- Macro: We expect a late-cycle relief rally in 2020 as industrial production rebounds and recession risks recede.
- Fixed income: With global growth likely to revive and central banks on course to keep short-term interest rates low, yield curves should steepen.
- Currencies: The US dollar may correct from the position of strength it has sustained for several years, relieving pressure on emerging market currencies.
- Emerging markets: Despite the headline noise, most emerging markets will continue to consolidate the macroeconomic stability gains they have made over the last few years.
- Equities: As macro uncertainty moderates, trends in equity markets could reverse, with investors shifting back towards cyclical stocks.
- Equity portfolio strategy: Divergent valuations between expensive US stocks and relatively cheap Asian stocks are offering an opportunity to build strategic equity exposure to Asia.
- Alternatives: Gold could be a valuable diversifier next year, as bonds are likely to offer poor defensive properties.
This is still not normal. Eleven years into the recovery and the US Federal Reserve (Fed) has not yet managed to ‘normalise’ policy. To sustain a flagging US economy, it has shelved attempts to raise interest rates to its estimate of neutral and shrink a balance sheet inflated by quantitative easing. Meanwhile, European and Japanese interest rates remain negative. In all, some 25% of government and corporate debt worldwide offers sub-zero nominal yields.
11 years into a growth cycle financial market conditions remain abnormal
UK Bank Rate
Source: Investec Asset Management, Bank of England, Bloomberg, November 2019.
Note: UK Bank Rate, Minimum Lending Rate, Repo Rate and Official Bank Rate are interest rates.
Central banks are understandably concerned about the global economic outlook. Having held up in 2018, the US economy capitulated in 2019 to the broad trend of slowing growth, leading to a dramatic flattening of yield curves and heightened recession fears.
However, the global consumer remains resilient, offsetting weakness in the manufacturing sector. This should pave the way for a rebound in industrial production as the global inventory cycle swings back into positive territory, causing recession risks to recede. In part, robust consumption reflects a lagged response to the (increasingly synchronised) looser monetary and fiscal conditions introduced to counter economic weakness, the supportive impact of which should grow steadily over 2020.
It is noteworthy that developing economies have not followed the normal pattern of raising rates in response to slowing growth and interest rate cuts in the developed world, in contrast to similar episodes in the past. In general, they have been able to cut interest rates and implement pro-growth policies.
Reduced tail risks
One positive consequence of the clouded macro backdrop is that it has helped to reduce the chances of being stung by the tail risks that have dominated headlines for months, including the potential for a very damaging outcome from the US-China trade dispute and a ‘hard’ Brexit.
The weakening US economy — combined with the upcoming presidential election — is fast eroding Donald Trump’s negotiating position with China, making a trade truce increasingly desirable. On the other side of the table, China will welcome a respite from tariff-induced economic weakness as it continues to transition to a domestically-led growth model. Beijing also needs time to address the Chinese banking sector’s foreign liabilities, which have been considerably understated. Similarly, weak growth in the UK and Europe is pushing both sides towards a Brexit resolution, lowering the risk of a ‘no-deal’ UK exit from the European Union.
Other tail risks – ‘unknown unknowns’, in the words of former US Secretary of Defence Donald Rumsfeld – may surface. But at present, the leading actors in 2019’s major dramas are strongly incentivised to play nicer.
Recession and trade concerns set to reduce
Source: Investec Asset Management, NFIB Bloomberg, September 2019.
Race for the White House
A ‘known unknown’ in 2020 is the US presidential race, which may lead to greater-than-usual domestic US policy uncertainty next year. At the time of writing, a Trump vs. Warren contest looks the most likely pairing for the main event. A win for the Democratic candidate would usher in a significant shift away from pro-business Trumpian Republicanism and towards a redistributionist, environmentally friendly, anti-big business stance.
Odds for winning the 2020 presidential elections
Source: Investec Asset Management, Predictit, 30 October 2019.
US-China dispute: accelerating China’s transition
Although China’s growth has slowed, it is now at a more sustainable level and capital productivity continues to improve.
If anything, the Trump administration’s attempt to check China’s rise and reset the relationship between the world’s two largest economies is having the opposite effect. US pressure is playing into the hands of Beijing’s reformers, who are accelerating plans to open China’s capital markets and introduce stronger intellectual property protections, among other initiatives.
In the key battleground of technology, US moves against China are fuelling a drive for greater technological self-reliance. China is already less of a ‘copycat’ than US trade negotiators seem to realise, and the country leads the world in a growing number of high-tech sectors. Meanwhile, the digital integration of China’s unsung rural economy is proceeding apace, raising the incomes and spending power of the country’s approximately 560 million rural inhabitants.
Consumption growth now consistently exceeding investment growth
Source: CEIC, Morgan Stanley Research, Investec Asset Management as at October 2019.
A green re-boot for Europe?
Weak Chinese demand has hit Europe’s export sector hard, but the growth picture for the European Union should brighten in 2020 in absolute and relative terms, albeit from a low base.
A belated realisation of the risks and limitations of relying too heavily on monetary policy to underpin growth — coupled with a changing of the guard at the European Commission (incoming: Ursula von der Leyen) and at the European Central Bank (Christine Lagarde) and growing acceptance that Brexit is inexorable — is likely to result in a relaxation of fiscal constraints and the adoption of a pan-eurozone industrial policy centred around accelerating the region’s energy transition to renewables. That should spur the European economy, at least temporarily.
Longer term, high debt and unfavourable demographics remain big challenges for the EU. The lesson from Japan’s lost decade (and more) is that a comprehensive plan is needed to mitigate these headwinds, one that co-ordinates monetary and fiscal policy and addresses structural weaknesses.
A green industrial policy and an end to austerity
Source: European Commission, Investec Asset Management as at October 2019.
Bond markets: yield curves on the up
With global growth likely to revive and central banks on course to keep short-term interest rates low, yield curves look set to steepen once more.
The Fed’s policy volte-face in 2019 shows that inflation targeting, the lodestar of central-bank policy since the 1980s, is effectively dead: financial-system stability and growth are becoming the dominant policy objectives.
This implies that economies will be allowed to run hot, potentially setting the scene for the last phase of this elongated cycle. Should this be the case, the inflation expectations embedded in fixed income valuations look too low. Government bond issuance is also rising, which could put further upward pressure on real interest rates.
The yield curve has the potential to steepen sharply
Source: Investec Asset Management as at October 2019.
Currency: a softer dollar
With the US’ relative advantage in terms of growth rates, interest rates and corporate margins set to decline in 2020, combined with the prospect of a polarised presidential election campaign, the US dollar may correct from the position of strength it has sustained for several years.
The fact that the greenback failed to climb materially higher in 2019 against other currencies, even though US growth was outstripping that of the rest of the world and US rates were rising in relative terms, suggests that the US dollar bull market has run its course — at least for now. That should relieve pressure on emerging market currencies.
Growth differentials set to reduce in 2020
Source: Federal Reserve, Investec Asset Management as at October 2019.
Not all credits are created equal
After a good year, credit should deliver reasonable, albeit lower, performance in a low-yield world. Fundamentally, companies remain in decent shape. If the global economy holds up, as we believe it will, default rates should remain low and consequently credit quality should remain solidly underpinned.
In 2019, ‘quality’ outperformed ‘value’ within credit markets, reflecting investor caution. But as the need for yield accelerates, investors might feel inclined to search in the latter area once more, particularly if macroeconomic tail risks are clearly seen to be moderating. However, credit spreads are already generally tight – especially in Europe, where the ECB is using credit markets not in the pursuit of investment return but as a monetary policy tool and the cycle is mature, making the performance of these securities very dependent on continued economic stability. Hence, over the medium term, ‘bottom-up’ selectivity will remain paramount.
Selectivity remains key in a late cycle environment
Credit valuations over a 15 year period
Source: Investec Asset Management as at October 2019.
Despite the headline noise from a few bad apples like Argentina and Turkey, under the surface most emerging markets will continue to consolidate the gains they have made in terms of macroeconomic stability over the last few years. Aggregate current-account balances will remain in surplus, while inflation across a number of major emerging markets — including Brazil, Russia and India — will consolidate at low levels never seen in history.
Growth has been disappointing, but this has been a global phenomenon. A moderate weakening in the broad US dollar will further ease financial conditions in emerging markets, which should ensure higher emerging market growth in 2020 than 2019. In turn, this could lead to unloved and underperforming local currency debt outperforming credit markets in 2020, reversing the trend of recent years. Countries to watch include Brazil, Russia, Indonesia, Egypt and Ukraine, which will go from strength to strength in implementing bold economic reform agendas. Chastened by the last two years, weaker emerging markets such as Turkey, South Africa and Argentina should at least go from bad to better, offering tactical opportunities for investors.
Most EM economies have avoided enforced counter-cyclical tightening
Source: Investec Asset Management as at October 2019.
Equities: rotations from bonds to equities; from US to ex-US; from defensives to cyclicals
In equity markets, index returns in 2019 belied the widely diverging performance within the asset class, driven by a crunching rotation out of cyclical stocks and into defensive and select growth stocks.
That shift was fuelled by growth fears. But with macro uncertainty set to moderate in the year ahead, we could see some powerful reversals of the trends that have characterised equity markets since 2017. As yet, the earnings dynamics of cyclical stocks remain weak, but markets may move well ahead of any actual improvement.
2020 may also be the year that US equity dominance — which has persisted since the 2008 financial crisis primarily due to superior US earnings-per-share growth, which in turn was driven by relative US economic strength and healthier margins — finally falters.
Generally unloved by investors, equity markets outside the US offer risk premia that look attractive on both an absolute and relative basis. The potential for positive macro surprises in the first half of 2020 looks strongest in Europe, where base effects could prove flattering; any improvement on ‘feeble’ in the data would cast Europe in a positive light. Meanwhile, Japanese equities continue to benefit from a structural trend of improving quality and an end to deleveraging.
The rotation to defensives reverses
Source: Investec Asset Management, September 2019.
Building strategic exposure in Asia
In our view, overall European equities’ appeal is largely tactical — though there are attractive individual securities. With a longer-term perspective, we have been using stock-market weakness in 2018 and 2019 to build strategic equity exposure to Asia, especially China. The difference in valuations between (relatively cheap) Asia equities and (extremely expensive) US equities is at a level that has historically been associated with protracted periods of outperformance for more moderately valued stocks.
Asian equity markets represent a prodigious and growing opportunity set, creating a great hunting ground for active investors. Asia’s superior growth rate is not, of itself, a sufficient reason to tilt allocations eastwards. But in a growth-starved world, the structural trend of the growing power of the Asian consumer is set to remain one of the dominant investment themes of our times.
Asian equity valuations - cheap relative to history and relative to the world
Source: Bloomberg, 30 September 2019.
Risks to our base case
The principal risk to our central case is a US, and hence global, recession. This could arise from a shock, or because manufacturing weakness has already infected the more important consumer sector in the US and other key economies. It may also turn out that policy loosening has come too late to undo earlier tightening in both China and the US. Other risks include the breakdown of US-China trade talks (again) and an escalation of Washington’s trade conflict with Europe. That would likely cause another wave of uncertainty and deepen the manufacturing recession.
Employment needs to remain supportive
Source: U.S. Bureau of Labor Statistics, NBER, October 2019.
Gold: a glittering defence?
With bonds likely to offer poor defensive properties — and perhaps even compound losses in the risk asset classes they are supposed to counterbalance — investors must seek other ways to diversify their portfolios. Gold is a strong contender to fulfil this role. Reaching a six-year high in 2019, the yellow metal has clearly benefited from heightened uncertainty, negative investor positioning and a reversal of the trend towards higher interest rates.
Supporting gold demand, central banks in many countries are showing a renewed interest in accumulating gold reserves instead of US Treasuries. The broad dedollarisation trend is being stoked by the US’ decision to abandon a co-operative approach to accommodating China’s rise and willingness to weaponise the greenback.
Gold stocks may prove to be an interesting complement to physical gold exposure in investor portfolios. After years of restructuring and balance-sheet improvement, a good number of gold producers are in robust financial health and well-placed to generate sustainable returns at prices well below current levels.
Gold trumps bonds as a source of defensiveness
Source: Investec Asset Management, October 2019.
Investment carries the risk of capital loss.