Taken together, the outlook is unequivocally positive for economic growth and risk assets, notably commodities and equities. Both should benefit from higher inflation and a pick-up in earnings growth following a contractionary 2019. Despite a low short-term interest rate environment, government bond yields should rise as safe-haven flows reverse and investors reassess the merits of 11 trillion US dollars of negative yielding debt. We are long cyclical stocks and emerging markets which should also benefit from a weaker US dollar. We also like emerging market debt where elevated real yields have room to fall, carry is high and weak currencies offer the potential for currency appreciation. Finally, we maintain our overweight allocation to inflation-linked securities, which should outperform as inflation picks-up later in the year.

Financial liquidity, rising oil prices and friendlier negotiations with China provided a risk-on backdrop to the global bond market over the previous quarter. As a result, our satellite positions in emerging market corporates, high yield and US inflation-linked securities performed well.

Our core-view this year is that the pick-up in global economic growth will drag bond yields higher. The chart below shows the average of the 2- and 10-year US Treasury yield which typically moves in tandem with the US Manufacturing index. The recent disparity between these two indices and the anticipated pick-up in manufacturing represents a fundamental opportunity to benefit from the re-evaluation in growth prospects. We have implemented this theme in the portfolios via an underweight allocation to government bonds and yield curve steepening trade.

Corporate bonds outperformed government debt last year, leaving spreads tight and yields low. This year, we see the liquidity provided by banks to corporations beginning to tighten, implying wider spreads in high yield credit. As such we prefer shorter-dated and/or higher-quality bonds that limit downside risk. We have implemented this in the portfolios via our allocation to the highest rung of the high yield market known as the Fallen Angels. This performed well last year, outperforming the benchmark which suffered from the sell-off in the riskier CCC-rated sector linked to the energy industry. Oil has been trading at historically cheap levels but has picked up recently following tensions in the Middle East and Saudi Arabia’s vested interest in supporting the price of oil. We prefer to play this theme via our satellite allocation to inflation-linked securities.

Accommodative monetary policy, trade stabilisation, and a pick-up in economic and earnings growth will support equity valuations in 2020. Within our smart-beta allocation, we continue to favour ‘quality’ which was the best performing single factor last quarter and throughout 2019. Russia was the best performing regional market in 2019; a position we entered in the second half of the year. It remains one of the only equity markets with a dividend yield above its PE ratio and the scheduled OPEC+ supply cuts will also aid the region going forward. We also see opportunities in Taiwan as their stock market has a high beta to the semiconductor industry, which is forecast to re-accelerate in 2020. Taiwan also benefits from shifting supply chains (a theme flagged in our Q3 2019 Quarterly Perspectives) and the Democratic Progressive Party’s recent electoral victory, which helped solidify the country’s regional autonomy, shoring-up business confidence.

In the UK, the Conservative Party’s overwhelming majority in the general election helped reduce Brexit uncertainty although the terms of future trading agreements remain outstanding. We believe UK domestic equities remain significantly undervalued and continue to offer considerable upside potential.

ESG considerations are now commonly incorporated into analyses of global equity markets. The integration of ESG and fixed income, however, is less mature, mostly due to the complexities associated with separating the various drivers of bond market returns. Yet, as ESG data improves, it is increasingly possible to determine the relationship between a government or company’s ESG-ness and their willingness or ability to repay debt – as the chart illuminates.

Regulatory authorities and central banks have responded to the development of ESG analysis by demanding greater disclosure of material ESG risks, used in turn by credit ratings agencies to calculate more representative credit ratings. The year ahead will build on the ‘sustainable’ strides made within fixed income in 2019, with innovation aplenty.

The size of the global market for ‘sustainable debt’ has ballooned in recent years, a trend that will likely continue – especially if central bankers begin to tilt quantitative easing programmes towards bonds with stronger ESG merits. The universe of sustainable-linked fixed income ETFs will expand in tandem, responding also to significant demand from passive investors for such products.

Looking beyond the recent events in the Middle East, the global 2020 vision remains favourable for risk-assets such as equities and commodities but remains negative for bonds. A return to QE in the US and in Europe will add another leg up to the record setting equity bull markets, with sizable gains in emerging markets as they play catch up to the rest of the developed world. A weaker US dollar will also support emerging market equities and local currency debt markets. Our favourite EM equity markets are China, Taiwan, Russia, Mexico and Brazil. Investor confidence in the UK is also rising. The “Get Brexit Done” mandate won by Boris Johnson has significantly reduced the cloud of uncertainty gripping Westminster. Investors are now looking at the UK for the first time in many years and this will be the catalyst for a significant rally in sterling and domestic equities. Gold remains attractive given the low level of interest rates and provides an effective hedge for any correction in equities. Most government bond markets (developed) are grossly overvalued and offer little protection from either the return of inflation or a move to fiscal stimulus.

In late October, US Fed Chairman Jerome Powell stated he would need to see a significant and persistent move up in inflation before raising rates. The announcement followed three interest rate cuts, between July and October, amid fears of a global growth slowdown and is significant because it signalled that the Fed wants to see inflation above the official 2% target i.e. to raise inflation. The Fed also made a commitment to boost liquidity in the ‘repo’ market, which is a short-term borrowing facility for banks. This very important market provides the basic plumbing for the banking industry. This ran into difficulties in September as lack of money in the system threatened to raise borrowing costs outside the target range, implying a loss of control by the central bank. The Fed responded by offering half a trillion US dollars to dealers to plug the funding gap. These developments are somewhat technical in nature but to most market observers, they simply resemble more quantitative easing, or QE4. The People’s Bank of China has returned to easy monetary policy by injecting liquidity into the market and recently reduced the reserve ratio for banks. Quantitative easing increases liquidity in the system, lifting asset prices.

Taken together, the outlook is unequivocally positive for economic growth and risk assets, notably commodities and equities. Both should benefit from higher inflation and a pick-up in earnings growth following a contractionary 2019. Despite a low short-term interest rate environment, government bond yields should rise as safe-haven flows reverse and investors reassess the merits of 11 trillion US dollars of negative yielding debt. We are long cyclical stocks and emerging markets which should also benefit from a weaker US dollar. We also like emerging market debt where elevated real yields have room to fall, carry is high and weak currencies offer the potential for currency appreciation. Finally, we maintain our overweight allocation to inflation-linked securities, which should outperform as inflation picks-up later in the year. 

Financial liquidity, rising oil prices and friendlier negotiations with China provided a risk-on backdrop to the global bond market over the previous quarter. As a result, our satellite positions in emerging market corporates, high yield and US inflation-linked securities performed well.

Our core-view this year is that the pick-up in global economic growth will drag bond yields higher. The chart below shows the average of the 2- and 10-year US Treasury yield which typically moves in tandem with the US Manufacturing index. The recent disparity between these two indices and the anticipated pick-up in manufacturing represents a fundamental opportunity to benefit from the re-evaluation in growth prospects. We have implemented this theme in the portfolios via an underweight allocation to government bonds and yield curve steepening trade.

Corporate bonds outperformed government debt last year, leaving spreads tight and yields low. This year, we see the liquidity provided by banks to corporations beginning to tighten, implying wider spreads in high yield credit. As such we prefer shorter-dated and/or higher-quality bonds that limit downside risk. We have implemented this in the portfolios via our allocation to the highest rung of the high yield market known as the Fallen Angels. This performed well last year, outperforming the benchmark which suffered from the sell-off in the riskier CCC-rated sector linked to the energy industry. Oil has been trading at historically cheap levels but has picked up recently following tensions in the Middle East and Saudi Arabia’s vested interest in supporting the price of oil. We prefer to play this theme via our satellite allocation to inflation-linked securities.

Accommodative monetary policy, trade stabilisation, and a pick-up in economic and earnings growth will support equity valuations in 2020. Within our smart-beta allocation, we continue to favour ‘quality’ which was the best performing single factor last quarter and throughout 2019. Russia was the best performing regional market in 2019; a position we entered in the second half of the year. It remains one of the only equity markets with a dividend yield above its PE ratio and the scheduled OPEC+ supply cuts will also aid the region going forward. We also see opportunities in Taiwan as their stock market has a high beta to the semiconductor industry, which is forecast to re-accelerate in 2020. Taiwan also benefits from shifting supply chains (a theme flagged in our Q3 2019 Quarterly Perspectives) and the Democratic Progressive Party’s recent electoral victory, which helped solidify the country’s regional autonomy, shoring-up business confidence.

In the UK, the Conservative Party’s overwhelming majority in the general election helped reduce Brexit uncertainty although the terms of future trading agreements remain outstanding. We believe UK domestic equities remain significantly undervalued and continue to offer considerable upside potential.