Enjoy the Twenties While You Can

There’s an old joke that a Russian’s idea of an optimist is someone who believes that tomorrow will be better than the day after tomorrow. Even recent headlines don’t compare with Russia’s cruel and tumultuous history, but what passes for optimism in the current tentative market consensus sounds very similar.

The December market rally blew through most price targets for all of 2020, so there was plenty of nervousness around, even before a fresh Iran crisis reminded us just how precarious the global order remains. Still, “tomorrow” doesn’t look too bad for now and we should enjoy it while it lasts. 

The American consumer, also known as the most reliable engine for global economic growth, continues from strength to strength: unemployment at 3.5%, wages growing 3.1% annually and a Christmas spending cycle clocking in at 3.4% more than the year before. The prospect of trade truce with China may help restore enough corporate confidence to raise business fixed investment from its recent doldrums near 2.25% [annual growth down from 7.7% in 2018]. Capital spending does not immediately translate to corporate earnings, but it remains essential to long-term growth. 

Fears of a hard landing in China have also dissipated, as its deft deployment of financial and fiscal tools has helped support demand even as it reined in excess credit growth. Neither Europe nor Japan is poised to soar this year as their structural challenges persist and negative interest rates continue to erode bank profitability. Still, European risks around a hard Brexit or an Italian budget crisis have dissipated. Japan has no further sales tax hikes scheduled. 

There are actually lots of bright spots that are often indicators of better times ahead: semiconductor sales are strong, Japanese machine tool exports are picking up, Germany’s business sentiment is brighter.

GLOBAL SEMICONDUCTOR SALES (M/M)

Source: Factset. As of January 9, 2020.

JAPANESE MACHINE TOOL EXPORTs

Source: Factset. As of January 9, 2020.

GERMAN IFO BUSINESS SENTIMENT SURVEY

Source: Bloomberg. As of January 9, 2020.

Any remaining questions about “the day after tomorrow,” though, are much more complex. 

We are still late in the cycle. Leverage is edging higher, margins are under pressure and earnings growth estimates lack inspiration. High yield spreads are tight by historical standards and some credit standards look frayed. 

U.S. CORPORATE PROFIT MARGINS

Source: Factset. As of January 9, 2020. Calculated as the Ratio of Profits After Tax/Corporate Contribution to GDP.

S&P 500 EARNINGS ESTIMATES (Y/Y)

Source: Bloomberg. As of January 9, 2020.

U.S. NONFINANCIAL CORPORATIONS TOTAL DEBT (% OF GDP)

Source: IIF. As of January 9, 2020.

Central bank accommodation and some prospect for more fiscal spending may help delay the next recession further still. But investors face a much greater mix of problems than a garden-variety slowdown. The start of every decade prompts reflection on the pace of global change, but this one looks like a doozy amid the accelerating forces of populism, technology and climate. 

If current trends of low global growth and low investment returns persist, recent flare-ups of political populism will spread to become fires. Calls to defend national identity have complex roots, but they are surely aggravated when growth looks limited and others—both inside your country and on the other side of the world⁠—seem to be prospering unfairly.

The challenge for investors is that populism has raised questions about fair trade, fair competition and fair pay, which forced governments on the right and the left to intervene in markets. In the United States, President Donald Trump has already launched his redesign of the global trading system with tariffs as his central tool; any Democratic successor will find it hard to take on Chinese subsidies without the threat of tariffs, too. Both Republicans and Democrats are mulling ideas to address the size and market power of the tech giants, and questions of inequality will remain a fundamental part of political debates, regardless of who wins the election.

"The start of every decade prompts reflection on the pace of global change, but this one looks like a doozy amid the accelerating forces of populism, technology and climate. If current trends of low global growth and low investment returns persist, recent flare-ups of political populism will spread to become fires."

These dynamics will be aggravated by the rapid technological change that is reshaping traditional business models, eliminating jobs and upsetting the balance of power between citizens and states. Vast amounts of data and powerful analytical tools are on the cusp of transforming entire industries, from mining to healthcare and education to finance, as companies learn to monitor current operations and predict customer needs with increasing speed and ever-greater accuracy.

While the promise of these breakthroughs will be irresistible, they will also open calls for more vigilant privacy protection and more vigorous defense of vulnerable cyber networks. By the way, a bumpy relationship with a Chinese government that is less squeamish about protecting privacy within a very different political model will make these issues far more difficult to navigate. 

Then there’s climate change, which is quickly shaping business considerations globally, even as it remains a trigger point in America’s emotional political landscape. But without touching questions around the causes of recent fires and storms and floods, dramatically different weather patterns are changing prices in ways investors cannot ignore: more expensive insurance in regions more prone to forest fires, cheaper land where flooding risks have risen and shifting relative costs as renewable energy undercuts hydrocarbons.

For companies, the choices will be difficult and expensive, as government regulation and social pressure force greater attention to carbon footprints. For investors, new winners may appear, but the overwhelming task will lie in identifying firms in their current portfolios that can deliver returns amid these changing costs and shrinking returns. 

Little of these populist, technological or climate headwinds are likely to dampen this year’s returns⁠—or perhaps even next year’s. But today’s investment calculus may look far different by the end of the decade. Enjoy “tomorrow” while it lasts.