Strategy note 2020: reality bites?
This time last year, financial markets expected the US fed funds rate to be approaching 3% by the end of 2019; the outcome has been a policy rate of 1.5% to 1.75%. US bond markets have responded positively, and the re-appraisal of policy rates was a key factor in driving markets in 2019 as risk assets have re-rated allowing global equity returns to reach 28%.
In many ways, market performance in 2019 was a reversal of 2018 with the US Federal Reserve (Fed) playing the key role in both years. The decision by the US central bank to end rate hikes and ease policy in early 2019, often referred to as the "Fed pivot", was critical. More widely, the Fed's move was bolstered by policy easing elsewhere such that we saw 56 central banks cut rates 129 times in 2019, according to data from CBRates. In addition, the European Central Bank (ECB) restarted quantitative easing (QE) as, debatably, did the Fed1.
Recession fears were present for much of the year as trade slumped
Central bank easing does not always lead to a re-rating of markets. Although lower rates create a strong incentive for investors to switch out of cash and search for yield in riskier assets, such a move also requires confidence in the outlook. If lower rates are associated with lower growth, then markets can simply de-rate as they anticipate weaker or falling corporate earnings.
For a while it looked like the US might suffer a similar fate in 2019; after an initial boost when the Fed signalled its change in policy, the equity market languished as global trade slumped and growth expectations dipped. During this period, the US Treasury yield curve inverted and there was widespread talk of recession.
Prospects for 2020
It was not until Q4 that the tide turned for equities: two factors changed which remain key to the outlook.
The first was the continued resilience of the US economy. Despite being the longest expansion on record in the US, consumer spending has shown little sign of flagging. Concerns that the slowdown in global trade would have a knock-on effect to the domestic economy have not materialised. Manufacturing, the sector most affected by the trade cycle, is important, but at 10% of US GDP does not have the weight to cause a recession in the economy as a whole. This can be seen in the continued growth in employment where the service sector has continued to hire. When combined with modest inflation and firming wages, the consumer remains well underpinned.
Indeed, household spending could be a source of upside surprise in 2020. Balance sheets are in good shape and the easing of monetary policy is supporting housing which has previously been a precursor of stronger consumption.
The second factor has been the easing in trade tensions between the US and China. The key reason behind our recent upgrade to global growth forecasts, the phase one deal has helped reduce the tail risks associated with an all-out trade dispute. The deal is expected to help trade stabilise and, by providing some clarity, enable firms to restart capex spending.
Our central outlook of steady growth, a continuation of easy monetary policy and an easing in the US-China trade tensions bode well for risk assets. We will not see such a generous boost to liquidity in 2020 as in 2019, nonetheless central banks are some way from raising rates and could ease if the nascent recovery was threatened. Inflation remains subdued so the Fed "put" can remain in play.
As always, there are many threats to the rosy scenario. Geopolitical events are one factor. The other would be corporate profits. Despite a better backdrop for global growth, the US profits outlook looks poor. We expect US corporate profits to decline in both 2020 and 2021 as margins come under pressure from rising wages.
Will 2020 be the year investors wake up to the reality of the profits outlook? There is certainly less scope for another liquidity-driven re-rating in equity markets. Some further easing is possible in the US and elsewhere such as the emerging markets, but the impulse would be smaller.
Another difference with last year is that markets already seem to be pricing in a bounce in growth. We noted last year that markets were priced for a slowdown. This year, global equities are anticipating a brisk recovery in indicators such as the purchasing managers index.
Overall, this would suggest a far more subdued year for equity markets with, at best, single digit gains and probably driven by factors such as M&A and returns to shareholders via asset sales and restructuring. It is also an environment where companies with good long run growth prospects beat cyclicals, thus continuing the outperformance of sectors such as technology and healthcare.
In short, investors will have to seek the themes which will deliver growth in a difficult environment. This, however, may be enough to keep equities grinding forward given the lack of any competition for funds from the bond markets.
1 The US central bank presented the move as a technical adjustment to smooth spikes in money markets although many saw it as a return to QE through the effect on the Fed's balance sheet.
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