Matt Peron shares his perspective on the U.S. equity market for 2020.

January 27, 2020

U.S. Equity Market 2020: Can the Strong Gains from 2019 Continue?

Healthy consumer confidence, low unemployment, stable inflation, rising corporate profits and, although slowing, a growing economy suggest 2020 will present another rewarding year — albeit a more modest one — for U.S. equities investors.

The economy and equities markets do face a number of developing risks that likely will curb gains from 2019's unusually powerful performance, including global trade tensions and increased volatility.

Overall, though, 2020 should bring further economic and stock market gains, with the longstanding bull market persisting and no recession likely in the near term. We estimate 5 percent to 7 percent total returns for U.S. equities, somewhat in line with anticipated modest earnings-per-share growth, as markets appear to be fairly valued, or close to it.

If this outlook sounds like it reflects mixed trends, there's good reason. Several competing forces amount to an ongoing tug of war between market drivers and dampers, which has prompted us to reposition our portfolios to trim risk by purchasing higher quality stocks than in years past.

Heading into 2020, we're favoring U.S. large-cap companies with clear earnings growth and healthy, rising dividends, while largely steering clear of smaller-cap U.S. companies. We consider the United States the best region to invest in, especially compared to other developed nations, which have struggled to expand margins.

In addition, Asian emerging markets, the only international region we're looking at now, offer a standout opportunity.

On the whole, after a great 2019, we consider our portfolios well positioned to outperform the S&P 500 in 2020, as they have for the past several years.

What factors go into our 2020 investment forecasts?

Modest Economic Growth

Starting with the big picture, we anticipate continued slow economic growth both domestically and globally, with contained inflation. The U.S. economy appears to be in the late stages of an economic expansion, with growth that is sustainable, if decelerating. 

Healthy wages and plentiful jobs continue to place consumers on solid footing, a key requirement for continued expansion. Consumer confidence and spending remain strong, although consumers' expectations for the future have slipped.

Industrial production has weakened and the global economy has slowed, however, largely due to uncertainties arising from U.S.-China trade tensions and tariffs.

While the two countries have reached a phase-one agreement that appears to have averted a worst-case escalation, the deal has yet to be finalized, leaving China trade tensions a potential risk for now.

Unlikely Recession

The risk for recession, although higher than in 2019, remains relatively low and linked to worst-case outcomes in trade tensions and geopolitical instability.

Moreover, when the next recession does occur, we expect it to be mild rather than a replay of last decade's great financial crisis, given historical patterns and a lack of excesses in the current economy.

While my team and I do see pockets of concern — in some private equity valuations, erosion of mortgage lending standards and increases in many banks' loan-loss provisions — recession appears unlikely barring an unanticipated outside shock.

Muted Earnings Expansion

Given the slowing global economy, we forecast modest 3 percent to 5 percent earnings-per-share growth in the S&P 500 this year, lower than the consensus Wall Street estimates.

A variety of other factors also shape this EPS view, with stock buybacks and higher revenue boosting the outlook, partly offset by rising wages, tariffs and dwindling benefits from the 2017 tax cut.

Along with modest economic growth, we also expect stocks to continue to be lifted by attractive dividend yields compared to bonds, and a supportive Federal Reserve. The Fed's ability to stimulate the economy further is probably limited now, however.

In keeping with the tug-of-war theme, equities may be pressured by unknowns surrounding U.S. politics and quantitative trading strategies, in addition to global political concerns.

Meanwhile, we believe investors have been keeping significant levels of cash on the sidelines, based on the ratio of the country's money supply to total stock market value. It appears as much as $1 trillion could move into the markets, potentially raising equity values.

U.S. Politics

While the new year brings a U.S. presidential impeachment trial and the presidential election, these historic events may have limited effect on the stock market.

My team looked at the Nixon and Clinton presidential scandals and it suggests that prevailing economic conditions, rather than constitutional crises themselves, have historically had greater impact on financial markets.

When the Watergate scandal hit, the country was experiencing a recession featuring high oil prices, rising unemployment, declining corporate profits, falling confidence and increasing interest rates.

During the Clinton impeachment, the economy was experiencing strong GDP growth, low unemployment, low inflation, rising confidence, and strong growth in corporate profits and the global economy, among other tailwinds.

The economic backdrop for the Trump impeachment lies somewhere between those two economic scenarios.

As far as the election, the stock market historically has performed well regardless of Washington leadership, even when one party controls both Congress and the White House. The tendency for companies to grow dividends and earnings plays a far more influential role in stock prices.

Data suggest the election will result in continued two-party control in Washington, making it unlikely that meaningful shifts will occur to alter the economy's current growth trajectory.

That's not to say the elections will have no effect. Policymakers have been scrutinizing healthcare costs for years, for example, and industry pressures could intensify in that sector, depending on the election outcome.

Favored Industries

The ability to identify mega-trends, in addition to a focus on long-term capital gains and tax efficiency, helps guide us in choosing stocks.

Heading into 2020, we're avoiding companies exposed to trade tensions and tariffs, such as heavy metal industries tied to building infrastructure in China, and are interested instead in services, aerospace and defense, and companies tied to healthcare innovation and the digital revolution.

Rather than focusing on companies like John Deere and Caterpillar, we've been buying service names like Cintas, which enjoys high organic growth.

We also like digital e-commerce toll collectors like Visa and Mastercard, cloud computing and software transformation players such as Microsoft and Adobe, and aerospace and defense giants like Northrop, Raytheon, Boeing and Honeywell.

Next-generation surgery and diagnostics companies like Edwards Lifesciences and Thermo Fisher Scientific also are appealing, as are firms offering services for the aging population, such as UnitedHealth Group.

We've trimmed exposure to some of these stocks over the last year to lock in sizable gains, part of our active risk management process.

At the same time, we're underweight in big tech companies facing Department of Justice scrutiny, like Apple, Google, Facebook and Amazon, and in companies subject to drug-pricing pressures. We also avoid "bubblicious" tech and healthcare stocks with excessively high valuations.

While we're well-prepared for 2020, we're ready to pivot if the market outlook meaningfully changes, whether recession risks increase, stocks become overly valued, or the regulatory environment changes for health and big-tech stocks.

Should you have questions about your portfolio positioning heading into 2020, our experienced team at City National can help. Contact us to start a conversation.

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