Market views from BlackRock Active Equities

Taking stock: Q1 equity market outlook

Tony DeSpirito |Feb 5, 2020

Risk-on and risk-aware. Investors are looking to the new year with one key question: Can stocks continue their 2019 momentum? We think equities can soldier on, but it may be more of an uphill battle in 2020:

  • We see a 2020 recession as unlikely. Our outlook is for slow but positive U.S. growth.
  • Our return expectations for the S&P 500 are also positive, but muted, given high valuations.
  • A looming election and ongoing U.S.-China tensions could incite higher volatility.

Market overview and outlook

U.S. stocks have outpaced their global counterparts year-to-date, with strong performance across sectors. Technology was a clear leader and remains one of our favored sectors heading into the new year, along with financials and health care. We see reasons for both optimism and caution on U.S. stocks as the calendar turns to 2020. This has us risk-on but acutely risk-aware as the decade-old cycle wears on and the looming presidential election stokes volatility. Our outlook is for another positive year for the S&P 500, though 2019 will be difficult to match.

‘Slow but positive’ is the single phrase that we could apply to both the U.S. economy and stocks as we assess the landscape for 2020.

Reasons for caution

High valuations. Stocks remain attractively priced versus bonds, but expensive relative to their own history. High valuations suggest investor optimism, but also make stocks vulnerable to a slide. There is simply little buffer to absorb bad news. Earnings growth will be a key driver of valuations in 2020.

Profit pressures. Profit growth is a function of revenues and margins. We expect modest revenue growth absent a material weakening in the U.S. dollar. On margins, expectations are for further expansion, but we see three reasons for pause: 1) cost pressures from rising wage growth and trade-related disruptions to the global supply chain; 2) little room for improvement in interest expense ― rates can’t go much lower; 3) optimal corporate tax rates, with the benefits of the 2018 cut having played out and political pressure for an increase.

Inflation complication. We are outside the consensus, but see potential for inflation to surprise to the upside in 2020. The likely culprit? Rising wage growth. Despite decade-low unemployment and other signs of a tight labor market, wage growth hasn’t accelerated. More people have entered the workforce since 2015, suggesting a hidden supply of labor continuously being tapped. This resource will eventually be exhausted, especially as more baby boomers retire, putting upward pressure on wages — and inflation.

Reasons for optimism

Consumer strength. The U.S. personal savings has stabilized above 7% in the past decade, levels not seen consistently since the mid-1990s, according to data from the U.S. Bureau of Economic Analysis. The unemployment rate is near multi-decade lows and lower- and middle-class households are finally seeing wage growth. Strength on these measures bodes well for the economic backdrop, as personal consumption accounts for roughly 70% of U.S. GDP.

Corporate efficiency. Company balance sheets broadly look buoyant. Corporate America has taken advantage of low interest rates and prudently locked up cheap long-term financing. This can accrue to earnings ― as long as companies generate returns above their cost of capital. On average, we see companies spending less but generating higher returns on invested capital (ROIC). Many are also replacing traditional labor costs with investments in productivity-enhancing technology and R&D.

Policy support. Both monetary and fiscal policy are supportive of stocks. The Fed has signaled interest rates will remain on hold as the committee assesses incoming economic data. Meanwhile, ongoing federal spending provides near-term economic stimulus. We expect continued slow growth from the U.S. economy.

The 2020 presidential election presents a mixed bag. We expect it will create a moment (or moments) of panic that will weigh on markets. Yet history offers reason for optimism: On average, the fourth year of a presidential term has coincided with positive returns for the S&P 500. Year-three has historically had the best showing, not unlike 2019.

A vote for U.S. stocks?
Performance through presidential terms, 1945-present

Equity Outlook

 

Source: BlackRock, with data from LANA Lipper, December 2019. Chart shows S&P 500 Index median price returns from Dec. 31, 1945, to Nov. 30, 2019. The S&P 500 is an unmanaged index of 500 large-cap U.S. stocks. It is not possible to invest directly in an index. Past performance is no guarantee of current or future results. 

Netting it all out

We see the potential pitfalls as greater now than at the start of 2019. That does not mean stocks cannot move higher in 2020. The economic backdrop is supportive and company fundamentals are on solid ground. But the opportunity for broad share price gains is simply lesser and the indexes will likely find it harder to make sweeping positive progress. Selectivity is more important in this environment. Maintaining a long-term lens also can be prudent.

Sector highlights

Technology remains on our “like” list given our focus on companies with good business models and free cash flow. These characteristics are evident in many companies across the technology sector.

Financials are a favored “value” exposure. We believe the opportunity has been underappreciated as falling rates were seen as limiting bank profitability. Yet many banks are in their best fiscal shape since the financial crisis and valuations are attractive. A Fed on hold is a positive.

Health care is a preferred “stability” exposure. A record of innovation and an aging population are strong structural tailwinds. Politics is a factor, but may be overly discounted. We like the HMOs, with “Medicare for all” being politically divisive and a low-likelihood event. We also like the growth potential of pharmaceuticals, despite drug pricing scrutiny on both sides of the aisle, and view companies with sticky consumer product brands as good diversifiers of political risk.

Environmental, social and governance (ESG) issues are an increasingly important consideration for investors as well as the population at large. We see this creating opportunity in areas such as sustainable packaging and power generation, where both fundamentals and valuations are supportive.

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