As of the close of December 18th the S&P 500 is +1.6% MTD and +27.3% YTD, and the MSCI World is +1.8% and +23.9% YTD.
- This month of December seems that we are finally hitting on a lot of the things we were looking for in the past months. Namely, we got:
1) more clarity on Fed, 2) strong employment numbers for November, 3) Brexit looking resoundingly on the right path with the outcome of the UK elections, and 4) it feels like we may have a deal with China. Of the four, the UK election outcome is arguably the most definitive, with a better than expected Conservative majority paving the way for Brexit early next year.
- On the trade deal, the much awaited phase one US-China deal looks comprehensive, in addition to more agricultural exports it is also expected to include IP, financial services, tech transfer, currency transparency, etc. With the US and China delivering a rare occurrence of coordinated communication regarding the progress of negotiations, the S&P 500 this month is at yet another all-time-high and +27% YTD.
- As for the Fed, no major surprises in the FOMC statement as the committee continues to maintain its willingness to react to changing data and cut or raise rates if appropriate. However for the foreseeable future, Fed policy appears to be solidly on hold. The economic projections presented at the FOMC meeting were broadly stable—the median policymaker continues to expect growth will stabilize around 2.0% next year, but even with steady economic growth and a 3.5% unemployment rate. Policymakers also continue to project low inflation next year, with core inflation expected to pick up from 1.6% in 2019 to 1.9% in 2020. A Fed that remains on hold is currently most economists’ baseline expectation through 2020, though for some, the path for inflation remains highly uncertain and binary risks around trade remain.
- Equity market bulls point to improving data and business dynamics…PMI’s are starting to inflect, the business conditions indices have risen above 50 for the first time since early July with fundamental components strong, there’s been an uptick in M&A activity, and an accommodative Fed is supportive of the ERP “Equity Risk Premia” dynamic.
- On the flip side, for those who argue that good news are priced in and think it’s time to be more prudent point to a few things: multiples have expanded all year, the outlook for US earnings isn’t great (MS Chief US Strategist Mike Wilson estimates 0% EPS growth for S&P next year), labor costs are rising, positioning is no longer light, and quite frankly, you could argue that the catalysts we were waiting for have, for the most part, played out.
- Positioning is still barbell-like, with few involved in Cyclicals / Value. As mentioned in earlier ICs: First, there are those that believe it’s best to own Growth/Quality, against a backdrop of anemic global growth and accommodative central banks. These investors (this has been our position) continue to deploy a Barbell-like approach—on one side they own expensive, high growth names, while on the other they balance this with names from more defensive cohorts—all the while avoiding cyclicals. For the most part (albeit with a few temporal rotations in recent months), this strategy has worked well in 2019, which likely incentivizes active managers to stick to the game plan so long as their view of the macro hasn’t changed drastically.
- Second, those that continue to worry about global growth prospects and risks to earnings, capex, and consumer confidence, and
- Third, those that are positioning for the reflationary trade in the event of a sharp inflection in the global economy. What would it take for the latter to play out? In order for Cyclicals and Value to sustainably work / attract flows, hard data would need to start inflecting higher, similar to what soft indicators (EA PMI new orders, Caixin PMI, EA ZEW, US Markit PMI) have already done. It is still to be seen exactly what course all of these trends will take, but for the most part, we would argue that investors are feeling significantly more at ease with the current environment vs. 6 months ago—and certainly vs. a year ago.
- On the data front, which has been marginally better as of late, last week we saw positive prints out of China and Germany. Perhaps the most notable data point last week came from Germany with ZEW expectations surging in December to 10.7 surpassing consensus estimates of 0.3. Further East, we saw China CPI surging to 4.5%. All these data points have been supportive of the 2020 view which is global growth recovering driven by an improvement in the rest of the world excluding the US.
- November employment numbers, released December 6th, came out higher than expected
- Nonfarm payrolls surged by 266,000 in November, better than the 187,000 expected by economists.
- The unemployment rate ticked down to 3.5% from 3.6%, back to the 2019 low and matching the lowest jobless rate since 1969.
- The end of the GM strike had a big effect, boosting employment in motor vehicles and parts by 41,300, part of an overall 54,000 gain in manufacturing.
- Average hourly earnings rose by 3.1% from a year ago, slightly above the 3% expected by economists.
- This blockbuster report clearly affirmed that imminent recession risks are muted.
- Last month (November 20th) we circulated the Morgan Stanley (MS) 2020 outlook. In the case of the MS Global Economists forecast, global growth will improve from 1Q20 onwards, reaching 3.2% by year end, as compared to an estimated 3.0% in 2019. Given their team’s expectations of a 1Q20 growth recovery, they’d expect to see an inflection in high frequency indicators, like PMIs and trade, in the coming 2-3 months. They see both trade tensions and policy easing moving in the right direction for the first time in seven quarters, helping to support the global economy. However, it is worthwhile to mention risks still remain skewed to the downside, with uncertainty related to macro policies likely to linger. Conclusion from the MS 2020 Global Macro Outlook: The late-cycle expansion extends. 2020 will be a year of mini-cycle recovery in the context of a late-cycle expansion.
- MS Global Strategists are also focused on bottoming growth and high valuations leading to range-bound markets but larger reversals in leadership. MS Strategists believe the sequencing of this modest recovery is key to where these reversals lie. Similar risk-adjusted expected returns keep allocations clustered around neutral: Equities (-1%), rates (0%), credit (-2%), commodities (-1%), cash (+4%). MS Strategists prefer value over growth and Ex US exposure over US Equities, treasuries over gilts, European IG over US HY, and copper over oil and gold.
- Central banks are easing financial conditions globally. An improvement in growth could change that trajectory, investor sentiment and markets can turn faster than central banks can turn more hawkish. We remain constructive on the US equity markets and do not believe that we are in a similar situation as this time last year.
Europe and the UK
As of the close of December 18th the Eurostoxx is +1% MTD and +24.6% YTD, the FTSE +2.6% and +11.9% and the MSCI Europe is +1.7% and +21.9% YTD.
- With Brexit uncertainty receding further, we are carefully examining UK equities. As one of the most unloved and undervalued equity markets, positioning is still very light and MSCI UK has traded at around a 30% discount to MSCI World.
Asia and Emerging Markets
As of the close of December 18th :
-Topix is +2.2% MTD and +16.2% YTD,
-MSCI Asia ex-Japan is +5.9% MTD and +14.9% YTD, and
-MSCI Emerging Mkts. is +6.7% MTD and +14.9% YTD.
These later two indices are still down from their peak on March 30th, 2019.
In addition both the Topix and the MSCI Asia ex-Japan are still down respectively since the end of 2017.
- There are bright spots in Asia. Japan is benefiting from both a cyclical upturn in the tech supply chain while also being a value trade due to low positioning. TOPIX is up 18% since the August low. Taiwan is also experiencing re-engagement (+5.5% MTD and +24.6% YTD), with the foreign buying month-to-date continuing into names like Hon Hai Precision (2317 TT); +4.4% MTD and +37% YTD.
- In Latin America, the equity markets are strongly positive for the month of December – MSCI Latam +7.75% MTD and +11.6% YTD – led by Brazilian equities that are now +28% YTD.
Currencies and Commodities
- In currencies - The USD weakened slightly to around 1.114 against the EUR. Even with the tariff turmoil the currency markets have remained extremely stable.
- The GBP/USD has experienced a strong rebound from the mid-year low levels of around 1.2 to currently 1.31. This represents a +10% rebound, even though from its trough level this summer to its recent peak, the move has been +12.5%.
- In commodities – A run of record and multiyear highs across equity markets reflects faith in a cyclical rebound over the coming months, loaded with hope for a rise in profits and lighter margin pressures. But commodity markets do not concur. Industrial metals have produced a less effusive performance. However in the month of December copper prices are rebounding (+5.7% MTD and +4% YTD), a barometer of future economic activity. Even though oil has faced a rising tide of supply most of the year, in the month of December with a new potential agreement for OPEC to cut suppy MTD WTI and Brent are up +9.6% and +5.4% MTD respectively and +33% and +22% YTD.
- Gold has stabilized in December to $1,478 an ounce, +1.2% MTD and +15.3% YTD
- In US Fixed income - The yield curve has continued to change shape since the extreme rally in the beginning of the month of September. With Fed Fund rates at 1.75% (after the cut of 0.25 at the end of October), current 2 year rates are unchanged since the last IC at 1.64%, 5 year rates at 1.75% and 10 year at 1.94%. The yield curve has continued to steepen in the medium to longer part of the curve.
- In European Fixed income – the yield of Germany’s benchmark 2-year bond is also unchanged at -0.62% and the 10-year, is now -0.22%. As in other fixed income markets rates in Germany are slightly higher than the last IC. Weak German growth data, remain the main driver for negative interest rates in Europe.
- The expansion of negative yielding debt, and indeed its acceptance as part of the current financial system, compounds the asset allocation problems facing investors in the future. Above all, it heightens the worry that a major accident could be around the corner. An entrenched world of negative yields upends the important role played by government bonds in providing insurance or ballast for portfolios that generally favor equities and credit.
- As fixed-rate coupons disappear, and as bond investors rely ever more on price appreciation to hit return targets, holding bonds becomes little different from holding stocks. The distorting influence of negative yields across global fixed income has emerged in recent years as central banks have become major holders of bonds as they try to boost economic growth and inflation. But such activities have failed to offset long-term trends depressing bond yields such as ageing populations and rapid technological change, which respectively boost savings rates and dampen inflationary pressure.
- This means that holders of bonds with low and negative yields are painfully exposed to even a modest rebound in growth and inflation expectations, which should naturally cause yields to rise. But as the global economy feels a squeeze on manufacturing and waits for signs of a genuine truce in the US-China trade war, bond prices, for now, reflect expectations of weaker growth and the hope that central banks will repeat their previous doses of extraordinary monetary policy.
A tale of three market phases in 2019
The year 2019 began after one of the worst periods in equity markets in history, where in the Q4 2018, the MSCI World (MXWO), the S&P 500 (SPX) and the MSCI Europe (MXEU) lost -13.7%, -14% and -11.6% respectively. In 2018, the S&P 500 had its worst December since 1931, losing -9%.
A strong and sharp recovery from January to the end of July (market top on 26/7/2019) where the MSCI World, S&P 500 and the MSCI Europe exhibited very strong positive moves, +17.6%, +20.7% and +15.3% respectively. This recovery was based on a strong reversal from the losses of 2018, short covering, a strong unemployment in the US in January, where more than 304,000 non-farm jobs were created, that restored some calm in the markets.
A sharp correction from the end of July (26/7/2019) to mid-August (15/8/2019) of around -6% in a two week period: this was caused by a major trade escalation (that had already started in May 2019 – when Trump announced 25% tariffs on $200 billion of Chinese imports). This further culminated with a further decision of Trump to increase tariffs to 30% on $250 billion of Chinese imports – in total tariffs on $550 billion of imports from China have been imposed by the US, and China has set tariffs on $185 billion worth of US imports. In addition to the tariff announcements there were inflammatory tweets and the belief that we were entering into a global recession, leading 10 year US rates to touch a low of 1.5% and German rates to -0.7%. By the end of August, approximately $16 trillion of sovereign debt was negatively yielding.
THIRD AND CURRENT PHASE
A recovery from the end of August to now: the Fed cut rates for the third time (July 31st, September 18th, and October 30th) from 2.5% to 1.75%, providing a positive monetary stimulus to the markets, the ECB (on September 12, 2019) announces a change of monetary stimulus cutting the base rate by 10 bps to -0.5% and announcing a resumption of QE (bond buying) of €20 billion/year. Furthermore a change of rhetoric between the US and China and a “phase one” trade agreement has been negotiated and the belief that monetary stimulus is starting to work and economic growth is stabilizing.
- 2019 has been a year of dislocation and disruption, and for the equity markets a diversion between strong stock market returns and weak economic growth. The story for investors this year has been the reverse of what they experienced during 2018 and revolves very much around the level of the 10 year government bond yields. Rising yields in 2018 crushed equity multiples, while this year, share markets have bounced back as benchmarks substantially reversed course.
- In fact, as could be seen in the preceding graphs, the strong negative correction in 2018 has been followed by a positive one in 2019. Both years together have yielded mild positive returns, in most cases.
- Over the year, economic activity and asset markets moved in opposing directions as earnings growth dwindled and world GDP sank to below trend, yet all major asset classes posted strong gains; a simple USD 60/40 stock-bond portfolio has delivered a +17% year-to-date.
- The investment outlook for 2020 that we are centering on are dominated by common themes already discussed: political noise on trade, and the US election cycle, the resilience of leading economies, switches between value and growth, relative allure of the US equity markets and cheaper rivals such as emerging markets and Japan. However, most probably earnings and the business cycle are the most likely drivers of equity market performance in 2020. A run of record and multiyear highs across equity markets reflects faith in a cyclical rebound over the coming months, together with hope for a rise in profits and lighter margin pressures.
- The key questions we are asking ourselves, as we move into 2020 are: What led to this unusual divergence of growth and returns, and will this environment persist into next year?
- In our view, three factors have been the distinctive characteristics of 2019 — a global manufacturing slump, heightened geopolitical tension and easier monetary policy. That is to say, manufacturing weakness and geopolitical uncertainty weighed negatively on GDP and other activity data via weaker capex, inventories and confidence channels. On the other side, policy easing impacted asset returns positively, boosting valuations on stocks and bonds alike.
- Over the next 12 months, we expect the recent recovery in economic momentum will gain traction, with global economic growth returning to trend by mid-2020. We also believe the trade tensions that contributed to this year’s complicated geopolitical environment will appease as the political atmosphere in Washington tilts toward preparing for November’s presidential election. We expect 2020’s recovery in economic activity to be more tempered than the rebound we saw in 2017, as the ingredients for a synchronized upswing in global growth are not so fresh and pent-up demand less evident. We also believe that downside tail risks have declined and the balance of economic risks for 2020 is rather more even than in 2017; some upside risks, such as a recovery in corporate confidence and activity, now appear more likely.
- Our economic outlook anticipates a rebound in activity sufficient to provide trend-like growth and maintain high levels of employment, but not strong enough to stoke inflation and force central banks to rethink their accommodative policy. Overall, we see a year of growth and moderation ahead: Growth in terms of the economy and earnings but moderation in terms of monetary policy, multiple expansion and asset market returns. Downside risks are fading, but a renewed bout of trade tension and further weakness in China are key factors to monitor in 2020. So too are upside risks from increased corporate activity or a more emboldened consumer.
- Equity returns in 2019 were entirely driven by valuations, but given where they started — immediately following a fourth-quarter sell-off in 2018 — valuations on global equities are now roughly back in line with their long-term average. A modest, mid-single digit rise in earnings in 2020, combined with typical dividends, would suggest upper-single digit global equity returns even without any heroic assumptions on margins or valuations. One risk is that earnings could deteriorate. That would really challenge generous equity valuations and risky assets, and throw the balance of monetary policy and equities into question.
- Nevertheless, we continue to overweight U.S. equities over the rest of the world. The view that cyclical/value stocks could outperform growth shares, is becoming more and more compelling, and that is why we have reinforced our position in the Russell 2000 Value.
- It seems to us that the S&P could absorb a lot of the good news on trade, if and when it occurs, as well as further interest rates cuts. Were global economic data to pick up more strongly than we are forecasting, it is likely that emerging market equities would be a beneficiary, alongside other more cyclical regions, like Japan and Europe.
REGARDING FIXED INCOME:
- Bonds are likely to suffer as yields rise modestly in 2020. Extremely low yields, flat curves and a recovery of risk appetite could be the recipe to generate a strongly negative signal for global duration.
- Consequently, we remain cautious on duration – prefer short duration fixed income instruments. We believe long duration can be extremely painful if the curve moves higher and steeper, as the sensitivity of longer duration fixed income assets will be extremely high. Fixed income is likely to see a continued hunt for yield, with higher quality corporate credit, as well as EM hard currency sovereign debt, the potential beneficiaries within the asset class.
In a world of contained sovereign yields and accommodative central banks we still favour equities for generating returns. This economic outlook leads us to continue to be positioned with an overall overweight in equities and an underweight in global bonds - with a short duration profile. Overall we probably prefer to add units of risk to equities rather than credit. Finally, we can maintain some USD cash, where real yields are not punitive and we are afforded a little “dry powder” in the portfolio.