What Happens to Markets When Policy Drivers Pause?

It’s easy to underestimate how much public policy has played a role in the exceptional market gains of the past year—the S&P 500 is up more than 26% for the year to date and a major bond index is up 9%. Gains were strong for the last 10 years as well. Since March 2009, U.S. stocks have compounded at a 14% annual rate, twice the rate of the last century. U.S. bonds have returned more than 9% a year in that time, triple the historic pace. Accommodative Federal Reserve policy, the impact of tax reform and deregulation and an easing of trade tensions have all played a role.

One important facet of policy-driven markets is that, just as a rising tide tends to lift all boats, stock and bond prices can rise almost indiscriminately. In these conditions, passive index investing typically outperforms active management, which we’ve seen not just in 2019, but for most of the last 10 years.

In 2020, however, some of the key policy drivers of 2019 gains are unlikely to play a big role. That has profound implications for how to invest and suggests that active management will outperform passive. Consider these drivers:

• Federal Reserve stimulus: At its meeting last week, the Fed affirmed it is on hold and suggested it would take a major economic move for it to either raise or lower interest rates in 2020. Fed rate cuts were a big driver of stock and bond gains in 2019 and additional bond buying to shore up the overnight lending market added liquidity late in the year. In 2020, rates are likely to be stable and the excess liquidity removed.

• Fiscal policy: The impact of tax reform was already waning in 2019, but investors have held out hope that there could be more tax cuts or fiscal stimulus in 2020. Given the polarized election year environment and the potential for gridlock, I think additional fiscal stimulus is unlikely in the coming year.
  
  
• Trade levers: While a trade deal would serve to de-escalate tensions, the terms of the current proposed Phase One trade deal with China, as well as the proposed deal with Mexico and Canada do not seem likely to be economically meaningful in 2020 and their benefits have already largely been priced into markets. Once they are behind us, it’s hard to see upside from further trade policy gains in 2020.

Without the heavy hand of monetary, fiscal and trade policy lifting markets, investors will need to focus on the fundamentals of individual companies and sectors for returns. I expect actively-managed funds to outperform index funds and stock and bond markets to be range-bound, but more volatile. Investors should focus on high quality stocks and managing risk through diversification across regions and asset classes.