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The equity market turbulence in May and late summer seems like a distant memory. Time—and especially gains—heal all wounds. What stands out now about 2019 are the strong rally since early Oct. and well above-average year-to-date returns of most equity markets, with the U.S. leading the way.

A banner year for equities
2019 year-to-date index returns (not including dividends)
2019 year-to-date index returns (not including dividends) chart

Source - RBC Wealth Management, Bloomberg; data through 12/18/19; data in local currencies

We think three factors have contributed most to the S&P 500’s surge this year:

Fed rate cuts—just enough and at the right time: As recession and trade war risks were rising, the Federal Reserve delivered three 25 basis point rate cuts. This provided “insurance” for the economy, elongating the longest-ever economic expansion cycle, and thereby boosting the equity market. The old maxim “don’t fight the Fed” once again rang true in 2019.

Prospects for continued economic growth: The strength of the U.S. consumer is the key to this story, in our view. Unemployment is at a 50-year low, wages are rising nicely, and workers have flexibility to change jobs. All of this sets the table for higher U.S. consumer spending in 2020—in an economy that garners about 70 percent of its activity from household spending. The fact that we expect this to occur in the world’s largest economy is not something to overlook. U.S. consumer trends influence the global economy.

Decreasing U.S.-China trade tensions: The constructive signals sent by Washington and Beijing helped boost the market for the past two months, and the recent announcement of a “phase one” trade deal has been embraced by markets globally. While we think much of the positive news is largely priced into markets, the deal diminishes a meaningful trade headwind for 2020.

The market’s strong performance in 2019 came with almost nonexistent earnings growth and at a time when the S&P 500’s valuation was above average for much of the year.

The lack of earnings growth can be excused given S&P 500 profits expanded by a whopping 23 percent y/y in 2018, with corporate tax cuts representing about eight percentage points of the total. Such robust growth late in the expansion cycle is rare and set a high hurdle for this year.

Regarding the market’s above-average valuation, we think the low interest rate environment makes it more tolerable. Investors have historically been willing to “pay up” for every dollar of earnings when rates and inflation were low. The S&P 500 is now trading at 18.4x RBC Capital Markets’ 2020 earnings forecast of $174 per share versus a long-term average of 16.2x. While we’re still not overly bothered by the elevated valuation, we see less room for it to expand in 2020 and acknowledge the U.S. valuation is stretched vis-à-vis other developed markets.

RBC forecasts moderate U.S. earnings growth
S&P 500 annual EPS estimates
S&P 500 annual EPS estimates chart


RBC Capital Markets

*We think the 2021 consensus estimate of $197 is far too high, as is often the case when industry analysts forecast two years ahead. It should be taken with a grain of salt.

Source - RBC Wealth Management, RBC Capital Markets, Refinitiv I/B/E/S (consensus); data as of 12/18/19

Challenges for 2020

For the upcoming year, we have a bullish bias with new highs and moderate returns forecast for the S&P 500. Right alongside this is a heightened need for caution acknowledging that the late cycle carries particular challenges for both the economy and stock market. Our outlook has been well telegraphed in this full report and brief summary.

There are a few additional things to keep in mind as the new year approaches, especially regarding the U.S. equity market:

Put political angst and biases aside when it comes to investing: The media, both mainstream and alternative varieties on each end of the ideological spectrum, is quite adept at inflating the importance of U.S. presidential elections. While the person occupying the Oval Office certainly has great influence and can help or hinder the country’s economic progress and overall direction, many other factors also determine U.S. asset class returns. Financial market performance has greater linkages to the state of the business cycle, corporate earnings, and monetary policy than it does to actions that emanate from the White House and Capitol Hill. The Fed actually has a bigger influence on recessions and recoveries than the president, in our view. We advise investors not to allow the roar of 2020 election coverage to get in the way of sound portfolio management.

Trade tussles may yet again create volatility: With the U.S.-China phase one deal and NAFTA 2.0 (USMCA) almost completed, other trade and sanctions issues could jostle equity markets at times in 2020. The UK-EU trade agreement related to Brexit may be the toughest nut to crack. In this connection, trade tensions and uncertainties can impact regional growth, and thus, the global economy. There could be more strains in the U.S.-China trade and business relationships. There are also unresolved trade issues between the U.S. and EU related to automobiles and aircraft subsidies, and between the U.S. and Japan on automobiles. Last but not least is the hobbled state of the World Trade Organization’s appellate body. Trade battles have been a cornerstone of President Donald Trump’s agenda, and we’d be surprised if he reverts to a quiet posture heading into the November 2020 election.

Beware of complacency: The problem is that as the economic cycle wears on and the equity bull market persists, complacency tends to set in. We encourage investors to remain vigilant. The late stage of the business cycle often brings with it challenges for the economy and financial markets, especially equities, just when they’re least expected.

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