The bank for a changing world

A HUMBLE ENCOREInvestment Insights 2020 Outlook

December 19, 2019

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Investors should experience fading tailwinds as we enter a new decade. Financial markets have been exceptionally resilient over the last few years and 2020 may be another upbeat year, albeit a more modest one. A rise in volatility is likely amid softening economic data and continued geopolitical issues.

Forecasted Key Themes for 2020:

• Our investment strategy for 2020 will be opportunistic in the event of shorter term volatility – buy the dips. While our base case projection involves a shallow economic slowdown and a choppier stock market, we still see stocks outperforming bonds again next year.

• Currently, our strategies hold a slight overweight to stocks and alternatives, and an underweight to bonds. Caution continues to be warranted given economic concerns and investors should be prepared to proactively adjust allocations as the outlook for the economy becomes clearer.

• Stocks performed exceptionally well in 2019 and there is still potential for positive, albeit likely more limited, returns in 2020. Domestic stock market valuations are elevated, which may hasten volatility. An expected re-acceleration in earnings growth should support prices.

• International stocks may attract more favor in 2020 given their relative valuations versus domestic securities. A rebound in select European countries as well as emerging economies after potential trade deals could provide a boost to stock prices.

• 2019 was an unexpectedly strong year for bonds, which suggests more muted returns in 2020; however, a flight to quality leaves potential for another above-average year. Our baseline forecast continues to be a gradual, long-term rise in rates barring significant economic concerns.

• Alternative investments remain a core focus for lower-correlated returns. Precious metals, such as gold, along with hedged strategies and reinsurance should be strategic allocations. The U.S. dollar remains relatively expensive, but with potential downside in 2020 if international growth rebounds.

• Geopolitics will continue to be a notable factor, but less so than in 2019. A back-and-forth between the U.S. and China, regardless of phase one progress, will likely continue and Brexit should occur in an orderly manner. Trading conflicts, populist movements, and the U.S. presidential election may add to volatility.

• Inflation remains persistently low, but may be poised for a minor upturn from lower rates and higher labor costs. The Fed and central banks globally will be even more focused on inflation in 2020, which will help to drive monetary policy and asset prices.

• Our base case for monetary policy is that the Fed will hold rates steady in 2020. However, a shallow economic slowdown and another consecutive year of hushed inflation could spur one or two rate cuts. The Fed will need to tread carefully – both cuts and hikes are still on the table over the next year or beyond.

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Rounding Out the DecadeMost investors would consider 2019 a year of surprises – both positive and negative – as the Fed countered widely expected rate hikes with cuts, the U.S.-China trade war ebbed and flowed while international trade dynamics radically changed, and the stock markets defied fate and extended their remarkable rally. In contrast to a rocky 2018, this year became a period of resilience for financial markets and robust returns for most major asset classes. Global stock markets may end the year well within the 20 percent range, led by U.S. shares, and even the broader U.S. bond market neared double-digit returns for the calendar year. Volatility from geopolitical issues, especially the fluid situation of trade between the U.S. and China, and a mixed bag of economic data churned prices throughout the year, but optimism prevailed and propelled stock gauges higher toward the end of the year.

Many of our forecasts from last year proved true during 2019. Stocks outperforming bonds, the U.S. stock market leading international and emerging stocks, slower GDP growth in the U.S. without recession, and a deceleration in China were all validated throughout the year. Even our calls for increased correlation between stocks and bonds, and our $65 price target for oil played out fittingly. However, 2019 had a few surprises in store for us and for many other investors. Going into 2019, the Fed – and most of the market – had expected two rate hikes. After some economic fundamentals faltered and geopolitical risk increased, the two expected hikes became three rate cuts – a substantial distinction from what we, and the rest of the market, had expected. Uncertainty also drove a flight to quality, pushing bond yields lower and boosting price return for the bond market after our initial expectation of a grind upward in yields. Those root causes, worries over trade and the global economic outlook, were not fully resolved this year and will likely rear their heads again in 2020.

“Everything has to come to an end, sometime.” — The Wonderful Wizard of Oz, L. Frank Baum

The new year will likely be another of segmented, but overall positive, returns for stocks. The U.S. stock market has become strikingly expensive, which is one of the reasons why we see a limited upside going into 2020. The S&P 500’s price-to-earnings ratio is currently sitting around 21 – slightly above the 10-year average of 18, according to Bloomberg. While price-to-earnings ratios are a staple for investors seeking isolated valuation metrics, other gauges are showing an even more dire case for expensive valuations. The so-called “Buffet indicator,” popularized by quintessential value-investor Warren Buffett, is a ratio of the total U.S. stock market capitalization to GDP. According to the gauge, the stock market may be overvalued by the most in decades with a reading close to 150% of GDP, compared to highs around 140% before the dotcom bust and similarly before the financial crisis of 2008. Even on inflation-adjusted terms, price-to-earnings valuations are almost at 29 – well above the 10-year average of 21 for the gauge.

That richness may also intensify any negative news or catalysts as investors err on the side of caution. An overvalued market combined with potential disappointments in growth and economic data may precede a healthy market correction, or increased volatility in general, which would reset valuations in the first part of the year. We continue to see a sensibly positive return for U.S. stocks and, while overvalued markets are a factor, other market fundamentals are supportive to modest gains by the end of the year. One of those dynamics may come from earnings breaking out of its lull. As companies came off the 2018 tax break sugar high, quarterly earnings reports were fairly lackluster this year with projected earnings rising a mere 0.3% in 2019. That trend will likely be bucked in 2020 with the first two quarters accelerating to 5% and 7%, respectively, and forecasts anticipate 10% earnings growth for all of 2020, according to FactSet data. Similar analyst data, including bottoms-up price projections, are reflecting a potential 7.5% price uptick over the next 12 months for the S&P 500, which is in stark contrast to the more typical 20%-

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30% predictions. Even with earnings getting back on track, most of Wall Street isn’t too confident that stock prices can continue much higher. The market should end positive, but may meander throughout the year to get there.

While valuations may be an issue for U.S. stocks, their global counterparts may have a few advantages. Both EAFE stocks – ones in developed countries making up most of Europe, parts of Asia, and Australia – and emerging markets are well below their longer term averages for price-earnings, giving a much more attractive valuation when compared to U.S. stocks. Additionally, according to Bloomberg and MSCI data, EAFE stocks are surprisingly expected to beat both U.S. and emerging market companies in earnings growth for 2020. International stocks may – finally – have their day in the sun after considerably lagging domestic stocks during the recovery. Stocks should perform well after some bouts of volatility, but 2020 may be their last hurrah as global inflation expectations and monetary policy will likely drive asset prices even more so over the coming few years.

The Inflation Pickup that Never CameSlowing global demand has been a key concern for economists and policymakers in the wake of the last recession. Consumers were the lynchpin in the decades of historically high GDP growth, but never fully returned after the 2008 crisis hampered economies and purchasers globally. That same demand, combined with other economic factors like below-par wage growth, has yielded an environment of persistently low inflation – a problem the Fed has been trying to tackle for several years. The long-held expectation was that rate cuts from the Fed would drive an array of economic activity, boosting growth and inflation in a gradual and managed way. So far, U.S. economic growth remains in its supposed “new normal” rate in the ballpark of an annual 2% compared to the livelier 3%-4% growth during the early 2000s and the late 90s. Unsurprisingly, inflation has been in a similar boat.

Each year, the Fed and others have hoped for a pickup in inflation that would reflect increased spending and rising value of goods and labor. That progress never came. Both overly high and notably low inflation can be detrimental to the economy – the Fed needs to find the “just right” policy, or neutral rate, that isn’t too hot or too cold. However, monetary policy can only do so much and structural change may be keeping inflation in the doldrums. Aging demographics, technology, and aggregate demand forces may put downward pressure on prices. This is also evident after years of global disinflation have dragged on longer term inflation expectations – a key factor in the economic outlook and asset pricing. While lower rates may aid an uptick in inflation in the coming quarters, it will be difficult for policymakers to keep a sustained acceleration in the gauge. The Fed, and central banks around the world, will be focused on avoiding stagnation and attempting to rekindle inflation, which could lead to rate hikes and a potential end to the cycle.

“Nothing is so painful to the human mind as a great and sudden change.” — Frankenstein, Mary ShelleyThe Federal Reserve will be under even more scrutiny next year after the surprise cuts in 2019 and going into the U.S. presidential election. One of the underlying shocks to the financial markets this year was the disparity between rate expectations and what actually happened. Fed officials had conveyed their target of raising rates at least two times in 2019, but disappointing data and lower sentiment pushed them to action, cutting rates three times during the year. It is important to remember that the targeted path for rates is just as important as the actual rate adjustments themselves, and such a gap between the two is rare. Toward the end of this year, the Fed has again provided their outlook to the general public and the consensus is for holding rates steady throughout 2020.

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Our team is more in agreement with the Fed than some of the market; we don’t see a high likelihood for rate cuts, and even less so for rate hikes, barring any significant changes in the economy or financial market instability. The elections should support a less active Fed as they seek to be viewed as impartial to the election process, but will still prioritize the economy over politics. The stage seems to be set for a slumbering Fed, but weak economic activity in the first part of the year and other mounting risks such as a continuing U.S.-China trade war could sway the Fed toward further rate cuts. After missing the committee’s inflation target over the last 10 years, the Fed will likely let inflation run rather than potentially hampering it. The least likely scenario, in our view, is for rate hikes in 2020, which would require a sustained, sizable, and surprising uptick in inflation to spur the Fed to action.

The bond markets performed admirably in 2019 as a flight to quality pushed yields lower and brought about an above-average year for performance. We continue to believe that structural shifts should push longer term rates gradually higher. The benchmark 10-year Treasury yield has been on an upward trend over the past few months and we believe that will continue in 2020, possibly reaching around 2% by year-end. Higher volatility in stocks, or a major shift in the economic outlook, could cause another risk-off movement, which would drive yields lower, but we see most of those occurrences as transitory. We expect credit spreads to remain tight given the projections for economic growth; however, we continue to monitor leverage and quality of credit. In the municipal markets, demand continues to be strong for tax-exempt income and supply constraints should keep yields relatively steady. Similar to stocks, the bond markets are likely in store for a more modest year.

The Last HurrahWe continue to expect stocks to outperform bonds; however, that dynamic may come to an end after next year as the business cycle reaches a crossroads

with monetary policy. Caution is warranted given our base case for a minor economic upset and increased volatility; however, the overall year should be a positive one for investors. Geopolitics will have less of an effect on markets than this year, but we expect a continuation of the trade war and other trade conflicts as rhetoric increases before the election. 2020 is set to be one of fairly modest market returns given valuations, current year returns, and our expectations for next year, though the U.S. presidential election will be a vital topic as changing policies influence markets.

The Bank of the West strategies continue to hold a minor overweight to stocks and alternatives, and an underweight to bonds going into 2020. Our stock portfolios are positioned well for upside in the coming year with a focus on domestic large cap stocks and a target weighting to emerging markets. Europe and foreign developed stocks are an area of interest. Valuations may play a larger role next year due to unusually expensive U.S. markets. In bonds, we are favoring spread products like corporate bonds and targeting a lower-than-benchmark duration as we expect rates to rise overall. Alternative assets remain an integral part of our investment strategy for lower or uncorrelated returns, which can benefit clients in low-return environments or even in times of increased volatility – like we expect for 2020. Our allocations to precious metals, hedged strategies, and weather insurance-related securities should add notable value.

Overall, we see 2020 as a modest encore to the exceptional financial market returns over the past decade. The new year will be a time for investors to be opportunistic during a choppier stock market and to allocate to non-traditional sectors to improve the return and risk profile of their portfolios. While we have created a plan and plotted a course for next year, that strategy isn’t strictly rigid – remaining tactical in the upcoming environment will be crucial to success.

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GlossaryAlternative investments are investments that are not one of the three tradi-tional asset types (stocks, bonds and cash). Alternative investments include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.

Barclays U.S. Universal Bond Index is an unmanaged index comprising US dollar-denominated, taxable bonds that are rated investment grade or below investment grade.

Bloomberg is a major global provider of 24-hour financial news and informa-tion including real-time and historic price data, financials data, trading news and analyst coverage, as well as general news.

Bloomberg Commodity Index is a broadly diversified index that allows inves-tors to track commodity futures through a single, simple measure. The Index is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME).

Brexit is an abbreviation of “British exit”, which refers to the June 23, 2016 ref-erendum by British voters to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades.

Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food and medical care. The CPI is calculated by taking price changes for each item in the predetermined basket of goods and averaging them; the goods are weighted according to their importance. Changes in CPI are used to assess price changes associated with the cost of living. Sometimes referred to as “headline inflation.”

Corporate bonds are debt obligations issued by corporations. An investment in corporate bonds is subject to a variety of risks including credit and default risk, market risk, event risk, call risk, interest rate risk, foreign risk, and sector risk.

EAFE is a grouping of developed markets outside of the U.S. and Canada, and is maintained by MSCI, Inc. The acronym stands for Europe, Australasia, and Far East.

Emerging Market countries have economies that are progressing towards be-coming advanced, as shown by some liquidity in local debt and equity markets and the existence of some form of market exchange and regulatory body.

European Central Bank (ECB) is the central bank responsible for the monetary system of the European Union (EU) and the euro currency.

European Union (EU) is a group of European countries that participates in the world economy as one economic unit and operates under one official currency, the euro. The EU’s goal is to create a barrier-free trade zone and to enhance economic wealth by creating more efficiency within its marketplace.

Federal funds rate is the interest rate at which depository institutions actively trade balances held at the Federal Reserve, called federal funds, with each other, usually overnight, on an uncollateralized basis. Institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances.

Federal Open Market Committee (FOMC) is a committee that sets interest rate and credit policies for the Federal Reserve System, the U.S. central bank. The committee decides whether to increase or decrease interest rates through open-market operations of buying or selling government securities.

Federal Reserve (Fed) is the federal banking authority in the U.S. that performs the functions of a central bank and is used to implement the country’s mon-etary policy, providing a national system of reserve cash available to banks.

Frontier Markets are less advanced capital markets from the developing world. Frontier markets are countries with investable stock markets that are less established than those in the emerging markets. They are also known as “pre-emerging markets”.

Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. Real Gross Domestic Product is an inflation-adjusted measure that reflects the value of all goods and services produced in a given year, expressed in base-year prices. Often referred to as “constant-price,” “inflation-corrected” GDP or “constant dollar GDP”. Real GDP can account for changes in the price level, and provide a more accurate figure.

HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of all eligible hedge fund strategies; including but not limited to convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merg-er arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.

High yield bonds are high paying bonds with a lower credit rating than invest-ment-grade corporate bonds, Treasury bonds and municipal bonds. Because of the higher risk of default, these bonds pay a higher yield than investment grade bonds. Based on the two main credit rating agencies, high-yield bonds carry a rating below ‘BBB’ from S&P, and below ‘Baa’ from Moody’s. Bonds with ratings at or above these levels are considered investment grade. Credit ratings can be as low as ‘D’ (currently in default), and most bonds with ‘C’ ratings or lower carry a high risk of default; to compensate for this risk, yields will typically be very high.

International Monetary Fund (IMF) is an international organization concerned with promoting international monetary cooperation and exchange rate stabili-ty, fostering economic growth, and providing temporary financial assistance to countries to help ease balance of payment problems.

Investment-grade (IG) is typically used in reference to fixed income securities that possess relatively high credit quality and have credit ratings in the upper ranges of those provided by credit rating services. Using Standard & Poor’s ratings as the benchmark, investment-grade securities are those rated from AAA at the highest end to BBB- at the lowest. To earn these ratings, securities, in the judgement of the rating agency, are projected to have relatively low default risk.

MSCI All Country World Index (ACWI) is a market capitalization weighted index designed to provide a broad measure of equity-market performance through-out the world. The MSCI ACWI is maintained by Morgan Stanley Capital In-ternational, and is comprised of stocks from both developed and emerging markets.

MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the U.S. and Canada.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

Municipal bonds are debt obligations issued by states, cities, counties, and other public entities that use the loans to fund public projects. The interest income from municipal bonds is generally exempt from federal taxes and may be exempt from state and local taxes. Municipal bonds are subject to a number of risks such as interest rate risk, call risk, inflation risk, credit and default risk, and tax risks.

Price-Earnings Ratio (P/E Ratio) is a valuation ratio of a company’s current share price compared to its per-share earnings.

Purchasing Managers Index (PMI) is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

The S&P 500 Index is a capitalization-weighted index of 500 stocks traded on the NYSE, AMEX and OTC exchanges, and is comprised of industrial, financial, transportation and utility companies.

Treasuries are debt obligations issued and backed by the full faith and credit of the U.S. government. Treasuries are subject to interest rate risk, call risk, and inflation risk. As Treasuries are backed by the full faith and credit of the federal government, they have low credit or default risk. As a result they generally offer lower yields relative to other bonds.

Treasury Inflation-Protected Securities (TIPS) are treasury securities that are indexed to inflation in order to protect investors from the negative effects of inflation. TIPS are considered an extremely low-risk investment since they are backed by the U.S. government and since their par value rises with inflation, as measured by the Consumer Price Index, while their interest rate remains fixed.

West Texas Intermediate (WTI) is light, sweet crude oil commonly referred to as “oil” in the Western world. WTI is the underlying commodity of the New York Mercantile Exchange’s oil futures contracts.

One cannot invest directly in an index.

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The discussions and information set forth in this newsletter are for informational purposes only. They do not take into account the exceptions and other considerations that may be relevant to particular situations. These discussions and information should not be construed or used as legal or tax advice, which has to be addressed to particular facts and circumstances involved in any given situation. To comply with the Internal Revenue Service and other applicable tax practice standards, any tax information and advice contained in this newsletter is not intended or written to be used, and may not be used, for purposes of avoiding tax penalties imposed under the United States Internal Revenue Code or for the purpose of promoting, marketing or recommending to another party any tax-related matters. The discussions and information contained in this newsletter should not be construed or used as a specific recommendation for the investment of assets of any customer of Bank of the West or its affiliates and is not intended as an offer, or a solicitation of an offer, to purchase or sell any security or financial instrument, nor does the information constitute advice or an expression of the Bank’s view as to whether a particular security or financial instrument is appropriate for you and meets your financial objectives. Economic and market forecasts reflect subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. Nothing in this newsletter should be interpreted to state or imply that past results are an indication of future performance. This information is given without regard to the specific investment objectives, financial situations, or particular needs of any person who may receive this newsletter. Investors should seek financial advice regarding the appropriateness of any securities or strategies recommended in this newsletter. Bank of the West does not guaranty the results obtained from use of any information contained in this newsletter and will not be liable for any investment decision based in whole or in part on the information contained in this newsletter. The opinions expressed in this newsletter are those of Bank of the West’s Global Investment Management Team, and neither Bank of the West or its affiliated entities shall be held liable for any content, regardless of cause, or the lack of timeliness of, any information contained in this newsletter. THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO THE ACCURACY, COMPLETENESS, OR RESULTS OBTAINED FROM ANY INFORMATION IN THIS NEWSLETTER OR FROM ANY ‘LINKED’ WEB-SITE.

Investing involves risk, including the possible loss of principal and fluctuation in value.

Among other risks, fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

Alternative investments contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors.

International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.

Diversification and asset allocation does not ensure a profit or guarantee against loss.

Index performance is shown for illustrative purposes only. You cannot invest directly in an index.

Important Information Regarding Bank of the West and its Affiliates

Bank of the West Wealth Management offers products and services through Bank of the West and its various affiliates and subsidiaries.

The discussions and information set forth in this newsletter are prepared by and are the views of the Global Investment Management Division of the Bank of the West Wealth Management Group.

Securities and variable annuities are offered through BancWest Investment Services, a registered broker/dealer, Member FINRA/SIPC, and SEC Registered Investment Adviser. These products are offered by Financial Advisors who are registered representatives of BancWest Investment Services.

BancWest Investment Services is a wholly owned subsidiary of Bank of the West. Bank of the West is a wholly owned subsidiary of BNP Paribas.

Bank of the West and its various affiliates and subsidiaries are not tax or legal advisors. Please consult your tax or legal advisor for more information regarding your personal situation.

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