Economic Commentary | Looking at The Year Ahead
The S&P 500 posted a 30% return for 2019. That is simply an investment measurement that reflects the reality that the longest economic recovery in history is continuing. As we’ve written before, the length of recovery doesn’t really matter. Its strength is more important, and that strength has improved. In the first part of the recovery, real GDP growth averaged 2.2%. From the start of 2017, it accelerated to 2.6%.
The acceleration was due to a positive change in tax rates and regulatory policy, and this has important implications for the future. We believe the economy will continue to grow at a very healthy rate due to the continuation of the lower tax rates and regulatory burdens. While there are many components to this, just remember that prior to the tax rate reductions, the U.S. imposed one of the highest corporate tax rates among the developed nations. Large and small firms, alike, could choose where to invest, where to place their next factory, and where to hire their next worker. High tax rates discouraged them from investing in the U.S. or even investing at all; often they just sat on their hands and accumulated capital without putting it to work.
That all changed in 2017, and all that idle capital was and is being, put to work. As a result, growth accelerated, and the unemployment rate dropped to its lowest level in some 50 years, while inflation still remains tame at 2.2%.
The consensus for future growth seems to be in the 1.8% to 2.0% range for 2020, but we believe the consensus is wrong. We believe the environment will still support stronger growth in the 2.5% to 3.0% range. That may also mean continued improvements in the jobless rate, but it will most certainly mean improvements in wage levels, especially for low-income workers.
Inflation should also stay at acceptable levels even if it creeps up a bit, roughly 2.5%. Monetary policy is still too loose. While we’d love to see the Fed increase interest rates – which would not hurt the economy – we doubt this will happen in an election year. Accordingly, inflation may rise a bit, but nowhere near worrisome levels.
So, we remain very confident in 2020, and most likely into 2021 as well. We wouldn’t be surprised to see equity values increase 10% to 15% from 12/31/19’s levels. Many economists disagree with that assessment, seeing weaker returns because they project weaker growth in the economy. Only time will tell, but we see several key factors supporting the higher estimates of stock growth.
Stock prices and rates of return ultimately reflect the value investors as a whole place on the profits generated by all the companies they are investing in. Those profits remain strong, and there is much to suggest they will actually increase. The value of those future profits is determined by what investors perceive as their “present value”, which is influenced by interest rates; as rates rise the present value of future profits decreases.
Today’s interest rates are still at historically low levels. We acknowledge that. But we are not relying on today’s interest rates for a sense of the present value of those future profits. We assume that interest rates will rise. But even if the Fed were to raise rates to the high 2% -low 3% range, there is still room for 10% growth in stock values based on a present value calculation of the current level of future profits. If profit levels actually rise – as we believe they will – there would be even more room still for growth in stock prices.
Behind some of this arcane conversation is a more practical common sense understanding of our economy. The US has one of the greatest environments for entrepreneurs to flourish; we encourage innovation; we reward those who perform well, creating economic incentives to grow and innovate. Accordingly – to take just two examples – we have gone from being net importers of petroleum products to net exporters. Our dependence on Mideast supplies has therefore decreased dramatically. Second, the power of the technology we all hold in our cell phones and tablets dwarfs the power of desktops 10 to 20 years ago. The cloud allows us all to tap into data and resources imagined just a few years ago. Our economy benefits and grows because of amply energy supplies and continued innovation.
The risks we see come from the public policy realm. 2020 is an election year, and everyone has their predictions of who will win the presidency. From an economics perspective, however, what matters is whether the current tax and regulatory policies will change significantly. We believe that would require a more sweeping set of changes at all levels (presidency, senate & house) than is likely to happen. There are never any guarantees, and policymakers have been known to blunder, but for now, we do not project any major policy disruptions in the economy. There will still be volatility, but that is just our now-not-so-new… normal.
Put this all together, and we see a strong year ahead with minimal risks of a recession, but with the normal hiccups, faints, and swoons in the market. In short, positive returns at year-end with some red ink along the way.