Q1-2020 Quarterly perspectives

Tavistock Wealth - Investment Outlook

Welcome to the Q1-2020 ‘Quarterly Perspectives’ publication

2019 Review

2019 will go into the history books as one of the best in financial markets since the early 1990s. At the start of the year, few would have expected such stellar returns as investors grappled with any number of anxieties such as the slowing global economy, escalating trade wars and potentially higher interest rates from the US Fed. These fears failed to materialise and the sharp sell-off in equities in the final quarter of 2018 helped set the scene for a strong recovery in risk assets. Meanwhile, central banks across the globe reverted back to accommodative monetary policy via lower interest rates and/or money creation schemes such as quantitative easing. This led to a flood of liquidity across the financial system. Even as equities reached new record highs, government bond yields continued to reflect slowdown concerns, sending bond yields lower, notably the 10-year US Treasury which fell from 2.69% to 1.91%. The combined rally in global bond and equity markets led to the highest returns in more than two decades.

Key Themes

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.

Chart of the Quarter

Global liquidity has surged over the last year. This should translate into a pick-up in the business cycle. The red bars in the chart represent the Bundesbank World Industrial Production index. This is based on 6 leading indicators designed to predict the cyclical turning points of global industrial production. This index has started to pick-up and is early in the new cycle.

Fixed Income

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.

Equities

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.

Russian equities trade at their cheapest levels since the financial crisis, whilst offering the highest dividend yield in almost two decades. Both earnings and dividends are expected to continue to grow.

Our best performing position last year was the S&P 500 Technology ETF. Interest rates are likely to stay low for longer leading to further outperformance in 2020.

Commodities

We expect commodities to behave in a different manner to that of the last decade and to perform well this coming year. This is best captured in the chart below which highlights the valuation differences between equity markets and commodities. The red line, MSCI world, has been increasing steadily whereas most commodities are cheaper now than they were 10 years ago. This is highlighted by the S&P Goldman Sachs Commodity Index in orange, with the notable exceptions of palladium and gold. We do not expect this disparity to continue as a broad-based global recovery takes hold, the US dollar weakens and interest rates stay lower for longer. Sustainability and technological change continue to shape demand trends and supply capacity. Looking into 2020, we will further invest in economies and companies attempting to define the modern commodity space. Demand for rare earth minerals, and those elements needed in electric cars, semiconductors, and renewable energy will continue to rise. We are exposed to this theme, indirectly, via our recent allocation to Taiwanese equities.

Foreign Exchange

The US dollar index is a measure of the currency’s value relative to a basket of its main trading partners. We believe this index is now starting to weaken and could fall from 97 to 85 this year as the Federal Reserve continues to expand its balance sheet. This would be unambiguously positive for risk assets such as commodities and equities as well as emerging market securities.

There are a number of reasons we are likely to see a weaker US dollar. The main reason is the rest of the world is catching-up with strong US economic growth and this will influence currency flows. Catalysts include progress in terms of Brexit, the USMCA agreement and the phase one trade deal between the US and China. Also, Donald Trump has been very effective at achieving desired market outcomes, one of which is a weaker dollar. It’s one of the few policies that both he and Elizabeth Warren, the potential democratic nominee, agree on. It is likely that
markets will start to price-in greater US political risk relative to the rest of the world, thereby reducing the demand for the greenback.

Technically, the US dollar is already starting to weaken. In early December, the currency fell out of the channel within which it had been appreciating over the prior 2 years. The black line is important because it shows the 200-day moving average. Prior occasions where the currency has crossed this level have pointed to a significant move higher or lower. Not only has the currency just broken below this line, but the average level seems to be acting as resistance against a move higher. The recent trend of lower highs and lower lows will likely continue throughout the year.

ESG Investing

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.

A 2019 study investigating the relationship between ESG factors and credit risk for 59 countries between 2009 and 2018 found there to be a strong link between the two variables; namely that countries with higher ESG scores (closer to 100) tended to be less risky than those with weaker ESG scores. 

Final Thoughts

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.

The tide is turning for emerging market equities, which have underperformed their developed market peers for more than a decade. We see significant scope for catch-up over the next year and maintain our positive outlook for emerging market equities and local currency bonds.

2019 Review

2019 will go into the history books as one of the best in financial markets since the early 1990s. At the start of the year, few would have expected such stellar returns as investors grappled with any number of anxieties such as the slowing global economy, escalating trade wars and potentially higher interest rates from the US Fed. These fears failed to materialise and the sharp sell-off in equities in the final quarter of 2018 helped set the scene for a strong recovery in risk assets. Meanwhile, central banks across the globe reverted back to accommodative monetary policy via lower interest rates and/or money creation schemes such as quantitative easing. This led to a flood of liquidity across the financial system. Even as equities reached new record highs, government bond yields continued to reflect slowdown concerns, sending bond yields lower, notably the 10-year US Treasury which fell from 2.69% to 1.91%. The combined rally in global bond and equity markets led to the highest returns in more than two decades.

Key Themes

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. 

Chart of the Quarter

Global liquidity has surged over the last year. This should translate into a pick-up in the business cycle. The red bars in the chart represent the Bundesbank World Industrial Production index. This is based on 6 leading indicators designed to predict the cyclical turning points of global industrial production. This index has started to pick-up and is early in the new cycle.

Fixed Income

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.

Equities

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.

Russian equities trade at their cheapest levels since the financial crisis, whilst offering the highest dividend yield in almost two decades. Both earnings and dividends are expected to continue to grow.

Our best performing position last year was the S&P 500 Technology ETF. Interest rates are likely to stay low for longer leading to further outperformance in 2020.

Commodities

We expect commodities to behave in a different manner to that of the last decade and to perform well this coming year. This is best captured in the chart below which highlights the valuation differences between equity markets and commodities. The red line, MSCI world, has been increasing steadily whereas most commodities are cheaper now than they were 10 years ago. This is highlighted by the S&P Goldman Sachs Commodity Index in orange, with the notable exceptions of palladium and gold. We do not expect this disparity to continue as a broad-based global recovery takes hold, the US dollar weakens and interest rates stay lower for longer. Sustainability and technological change continue to shape demand trends and supply capacity. Looking into 2020, we will further invest in economies and companies attempting to define the modern commodity space. Demand for rare earth minerals, and those elements needed in electric cars, semiconductors, and renewable energy will continue to rise. We are exposed to this theme, indirectly, via our recent allocation to Taiwanese equities.

Foreign Exchange

The US dollar index is a measure of the currency’s value relative to a basket of its main trading partners. We believe this index is now starting to weaken and could fall from 97 to 85 this year as the Federal Reserve continues to expand its balance sheet. This would be unambiguously positive for risk assets such as commodities and equities as well as emerging market securities.

There are a number of reasons we are likely to see a weaker US dollar. The main reason is the rest of the world is catching-up with strong US economic growth and this will influence currency flows. Catalysts include progress in terms of Brexit, the USMCA agreement and the phase one trade deal between the US and China. Also, Donald Trump has been very effective at achieving desired market outcomes, one of which is a weaker dollar. It’s one of the few policies that both he and Elizabeth Warren, the potential democratic nominee, agree on. It is likely that
markets will start to price-in greater US political risk relative to the rest of the world, thereby reducing the demand for the greenback.

Technically, the US dollar is already starting to weaken. In early December, the currency fell out of the channel within which it had been appreciating over the prior 2 years. The black line is important because it shows the 200-day moving average. Prior occasions where the currency has crossed this level have pointed to a significant move higher or lower. Not only has the currency just broken below this line, but the average level seems to be acting as resistance against a move higher. The recent trend of lower highs and lower lows will likely continue throughout the year.

ESG Investing

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.

A 2019 study investigating the relationship between ESG factors and credit risk for 59 countries between 2009 and 2018 found there to be a strong link between the two variables; namely that countries with higher ESG scores (closer to 100) tended to be less risky than those with weaker ESG scores. 

Final Thoughts

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.

The tide is turning for emerging market equities, which have underperformed their developed market peers for more than a decade. We see significant scope for catch-up over the next year and maintain our positive outlook for emerging market equities and local currency bonds.

This investment Blog is published and provided for informational purposes only. The information in the Blog constitutes the author’s own opinions. None of the information contained in the Blog constitutes a recommendation that any particular investment strategy is suitable for any specific person. Source of data: Tavistock Wealth Limited, Lipper for Investment Management and Refinitiv Datastream. Date of data: 22nd January 2019 unless otherwise stated.

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