BMO Multi-Manager People's perspective
Some thoughts for 2020
A look back on 2019 – a year when markets took the ‘glass half full view’ of the world
Despite a huge number of political distractions and a deteriorating economic backdrop, we can look back on 2019 as a year when almost all financial assets enjoyed a strong period of returns. The slowing pace of economic growth amidst an escalating US-China trade war did little to slow the progress of equity markets, while government bonds saw yields (which move inversely to bond prices) touch new record lows in the late summer as bond investors took a more negative view of the economic outlook. As the year entered the final quarter, a perceived easing in the pace of the global slowdown, additional central bank liquidity and more optimism over a resolution to the US-China trade war saw equities rally further with many indices reaching record highs, and bonds gently selling off.
Assisting the reassertion of risk appetite after the difficulties of 2018 was the shift in policy from the central banks, led by the US Federal Reserve (Fed). The backdrop to markets in 2019 has been one of loose central bank policy, something that was not seen as likely going into the year, with the Fed hiking rates in December 2018 and the European Central Bank bringing (ECB) an end to their €2.6 trillion QE program. 12 months later, was saw the Fed cutting rates three times, a total of 75 basis points of cuts, whilst the ECB cut interest rates and restarted QE to the tune of €20 billion a month with no end date. The Fed began to increase once again the size of their balance sheet and whilst this is not QE per-se, the liquidity impact on markets appears to have boosted returns in the past few months.
Hence two of the major central banks have seen a significant pivot in policy, which is a huge change from what most investors were expecting at the start of the year. There has been a shift from central banks globally to an easing bias, as the impact of a slowing global economy, elevated trade tensions and the continued absence of inflation weighed on policymaking. The proportion of central banks with an easing bias is now at the highest level since the 2008-09 global financial crisis. 2019 was certainly a year to remind investors that economics and equity markets often disconnect, with a very strong year of returns despite a global economic slowdown.
2019: a year as much about what didn’t happen as what did!
We have spent a huge amount of time in 2019 speaking, writing and thinking about both Brexit and the trade war, neither of which were resolved in the timeframe expected at the start of the year. Two Brexit deadlines came and went, though the 12 December general election finally gave us some clarity and the UK is now certain to leave the EU in early 2020. Markets have spent much of the year being strung along with US politicians talking of “constructive” trade talks with China but the reality is that tariffs have been ramped up over the course of the year, and only with the announcement of a ‘phase one’ deal in mid December did we finally see the détente in the trade war that markets had been anticipating for most of the year.
Possibly the biggest overhyped theme for 2019 and a theme we thought would be significant when we wrote our 2019 market outlooks was Quantitative Tightening (QT). We went into the year with the Fed busy reducing the size of their balance sheet, and the ECB calling time on QE. The year ends with the Fed rebuilding their balance sheet by around $60 billion a month, and the ECB restarting QE. In the space of 10 weeks towards the end of 2019, the Fed has already reversed 40% of the balance sheet reduction that took place over 2018 into 2019. 2019 may well have been the year that it became clear that the era of central bank intervention and support for the global economy (and financial markets as a by-product) is likely to be a very long one. The ‘failure’ of central banks to be able to reduce their balance sheets is as much a political one as anything else – certainly in Europe where the repeated calls for fiscal stimulus from the now ex-President of the ECB, Mario Draghi, were ignored by Europe’s leaders. We go into 2020 with no expectations of central banks paring back their balance sheets, indeed the opposite may well be the case for some time to come.
Is 2020 the year when the party ends, or have the central banks bought us some more time?
For a long part of 2019, the economic data was deteriorating to such an extent that many commentators were suggesting a recession seemed likely in 2020. Indeed, market indicators such as an inverted yield curve were pounced upon as signs this very long economic cycle was coming to an end. However, the shift in policy from the central banks may have bought us a little more time. This was certainly the view of equity markets, where the looser monetary policy backdrop boosted sentiment despite falling corporate earnings. The economic data does suggest the impact of the US-China trade war, along with the broader economic slowdown, has hit the manufacturing sector the hardest, with many developed market manufacturing sectors in contraction. The key question over the second half of 2019, and extending into 2020, is whether the services side of the economy, driven by the consumer, can keep overall economic growth in positive territory. For the moment, the data suggests this will be the case, but it would not take too much of an economic or political shock to send the growth outlook lower. The central banks, with their aggressive policy shifts in 2019 have certainly attempted to extend this cycle – help from the politicians on the fiscal side could also act as a further stimulus. We see the possibility of recession at around 25% in the second half of 2020.
A year where politics goes quiet? Not likely.
In the UK, we may finally be emerging from over three years of political gridlock, after three general elections in five years plus the Brexit referendum. With a new government installed that has a significant majority in parliament, the path to Brexit is now clear. The size of the majority gives the Prime Minister plenty of flexibility and ability to legislate on the next – and arguably more difficult – phase of Brexit. There is now certainty that Brexit will happen, but there should be less pressure on the government, as it is less reliant on the support of the ERG within the Tory party, which could give some flexibility on agreeing a trade deal with the EU27 by the end of 2020 – the point at which the transition period comes to an end, a date the government is firmly committed to. The economic consequences of the Prime Minister’s deal should now come back into focus – and we should remember this deal is in theory worse than that agreed by Theresa May given that at this stage there is no guarantee of frictionless trade post-Brexit. All the same, UK assets now have the certainty of what should be a more stable government and policy outlook – certainly more stable than the last three years, and the perceived risks of a profligate Labour government, intent of nationalising various industries, is off the table.
2020 is a year without a huge number of scheduled major elections globally, except of course the United States where President Trump will be seeking a second term in office. Trump is clearly a very divisive individual, but his presidency has been a positive one for US assets, despite all of the noise around the trade war and other issues. The market consensus remains that Trump will be re-elected but taking a view with any level of confidence before we even know who his Democrat opponent will be is a little hasty. The election campaign has the potential to weigh on US assets if the Democratic candidate is seen as (a) being significantly less market friendly, and (b) doing well in the opinion polls.
The usual list of geopolitical concerns will serve as a backdrop to market events, from the Middle East across Europe and Russia and North Korea to China, whose patience with the ongoing protests in Hong Kong may begin to wear thin. Most of these ‘tail risks’ tend to be ignored by markets until they cause a spike in volatility, often short lived and hard to predict. All the same, they serve to remind us that the global political backdrop is far from calm, and with populist politics driving protectionism and nationalism, persistent political uncertainties will always have the potential to disrupt sentiment at times.
Central banks – the ‘invisible hand’ that continues to calm markets
The path for central bank policy looks to be one of stable or lower rates unless we see a significant acceleration in economic activity in 2020. Even then, the hurdle for central banks, in developed countries at least, to begin hiking rates appears very high. For the moment, it does not appear that the global economy is on the brink of recession with the consensus being that we are set to see a mild pickup in the data in the first half of the year (a reminder here that we see the possibility of a global recession led by the US is around 25%). If this is incorrect, we may well see central banks further loosen policy to counter the economic headwinds, using policies such as QE and negative rates, with the possibility of fiscal stimulus as well.
Markets in 2019 were driven by the “bad news is good news” maxim – weaker economic data means looser central bank policy. In 2020, we may well see central banks’ resolve tested whichever way the economic data goes – an economic recovery will raise the spectre of inflation, and an end to the ultra-loose policy of recent months, conversely a deterioration in the data could well force the banks to take even more extreme policy measures to counter weakening economic trends. An old investment adage: “don’t fight the central banks” continues to ring true – the past decade has proved that a flood of liquidity from the central banks will float most, if not all boats – frustrating for fundamental investors but a problem that may not have completely gone away.
Stronger economics, weaker markets?
With improving optimism over the economic outlook, certainly for the first half of 2020, a better dialogue on the US-China trade war and some stability in UK politics, the backdrop for risk assets is substantially more benign than it has been for some time, though the longer-term concerns over mediocre economic growth and alarmingly high debt levels certainly temper our enthusiasm.
Recent months have seen more positive thinking about the economic outlook – it seems we need to see far worse corporate or economic data than that witnessed in 2019 for investors to start worrying. If the economic data continues to be sluggish but not awful, the market momentum could continue albeit with further rotation into cyclical stocks on the expectation that the economic data should stabilise and improve over the course of the year. A lot of the pain of recent years in terms of weaker growth has been self-inflicted – be it through policies such as trade conflicts or austerity; a reversal of these themes will serve as a tailwind for economic growth. Indeed, the consensus amongst analysts appears to be that global growth will reaccelerate though to a relatively low trend rate. We still harbour concerns that markets are pricing in a lot of good news at the moment even though there remains plenty of political risks out there to cause upset as well as a lot of assumptions being made about the path of economic growth.
2020 could well be a year of stronger economics but weaker markets. The strength of returns in 2019 were driven not only by central bank liquidity, but also an assumption that eventually there would be a positive outcome to ongoing headwinds from the trade war and Brexit uncertainty. With more clarity on these issues, there is the potential for further upside but arguably a lot of this good news is already priced in. 2019 was also a year without a significant market pullback – a year without a 10% correction at some stage is a rare occurrence – and if valuations are a guide, investors should be cautioned that future returns are likely to be lower than they have been in the past.
A longer-term issue is one of debt – since the Global Financial Crisis, we have seen 768 central bank rate cuts, $12.4 trillion in asset purchases and interest rates at historic lows, all of which has failed to translate into higher economic growth but has served to exacerbate wealth inequality and drive up corporate, household and government debt to unprecedented levels. Navigating any economic difficulties will not prove simple, nor will any pickup in economic growth as it could serve to reawaken concerns over inflation; bond markets are certainly not pricing in better economic news, and a sharp repricing of bonds would likely unsettle all financial assets.
Given elevated market valuations, a sluggish economic backdrop and concern over the corporate earnings outlook versus expectations, our view is that current market levels give little margin for error and we enter 2020 in a cautious frame of mind. In 2019, global growth slowed, and corporate earnings were at best flat (in the US) and elsewhere (Europe, Japan and emerging markets), down just over 10%. In this context, the strength of returns from risk assets in 2019 was even more impressive. Price/earnings ratios re-rated over the year, and now sit close to the 15-year highs seen at the end of 2017. The strong returns are not exclusive to equities; Greek government debt for example yielded almost 35% back in 2011; the same 10-year bonds yielded just under 1.5% at the end of 2019. We would observe that expectations for corporate earnings in 2020 imply a significant acceleration in global economic growth in 2020 to more like 5% – a level never achieved in the decade since the financial crisis. Therefore, we see considerable scope for disappointment, with a lot of good news already priced in, and what we see as over-optimistic assumptions being made for economic and earnings recoveries in 2020.
The pace of the slowdown in the latter months of 2019 may have eased, but having seen significant falls in corporate capital expenditure (i.e. investment) and industrial production globally, the world economy is increasingly reliant on consumers to be the engine of growth. We will therefore be watching employment and consumer related data very closely for signs of any cracks.
We remain happy to be very slightly underweight in equities for now, but with exposure to underlying fund managers who are telling us that despite all the noise, there are plenty of opportunities at the stock picking level. We are also underweight in fixed income – our concerns over bond market dislocations and liquidity are noted in this document and we are focusing on the most flexible, dynamic and liquid funds with managers that are well known to us for an ability to navigate choppy waters. Liquidity is also a concern in the property sector – this is an area where we have found plenty of ideas and are broadly neutral. However, we choose to invest in products where there is no mismatch between daily liquidity and illiquid underlying assets. Hence our exposure to closed-ended property funds or funds that are not marketed to retail investors. We continued to hold slightly above average cash positions, reflecting our caution on current market levels; some of our cash is held in gold as a hedge against number of risks crystallising, be it inflation, political risks or confidence concerns over the central banks. We have some exposure to absolute return funds, again as insurance against a market pullback and heightened volatility.
In terms of regions, it is worth bearing in mind we do not take particularly aggressive views – we believe we will generate more alpha by selecting the right fund managers for the market environment. Furthermore, attempting to second guess macroeconomic and political outcomes in a world of increasing social, economic, environmental and political uncertainty is unlikely to generate significant returns. All the same, we go into 2020 with a neutral exposure to the UK, with a bias towards small and mid-cap managers as well as value investors. Value investing has been a tough environment in the UK and beyond in recent years, but we do see and hear evidence of this style of investing finding more favour. We are slightly underweight in Europe given the pace of economic growth and the fact that European assets had such a strong run in 2019; we see more positive opportunities elsewhere, not least when we look east towards Asia and Japan. We continue to be overweight Japan, where we see continued domestic reforms and shareholder friendly policies along with continued central bank support as a positive backdrop for an equity market that is still relatively good value, and with a more positive earnings outlook than other markets despite tepid economic growth. We also are overweight Asia and emerging markets, where interest rates continue to fall and the growth outlook, assuming a stabilisation in global growth, looks reasonable. We do see risks from China’s economic evolution to a more consumer-led economy but believe the Chinese authorities will continue to take steps to smooth this transition and stimulate the economy to maintain growth around 6% – although we would caution on political factors not least the lingering democracy protests in Hong Kong. We are slightly underweight the US, believing that the outperformance of recent years may be drawing to a close given valuation levels and potential scope for disappointment on what look like very optimistic earnings expectations for 2020.
We enter 2020 with the potential for the market momentum to continue on a huge wave of central bank liquidity – this is not a wave you would want to try to ride given that at least $700 billion of central bank quantitative easing is expected in 2020. But our enthusiasm is tempered by the concerns we have over mediocre economic growth leaving corporate earnings well below expected levels as well as continued concerns over debt levels and bond markets that still appear to be mispriced. Above all, the starting valuations for most financial assets leave little room for error given these variables.
The economic data remains unclear – the slowdown in the middle of 2019 has eased and there are now expectations of a moderate pickup in the early months of 2020. We have not seen enough convincing data yet, but equally there is not enough data suggesting an imminent slide into recession either. We could just be set for a sluggish period of low growth. How that translates into market returns will be driven by how well companies can manage to deliver earnings growth, as well as by a less visible factor – the continued liquidity flows from what is now, once again, very loose monetary policy from the central banks.
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Anthony Willis takes a detailed look at the themes that could shape markets in 2020, including:
- Central bank actions are likely to be supportive for risk assets in 2020
- Consensus expectations for economic growth suggest a moderate pickup in 2020
- We remain concerned about the burden of debt as a longer-term theme
- Persistent uncertainty from the world of politics could disrupt sentiment
- A year of stronger economics, but weaker markets?
- Valuations of many risk assets leaves little room for error