Q4 Review & Outlook for 2020

Global equities ended the quarter at multi-year highs following a strong performance in December. The rally in Q4 was broad based with most asset classes contributing to the upside move; Emerging Markets (EM) outperforming Developed Markets (DM), the dollar weakening and bond yields rising. Investor sentiment and positioning have turned sharply higher and bullish into the year end and the market rapidly adjusted to the US- China Phase 1 deal and the large Conservative election majority in conjunction with major central banks back in accommodative mode.

Key headlines that aided market momentum in Q4

  • Financial Conditions improving and Fiscal Policy moving into expansionary territory
  • Trade disputes easing
  • Market friendly UK election outcome and Brexit uncertainty diminishing
  • Global labour market resilience

Driven by expectations of easing uncertainty and improving macro, equities outperformed most of the other asset classes in 2019, by a healthy margin. It’s not been a constant and steady rise as concerns on Brexit, UK Election, Trade Wars and the health of the global economic cycle resulted in bouts of volatility. However, poor macro data has been shrugged off as supportive governmental action and ultra-low policy led to a flood of liquidity which boosted global asset prices. Heavy price action on market down days led to aggressive buying and the market recovery was acute.

Fixed Income

The significant change in macro policy rate outlook, more QE and dovish Central Banks skewed fixed income yields leading to investors looking towards both duration and credit risk more closely. With the move in yields it led to the search for positive asset return in equities and alternatives. Gilts have followed the drop in global yields but will be dictated by the Brexit outlook now the election is out the way and UK credit markets continue to trade within a small range.

During the last cut, (Fed Chairman) Jerome Powell stressed that the cut was an “insurance cut” and a “mid-cycle adjustment”. If the Fed eases aggressively or, conversely, delivers fewer rate cuts than anticipated, the Treasury yield curve should still steepen: either front end rates will fall faster than the long end or the long end will sell off more than the front end – this is the quandary facing the fixed income market –  investors seeking returns over the long term may be tempted to move further down the risk scale (Investment Grade to High Yield to equities).

In Europe yields remain in negative territory and have continued in a downtrend for most of the year and with new QE measures from the ECB, questions remain over the rationale for holding a negative yielding asset.

Source Exane

The market takes another view – as there remains a significant cash allocation still invested at negative rates suggesting that this could shift to higher return alternatives (as nearly $16trn of bonds offering negative yields) if we get more positive visibility on macro developments.

Europe’s economy has borne the brunt of macro tensions through 2019 and in Q4 concerns focussed on tariffs and the outlook for the auto industry and the correlation with EM weakness that’s been holding the European Market back. Positive trade news prompted the Dax to perform strongly into the year end – beating other major benchmarks. The German market is inherently highly leveraged to global trade, with Autos being a major component therefore pre-trade narrative led to continual underperformance given the looming threat of tariffs on European cars into the US and the US into China. Recent data suggests that Q3 GDP could signal a bottom with manufacturing PMIs and ZEW surveys having turned into positive territory (both acting as leading indicators of economic sentiment). In addition, recent stimulus from the ECB should also act as a supportive backstop in case the recovery does not materialise – in effect acting as a buffer to downside risk. European cyclical sectors are particularly sensitive to any fiscal easing, having outperformed defensives by 12.5% during periods of fiscal expansion.

The Eurozone has underperformed significantly vs the US – it remains under-owned and continues to trade at a discount to other markets. Investors often view the Dax as a proxy for world trade with over 30% of the index constituents in the chemical and auto sector (highly cyclical), little weighting in tech, thus the huge rally in the technology sector left the Dax behind (relative to other indices).  Moving into 2020 further monetary stimulus, bottoming out in PMIs, rotation into Value and fading political risks could help narrow the valuation discount. We expect the nascent rotation towards Value to carry on into 2020, as the valuation dispersion with Growth remains extreme while bond yields and activity are stabilising. Opportunities exist outside the over-owned narrow band of quality names and crowded technology growth trades which look to be vulnerable given positioning and valuation.

 During Q4 US indices achieved several new record highs as investor sentiment turned more positive, bolstered by receding headwinds such as revisions of US earnings and macro/trade pressures. The accommodative change in rhetoric from central banks certainly aided the rally as liquidity had previously been a concern however, the recent announcement to add $500bn into the repo market added to positive sentiment and the Fed’s balance sheet will now be greater than what is was during the Financial crisis in 2008.

A major catalyst for further upside momentum would be a comprehensive and finalised trade deal. However, we would also be cautious about chasing any rally following a potential Phase One deal between the US and China. After all, such an agreement may not reduce currently imposed tariffs or eliminate future friction between the two countries. Many of the other thorny issues remain beyond the pure trade perspective, including tech transfer restrictions and possible restrictions on US capital to China.

US (and indeed Global) markets will also have to contend with the election and how closely contested it will be (recent polls suggest that it will be a very close contest between the Democrats and Republicans). Historically, the S&P 500 has struggled in years when there has been a switch in the party of the president as policy changes are hard to quantify. We note that market would likely perceive a victory of Democratic candidates Bernie Sanders or Elizabeth Warren as the biggest downside risk given these candidates are focused on dismantling a number of the structural pillars that have supported US equities over the past decade. These include breaking up the major tech companies, reducing companies’ abilities to repurchase shares and potentially reversing the Trump administration’s tax reform. The market may want to know who the Democratic nominee is likely to be first and that will have to wait until at least Super Tuesday’s primaries in early March until we find out.

 Positive news on tariffs gave the market some comfort into the year end as we await to see the effect of stimulus and easing of trade narrative. Given that this is seen now as more of a political play, with continual commentary regarding a deal it is the interest of both the US and China to announce a meaningful resolution.  Trump would not want to risk a further downturn in US manufacturing going into an election year, while China would welcome an opportunity to support its slowing economy. The rhetoric has been mostly upbeat, with China inviting US negotiators for another round of talks and President Trump repeatedly stating that a ‘Phase 1’ deal is very close to being signed and that it might be the first in several phases of trade agreements. There are some key microeconomic adjustments taking place. For example, in the Financial sector, new regulations regarding structured deposits should help to lower deposit rates for regular banks, which should support their Net Interest Margins (NIMs) and earnings growth. We are also seeing signs of stabilisation in China’s auto industry leading to economists forecasting Chinese GDP at 6.2% for this year and 5.8% for 2020. Overall supportive measures are being put in place that should allow some domestic pressures to ease.

The MSCI Japan posted gains of +18% for 2019; it was among the best-performing markets in Asia over the past quarter thanks in part to the easing in trade tensions between the US and China as well as Japan’s own agreement for a new trade-deal with the US, which was a relief for investors who thought Japan may be exposed to US auto tariffs.

On an absolute vs. benchmark basis, the weighting of global funds in Japanese equities is the lowest of any major region globally. Additionally, valuations look extremely inexpensive as they have de-rated sharply. On a PE basis, the market is approaching the lows of the Global Financial Crisis, and on a several other key valuations metrics such as ROE (Return on Equity), the market is one of the attractive equity markets. This means that we could see a meaningful rotation into Japanese equities if we see the trade backdrop improve and global economic growth accelerate.

Japan benefits from its inexpensive valuations, bearish investor sentiment and the relentless ETF purchases by the Bank of Japan (BoJ). We expect that the BoJ will continue its ETF purchases in 2020, which should provide a key source of downside protection in periods of heightened volatility.

 Pre-election the UK market continued to underperform global peers hindered by concerns over the implications of a Labour government. Investor positioning was light, and outflows continued for most of this year (led more by the domestic orientated FTSE 250 whereas the 100 continued to see inflows). When the polls were initially released and showed a Tory majority win the positive reaction was evident with a near 2.7% rally in GBP. The aggressive rally in UK assets with some housebuilders and banks notching +20% gains illustrated how relieved and under-owned the UK market was. The follow on from the initial euphoria was a sustained and significant inflow of money back into UK domestic names and the spike in sterling also lifted both the sterling sensitive FTSE 100 and the domestically focused FTSE 250. With the Conservatives victory and a change in the Labour leadership some tail risks have been removed but as we write there is a lack of clarity at the end of the transition period in December 2020. The withdrawal agreement is expected to pass early next year but with a lack of any fiscal stimulus in H1 2020 the UK is at risk of subdued investment growth and continued reliance on consumption. Debate centres on the short and medium-term trajectory off GBP with hints of a possible rate cut causing the GBP/USD rate to retract.

More importantly the FTSE 250 derives circa 50% of its revenues from the UK domestic market compared to 23% of the 100 & 37% of the 350 hence the rationale for its short-term post-election outperformance. In this scenario, from a GBP move perspective only, housing, banks, utilities, retail and real estate should be the main movers whereas conversely commodities, healthcare and staples have been the relative laggards. At a market level, excluding purely GBP volatility, the majority Conservative mandate is set to focus on fiscal spending targeting healthcare, infrastructure and home affairs – these sectors should have the necessary catalyst(s) to re-rate as the end to austerity commitment materialises. Now with one key tail risk (election) removing some uncertainty global allocation back into the UK market should start to take shape. The enhanced political visibility also increases the chances of further M&A activity (we remain aware that private equity has $2.5trn sitting in cash looking for deployment).

Source Barclays

It should be noted that short interest in the UK domestic sector and GBP remained high for most of 2019 and as it reverses will also involve some forced buying.

Asset Allocation

If the anticipated earnings recovery can materialise in the next set of corporate updates then equities, relative to bonds, continue to represent compelling value and the improved fundamentals could prompt the next leg of another meaningful rally. Signs of easing trade tensions and China’s cabinet-approved plans to cut import tariffs for all trading partners on more than 850 types of products is the latest step toward a so-called phase-one trade deal with Washington.

Equities have delivered strong returns YTD across many major markets. 2019 has resulted in new highs for multiple asset classes helped by dovish Central Banks, even in the midst of trade tensions and hints of slower economic growth the US has made all-time highs. Despite the political challenges, we still believe selective equities have scope to move higher, albeit modestly. Improving growth prospects, limited recession risks and accommodative monetary policy should arguably provide a base for equities. Record-low bond yields and a stockpile of USD11.5trn of negative yielding debt is likely to ensure that the narrative of “there is no alternative” (TINA) continues to encourage investors into the equity market despite high valuations and concerns over the duration of this bull market.

The return of dovish Central banks switching from tightening to easing mode has eased credit conditions and thus the return of easy money should help activity rebound in 2020. Cheap funding costs remains a key support to the economy and corporate sector – earnings had slowed but the forced stimulus should turn earnings momentum positive. Support has come from central banks globally with over 40% now resuming monetary loosening, a move that had historically proceeded an improvement in the economy. However, with interest rates at record low levels, there is increasing debate about the diminishing impact of monetary policy. Instead, there is a growing chorus of support for monetary easing to be delivered alongside fiscal stimulus. A large global fiscal stimulus package – led by the G20 – could be a strong antidote to slowing activity.

Much has been debated on the rotation from Value to Growth and we acknowledge that growth has outperformed value over the last 10 years due to superior earnings and falling bond yields. Since the start of September, European Cyclicals are outperforming Defensives by 11%, while Value is outperforming Growth by over 5%. In the US, the outperformance is 4% and 2%, respectively. Value stocks have led the market upside since late August. Sector ETF flows turned in favour of Cyclicals, Value and Financials last month, while Defensives and Growth plays had outflows. Amid reducing trade and Brexit tail-risks, further stabilisation in PMIs and bond yields could prompt investors to trim their duration exposure and add back to Value. Despite the recent rotation, mutual funds’ exposure remains heavily skewed towards low-volatility equities, and the valuation dispersion between Growth and Value is still near extreme levels. The current bull market has been a pure driver for growth/ quality / low volatility equities (which would most likely be the laggards in a downturn).

The Fed’s expansion of its balance sheet alongside ‘un-coordinated’ fiscal easing is set to keep US real interest rates negative and global growth cushioned. The ECB have reactivated their €20bn of monthly bond purchases which started in November. China and India have both eased fiscally in the past six months.  Japan’s announcement of a further fiscal spending package worth ¥26trn (US$239bn) to help the economy recover from natural disasters and to prepare for an economic downturn caused by trade friction. Greater clarity on China and Brexit would not only provide an impetus for valuation expansion but could also provide an important tailwind to the capex cycle. Corporate investment has remained sluggish as a result of the sustained uncertainty and falling corporate confidence.

Our thesis for a more supportive economic outlook into 2020 is based on a recovery in global trade and manufacturing which in turn should give a boost to trade dependent economies and regions such as Japan and Europe. Emerging markets given they are indirect / direct beneficiaries of global manufacturing and trade should also see some bottoming out. EM economic activity will also benefit from recoveries in economies (such as Argentina, Brazil, Hong Kong, Mexico, Turkey and South Africa) where we anticipate country-specific factors to promote recovery from recessions or very sluggish growth in 2019.

Key drivers for further upside in equities

  • Return of reflation – similar to ’16-’17
  • Long-only investor positioning is still light and the ‘Fear of Missing Out’ should support steady equity inflows
  • Equity valuations are not cheap in absolute terms, but still attractive compared to expensive bonds
  • Key consumer and employment data are resilient in US and Europe, manufacturing destocking is well advanced and Chinese dataflow keeps improving
  • Financial conditions are supportive, courtesy of the dovish central banks
  • Earnings delivery above consensus projections
  • Equities deliver mid- to high-teen returns
  • Growth downtrend stabilises
  • Trade war sees a ceasefire

Key downside risks 

  • Slowing economic cycle in China
  • US recession (Fed has eased, but without HY spreads or jobless claims spiking, both of which typically deteriorate into a recession and according to the New York Fed, the probability of a recession happening in the US over the next 12 months stands at 29% currently, which is down marginally from the recent 10-year high)
  • Outcome of 2020 US election
  • Hong Kong Protests
  • Late cycle dynamics
  • Trump impeachment
  • Details of the UK exit from Europe

Global growth should recover from the downtrend of the past seven quarters as the reduction in trade tensions and easing of monetary policy filter through. Easing trade tensions (the key factor in the global downturn) will reduce business uncertainty and make policy stimulus more effective. An environment of reduced uncertainty and lower rates coupled with moderate wage growth should support consumer spending and sustain the recovery.

All these factors dominate the market as investors (ourselves included), seek to incorporate downside risks in asset allocation. Negative headlines and/or data points result in extreme selling pressure which can cloud the investment horizon, recently these have receded, but we are alert to the fact that this may not follow the same pattern during Q1, so we remain vigilant.

We recognise the benefits of a diversified portfolio in mitigating risk and enhancing returns while reducing volatility and ultimately helping to achieve investment goals. Diversifying across different asset classes, industries and geographies can reduce the amount of corelated investments and this can help protect against market declines. Given the fluid nature of the current macroeconomic environment we incorporate exposure to names that continue to exhibit quality and resilience in the midst of uncertainty. This enables us to retain a focus on longer term trends that will allow us to take advantage of structural growth themes whilst filtering out and avoiding making decisions based on snap data points and policy maker headlines. We can be reactive when the market is volatile by applying tactical asset allocation where mispricing occurs by having a sound understanding of what the short-term drivers are.

Ultimately, we acknowledge that whilst returns are unpredictable, risk is manageable, and it is not inherently bad – we understand that volatility is often a necessary trait of companies investing for the future in the pursuit of growth and therefore instead we focus on ensuring that any risk being taken is intentional.