Market summary

January 21st, 2020
HIGHLIGHTS

 

United States

 

As of the close of December 31st, 2019 the S&P 500 was up +28.88%, and the MSCI World ended up +25.19%.  Year-to-date as of the close of January 17th 2020, the S&P 500 and the MSCI World were up +2.84% and +2.42% respectively.

 

  • We have begun the new year with a continuation of the December 2019 market rally. After an initial rise earlier this month, the market corrected on fears of a potential Iran-US conflict due to the targeted death of General Soleimani in Bagdad.  Yet these fears dissipated and the markets have continued to grind higher.

 

  • The S&P 500 is now 5% away from posting its largest and longest ever rise without falling more than 20% - the standard definition of a bear market. In the 1990s, the S&P 500 posted a 417% return over 9 ½ years, but the current bull market is already longer: 10 years and 10 months and is close to breaking that all-time gain. In fact, if the S&P 500 gets to the 3,498 level (it closed January 17th at 3,329.62), it will become the longest and largest bull market, ever.

 

  • However the S&P 500’s forward P/E of 18.4x is also the highest since 2002.

 

  • As mentioned in earlier occasions the markets are relishing on:
    • clarity on the Fed maintaining rates low,
    • strong employment numbers for November and December,
    • the signing of a phase one trade deal between the US and China,
    • Brexit looking resoundingly on the right path with the outcome of the UK elections.

 

  • In short, 2019 was an exceptional year for almost all markets, such as world equity markets (led by US stocks), most long term government bonds, high yield bonds, commodities (gold, silver, oil, etc), bitcoin and even forgotten markets, like Greek equities and corporate bonds.

 

  • Going forward, the general backdrop into 2020 looks constructive, with an accomodative Fed, a recent uptick in global data, Brexit on the right path, and what feels like the worst behind us with US/China trade tensions.

 

  • Fed Policy
  • Investors have rushed to buy US equities in the later part of last year and in January of this year, as concerns receded that the US – China trade war would cause serious damage to the world economy and as the Federal Reserve implemented an easier monetary policy lowering interest rates in July 2019 (a total of 3 cuts to 1.75% now). In summary for the foreseeable future, the Fed policy appears to be solidly on hold, which in line with most economists’ baseline expectation through 2020. In addition low interest rates have crushed market volatility.

 

  • Regarding Fed policy and the possible consequences of a looser monetary policy, there is a growing worry over the direction of inflation. In late October 2019, Fed chair Jay Powell said that he would need to see “a really significant move up in inflation that’s persistent before we could even consider raising rates to address inflation concerns”. Does this means that higher inflation is now the goal of the Fed Chairman? Remember that the Fed cut interest three times last year, taking its target range to 1.5% to 1.75%. The Fed has a dual mandate of stable prices and sustainable employment, but with unemployment at a 50 year low, why cut short term rates three times in three months? Is it the fear of deflation? This is coinciding with Trump’s relaxed fiscal constraints, leading to an expected $984 billion budget deficit for 2019, the most in seven years, as it coincides with a drop in tax revenues and higher military spending. The effects of the trade war with China may work their ways through higher consumer prices, now that they know that existing tariffs will not be eliminated until after the US election. The reason that the US has not seen more inflation so far from the tariffs is that companies have absorbed these tariffs accepting a squeeze on their margins. That might not continue in 2020. This is why we maintain a short duration exposure in our fixed income exposure with an exposure to floating rate instruments, as loans, as well as gold.

 

  • US-China Trade Deal
  • On the trade deal, the much awaited phase one US-China deal is now signed, sealed and delivered. The deal looks comprehensive, and in addition to more agricultural exports it is also includes IP, financial services, tech transfer, currency transparency, etc…

 

  • However the deal contains many over optimistic assumptions. First, the US is not rolling back the full existing tariffs on $360 billion of Chinese products until the agreement of a “phase two” deal. This deal will not happen until after the US elections in November 2020 (at the latest). Second, there could be many losers if the phase one deal conditions are actually implemented, in particularly the purchase of China of $200 billion of US goods over the next two years as agreed. In order to comply, China will need to shift existing and future purchases of goods from the likes of German manufacturers and Brazilian farmers towards the US. Probably the US Treasury will keep up its campaign against potential currency manipulators, like China, Japan, Korea, Germany, Italy, Ireland, Singapore, Malaysia, Vietnam, and Switzerland, all sitting in the monitoring list. Third, as Chinese subsidies and alleged cyber theft were left for the phase two agreement, it is possible that two separate technology systems in the US and China are created and companies are forced to decouple their supply chains, putting Europe and many global oriented companies in a tight spot.

 

  • US Equity Market
  • 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 strong fundamental components, not to mention an uptick in M&A activity.

 

  • With the geopolitical noise behind us (for now), we are heading into the bulk of earnings season. One could argue risks are slightly skewed to the downside since corporate earnings remain the uncertain factor. We have to remember that global equity markets performance in 2019 was entirely driven by multiple expansion, with multiples expanding by the most since 1988 (bar 2009). This means there is now pressure on companies to re-affirm 2020 estimates. If 4Q earnings season fails to deliver a better profit outlook, equity markets could struggle.

 

  • Another theme that we have discussed in the past is the leadership of the market, investor crowding, and investor positioning. The leadership remains in the expensive, growth names, with investors generally in the same sector tilts they’ve been in for the past year. The positioning data speaks to this dynamic, Growth/Quality like Tech exposure  is in the top quartile. 

 

  • The question we need to ask ourselves relates to the high levels of ‘crowding, and if this represents a potential risk for many investors.  As in the past,  these periods of crowding are followed by increasingly driven periods of factor volatility, de-risking, and fund underperformance. 

 

  • As an example of this, Tech continues to push the market higher (FB, AAPL, AMZN, NFLX, and GOOGL make~11% of the S&P):
    • Facebook (FB) +56% in 2019, +8.2% YTD
    • Apple (AAPL) +86% in 2019, +8.2% YTD
    • Amazon (AMZN) +18% in 2019, +0.9% YTD
    • Netflix (NFLX) +21% in 2019, +5% YTD
    • Alphabet (GOOG) +29% in 2109, +10.7% YTD
    • Microsoft (MSFT) +55% in 2019, +6% YTD
    • Alibaba (BABA) +55% in 2019, +7.2% YTD

 

  • From a positioning perspective, net exposures in long/short equity funds continue to tick up and are elevated versus where they were throughout much of last year. Yet, while positioning is no longer 'light' with net exposure now at 49%, which is much higher than where it was in 2010 (38%), you could argue there is room for the market to grind higher.  Net exposure at 50% is much higher than where it was a year ago. As for performance, while 2019 ended on a positive note for most hedge funds, 2020 is off to one of the best starts. In fact, Global Total Alpha among L/S funds is tracking in line with some of its best starts over the past decade. Notably, crowded longs in N. America have more than doubled the gains of the S&P, with the top 50 most crowded longs up ~4.5% as of Wednesday close.

 

  • Economic Data
  • On the data front, many economists and strategists are starting to highlight better economic figures. Globally, soft and hard growth data points are surprising to the upside confirming the inflection in the global cycle. Morgan Stanley expects global GDP growth to rise by 60bps over the next five quarters from a trough of 2.9% y-o-y in 2019 Q4 to 3.5% y-o-y in 2021 Q4, led by a stronger recovery outside the US. Risks to the outlook include a reescalation in trade tensions, geopolitical tensions and the emergence of late-cycle challenges in the US.

 

  • Corporate Earnings
  • Current expectations reveal a continuation of the earnings deceleration and a margin compression story that we’ve experienced on the back of the tremendous, yet, fiscally-driven earnings growth in 2018. That said, the extent to which this is offset by lowered analyst estimates for 2019 Q4 remains to be seen.  Last quarter, ~40% of companies that beat consensus EPS forecasts would not have beat their respective consensus EPS forecast at the start of 2019. As we head further into this reporting cycle, it is important to keep in mind that analyst earnings forecasts were revised lower in every sector. This lowered bar, however, could re-risk the quarter.

 

  • Financials kicked off the fourth quarter US reporting season with large cap banks dominating last week’s announcements. JP Morgan (JPM) and Citi (C), started off strong with trading revenue beats, while other key highlights included JPM’s consumer business operating leverage and C’s ROTCE target exceeding expectations. Wells Fargo (WFC) expenses remained in focus, with missed and lowered guidance, as the new CEO Charlie Scharf did not provide concrete and clear guidance on how expenses will improve. Bank of America (BAC)’s print hinted that its trajectory will likely not be uniform through 2020, and Goldman Sachs (GS) rounded out the strong beat in trading across money centers. Overall, large cap bank results reflected notable strength in fixed income trading in the last quarter—a recovery from the tough quarter of 4Q18—as well as credit quality beats. On a macro level, several bank CEOs noted an improvement in corporate sentiment heading into 2020 and sounded incrementally more constructive on China.

 

  • December employment numbers, released January 10th, came out slightly lower than expected, but the unemployment rate remained at 3.5%.

 

  • The Labor Department said nonfarm payrolls increased by just 145,000 while the unemployment rate held steady at 3.5%.

 

  • Economists surveyed by Dow Jones had been looking for job growth of 160,000. The jobless rate met expectations for staying at a 50-year low.

 

  • A more encompassing jobs rate that includes discouraged and underemployed workers fell to 6.7%, the lowest it’s ever been in records going back to 1994.

 

  • Over the past 12 months, wages grew just 2.9%, lower than the 3.3% average of 2018. In total 2.1 mm jobs were created in 2019 in the US.

 

  • Limp wage growth is puzzling when the jobless rate has settled at 3.5%. A monthly survey by the National Federation of Independent Business (small business owners), found that finding qualified workers was the top challenge. It seems what the  tight labour market has done is to draw in people who were not previuously job hunting. 

 

  • On top of this, the Morgan Stanley Business Conditions Index (MSBCI) also started the year in solid territory, rising one point in January to a level of 53. Fundamental components were firm, raising the Composite Index to a level of 56, further evidence that the economy is on sounder footing today versus where we were 12 months ago.

 

 

Europe and the UK

 

As of the close of December 31st  the Eurostoxx finished up +24.78% for the year, the FTSE +12.10% and the MSCI Europe +22.24%.

Year-to-date the Eurostoxx is up +1.69%, the FTSE +1.76% and the MSCI Europe +2.14%.

 

  • Economic data surprised to the upside more in the Eurozone than anywhere else. The Eurozone economic surprise index had risen to a 2-year high, this metric has risen further and is now moving up toward 5-year highs. Looking at equities broadly in Europe Banks, Real Estate and Diversified Financials have seen the biggest improvement in their earnings revisions ratio across all sectors over the last three months.

 

  • With Brexit uncertainty receding further, as mentioned in previous ICs, 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.  Valuation spreads between the cheap and expensive stocks in the region have never been more extreme and from a high level MSCI UK trades at a 34% discount to MSCI world.

 

 

Asia and Emerging Markets

 

Both the Topix and the MSCI Asia ex-Japan are still down respectively since the end of 2017.

As of the close of December 31st:      

Topix  +15.21% 

‐MSCI Asia ex-Japan  +15.37% 

‐MSCI Emerging Mkts  +15.42% 

 

As of the close of December 31st:  

-Topix  +0.82% YTD

-MSCI Asia ex-Japan  +3.70% YTD

-MSCI Emerging Mkts  +2.89% YTD

 

 

  • Investor sentiment is best described as “recovery” or “risk-on mode” in Asia. In Asia, the strong start continues, with the Hang Seng Index up 3% and KOSPI up 3.5% year-to-date. Interesting to note that China was the most net bought country in 2019, accounting for almost half of global net buying by hedge funds last year. As a percent of global net exposure, China net exposure rose from ~10% at the start of 2019 to as high as ~18% in the middle of of Q4 2019, before falling back to ~16% towards the end of the year. While that exposure has climbed back towards all-time highs, global GEM managers are still 3% underweight China within their benchmark allocation. We are still confident regarding the long term upside. There are other 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 +16.9% since the August low. Taiwan is also experiencing re-engagement.

 

  • In Latin America, the equity markets are strongly positive for the month of December alone, the MSCI Latam was up +9.81%, +13.71% in 2019 and +0.24% YTD, led by Brazilian equities that are now +2.45% YTD.

 

 

Currencies and Commodities

 

  • In currencies - The USD is unchanged to around 1.109 against the EUR. Even with the Iran-US escalation the currency markets have remained extremely stable.

 

  • The Swiss franc climbed to a multiyear high after Switzerland was added to the U.S. Treasury’s watch list of currency manipulators earlier this month. The current level against the € is 1.073.

 

  • In commodities – industrial metals and in particular copper prices continue to rise, up +1.6% YTD after a positive 2019.

 

  • In energy - International benchmark Brent crude surged toward $70 / barrel and U.S. West Texas Intermediate to $64, on January 2nd and 3rd,  after a U.S. airstrike in Baghdad killed General Qasem Soleimani, who led a special forces unit of Iran’s elite Revolutionary Guards. However this surge faded quickly and currently the Brent is at $64.8 and WTI $58.5, paring all early gains and are negative year-to-date.

 

  • Gold, after surging +18.3% in 2019, is up another +2.8% YTD at $1,577 / ounce.

 

 

Fixed Income

 

  • 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 remain slightly lower since the last IC at 1.55%, 5 year rates at 1.62% and 10 year at 1.82%.

 

  • In European Fixed income – the yield of Germany’s benchmark 2-year Bund is also unchanged since the last IC, at -0.6% and the 10-year, is now -0.21%.

 

  • 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.

 

 

Conclusions

 

  • 2019 was 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 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.

 

  • The investment outlook for 2020 that we are centering on are dominated by common themes already discussed: political noise on trade, 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 multi-year 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.

 

  • REGARDING EQUITIES:
  • 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.

 

  • CONCLUSION:
  • 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.

 

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