Why investors may need to dig a little deeper in 2020
As we move into a new decade, we don’t think it’s time to party like it’s 1999, but it’s not a time for pessimism either.
Certainly, all is still not rosy economically and we are seeing anaemic measures of industrial activity. However, the absence of inflation has allowed central banks to be much more pro-active than they would normally be and we are seeing signs of stabilisation in the money supply.
Against an uncertain economic backdrop investors sought out companies that offer steady and reliable growth.
For the year ahead, areas more sensitive to the economic cycle may return to favour as long as we see the economic data stabilising. The challenge on this front is two fold: firstly, US fiscal stimulus is waning and secondly, trade tensions between the US and China remain a key risk.
As a consequence, markets are likely to remain very dependent on liquidity. They have become reliant on the effects of quantitative easing (QE), the much-heralded policy that has seen central banks buy vast amounts of government bonds or other financial assets to inject liquidity into the economy.
One of its effects has been to keep bond yields suppressed and thus underpinned higher valuations of equities (shares). Despite the unwinding of QE, I believe the path of least resistance is for shares to move gradually higher.
Beginning with bonds
In 2019, the fall in bond yields improved the valuations of most other asset classes, so it is important to start with expectations for developed government bond yields.
On this front, my view is that any rise in bond yields (and thus any fall in prices) is likely to be contained by the absence of an emphatic economic recovery, low inflation and the institutional demand for yield as pension funds seek to de-risk. (This means they are reducing exposure to riskier assets such as equities in favour of more stable assets such as bonds that provide a yield).
This provides some support for equity valuations, although from here it is hard to see a further re-rating, whereby investors get more excited about equities and are willing to pay a higher price for them.
Low rates also lead to an unrelenting search for yield in corporate bond (credit) markets, which we expect to continue. But we would advocate a more selective approach within credit markets.
Mixed picture for earnings and equities
Which brings us on to corporate earnings (profits), where we think estimates for 2020 look high, particularly in the US. This is because the US is in the later stages of its economic cycle. The economic cycle is how an economy fluctuates between periods of expansion (growth) and contraction (recession). At this late stage of the cycle (the period that precedes recession), companies’ input costs such as materials and labour rise. We expect this to erode US companies’ profit margins, potentially leading to low, single-digit earnings growth.
Yet, earnings are depressed in Europe, Japan and China, providing the potential for more significant improvement in the rest of the world in 2020.
There has been a stabilisation in manufacturing surveys, which monitor changes in production levels from month to month. This bodes well for emerging market equities, which have lagged other markets this year. All in all, we are positive on international equities relative to US equities and, as we mentioned previously, we think equity markets’ most likely direction of travel is upwards.
The liquidity provided by the central banks, particularly the US Federal Reserve (Fed), has reduced the risk of recession but commercial bank landing remains subdued. A more pronounced economic recovery would require evidence of private liquidity growth.
The efforts of the Fed may serve to weaken the US dollar, which would be a positive for emerging markets in particular. But, for now, the US dollar remains supported by the fact US interest rates are higher than those in other major markets, so it could remain at expensive levels a while longer.
Fiscal policy (governments’ use of tax and spending measures) has been much-discussed among investors recently. Our view is that we expect a loosening of fiscal policy in the UK. But fiscal stimulus is waning in the US and the political will for significant fiscal easing in Germany seems to be absent.
Economically speaking, we expect to muddle through next year.
Politics remains the wildcard
In a world of rising inequality and a consequent increase in political extremism, politics continues to be the wildcard.
From a global perspective, developments in the US are particularly key. With the underlying tone of global trade growth being weak, a deterioration in trade relations between the US and China would be difficult to withstand from these starting valuations, and with the election looming, President Trump’s strategy is difficult to predict.
At the same time, US corporate profitability has been boosted by low tax rates, so developments in the Democrat camp also need to be monitored. Finally, for Europe, a no-deal Brexit really needs to be off the table because of the market uncertainty it could create. Meanwhile, in Asia, the situation in Hong Kong remains volatile.
Focus on relative value
After a strong 2019, we expect market returns to be more muted in 2020. Under the surface, however, there are opportunities.
2019 saw strong performance from the most expensive assets, be it defensive “quality” stocks or European bonds. This means that an anaemic economic environment is reflected in market valuations.
As data stabilises and the risk of recession is reduced by central bank action, a general theme across our investment teams is that we are seeking to exploit some of the extremes in valuations that this flight to perceived “safety” has created. This means focusing on areas of relative value, be it favouring US bonds over negative-yielding European bonds, international stocks over US equities or cyclical stocks over defensive stocks.
The overall market levels might look dull, but digging a little deeper we find pricing within markets is provocative for active fund managers like us.
- You can read and watch more from our 2020 outlooks series here
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