2019: The year when liquidity trumped growth
The year when liquidity trumped growth
Central bank support made 2019 a better year than it had any right to be – but while investors should be grateful, they shouldn’t be fooled. With valuations now ranging from “fair” to “demanding”, conditions are ripe for risk premia to reassert themselves, along with volatility.
The key theme for 2019 was the return of central banks (most notably the US Federal Reserve), which, in the absence of recession, pushed the litany of geopolitical concerns (tariffs, Hong Kong, Brexit, US presidential impeachment) into the background. It was, as a result, a much better year for investors across the board than it had any real right to be.
Lessons from 2019
There are some important lessons from the 2019 experience.
Firstly, that asset prices are systemically important and policy makers (especially central bankers) are not yet ready to withdraw or materially temper their support. Central banks won’t give in easily.
Secondly, that in the absence of recession, liquidity trumps growth –, and while the liquidity taps remain on, markets will be supported.
Thirdly, geopolitics only really matter when they impact real economic outcomes, and not always in the way people naively expect. The accelerating trade tensions between the US and China did hurt industrial production and trade (and continues to do so), but the fact that it relieved some pressure on a potentially overheating US economy and brought the Fed back to the table for another round of easing ultimately meant it had a net positive impact on markets. Markets do clearly climb the “wall of worry”.
The outlook for 2020
All this said, 2020 is unlikely to be a repeat of 2019.
Valuations across almost all asset classes and markets range from “fair” (say, in the case of Australian equities) to “demanding” (in the case of US equities). Sovereign bond yields have fallen markedly in key markets and across the yield curve, and credit spreads have also narrowed.
Our return forecasts, which are generally quite low across the board, reflect this. This compression in risk premium has been a direct reflection of central bank intervention to ensure interest rates and liquidity conditions remain supportive of economic growth and stability in markets.
While we do not expect a recession as a base case in 2020, we do expect volatility to pick up and, as a result, asset allocation will continue to reassert itself as an important driver of active returns. Geopolitics will feature heavily and, when set against optimistic asset pricing, this may test investor resolve. Capital preservation will need to be balanced against opportunistic buying opportunities.
Within equities, we prefer Australia, Japan and selected emerging markets. Australian equities are trading on reasonable valuation metrics and with high dividend yields still on offer will likely benefit from investors seeking income against a backdrop of record low official interest rates, deposit rates and investment rates. Japan has been an underperformer and is still trading at reasonable valuations. Emerging market equities, while still inherently riskier than their developed market counterparts, offer reasonable valuations and potential outperformance should the US dollar weaken.
Notwithstanding low yields, we continue to believe sovereign bonds (and duration) will be effective hedges against recession and would encourage investors to continue to hold sovereign bonds for this purpose, even though yields are very low and the rewards in a steady state environment are likely to be modest. Investors should also consider their overall asset allocation in this low interest rate environment.
We think investors should be grateful, but not fooled by the strong outcomes across the board in 2019. Historically some of the best years for investors are very late in the investment cycle (1999, for example). We would encourage investors to remember the much more challenging environment of 2018. The bull market didn’t end in 2018, but investors did start to price in uncertainty and demand a premium for taking risk in their portfolios. This may provide a better roadmap for the year ahead.
December saw global equities rally over 3.5% for the month and almost 9% for the quarter. This helped push 2019 to a very solid return of over 27%. Abundant central bank liquidity, the phase one US–China trade deal and the decisive UK election win helped boost sentiment. Australian equites had the weakest returns over the month and quarter, at -2.2% and 0.68% respectively, as overseas investors took profit into year end. US equities posted strong results with over 3% for the month and almost 9% for the quarter in USD terms. Emerging markets outperformed over both periods, delivering 7.5% and 11.8% respectively in USD terms.
We remain dynamic within our equity allocation, adding 5% back to our exposure in early November, bringing the overall weight to 25%. While we remain cautious as valuations remain problematic, two major geopolitical risks have improved on the margin and markets are awash with central bank liquidity, providing an opportunity to add back to risk.
Within equities, our preferred markets are Australia and Japan, based on expected returns and relative valuation support. Given the improvement in trade and a potentially weakening USD, we have also increased our allocation to emerging markets. We continue to prefer value over growth.
The improving economic outlook has seen manufacturing PMIs bottom and the global index move above 50. That has seen sovereign bonds sold off as yields have started to steepen. US 10-year yields widened 14bps over the month and 25bps over the quarter, losing 0.68% and 1.45% in value. Australian yields rose 35bps over the month and quarter, causing the current 10-year bond to lose more than 3% over both periods.
In December we reduced our duration by 0.25 years, bringing our overall portfolio duration to around 1.75 years. While we remain attracted to duration for its return potential if and when downside risks to growth unfold, we believe yields could back up further from here as manufacturing and global trade improve over the short-term.
Within credit, US investment grade spreads tightened 10bps over the month of December and 20bps over the quarter, delivering price gains of more than 1% for the quarter. Australian investment grade spreads remained flat over the period, delivering losses overall. Emerging market assets were the best performers for the month and quarter across corporate, hard currency sovereign and local currency bonds. This saw our allocation to Asian credit add almost 2% over the quarter, but while emerging market sovereign bonds returned more than 3% in USD terms over the quarter, this gain was offset by the strength of the AUD.
Over the quarter we added to credit. In November, stretched valuations led us to reduce exposure to our Australian higher yielding credit pool in favour of RMBS and commercial mortgage loans. We also added to global high yield and Asian corporate credit. While credit remains expensive overall, spread compression can continue given ample liquidity. However, we continue to search for relative value within the asset class.
The risk-on mood and US-China Phase One trade deal saw the AUD gain around 4% for the month and quarter, relative to the USD. The trade weighted USD (DXY) fell over 3% over the quarter, predominately from gains in EUR and especially GBP. GBP rallied almost 8% against the USD this quarter and almost 4% against the AUD. We added an extra 1.5% to GBP in October but reduced this by 1% in December after strong performance following the UK election results. We continue to believe that the GBP remains attractively valued, but there still remains a great deal of uncertainty about Brexit and hard Brexit remains a potential scenario, so took some profit in the interim.
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