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Party Like It's 2019 - Can the Good Times Continue in 2020?

Photo of author, David Nolan.
David Nolan
Senior Investment Strategist
1st Quarter and 2020 Market Outlook

The markets’ performance in 2019 was a good reminder of the difference a year can make. In January 2019, the S&P 500 was coming out of its first negative year in a decade; worries about the global economy were surging due to the U.S.-China trade war and the Federal Reserve had just hiked interest rates the previous month.

Now, we begin 2020 on the opposite end of the spectrum.

  • The S&P 500 just registered its best annual return since 2013
  • Worries about the global economy are receding thanks to the U.S.-China trade deal
  • The Fed cut interest rates three times in 2019
  • Optimism is quite high

For us, the takeaway from this is clear: What happened in the markets last year doesn’t mean much for what could happen in the markets this year. Put in more familiar phrasing: Past performance is not indicative of future results. So, while the macroeconomic environment is favorable as we begin 2020, a new year always brings new challenges and uncertainties, especially when it’s an election year.

More specifically, as we begin 2020, we are monitoring several unknowns that, with the market at historically high valuation levels, could cause volatility in 2020.

  • Regarding U.S.-China trade, markets are now wondering about the details of the phase one trade deal and its enforceability.
  • Turning to the economy, markets are expecting a rebound in global economic growth. So, the upcoming economic data needs to continue to show signs of stabilization and, ultimately, a re-acceleration of economic growth not just in the United States, but globally.
  • Looking at domestic politics, markets have ignored the impeachment of President Trump and that’s not likely to change as the odds he is removed from office by the Republican-controlled Senate are very low. But there is an election coming in November; and while many analysts don’t expect it to begin to influence the markets until later this summer, we could know who the Democratic nominee is by the end of March. Depending on who that person is, it could cause unexpected volatility.
  • Meanwhile, on the geopolitical front, we have relative calm; although tensions with North Korea and Iran are potentially rising.

Consider just some of the possibilities of what could go wrong in 2020 to upend the 10-year-plus expansion, the longest since the beginning of records in 1854.

  1. Consumer pullback

The consumer has been carrying the economy through the trade war and manufacturing recession. Even housing, which is usually one of the leaders in the early stages of a recovery because of its sensitivity to interest rates, is getting a second wind. Both new home sales and single-family housing starts have picked up in recent months. Residential fixed investment, as it is known in the gross domestic product (GDP) accounts, had declined for six consecutive quarters before turning positive in the third quarter of 2019. With the job market strong and wages rising, it’s hard to see what would cause a major retrenchment in American consumers’ appetites. And because consumer spending accounts for 68% of GDP, as the consumer goes, so goes the nation.

Graph 1_Civilian Unemployment

Which doesn’t mean an economy can prosper from consumer spending alone. Business investment, which has been weak and even declined in the second and third quarters of last year, is the key to productivity growth, which in turn benefits everyone because producing more with less enables prices to fall.

The consumer seems unlikely to retrench on his own. However, the motivation for a change could come from any of the items below.

  1. Stock market reversal

Stocks finished their best year since 2013, with the S&P 500 Index up 31.5%. But they aren’t exactly cheap. As measured by economist Robert Shiller’s cyclically adjusted price earnings ratio (CAPE), the benchmark index is at a level seen only a few times in history. At 31.2, the CAPE matches the high set before the 1929 crash. This year’s solid gains were accompanied by tepid earnings. On a 12-month forward basis, the price-to-earnings (P/E) ratio for the S&P 500 is at 18.3, according to FactSet. That compares with a 25-year historic average of 16.3.

Graph 2_S&P500

Fortunately, the Federal Reserve has no plans to raise interest rates anytime soon to spoil the party. The economy is still adding jobs at a rate faster than that required to sustain the unemployment rate at its half-century low of 3.5%. Probably the most nerve-wracking aspect of the stock market euphoria is that daily increases have become the norm. With economic prospects good, the Fed on hold and the earnings outlook brighter for 2020, few appear to be concerned. Which is probably the best reason we should be.

Graph3_Fear and Greed
  1. Debt crisis

History repeats itself, but usually with an adequate interval and a slight twist. The Savings & Loan crisis of the late 1980s was centered on commercial real estate. Fast-forward almost two decades, and it was subprime mortgage loans for residential real estate that fueled the financial crisis and Great Recession. It may be too soon to repeat the pattern of a debt-fueled binge precipitating another downturn. But if that turns out not to be the case, U.S. corporate debt, which has risen to more than $10 trillion, or 46% of GDP, will likely be the culprit this time around.

The proliferation of low-credit-quality bonds has garnered the attention of policy makers and the International Monetary Fund. “High corporate debt-at-risk,” defined as debt owed by companies whose earnings are insufficient to cover interest payments, “may translate into higher credit losses for financial institutions with significant exposures to corporate loans and bonds,” according to the IMF’s October Global Financial Stability Report. Some of the most highly leveraged firms are taking on an increasing amount of debt for “financial risk-taking…fueling a further buildup of vulnerabilities in some sectors and countries,” the IMF said. Corporate leverage can amplify shocks, the IMF explained.

The burgeoning supply of at-risk debt might not be enough to bring the house down, but once it starts falling, watch out below. Currently, the high-yield debt markets (gray line below) are not showing any concerns about the direction of the economy.

Graph 4_Default Rate
  1. Trade wars

The expected signing of a phase-one trade deal between the U.S. and China is not the end of trade tensions; it’s merely a pause. President Trump would be the first to tell you that he loves tariffs. They are his weapon of choice against any real or perceived adversaries. The phase-one U.S.-China trade agreement offers tit-for-tat relief from tit-for-tat tariffs: a halt to new U.S. tariffs and a halving of the rate on some existing ones in exchange for China’s promise to boost agricultural purchases from the U.S. It does little to address major structural issues, such as China’s subsidies to state-owned enterprises and strategic businesses. President Trump has threatened new tariffs on European auto exports and 100% duties on some French consumer products, such as Champagne and cheese. The trade war, which started in 2018, put a damper on business investment, forced firms to reroute supply chains, and sent manufacturing into a tail spin.


It’s not clear that a temporary pause in the trade war would eliminate uncertainty and encourage new investment in plants and equipment. Any escalation in international commerce tensions would further dampen manufacturing activity, eventually depressing hiring and crimping consumer spending.

When it comes to President Trump and trade, there is never a final resolution. His embedded belief that trade deficits are a sign that the U.S. has been taken advantage of all these years means that the administration’s trade policy remains a viable threat to the economy. Even if missteps won’t cause a recession, they would no doubt act as an accelerator.

  1. Unforeseen events

The world is a scary place. The rise of populist and nationalist movements across the globe, the breakdown of the post-World War II global order, the strained relationships with long-term allies, protest movements in countries from Hong Kong to Chile to Iran and Lebanon: this is the backdrop against which any flare-up would play itself out.

Then there are the “unknown unknowns,” as former Defense Secretary Donald Rumsfeld called them: the ones we don’t know we don’t know. Rising economic and political tensions could ignite a global conflagration, especially with an impulsive president in the White House. As a result of the U.S.-ordered killing of Iranian General Qasem Soleimani, Iraq now threatens to expel U.S. forces from its country while the Pentagon sends thousands of fresh soldiers back to the region. While it’s tough to say what happens next, the seeds of geopolitical uncertainty have no doubt been sown.

This is all happening at a time when central banks lack the ammunition to stimulate aggregate demand sufficiently to offset any shock that sends consumers and businesses reeling. At a time when the institutions designed to ensure global peace and prosperity have been threatened by the rising tide of nationalism, the geopolitical arena seems to be where the greatest risk lies.

The fundamental outlook for the economy and asset markets has improved since the depths of the 2018 correction, and stocks have responded accordingly. But it’s very important to realize that, despite the strong performance in 2019, markets still face significant uncertainties, and we are committed to monitoring these situations and their impact on the markets and your portfolio.

For 2020, we believe the following:

  • Market volatility will be higher than in 2019 as we deal with impeachment proceedings, the presidential election, global tensions, and trade uncertainty.
  • As we have been positioned for the past year, stocks should still be overweighted vs. bonds as low interest rates, low inflation, and a strong U.S. consumer should continue to support U.S. equity valuations over the course of the year. While market corrections can occur at any time, the fundamentals of the economy are conducive to rising stock prices over time.
  • International stocks, especially emerging markets, are inexpensive relative to U.S. stocks, have higher dividend yields, should report strong earnings in 2020 based on a recovery in global growth, and should have meaningful representation in all equity portfolios.
  • Bonds, while not as attractive as they were at the beginning of 2019, still represent an “insurance policy” for investors who have portfolios with a larger allocation of stocks than bonds or bond funds. High quality bonds tend to act as safe havens for investors in the event of a stock market pullback due to concerns about the health of the economy.


2019 Recap

Markets welcomed the positive resolution of several key macroeconomic unknowns in the fourth quarter, and that improved clarity sent the broader stock market higher over the past three months. The solid fourth quarter gains helped the S&P 500 index achieve its best annual return since 2013.

At the start of the fourth quarter, markets were facing four significant macroeconomic uncertainties: Could the U.S. and China strike a trade deal? Would the Fed cut interest rates for a third time in 2019? Could U.S. and global economies stabilize? Would Brexit get passed? Each of these unknowns, which had weighed on markets earlier in 2019, saw positive progress throughout the final three months of the year.

By far, the most important event for markets during the fourth quarter was the agreement to a “phase one” trade deal by the U.S. and China. Since early 2018, the U.S.-China trade war, and the tariffs that came with it, pressured the global economy and weighed heavily on investor sentiment. Twice in 2019, first in May and again in August, tariff increases caused a significant spike in market volatility.

But in mid-October, after intensive negotiations, both the U.S. and China agreed, in principle, to a phase one trade deal that would result in the reduction of some existing tariffs, the promise of no additional tariffs, and increased imports of American goods by China. Anticipation of this “in principle” deal being formally agreed to powered stocks higher from mid-October through mid-December. And then on December 13th, more specific details of the phase one deal were announced, and that clarity helped stocks extend the 2019 rally into year-end.

Improvement in U.S.-China trade relations wasn’t the only positive event in the fourth quarter though. The Federal Reserve met market expectations by cutting its benchmark interest rate by another 25 basis points at the meeting on October 30th. That cut brought the total reduction in interest rates in 2019 to 75 basis points, the largest annual reduction in over a decade. Additionally, at the December policy meeting the members of the Federal Open Market Committee showed they do not expect to raise interest rates in 2020. That added clarity for Fed policy expectations, specifically that the market can expect rates to stay low for the foreseeable future, also helped power stocks higher in the fourth quarter.

The global and U.S. economies also showed signs of stabilization in the fourth quarter after losing positive momentum for much of 2019. First, in the United States, concerns were growing that sluggish business spending and investment would potentially cause a broader economic slowdown. But the market’s preferred measure of business spending and investment, the monthly Durable Goods report, rebounded in the fourth quarter, easing some of those growth concerns. Internationally, measures of Chinese manufacturing activity, which had shown the industry was in contraction for the past several months, turned positive again in December, and that implied activity was stabilizing. So, while concerns remain about the next direction of the global economy, these signs of progress in the fourth quarter helped stocks rally.

Finally, after three-and-a-half years of Brexit uncertainty, investors can finally expect some progress as the mid-December elections in the United Kingdom resulted in a strong conservative (or Tory) party majority. As a result, the Brexit agreement with the EU is expected to pass Parliament in early 2020.

In sum, the fourth quarter of 2019 was a reminder that macroeconomic fundamentals matter, and the positive news on four key macroeconomic fronts fueled a broad rally in the stock market and makes it more likely, but not certain, that we will see improved global economic growth and better earnings in 2020.

4th Quarter and Full-Year 2019 Performance Review

The major U.S. stock indices were all solidly higher in the fourth quarter led by the tech-heavy Nasdaq, which handily outperformed thanks to rising optimism on U.S.-China trade and expectations for a rebound in economic growth. The S&P 500, Dow Jones Industrial Average, and Russell 2000 (the small-cap index) all had smaller, yet positive, quarterly returns. The performance of the major indices in the fourth quarter mirrored the full-year performance, as the Nasdaq easily outperformed the other three indices in 2019 as investors sought the secular growth potential of the tech sector amidst macroeconomic uncertainty.

By market capitalization, large caps outperformed small caps for the full year. That reflected investor concerns about a potentially slowing global economy, as large caps are historically less sensitive to slowing growth than small cap stocks. Notably, however, small caps did narrow the performance gap in the fourth quarter, which implied rising optimism towards the global economy in 2020, following the announcement of the U.S.-China trade deal. From an investment style standpoint, growth outperformed value again in the fourth quarter due to strength in large-cap tech. That widened the performance gap for the full year 2019, as growth considerably outperformed value, again thanks mostly to strength in the tech sector.

On a sector level, 10 of the 11 S&P 500 sectors finished the fourth quarter with positive returns. Technology, financials, and health care stocks led markets higher in the fourth quarter, which is a reversal from the defensive sector outperformance we witnessed in the third quarter of 2019. Expectations that the U.S.-China trade deal would lead to better economic growth combined with higher bond yields helped power the rally in tech and financials, while health care gained on a reduction in political headwinds as candidates who favor expansion of the government health care programs, dubbed “Medicare for all,” dropped in the polls. For 2019, the big fourth-quarter rallies by tech and financials helped those two sectors outperform on a full-year basis.

Sector laggards in the fourth quarter were the traditionally defensive market sectors. Real Estate was the only S&P 500 sector to finish negative in the fourth quarter, while utilities and consumer staples underperformed the S&P 500 as the U.S.-China trade deal caused investors to rotate into sectors that are more sensitive to a potential upswing in global growth. On a full-year basis, energy was the relative sector laggard as market worries about a slowing global economy combined with the potential oversupply of oil weighed on energy shares, although the energy sector still finished 2019 with a respectable annual gain.

CHARTS 1 and 2

Looking internationally, foreign markets saw positive returns in the fourth quarter thanks mostly to the U.S.-China trade deal, although most foreign markets still underperformed U.S. markets. Foreign developed markets posted solid gains in the fourth quarter but lagged emerging market returns. Emerging markets outperformed both foreign developed markets and the S&P 500 in the fourth quarter thanks to rising expectations for a global economic rebound, combined with some declines in the U.S. dollar. For the full year 2019, foreign markets registered solidly positive returns, with foreign developed markets modestly outperforming emerging markets. However, both underperformed the S&P 500 in 2019.

Chart 3

Commodities enjoyed strong gains in the fourth quarter, led higher by a rally in oil while gold saw a more modest rally over the past three months. Oil prices rose in the fourth quarter thanks to the decision by “OPEC+” to deepen production cuts this year, combined with the U.S.-China trade deal raising expectations for global growth and future oil demand. Gold, meanwhile, spent much of the fourth quarter in negative territory as investors rotated out of the safe-haven metal and into more risky assets following the de-escalation of the U.S.-China trade war. But, a late-year decline in the U.S. Dollar, combined with a mild increase in geopolitical tensions, helped gold rally late in December and register a positive return for the quarter. For 2019, commodities produced positive returns that were driven by a large gain in the price of oil, although commodities as an asset class lagged the S&P 500 on a full-year basis.

Chart 4

Switching to fixed income markets, the total return for most bond classes were positive in the fourth quarter, although longer-dated Treasuries saw mild declines, which is not surprising given rising expectations for a rebound in global growth. The leading benchmark for bonds (Bloomberg Barclays US Aggregate Bond Index) experienced slightly positive returns for the fifth straight quarter.

Looking deeper into the fixed income markets, longer-duration bonds underperformed those with shorter durations in the fourth quarter, which was a reversal from most of 2019. That is reflective of a market that is responding to the recent Fed rate cuts and beginning to expect a rebound in global economic growth going forward.

Confirming that improved sentiment, corporate bonds saw solidly positive returns in the fourth quarter as high yield debt outperformed investment-grade debt. The outperformance of lower quality but higher-yielding corporate debt also underscored rising optimism about future economic growth and corporate earnings.

Chart 5
Final Thoughts

At McKinley Carter, we’ve been through both good and bad markets, and those experiences ensure that we guard against complacency following a year of strong annual returns. We remain committed to helping you navigate this ever-changing market environment, with a focused eye on ensuring we continue to make progress on achieving your long-term investment goals. Our years of experience in all types of markets (both positive and negative) have taught us that successful investing remains a marathon, not a sprint.

Therefore, it remains critical to stay invested, remain patient, and stick to a plan. That’s why we’ve worked diligently with you to establish a personal allocation target based on your financial position, risk tolerance, and investment time horizon. Despite the strong market performance of 2019, we remain vigilant towards risks to portfolios and the economy, and we thank you for your ongoing confidence and trust. Rest assured that our entire team will remain dedicated to helping you successfully navigate this market environment.

Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review.

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