Three Key Thoughts:

1. Consumers March On

2. US Growth Stocks Lead the World

3. China: A Shifting Role

US Consumers March On

In the fourth quarter of 2019, the markets decided that the “growth scare” we spoke of in last quarter’s Thoughts was not real. Led by consumers, the US economy continues to grow at a reasonable pace, with low inflation and a strong job market. Stocks love this environment – they have defied the skeptics and marched to all-time high after all-time high. Meanwhile, bond yields rose a bit off of their pessimistic lows.

The US consumer continues to be in excellent shape: well-employed with a growing wage, low indebtedness and a solid housing market. Of course, there are geographies and demographics that aren’t doing as well as the overall averages. However, we believe the consumer is likely to continue driving the economy forward at least through 2020.

The weak link today is business investment. While hiring is strong, businesses have not had the confidence to make major new investments in property, plant and equipment. Indeed, current statistics show that the manufacturing sector is bordering on recession. We believe that some of this reticence to invest is fallout from trade policy uncertainty. With a “phase one” deal with China due to be signed shortly, and a path for Brexit more settled, we hope to see business confidence recover somewhat.

US Growth Stocks Lead the World

One place where confidence isn’t lacking is at US technology companies. Their businesses are growing quickly and their stock prices have been leading the markets higher. Unlike the late 1990’s, when technology valuations reached absurd levels on nascent business models, today’s leaders are delivering real cash earnings that are growing consistently, leaving their valuations relatively more attractive than many so-called defensive or low volatility stocks.

This dominance of growth companies over traditional value stocks is one of three major trends that persisted throughout the decade of the 2010’s. The other two are: (1) the strength of the US dollar relative to virtually all other currencies; and (2) the higher returns posted by US domiciled companies, compared to their non-US counterparts. Each of these trends has persisted for an unusually long time, leaving the gaps in each case at historically wide levels. This has defied our expectations (and many, many others) and the simple law of regression to the mean. For the last decade, the best thing an investor could have done was to buy a US large cap growth index fund or ETF and hold it. The only thing we can say with some degree of certainty is that this is not likely to repeat for another full decade!

China: A Shifting Role

Shifting gears, with all of the news about trade negotiations with China, we think it is important to comment about the shifts we see in the world’s second largest economy. For the last 30 years, China has been nothing short of an economic miracle. As its leaders recognized the opportunities a market-based economy could bring, they transformed the country into the manufacturer and supplier to the world. Hundreds of millions of people were moved from abject poverty to a middle-class lifestyle. Unburdened by legacy systems and infrastructure (and a democratically elected government), China has advanced at a breathtaking pace. In many ways, if you want to see how technology will change our lives in the near future, visit China – they are often far ahead of us.

As wages have risen dramatically over the past couple of decades, their people now have greater resources and are demanding more and more services. And, China is no longer the low-cost manufacturer. So the Chinese economy is becoming increasingly like the US: driven by consumers and the products and services they demand. This sets up a competitive, rather than cooperative, future relationship with the US.

Given the sheer scale of China and the willingness of their government to tip the scales in their favor, China will be a formidable competitor. For example, if China wanted to lead the world in EV (electric vehicle) production, its government could support the research necessary to advance battery power significantly. Once that research was ready for commercialization, the government could declare that internal combustion engine cars could no longer be sold after a certain date, creating the world’s largest EV market for its domestic companies in short order. As far as we know, this is a hypothetical example but you can imagine this same blueprint being applied in many other markets.

If you combine this potential market power with an increasingly nationalistic government (as President Xi’s is), it is easy to envision a China wanting to play by rules it establishes, rather than those developed by other, lesser powers. In this context, we think a trade deal that reduces tensions and supports cooperation is an important achievement. We have no idea whether this deal will pave the way for better returns from non-US investments, but we expect that it should improve sentiment, both here and abroad.

Investment Implications

We have made no major changes to our “late cycle” asset allocation approach, maintaining an overweight to US large cap stocks and an underweight to fixed income, particularly low-quality credit exposure. Our approach to investing in US stocks has a strong “quality growth” bias. To balance this, we have held more value-oriented funds in the international portion of client portfolios. Over the last quarter, we have shifted those international holdings to be more balanced between growth and value. And, we have added a significant position with a global equity manager with the flexibility to shift between markets at attractive opportunities arise.