As a new year and decade begin, the election in 2020, negative interest rates, aging demographics, and the growth of passive investing will likely have the biggest impacts on the financial markets going forward:
For the past 40+ years, we have lived in a world where business has become more global while politics have remained local. The result has been an increase in populism worldwide. The United States is basically a 50/50 country but there is a wide gap between the proposed policies on the left and the right of the political spectrum. Currently, the only evidence of any bipartisanship is the lack of concern over the $1+ trillion budget deficit. According to Strategas, Trump is unlikely to win the popular vote but likely needs just Wisconsin, Pennsylvania, or Michigan to win the electoral college. Expect the election in 2020 to be ugly. The only guaranteed winner will be ad spending.
Interest rates are the lowest in recorded history and the amount of bonds globally with yields below zero currently approximates $12 trillion. Bonds with negative yields are guaranteed to lose money if held to maturity and no rational investor willingly owns them. This financial paradox is largely due to the monetary policies of central banks and while irrational, negative interest rates can make Adam Smith’s “Invisible Hand” do crazy things that are technically justifiable economically. Corporations attracted by the siren song of low interest rates have been aggressively tapping debt markets and have utilized the proceeds primarily for buying back shares. The growing increase in leverage has caused credit quality to decline as approximately 50% of the Barclay’s Aggregate Credit Index is now rated BBB, just one notch above non-investment grade or junk. According to the International Monetary Fund, the volume of corporate borrowing has outstripped the cash generation of many companies as 33% of the constituents in the Russell 2000 Index have interest costs in excess of their annual earnings. While the economy remains relatively robust, many of these companies are effectively financial Zombies that will not be able to service their debt over any extended period of time.
According to The Economist, the world will have more people over the age of 30 than under in 2020 for the first time. The average Baby Boomer in the United States turns 65 in 2020 and there are now 10,000 people turning 65 every day in the United States. In Europe, 25% of the population is over 60 and Japan is considered “ultra-aged.” The Milken Institute states that Americans over 50 now account for $7.6 trillion of economic activity and own nearly 75% of all financial assets. Boomers will remain one of the primary engines of global economic growth in the coming years.
According to the Financial Times, there is now more than $11 trillion passively invested in index funds. Mutual funds and exchange traded funds that mimic indexes are effectively algorithms making investments based on the equity market capitalization of their constituents; the bigger a company’s equity market capitalization, the bigger its weight in an index. Over the past decade, holdings within indexes have become increasingly concentrated and relatively expensive. For example, the five largest holdings in the Nasdaq 100 Index are Apple, Microsoft, Amazon, Facebook and Alphabet (Google). Combined, these five companies only represent 5% of its holdings but now make up 43% of this index’s market value. Indexing does not take the valuations of its constituents into consideration and as more passive investment capital is allocated to the Nasdaq 100 Index, an increasingly disproportionate amount will continue to be invested in these five companies selling at earnings multiples of 25, 32, 84, 25, and 31 respectively or well above the market’s historical average. As a result, the downside risk of investing passively in indexes has continued to increase.
2020 and Beyond
The S&P 500 Index finished 2019 up 29.4% and 30,000 for the Dow Jones Industrial Average is merely 5% away. GDP growth was solid during 2019 as a result of robust consumer spending but the strength displayed by the S&P 500 last year while confronting trade wars, a yield curve that inverted, impeachment and a decline in manufacturing was truly impressive. However, it is important to note that the earnings generated by the S&P 500 last year were unchanged from 2018; its advance was caused by multiple expansion or the increase in its price to earnings from approximately 15x to 18.4x. Given the starting point of earnings multiples and interest rates, investment returns will likely be more muted in the decade to come.
Ted E. Furniss, CFA January 2, 2020