scare seemed to be a knee-jerk default to the worst possible outcome – an uncontrollable pandemic. This time around the market response seems more suited to the magnitude of the event, at least given what we know to date. Yes, this is a serious viral outbreak and yes, the main country involved is an economic giant. But so far there is no compelling evidence that it is verging towards being uncontrollable. The WHO has assessed China’s response to the outbreak in mostly positive terms, noting the number of medical facilities the authorities have constructed in a very short time period and the pragmatic measures taken both by China and by countries with frequent interaction with China to restrict contact with problem areas. In the US stock market companies with heavy China exposure have taken a greater hit to their shares than others – rationally so – but overall the trend has fallen well short of panic mode.

This could all change, of course, should new information surface that suggests a bigger and more complex problem. But in the absence of such information, it is at least somewhat heartening to see that all the trader-bots that make up daily trading volume were not programmed for hair-trigger freak-outs at the first sign of trouble. Maybe, hopefully, that’s progress.

The HBO comedy “Silicon Valley,” which recently concluded its final season, provided its viewers with a humorous yet dead-accurate take on the quirky, cynical culture of the modern-era tech world and the characters – the larger-than-life titans and desperate start-up kids and assorted hangers-on feeding at the deep-money troughs – who populate it. One episode early in the series featured a satire of one of those ubiquitous “tech crunch” competitions where wannabees pit their new-new thing against the established giants in hopes of catching an amorous glance from one of those deep-pocketed VCs out in the audience with whom to skip down the Yellow Brick Road towards the Emerald City (or at least a $1 billion valuation and the coveted “unicorn” status).

In this episode the plucky team of nerds from start-up Pied Piper hope that their revolutionary data compression engine will punch their ticket to untold riches. Unfortunately, they discover at the tech crunch event that evil nemesis Hooli (an entirely unsubtle stand-in for Google or Facebook or any other Death Star platform of your choice) has effectively swiped their technology and integrated it into their own vast, app-rich platform. After Hooli’s presentation (which ends with a live performance by Shakira, thus perfectly encapsulating how these things actually work in real life) one of the despondent Pied Piper guys sums up the lament of every would-be giant killer: “At best, we’re just a crummier version of Hooli.”

Head Lamps and Crochet Kits Delivered to You

We thought of that “Silicon Valley” episode a couple days ago while contemplating the stock market performance of a company called Shopify. We illustrate this performance in the chart below.

That’s a pretty stunning three-year performance, far outpacing even the market-leading tech sector (crimson trend line) let alone the S&P 500 itself (blue trend line). Have you ever heard of Shopify? Many people have not, but we would bet dollars to doughnuts that you have come into contact with many of the names that reside on its platform. Here’s how it works. Your online habits – what you buy, what you search for, how you connect on social media – are all part of what the giant tech platforms early on identified as “behavioral surplus” – basically, residual data that could be Hoovered up from your interactions with the various sites, packaged, used for analytical purposes and sold to third parties. That data would be invaluable to, say, a retailer of bespoke handbags who would love to pinpoint the subset of online humans predisposed at some given time to drop some cash on a classy one-of-a-kind bag. Shopify makes that happen: think of it as an online retail space that not only houses independent enterprises but performs all the back-end functions – logistics, payments and the like – so that the retailers can spend their time doing what they do best.

We would imagine that you have had the experience of reading something online and seeing those small, neat little ads strategically positioned to catch your eye and – more importantly – offering a product or service that is directly meaningful to you. For example one of us (Katrina) is an avid trail runner who also likes to crochet, and not a day goes by on her feed without the appearance of highly specific ads featuring companies that do nothing but make head lamps for night running, or cute kits for crocheting colorful blankets and the like. That’s Shopify, the foundation on which each of these little bespoke enterprises sits.

Fee, Fie, Fo, Fum

That’s a pretty successful business model, and its ubiquity in the online world can in part explain that sky-high price performance. But there’s a catch – there is always a catch. Shopify currently sports a price-to-sales (P/S) valuation of 25 times. Let us repeat: that is price-to-sales, NOT price-to-earnings. For purposes of comparison, the P/S ratio for the S&P 500 is currently around 2.3 times. Shopify doesn’t have a meaningful price-to-earnings ratio because the company has no earnings – from after-tax net all the way up to earnings before interest and taxes, Shopify is in the red. Investors buying in at these valuations have to imagine the company is going to grow exponentially and then some, uninterrupted, for the next five to ten years.

Unfortunately for Shopify, they operate in the shadow of the Hooli of retail – Amazon. While Shopify’s market share of around 4.7 percent of US retail eCommerce (according to eMarketer) is impressive and higher than Walmart, Apple and Home Depot, it pales in comparison to Amazon’s 36 percent share. And Shopify’s business model is simply too good for the Seattle Goliath to pass up. Indeed, Amazon is busy preparing the launch of a new platform for luxury retailers that sounds an awful lot like what Shopify offers. Except that this platform would come plugged into the full, sweeping array of Amazon fulfillment, logistics, payment, data warehousing and every other leading-edge service.

It may well be that Shopify defies the odds and manages to lock in a big enough network effect to grow at the levels those breathtaking valuations imply. On the other hand, it would not be hard to imagine a rueful lament in the not too distant future along the lines of “at best, we were just a crummier version of Amazon.” This lament is heard all over the technology space today – and we believe it is for the worse. Energetic but fair competition was supposed to be the foundational principle of our economy, and in its absence it is becoming increasingly missed.

Four years ago, in January 2016, world equity markets took a sharp turn lower following the release of some underwhelming economic data from China. Specifically industrial production and fixed asset investment, two of the mainstay growth drivers for the Chinese economy, performed below market expectations. While that may not seem like earthshaking news to the innocent bystander, market observers read it as a confirmation of the systemic problems in China’s economy that had surfaced the previous August, when a sudden devaluation of the Chinese currency popped an asset bubble in that country and spread to global risk asset markets. Fear of an unraveling in the world’s second largest economy led to a correction of more than 10 percent in the S&P 500 that January.

A Splendid Little Trade War

China released a raft of economic data today. The release was significant as it came on the heels of the apparent truce in the trade war, underscored by the signing of a “phase one” trade deal between the US and China on Wednesday. Today’s data points would give investors the chance to assess how much damage the trade war had inflicted. Were we to be in for another negative surprise like in 2016?

In short, no. Industrial production and fixed asset investment, those critical metrics that unnerved markets four years ago, were just fine, growing at mid-high single digits and significantly ahead of economists’ expectations. Retail sales were also strong, growing at a rate of 8 percent year on year. And real GDP growth, at 6.1 percent year-on-year, was slightly below expectations but very much in keeping with a recent pattern of moderating growth that predates the trade war. The chart below shows China’s GDP trend for 15 years, giving a clear picture of this slowing trend.

The slowdown in China’s growth has been a deliberate policy on the part of Beijing to try and shift the balance of economic activity from the frenetic infrastructure and property build-out of the late 2000s and early 2010s, and towards more consumer-oriented goals. Indeed, observers noted that the recent figures for fixed asset investment showed higher rates of growth in consumer-friendly areas like services and high tech, rather than the usual large-scale infrastructure projects and housing complexes.

A Little Less Uncertainty

The upshot from the two-year trade war would appear to be that it did not accomplish very much. China’s economy has survived the successive waves of punitive tariffs, and the US economy has likewise done just fine, thank you very much. The agreement reached Wednesday does very little other than to put a hold on any new tariffs (though existing ones will be staying around at least through the election, so the administration maintains). China’s obligation to purchase some $200 billion of US agricultural products is very unlikely to happen (there are sufficient outs baked into the contract terms) and for that matter probably a violation of World Trade Organization regulations about undue preferential treatment.

But the phase one deal does remove at least a little uncertainty from the economic scene, and that is what merits the “one cheer” in our headline. We think it is reasonable to assume that the trade war will recede into the background somewhat as a factor in stock market trends, as opposed to the pivotal role it played last year. Here at home, political considerations will be first and foremost between now and November, and the administration is unlikely to experiment with any new salvos that could increase economic risk and take away campaign talking points (watch out, though, for rhetoric aimed at Europe where the Trump team may try to gin up dubious threats and throw red meat to its nativist, EU-hating base).

Trade Is Not the Problem

Back in China, the cease-fire will probably also help sentiment in the short run. Chinese equity markets are off to a stonkingly good start, up around 5 percent since the beginning of the year. But there are other problems there that are due to surface at some point. In recent years Beijing has quietly yet firmly shifted economic focus away from the domestic private sector – which is home to the country’s most productive enterprises in the fastest-growing industry sectors – in favor of the state-owned enterprises which in terms of size still dominate a broad swath of economic activity. As a result, an increasing number of private businesses are either being starved of the liquidity necessary for growth, or are experiencing direct interference from the government in their activities. This trend includes some of the largest Chinese high-flyers like Alibaba, Tencent and Baidu.

We got a taste in 2016 of what happens when China catches cold – it’s contagious and spreads quickly to other markets. In 2019 the market’s obsession with the daily minutiae of the trade war may have been in large part due to concerns that it would result in another nasty bout of illness. But in shifting their attention away from trade following the phase one deal, investors would be well advised not to lose sight of the other potential problems bubbling under the surface in an economy too big to ignore.

Arian Vojdani was featured on Yahoo Finance yesterday, discussing market outlook now that phase one of the trade deal has been signed. The clip can be found here.

Summary

2020 is upon us and it is time for our annual outlook for the year ahead. This week’s commentary will serve as a summary of the longer report all our clients will be receiving a couple weeks from now. There is an interesting dynamic at play as the year gets underway: it could, on one hand, be one of the most far-reaching in modern history for shaping how we will live for many years to come. On the other hand, it may be a particularly uneventful year for investment markets, for reasons we will briefly touch on here and analyze in more detail in our forthcoming Annual Outlook.

The market has a history of ignoring both domestic politics and global geopolitical flashpoints. Despite the likelihood of a very noisy year in both of these arenas we expect that, barring as yet unforeseen circumstances, this pattern will likely hold true this year. Rather than wondering what, where and when the next Middle East crisis will manifest itself, or whether the US election season will be the most vicious and controversial yet (hint: with a high degree of likelihood, it will) we believe investors will have their attention riveted on three principal factors: global economic trends, valuations, and central banks. Sound familiar? It should, because these have been just about the only ingredients in the sauce that has sustained the second-largest bull market on record. It will take a sudden and extreme deviation on the part of one or more of these to derail the bull. We do not see such a deviation as a high-probability outcome for the year ahead but should caution that when and if it does occur, the impact could be deep and sustained.

Global Economy

In 2019 there were two primary aspects of the economy under the microscope: the effects of the US-China trade war on global trade patterns, and the related fear that a hotter trade war would lead to a more imminent global recession. Those fears peaked in late summer and then more or less dissipated entirely in the fourth quarter as bellicose rhetoric gave way to the vaguely comforting fog of a “phase one” deal that kicked all the real problems far down the road.

Even assuming (as we do) that the trade war will stay cool and contained for the year (at least until the November elections), the global economy is likely to slow further with little in the way of organic growth catalysts anywhere in the developed or principal emerging economies. Both the IMF and the World Bank have successively downgraded their growth outlooks for 2020 (currently estimated to be around 2.5 percent), with the US a bit below 2 percent, Europe closer to 1 percent and China failing to stay above 6 percent. That being said, slow growth expectations have been baked into investor assumptions for a long time. Should events play out as the current outlook suggests, it would probably not do much to change investor attitudes towards risk assets.

Valuations and Earnings

By just about any conventional valuation metric, the US stock market is very expensive. Not early-2000 stratosphere expensive, but still very, very expensive. The S&P 500’s 29 percent price appreciation in 2019 was accompanied by virtually flat growth in earnings per share for the index’s constituent companies. So effectively all the gains resulted from an expansion of the price-earnings multiple rather than from a tailwind of improved corporate performance. At 31 times cyclically adjusted earnings (using the Yale economist Robert Shiller’s CAPE methodology) the S&P 500 is currently just below the recent cycle’s peak of 33 times in early 2018. That, in turn, is a higher P/E mark than anytime in US stock market history other than the 2000 and 1929 bull market peaks.

There are two ways to look at this valuation puzzle. One is to say that what goes up eventually comes down, so unless corporate earnings suddenly burst out into sizable double digit gains (which few consider likely given the subdued patterns of global demand) there is not much room for further upside. In fact, many typically bullish Street analysts appear to be hedging their predictions for market price targets this year to moderate single digits because the fundamentals supporting a raging-bull case seem so dubious.

The other side to the coin, though, is that valuation metrics including the Shiller CAPE have proved in the past to be rather poor timing guides. In other words, just because something is expensive now doesn’t mean it won’t be even more expensive tomorrow. That viewpoint plays into the TINA argument – There Is No Alternative – that the easy money of recent central bank policies has literally forced institutional investors to keep on buying equities even when they appear expensive. And that leads us to the third of our key market drivers: the Fed and its fellow monetary mandarins in Brussels, London, Beijing and Tokyo.

The Central Bank Put

One can argue about whether a decade of easy money has been the right medicine for the economy of real goods and services, given that growth rates remain low by historical standards and price inflation has chronically lagged the central bankers’ two percent targets. What is not debatable is that asset prices have benefitted. By keeping interest rates low – or in many cases negative – monetary policy has pushed risk-averse investors into making larger allocations in equities, particularly the large and mega-cap stocks with generous shareholder payout policies that have led this bull market. The idea of a central bank “put” – i.e. that any market downturn will result in a flood of new money to push rates down and risk asset prices up – is as close to a law of nature as exists in the financial world.

Central bankers themselves are never shy about reminding investors that, while their monetary policy tools may be effective for softening the contours of market cycles, they are not magicians. Easy money cannot by itself improve business productivity, which is the only source from which genuine long-term economic growth can proceed. For now the central bank put is in place – should the economy soften by more than expected, or should the stock market take a tumble similar to what happened in late 2018 – it would be foolish to expect an outcome other than direct and vigorous central bank intervention.

The problems will start happening when and if the easy money formula fails to deliver the goods. Central banks are just about the only surviving public institutions to have kept their integrity pretty much entirely intact in recent years. But here we are in the longest economic growth cycle on record, without ever having completely weaned ourselves off the monetary stimulus. Last year’s rate cuts were given the somewhat misleading euphemism of “mid-cycle adjustments,” suggesting something other than keeping a patient medicated who has not been able to function independently for a very long time.

If the Fed can get through 2020 without the need for further rate cuts then we could see the duration of the current cycle extending out further. The default outlook as of today suggests that to be a reasonable assumption. But events can change quickly, and our outlook for the year ahead will not stay static.

Well here we are, at the start of a year which should live up to that old Chinese proverb “may you live in interesting times.” Just a few hours into the second trading day of the year we have seen the S&P 500 give up most of the substantial gains the index racked up on Thursday. Yesterday’s optimism over trade talks progression gave way to fears over escalating hostility between the US and Iran after an overnight air strike took out the regime’s top military commander (who was in Iraq at the time).

Neither Thursday’s cheer nor Friday’s fear will likely persist much beyond a day or two of market impact. But the short-term volatility offers a striking contrast to the slow, steady grind upwards that characterized the last two months of 2019. After last year’s rousing performance there are more than a few skeptical voices in marketland wondering how much more upside this bull has. In contemplating this question there is no better place to start the analysis than with the market’s heftiest driver – the tech sector.

Size Matters

The chart below shows the performance of the S&P 500 and its eleven primary industry sectors for the past twelve months. One sector stands alone – tech (the blue trend line). It also happens to be, by a very wide margin, the largest sector in the index.

The information technology sector currently makes up 25.2 percent of the S&P 500’s total market capitalization. The tech sector plus the communications services sector (home to Google and Facebook, among others) combined make up 36.7 percent of the index’s market cap. Moreover the combined size of five companies – Alphabet (Google), Facebook, Amazon, Apple and Microsoft – comprise 18.9 percent of the total index. By comparison the second largest industry sector – healthcare – makes up just 15 percent. That is a stunning amount of market concentration. It also helps explain some of those skeptical voices as 2020 gets underway. If the tech sector is unable to record a second consecutive year of greater than 50 percent in total return, where is the heavy lifting going to come from?

Watch Those Earnings

This is a tough market environment for bargain-hunters just about anywhere – but the tech sector is, unsurprisingly given those return numbers, particularly stretched. The next twelve months (NTM) price-earnings ratio for the S&P 500 tech sector is 22 times, the highest since the dot-com mania at the beginning of this century and well above its 10-year average of 14.7 times. Meanwhile the earnings outlook for the sector is relatively modest: the FactSet analyst consensus estimate is for mid-single digit earnings growth in the first half of 2020. Any price appreciation beyond five or six percent (if those estimates are correct, and chances are good that they will come down as the days go by) will thus involve a further expansion of those already-rich valuation multiples.

None of this means that the market is doomed to mediocrity, of course. Fundamentals like earnings and sales matter in the long run, but short-term price movements are largely untethered to rationality. But the math of the market is inescapable: its concentration in a relatively small number of names makes the fate of those names decisive for performance. Or, as we often say: when tech sneezes, the market comes down with the flu.

All things come to an end – good, bad and otherwise. As this will be our last market commentary for 2019 it seems appropriate to think back on the events that gave shape to the year in asset markets. Our word for the year is “pivot,” defined as “when a central bank plans to do one thing, then turns around abruptly and does the complete opposite instead.” The Fed pivot in January gave shape to what has resulted in the second-best performance for US large cap stocks this decade (with a decent chance of claiming the number-one spot from 2013, depending on how things go over the final two and one-half trading days).

Turn the Beat Around

The S&P 500 performance in 2019 is a bit less stellar in comparison to that banner year of 2013 when you consider where the year started: just days away from a near-bear market reached on December 24, 2018. The market’s strong bounce back in January was in part a trough recovery (by comparison, stocks had finished out 2012 with decent gains in the mid-teens before going onto that record-breaking performance in 2013). But it was arguably the magnitude of that December 2018 correction that pushed the Fed to abruptly reverse course in January, call off any future rate hikes and set expectations for a return to monetary easing. The Fed put was back – if in fact it had ever gone away.

From Rarity to Mainstream

The Fed was not alone in its renewed embrace of dovishness. The European Central Bank, worried that low growth in the Eurozone was edging closer and closer to negative growth, returned to its bond-buying ways as well. It gradually dawned on investors that monetary policy tools once seen as unconventional, to be used only in extreme circumstances, were in fact the new normal. A mindset took hold that weak organic growth, low productivity and never-ending cascades of easy money were now a permanent feature of the global economic landscape.

Be Careful What You Wish For

While the Fed’s initial reversal was met by investors with the expected exuberance, the good feelings started to run out in late spring with the first of several sizable market reversals. The flip side to “permanent easy money” is “chronic stagnant growth.” As spring turned to summer, it seemed at times as if the market was trying to talk itself into recession. Investors headed for the safe, but ultra-expensive terrain of high quality bonds. By midsummer over $17 trillion worth of bonds globally traded with negative yields. Stock markets experienced another mini-correction of around five percent. Market chatter turned to thinking the unthinkable: the idea that monetary policy might not be enough to keep the world afloat.

Risks Known and Unknown

A shaky start to October called to mind the ghouls and goblins of fall 2018, but all that dissipated with yet another apparent cease-fire in the weird soap opera that is the US-China trade war. A vague yet comforting proposal for a “phase one” deal seemed within reach, and that summarily took what the market viewed as the biggest known risk factor off the table, at least for the time being. At the same time, macro data releases almost all pointed to the conclusion that the earlier fears of imminent recession were truly overblown. Jobs, inflation, real GDP growth and other key metrics kept showing the same thing they have been showing for a long time. Finally, the Q3 earnings season that got under way in October, while not particularly impressive (earnings growth is set to be slightly negative for the full year) seemed to the consensus wisdom to be a bit better than expected.

These three drivers – trade war cease-fire, more or less healthy economy and better than expected earnings – fed into a positive momentum trend that gained strength over the last two months of the year (which we suggested was a likely outcome in a commentary in early November). FOMO – fear of missing out – is particularly viral in the closing weeks of a holiday market rally.

It’s easy to be complacent in an environment of steady daily price appreciation and accompanying low levels of volatility. Certainly a welcome change from last year’s frenetic December. But when things change, they often change rapidly. Easy money is not a free lunch. We got a taste of that back in September with that hiccup in the overnight repo market. Corporate balance sheets are loaded up with lots and lots of debt raised during this extended period of historically low interest rates. There are plenty of reasons to not be complacent as the old year gives way to the new.

May you and your loved ones have the happiest of holidays and a healthy start to the new year. See you next decade!

If you spend enough time immersed in the chatter of financial news outlets you will invariably come across the phrase “asset repricing.” As 2019 draws to a close there is much use of this phrase as a way to describe the (to many) surprising resilience of risk assets, particularly equities, over the past twelve months. But what does “asset repricing” actually mean, how does it affect stock prices, and can we expect to see more of it in 2020?

The Basics

To understand the basic mechanics of asset repricing, put yourself in the shoes of an equities analyst at some large securities firm. The analyst may cover anywhere from five to twenty-odd stocks, where “cover” means to research all the goings-on at these companies, make assumptions about their future prospects for growth and profitability, and arrive at projected target prices. “Company ABC should make more inroads into the domestic Chinese market which will improve top-line growth, but the associated marketing and administrative expenses will put downward pressure on profit margins. As a result, our 12-month target price for ABC stock is $55.”

The analyst will input all her various assumptions into a spreadsheet model – typically a discounted cash flow (DCF) or discounted dividend stream (DDS) model. The model will then produce a single number – the net present value of the future cash flows or dividends as the case may be. That number – the NPV – translates directly to the target stock price that will appear on the analyst’s quarterly report to the firm’s investing clients. “Repricing” means a change to that target number driven by external factors, which we will now explain in the context of what happened in 2019 (and what may happen in 2020).

Rates and Risk

The two most influential external factors driving an asset repricing are benchmark interest rates and prevailing risk, with the latter expressed as a premium (spread) to the benchmark rates.

In late 2018 investors expected the Fed to continue its rate hike program, so all those analyst DCF models had those rates baked into their assumptions. In early 2019 the Fed did a major U-turn: not only calling off any future rate hikes but clearly communicating the intention to start lowering rates (which intention, as we all know now, they delivered on in full). Now the analysts had to go update their models. Where, specifically? In the discount rate – the interest rate at which future cash flows are expressed in present value terms. The lower the discount rate, the higher will be the present value of a future cash flow (this, by the way, is the fundamental axiom of finance, from which all else flows).

So the discount rate came down, and the net present value (i.e. the analyst’s “target price”) went up. Writ large on the market itself, stock indexes rallied sharply for the first three months of the year.

It’s All Relative

But we said above that repricing involves two fundamental external drivers. What about the other one – risk? Risk – the spread between risk-free benchmark rates like US Treasury securities and riskier assets – was a moderate factor in the asset repricing that took place in early 2019. The spread between Treasuries and riskier assets didn’t change too much as the Fed pivoted to its dovish policy position. For example, at the beginning of 2019 the spread between the 10-year Treasuries and Moody’s Baa corporate bonds – low investment grade – was 2.43 percent. Three months later, as the second quarter began, the spread was 2.30 percent (slightly but not much tighter, which added a small net positive to the discount rate repricing). Since then, though, spreads have continued to tighten. The Treasury – Moody’s Baa spread is currently just around two percent – nearly half a percent lower than where it was at the start of the year. The gradually tightening spreads meant that asset repricing would continue to benefit share values even as the Fed cuts leveled off and (for the time being, anyway) remain stable.

To Understand Stocks, Watch Bonds

What does this mean for 2020? Any number of things, obviously, because nobody knows what events may emerge at some point to upend current expectations. For now, though, there does not seem to be much of a case for interest rate repricing as long as the Fed maintains the “stay the course” approach outlined at its recent December meeting. But the same may not be true for risk spreads. This is particularly of note in the high yield (junk) bond market where risk spreads currently appear more optimistic than present circumstances may warrant. In a recent Moody’s report the rating agency noted that high yield bonds have sharply rallied (i.e. yield spreads have narrowed) in the absence of observable improvements to underlying business sales and/or profit margins.

The high yield market has in the past served as a sort of canary in the coal mine, an early warning signal about impending risk asset trends. While the current environment remains benign for all intents and purposes, a change in sentiment may make its first reveal in the form of higher junk bond yields, then spreading onto investment grade debt and beyond. Asset repricing is a two way street. Upcoming earnings and sales reports will give an indication of where we are in relation to a rethink of current levels.