2019 was an outstanding year for the stock market, with the S&P 500 Index rising 31.5%, its best performance since 2013. This was a pleasant contrast to a 4.4% loss in 2018. Since the end of 2009, the total return of the the S&P 500 (gains plus dividends) is 257%, or 13.6% per annum. On a price-only basis (no dividends), the index has risen a total of 190% or 11.2% per annum. Over the ten-year period, higher corporate earnings growth accounted for about 80% of the S&P 500’s price gains, while higher equity valuations (e.g., P/E ratios) were responsible for 20%. In 2019, higher valuations accounted for all of the gains as corporate earnings declined.

Higher equity valuations over the 2009-2019 decade were driven largely by declining interest rates, which in turn reflect the near absence of inflation during the same period. As reported inflation hovered persistently below the Fed’s target of 2%, the Fed felt comfortable pumping liquidity into the economy, believing that by pushing interest rates lower, it could stimulate economic growth and goose inflation a bit higher towards its target. While the Fed did manage to stimulate growth, it did little to push inflation higher. In many ways this created the perfect environment for equities: steady earnings growth and a low starting valuation that has moved higher as the Fed has engineered declining rates in the context of minimal inflation.

As we have written several times over the last 10 years, inflation has been kept down by the twin forces of globalization and technology (particularly digital technology). These forces are not going away, and in fact, digital technology is becoming increasingly pervasive throughout the economy, dramatically increasing efficiency and lowering costs in industry after industry. We do not see this trend abating.

The key question for 2020 and beyond is whether inflation can overcome the dampening effects of continuous technological innovation and demographics and at long last begin to accelerate, thereby forcing the Fed to withdraw liquidity and raise interest rates. This question is vastly more important, and certainly more fundamental, than the obvious noise about tariff wars, Brexit, Mid-East conflicts and probably even the U.S. election. While we do not forecast an inflation breakout, we do think there are several ways inflation could return. Potential drivers of inflation include:

1) Tight labor markets that lead to rising wages, causing businesses (that can) to raise prices.

2) Tariffs raising the prices for affected goods.

3) Acceleration of global economic growth sparking commodity inflation.

4) Persistent Mid-East turmoil leading to higher oil prices, although growing US supply provides a nice offset.

The reason the inflation question is so important from an investment perspective is that equity valuations are inversely correlated to interest rates. Therefore, as interest rates drop as they did from 2009-2019, P/E ratios rise. Conversely, when interest rates start to rise, P/E ratios are likely to fall. Interest rates, of course, are positively correlated with inflation. So if inflation begins to accelerate, interest rates would likely rise, which should cause P/E ratios to decline. In the absence of countervailing earnings growth, this would likely result in declining equity prices.