Outlook 2020: Multi-manager
- Investors are overweight assets that benefit from bad news.
- We expect value-conscious active investors to beat passive investors.
- Past performance might serve best today as a contrary indicator.
After a weak 2018, it has been a jackpot 2019 for financial assets, particularly in the US.
Earnings growth for the S&P 500 has essentially flat-lined since the end of 2018. The wave of share buybacks has helped to offset the impact that slowing global growth has had on companies’ earnings per-share (EPS). But at the same time stocks have been boosted by a collapse in bond yields.
How bonds have driven shares
By way of illustration, between October 2018 and September of this year, the US 10-year Treasury yield more than halved from a high of 3.25% to 1.5%. This has had a powerful impact on equity valuations, as bond yields are a component of the discount rate used to determine the present value of future earnings.
Just like a bond, the category of stocks most sensitive to falling yields are those with the longest duration profile. Today, this style group is most commonly labelled ‘quality growth’.
The quantitative investment team at French bank Societe Generale recently published research highlighting quite how sensitive equity styles have become to ‘bond beta’ (i.e. the broad performance of the bond market). Essentially, for every basis point move in bond yields today, there is a corresponding 17 basis point move between the value and growth styles. That is, if yields fall, quality outperforms value by 17 basis points; if yields rise, value outperforms quality by the same amount. A decade ago, the equivalent move was closer to two basis points.
More than ever, past performance is no guide to future returns
As much of the past decade can be defined by central banks suppressing volatility by pegging long-term interest rates at unnaturally low levels, quality growth and other low-volatility style groups now boast crushing 10-year track records. Terrific returns and super-low volatility. Seriously, what’s not to like? Naturally, past performance continues to lure investors towards these richly-priced bonds and low-volatility stocks. Indeed, it has contributed to the huge concentration of capital we observe today in passively managed index funds. This is an investment approach that risks affording only minor consideration to fundamentals and price.
In our view, the low volatility assets that have been the primary beneficiaries of this trend in yields and index funds are ironically the riskiest segment of equity markets today. That doesn’t guarantee that they’ll be a disaster tomorrow, but much like the nifty-fifty era of the 1970s, they are now priced to deliver long-term disappointment.
How low can bond yields go?
Could the de-rating of this area of the equity market be a 2020 story? Perhaps. The main macro argument for owning these equities at today’s prices is to speculate on an economic downturn driving already depressed bond yields even lower.
We see two potential problems with this bet over the next 12 months:
- It might not happen. Central banks have cut rates and re-started quantitative easing, which should provide a degree of stimulus to the economy with a lag.
- Even if recession hits, we expect investors will swiftly begin to expect an extreme monetary policy response, such as modern monetary theory (MMT), which essentially binds fiscal and monetary policy. Such a response would likely move the dial on inflation expectations and thus be a headwind for bonds.
In both circumstances, low volatility assets would be highly vulnerable relative to value stocks. The latter have de-rated substantially in the last two years as global growth has slowed and bond yields have fallen.
For the avoidance of doubt, our portfolios today are light on bonds and quality growth stocks. Rather, they are biased towards value stocks and gold. Both have been out of favour for a number of years, but look increasingly attractive as we project forward.
Going for gold
Gold is an asset that has both demand and supply-related attractions. One string of the demand argument concerns fiscal policy and the prospect of further monetisation of government deficits globally. Debt monetisation is essentially when new money is printed in order to fund a nation’s spending.
Indeed, we appear to be moving seamlessly to an environment where central banks the world over print money so governments can spend what they don’t have.
Since Trump was elected in 2016, the US budget deficit has increased by 68%. Entitlements (social security, Medicare, Medicaid), defence and interest expense alone accounts for 112% of federal tax receipts.
The combination of increased borrowing to fund higher spending and lower demand for Treasuries from foreign central banks is the primary reason why the Federal Reserve (Fed) has recently been essentially forced to begin monetising $60 billion of T-bills per month. Supply is overwhelming organic demand. In the last nine weeks, the Fed has already undone 10 months of quantitative tightening in the process.
With US stocks at all-time highs, core and median CPI at 10-year highs and the unemployment rate at 50-year lows, it’s certainly an interesting time for the Fed to begin re-expanding its balance sheet.
With this backdrop, we think inflation expectations have the potential to build as we move into an election year, with both parties no doubt seeking to trump one another in terms of fiscal wildness (forgive the pun). This too plays to our positioning.
There’s a discernible pattern of alternation between stocks and gold at the present time. One moves while the other pauses. It then switches. Both have been making progress though. We would merely point out that only one has been in a bull market for ten years, underpinned by disinflation and falling yields, while the other (gold) has a far brighter future should inflation expectations begin rising.
We see this beginning to unfold over the course of the coming year, alongside near-term stabilisation and gradual improvement in economic data. Under such circumstances, the trillions of dollars of negative yielding debt in the world looks very exposed. Within equities, although we remain late-cycle, it indicates a reasonable backdrop for the rotation of recent months out of quality and into value continuing, at least for a while.
Please check back over the coming two weeks for outlooks focused on a variety of asset types and regions.
- You can read and watch more from our 2020 outlooks series here
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