09 Jan Understanding 2019
It’s often said that bull markets “climb a wall of worry.” This phrase refers to a market’s ability to continue to grind higher despite economic or geopolitical issues that would intuitively tamp it down. The S&P 500’s 31.5% total return in 2019 is a poster child for wall of worry climbing. Neither tariffs, nor trade deal (re)negotiations, nor geopolitical threats nor federal reserve tightening (to start the year anyway) could stand in the way of the market’s move higher. Furthermore, this year’s relatively orderly gain occurred after a large selloff to end 2018, rewarding those who stood pat. As shown on the right, both stocks and bonds notched large gains for the year while, despite a few spikes along the way, volatility fell roughly 46% from the start of the year.
We believe there were several factors that aided these moves: Federal Reserve easing, more clarity on tariffs, and economic fundamentals that continued to improve.
The trigger to the selloff that ended 2018 was undoubtedly the continuation of the “tightening” policy in which the federal reserve was engaged at the time. This is clearly seen in the chart below. The chart also shows the easing policy the Fed started at the July 2019 meeting.
The discontinuation of the tightening policy at the beginning of 2019 and the start of rate cuts in July proved to be a boon for both stocks and bonds. In both cases, the reason is mathematical. Since bond prices move inversely to interest rates, when rates go down, prices go up. The increase in bond prices provided much of the 8.5% total return on U.S. investment grade debt. Likewise, one of the most fundamental ways to value a stock is to place a “multiple” on the earnings (multiplying this year’s earnings per share by 15, for example). Mathematically, the multiple should be inversely related to interest rates, meaning all else equal, if interest rates move lower, stock prices should move higher.
In addition to the decreases in interest rates shown above, the Fed resumed buying debt on the open market, also known as “quantitative easing.” Between August and the end of 2019, the Fed purchased some $414 billion worth of debt, as shown in the chart on the left.
Quantitative easing has the effect of lowering market interest rates and increasing liquidity, which we know are both accretive to stock and bond prices.
There was a change in 2019 in investor sentiment on tariffs. In 2018, in addition to the worries about federal reserve policy, investors were unsure as to the impact tariffs would have on inflation and the economy as a whole. As it turns out, sellers and suppliers absorbed a significant portion of the tariffs that were placed on imported goods. This had the effect of dampening corporate profits, but did not show itself in dramatically increased consumer prices as feared by investors in 2018 as the trade wars ramped up. Furthermore, these tariffs were being paid in an environment of continually improving economic fundamentals and a strong consumer. With consumer spending accounting for about 70% of GDP, a strong consumer is good for the economy and stocks.
Despite all the short-term noise, the recovery we have experienced since the great recession has been remarkably smooth. The unemployment rate has continued to steadily and persistently decline, real GDP sits at an all time high, and consumer continues to improve. These fundamentals underpinned the market throughout the year, and indeed the decade.