What a difference a year makes: Just about every major asset class lost money in 2018, while in 2019 all major asset classes went up.
Among global equity markets, larger-cap U.S. stocks were once again at the top of the leader board. The S&P 500 Index posted gains in every quarter and surged 9% in the fourth quarter to end the year at an all-time high. Its 31% total return was its second–best year since 1997. (It was up 32% in 2013.) Smaller-cap U.S. stocks rose 25.4% for the year.
Foreign equity markets were also strong. European stocks gained 9.9% in the fourth quarter and 24.9% for the year. After struggling in the third quarter, emerging–market stocks shot up almost 12% in the fourth quarter and returned 20.8% for the year.
Given what would appear to be a “risk-on” investment environment, it may seem surprising to see investment-grade core bonds also post very strong returns. The core bond index was flat in the fourth quarter but gained 8.6% for the year—its best annual return since 2002. Below-investment-grade bonds also fared well in 2019. High-yield bonds gained 14.4% and the floating-rate loan index rose more than 8.6%.
Why did both stocks (risky assets) and bonds (defensive assets) appreciate sharply in 2019? The key driver was the Federal Reserve’s sharp U-turn toward accommodative monetary policy. This was followed by other central banks across the globe. Coming into 2019, the Fed was indicating it expected to continue to raise interest rates. This led investors to fear that higher rates could tip the U.S. and global economies into recession, bringing an equity bear market with it. The ongoing U.S.-China trade conflict didn’t help matters.
Ultimately, the Fed ended up cutting rates three times in the second half of 2019. Late in the year, it also started expanding its balance sheet again via purchases of Treasury Bills in order to boost banking system reserves and inject liquidity into the short-term lending markets. Other major central banks also cut rates and/or provided additional stimulus to the markets during the year. This lessened recession fears.
Meanwhile, inflation (and inflation expectations) remained at or below central bank targets. This lifted concerns that interest rates would be hiked anytime soon, and the bond market rallied. The 10-year Treasury yield dropped from 2.70% at the beginning of the year to as low as 1.45% in September, ending the year at 1.92%.
U.S. equity investors responded to the Fed policy reversal and stimulus much as they have during the past 10 years—by bidding up stock prices and valuations. A détente in the U.S.-China trade war late in the year (the “phase one” deal) was an added boost to market sentiment. Importantly, earnings growth did not drive U.S. stocks higher; the majority of the S&P 500’s return came from expanding valuations. Thus, the valuation risk in U.S. stocks, which we’ve highlighted for some time now, has only gotten worse.
There are reasons to be cautiously optimistic for financial markets in 2020: Monetary policy is easy, recession risks seem to be receding, and some geopolitical risks have abated. That said, we are watching a number of potential short-term risks. Given we think recent positive developments have largely been incorporated into prices and valuations are stretched for U.S. stocks and bonds, markets are particularly vulnerable to any disappointment or negative surprise. If that comes to pass, we stand ready to take advantage of any potential opportunities that come of that volatility. And we are already underweight U.S. assets in favor of more attractive asset classes: foreign stocks, flexible bond funds, and selected alternative strategies.
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