Stocks end 2019 on a high note, posting their best returns since 2013. Investor optimism regarding progress on US-related trade deals, green shoots in global growth as monetary easing kicks in and reassurance that central bank (US Fed and ECB) policies will remain accommodative for an extended period helped spur the rally. Consumer confidence also remained elevated, backed by strong employment levels in the US.
Large caps over small in 2019, but small caps make a move in Q4. Investors favored large caps for much of 2019 amid economic and geopolitical uncertainty, driving them to outperform mid and small-caps. However, since September 3rd, small-cap stocks have outperformed and we believe this will continue into 2020.
Growth dominates in Q4 and 2019. Growth beat value again across small- and mid-cap ranges in Q4—largely due to strong performance in healthcare (biotech) in the small-cap growth segment and technology (software and semi’s) in the mid-cap segment, according to Russell style indices.
Bonds eked out a small gain in Q4. Bond prices rose slightly as yield curves un-inverted with investor fears subdued due to signs of global economic deceleration bottoming and major central banks taking an accommodative monetary policy approach.
- The 10-year Treasury Yield closed at 1.92%, up +24 basis points during the quarter.
- The high-quality Bloomberg Barclays US Aggregate Bond Index gained 0.18% and underperformed the Bloomberg Barclays US Corporate High-Yield Bond Index, which rose 2.61% in Q4.
Convertibles deliver strong results, driven by underlying equities. Since convertibles are predominantly issued by small- and mid-cap companies in growthier sectors, their strong performance gave rise to the asset class in Q4. The Thomson Reuters All Cap Focus Convertible Index gained +6.74% while the cap-weighted BofA/Merrill AQ Convertible Index, which tilts toward large-cap issues, picked up +7.38. Convertibles finished the year at post financial crisis highs, +19.3% and 23.2% respectively. New issuance moderated in Q4, but has been robust for the year overall with 118 new US convertible issues totaling ~$53.0 bn. Technology and healthcare accounted for 57% of issuance in 2019, according to ICE/BofA Global Research.
Active management and security selection drove performance in Q4 and 2019. Staying true to our investment discipline and conviction in the strength of our holdings paid off with a sharp rebound in fourth quarter performance after a challenging Q3. Most of our strategies outpaced their benchmarks by a solid margin for the quarter and year. Positions in inefficient, niche segments of the market, such as smaller-cap healthcare and technology companies, were key drivers of absolute returns across all portfolios. (See page 4 of the pdf for performance results.)
Major pivot since year-end 2019. Outlook improves. As key headwinds abate–recession fears and escalation of trade war–we believe this creates room for a slow grind higher in the business cycle and equity markets, smaller caps in particular. Thus, our outlook has appropriately improved. However, we are monitoring risks to GDP due to global spread of the Coronavirus outbreak in China.
Key economic and market indicators have brightened, some less skewed to the downside:
- Green shoots in global growth outlook sprout, as PMIs (purchasing manager indices) for some large economies experienced an uptick. The global PMI reading in December was 50.1 vs. the 49.7 print in September, according to FactSet and Markit PMI data. (A reading below 50 indicates economic contraction) Leading global economic indicators also saw small improvements, according to the OECD (Organization for Economic Cooperation and Development). In combination, this suggests a bottoming of a third-mini recession in this post-financial crisis expansion.
- US-China trade tensions de-escalated after confirmation of a “phase one” trade deal with China, averting a series of additional tariffs and rolling back some tariffs introduced earlier. US Congress and President Trump also agreed to the terms of USMCA, which will likely improve US-Mexico-Canada trade.
- Disorderly threat of Brexit diminished with UK and EU compromise on a new Withdrawal Agreement.
- Resilience in consumer confidence shines bright. Decent holiday sales trends, solid Consumer Confidence Index data and strong US employment supportive of continued strength in consumer spending, should continue to drive economic growth.
- The Federal Reserve signaled downside risk had “eased in recent months,” but signaled the need for an accommodative policy stance to circumvent continued weakness in business investment.
- US GDP incrementally ticked higher in Q3 with CY’19 consensus estimates for real US GDP firmly at 2.1%. 2020 estimates remain positive, but with slower real US GPD growth of 1.8% due to waning tax-cut effects and the drag from previously strained US-China trade relations in 2019. Lower downside risks leave room for upside improvements.
Credit cycle should remain calm in 2020. Credit spreads are generally below historical averages…but with an elongated business cycle, credit should be supported by corporate cash flows. Smaller-cap stocks likely to get a boost if high yield spreads stay below average.
Faster earnings growth in 2020 than 2019. The knock-on effect of prior trade-related risks is expected to dampen Q4 earnings results. However, earnings and revenue growth recovery in 2020 is likely scenario on easier comps and improvements in the economic outlook. Coupled with lower interest rates for longer, multiple expansion is conceivable. Consensus forecasts set S&P 500 CY’20 EPS growth at 9.6% and 5.2% for revenue growth, according to FactSet.
Better outlook balanced with pragmatic view. With a clearer view of resolutions to prior economic and market risks of 2019, the worst may be behind us. However, we remain mindful of potential risks that could derail progress, including:
- GDP risk due to spread of the Coronavirus outbreak in China
- Rising US/Iran tensions
- Strain on corporate margins due to wage pressures
- Burgeoning government deficits
- US election cycle
WHERE WE STAND NOW
Outlook for active management remains positive. Declining stock correlations and greater dispersion in stock returns provide a positive set up for active management. As such, we believe company fundamentals will have a greater impact on returns. With this firmly in mind, we are focused on companies in inefficient and niche market segments that we believe can drive differentiated organic growth that is above and beyond the end markets that they serve, leading to an acceleration in their revenue and/or earnings growth.
We are also in the camp that growth and cyclicals with idiosyncratic catalysts are poised to do well in 2020. Factors supporting our view include:
- Consumer strength holds steady with lower unemployment and rising wage growth
- Improving economic backdrop and extension of business growth cycle
- Trade deal boost
- An accommodative Fed
Valuations are important. As multiples expand, we recognize that absolute valuations are not cheap at this stage in the cycle with the S&P 500 trading at 18.2x NTM P/E and the Russell 2000 Index at 23.4x NTM P/E according to FactSet. As a result, we continue to closely monitor portfolio holdings against various valuation metrics as part of our disciplined risk-monitoring process, which results in trimming or selling those that exceed their historical and industry averages.
Disclosure: Nicholas Investment Partners, L.P. (“Nicholas”) is an independent investment adviser registered with the SEC. Registration with the SEC does not imply a certain level of skill or training. The firm maintains a complete list and description of performance composites, which is available upon request. Policies for valuing portfolios, calculating performance, and preparing presentations are available upon request. Past performance is no guarantee of future results. No part of this material may be copied or duplicated or distributed to any third party without written consent.
Nicholas does not guarantee the success of any investment product. There are risks associated with all investments and returns will vary over time due to many factors such as changing market conditions, liquidity, economic and other factors. The value of investments can go down as well as up, and a loss of principal may occur. Although Nicholas attempts to limit various risks, risk management does not imply low risk. All risk models are inherently limited and subject to changes in economic, political and market conditions, as well as changes in the strategies’ holdings, among other things, which could affect the risk profile of any portfolio managed by Nicholas. Small- and mid-cap companies may be subject to a higher-degree of risk than larger more established companies’ securities. The liquidity of the markets for these small and mid-cap companies may adversely affect the value of these investments. Concentrated or sector strategies are expected to maintain higher exposures to a limited number of securities or sectors which could increase the volatility, market, liquidity and other risks of the strategy.
Some information herein reflects general market commentary and the current opinions of the author which are subject to change without notice. It is provided for general informational purposes only and does not represent investment, legal, regulatory or tax advice and should not be construed as a recommendation of any security, strategy or investment product. There is no guarantee any opinion, forecast, or objective will be achieved in the future. The information, charts and reports contained herein are unaudited. Although some information contained herein was obtained from recognized and trusted sources believed to be reliable, its accuracy and completeness cannot be guaranteed. Unless otherwise noted, Nicholas is the source of illustrations. References to specific securities, issuers and market sectors are for illustrative purposes only. Nicholas does not undertake to keep the recipients of this report advised of future developments or of changes in any of the matters discussed in this report.
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