This article is part of Fortune‘s quarterly investment guide for Q1 2020.
Following a relentless rise in the markets in 2019, it’s not easy to know how to approach the markets this year. When markets are falling investors tend to overreact and rush their decision-making. But when markets are rising investors tend to question the legitimacy of those gains. This is especially true for those of us who have lived through two enormous crashes this century. Is the stock market going to crash again? Is the U.S. overdue for a recession? How much will the 2020 election impact how investors feel about risky assets?
Here are five burning questions for investors to consider as we try to digest 10 solid years of market gains.
Are international stocks ready to run?
U.S. stocks have handily outperformed the rest of the world for some time now. There are a number of good reasons for American exceptionalism during this cycle. The U.S. dollar has appreciated relative to most other currencies around the globe. That’s a headwind for foreign stocks and companies. The U.S. also has a far greater weighting to tech stocks than the rest of the world, and technology has been one of the best- performing sectors as companies such as Amazon, Apple, Facebook, and Google have become some of the largest in the world.
Over the past 10 years, U.S. stocks are up roughly 250%, while foreign developed markets and emerging markets have risen just 67% and 35%, respectively, over that time. This disparity has caused many investors to suggest it makes sense to shun international diversification. It’s certainly possible this trend will continue and U.S. outperformance will persist. But history shows the relationship between U.S. and foreign stock market over- and underperformance is quite cyclical:
This chart shows the rolling three-year total return differential between the S&P 500 and the MSCI World ex-U.S. Index. There have been much greater differentials between this return series in the past, but this is the longest run of consistent outperformance by one region of the world going back to 1970. U.S. stocks have been handily outpacing the rest of the world by this measure consistently since 2012 or so.
U.S. stocks currently make up around 50% of total global equity markets, but we account for only 25% or so of world GDP and just 4% of the world’s population. Said another way, the rest of the world still makes up half of all stock market capitalization and provides a bulk of the growth. It can be tempting for investors to keep all of their stocks invested in the U.S. because of the recent outperformance and comfort in investing in what you know. But a home country bias can cause investors to miss out on the important diversification benefits international stocks provide.
Corporations have become more globalized over time, but cycles haven’t been outlawed. Eventually the rest of the world’s stock markets will play catch-up or the U.S. will slow down. It’s just impossible to know the timing of when that will occur.
Should we still be worried about a recession?
Because the U.S. economy is equal parts enormous and dynamic, it’s difficult to come up with useful signals that will tip us off to the timing of the next recession. The only reliable historical indicator we have is the onset of an inverted yield curve. In the past when long-term interest rates have fallen below short-term interest rates, that’s been a sign that the economy is going to slow. You can see each of the past four recessions have followed an inverted yield curve event:
The hard part, again, is the timing. The lag between an inversion and the onset of a recession in these five instances is a range of 10 to 22 months. You should also notice on this chart that we experienced an inverted yield curve towards the end of 2019 for about 15 minutes or so. The curve has now steepened, meaning long-term rates are back above short-term rates, which is what you would expect in a normally functioning interest rate environment.
But the 30-year Treasury recently yielded only 0.5% more than the 10-year Treasury, which itself yielded just 0.2% more than the two-year Treasury. So these spreads remain low by historical standards. It’s hard to say if the yield curve will continue to keep its predictive power in an era where interest rates are as low as they’ve ever been. But this chart is worth keeping an eye on for those who believe an unhealthy interest rate environment is a precursor to an economic downturn.
How will the interest rate environment impact expected returns?
Interest rates have been falling since the early 1980s, but the situation at the moment for investors in fixed income is made even more challenging by the fact that the yields on different-maturity debt have converged. In theory and all else equal, investors should be paid a higher interest rate for accepting the risk that comes with longer maturity on their bonds. This is because the further out you go, the harder it is to project what the future path of interest rates, inflation, and economic growth will be.
At the moment, as we’ve noted, there isn’t much of a difference between the yields investors can earn on 30-year Treasuries and the yield they can earn on two-year Treasuries. A half-percentage-point difference in yield isn’t much of a buffer for taking on 28 more years of maturity and thus, more volatility in price.
Interest rates could always fall further. There’s nothing stopping U.S. bond yields from going negative as they have in other developed countries all across the globe. But eventually, lower interest rates are going to act as a return suppressor on longer-term bond returns, no matter how much risk you’re willing to take in the space.
Investors in fixed-income assets basically have two choices in this environment: (1) You can adjust your return expectations accordingly by planning for lower returns in bonds than investors have become accustomed to; or (2) You can invest in riskier bonds or bond funds that pay a higher yield, such as corporates, mortgage-backed securities, or junk bonds. Understanding your appetite for risk in the land of fixed income is going to be more important than ever in the coming years. Just remember, risk never completely goes away. Earning a higher return typically involves taking more risk, whether you know it or not.
Is the consumer in better shape than most believe?
One of the reasons the 2008 financial crisis was so devastating is because so many Americans were overleveraged. People borrowed too much money to buy houses and other things they couldn’t possibly afford once an economic setback hit. Many are worried we’re due for more of the same when the next downturn hits. You can see total household debt has now surpassed the previous highs from 2007:
Based on the latest reading, we’re fast approaching $14 trillion in U.S. total household debt. The majority of the debt in this country is made up of mortgages (68% of the total), student loans (11%), auto loans (9%), and credit card debt (6%). While overall debt levels are at all-time highs, you can’t simply look at borrowing on its own. You also have to look at the income and assets available to service those debt payments.
Here you can see household debt service as a percentage of income has never been lower, going all the way back to 1980 when the Federal Reserve began tracking this data. Lower interest rates and more high-quality borrowing have both helped clean up the consumer’s balance sheet. Whenever the next economic downturn hits, there will be a number of people facing financial difficulty. That’s a given. But consumers are in a much better position than they were heading into the Great Financial Crisis, making it unlikely the next recession will be as damaging.
Will politics affect the stock market?
The 2020 presidential election is already underway but expect the volume to start getting louder as we head into the first quarter. The Democrats have already had a number of debates, but as that field slowly but surely begins to narrow, the policy implications on the markets and the economy will heat up in earnest. Data from Dimensional Fund Advisors shows that stock market returns have generally been strong under both Democratic and Republican presidential regimes:
Presidents always get blamed far too much when things go poorly and praised too much when things go well on the economic and market fronts. Still, expect to hear more about how much the outcome of the election in 2020 will impact the markets. Expect the predictions and rhetoric to really heat up in the coming months as the debates, poll numbers, and campaign promises come into full swing. Just remember, politicians don’t have nearly as much sway over the markets or economy as people think. And even if they did, there is a huge difference between the things presidential candidates say on the campaign trail and the actual policies they are able to enact while in office.
A final tidbit
With tensions rising in the Middle East following our recent conflict with Iran, many are worried about what’s in store for energy prices. While prices could rise if things get out of control, there is a buffer in the form of prices having gone nowhere for the past decade. In late December 2009, the average price of retail gas in the U.S. was $2.65 per gallon. In late December 2019, the average price of retail gas in the U.S. was $2.63 per gallon. That’s an entire lost decade of gas prices where they went nowhere. Of course, there were fluctuations along this 10-year journey of price points:
It helps that crude oil prices have also experienced a lost decade of their own. WTI crude oil prices have gone from roughly $72 a barrel a decade ago to around $60 a barrel today. Regardless of the reasoning behind this move in prices, the fact that gas prices are the same as they were 10 years ago should be helpful to the U.S. consumer, who accounts for 70% of economic growth in this country.
Ben Carlson, CFA, is the director of institutional asset management at Ritholtz Wealth Management. He may hold assets or securities in some of the investments mentioned in this article.
More from Fortune’s investment guide:
—Start a donor advised fund for your charitable giving
—The health of the economy in nine charts
—Goldman Sachs Asset Management’s Sheila Patel on her 2020 outlook
—Investors are uneasy over the surge of near-junk corporate bonds
—Chasing returns: 12 lessons for real estate investors
—10 stocks that are poised for a stellar 2020
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