Slowing growth never feels good. In 2019, global real GDP growth will likely decelerate from 3.6% in 2018 to just above 3%.1 The slowdown was most concentrated in industrial and trade-exposed sectors and economies (Exhibit 1), with the US-China trade war and a meaningful decline in auto demand weighing particularly heavily on activity. Service- and consumer-exposed sectors largely remained resilient, however. In the US in particular, household finances continued to improve on the back of labor market strength.
Exhibit 1: The Slowdown Has Been Concentrated in Industrial Sectors
G7 and China Motor Vehicle Sales/Registrations
* Deviations from 50 for Manufacturing PMI Industrial production as of August 2019. Trade volume as of August 2019. Vehicle sales/registrations as of October 2019 (Canada as of August 2019)
Source: Association des Constructeurs Européens d’Automobiles, China Association of Automobile Manufacturers, Haver Analytics, IMF, Japan Auto Dealers, JP Morgan/IHS Markit, Netherlands Bureau for Economic Policy Analysis, Statistics Canada, US Bureau of Economic Analysis
The key question for 2020 is whether 2019’s industrial deceleration is yet another replay of the slowdowns we saw in 2012–2013 and 2015–2016. While there are hopes for an industrial rebound, they have yet to be realized, and continued buoyancy in the service sector is not guaranteed. Looking ahead, our base case expectation is that consumers will remain resilient and that the US and most other major economies will avert recession—or a "hard landing”—in 2020.
Given our expectation for slow growth, but no recession, and extremely accommodative monetary policy, we have a moderately positive near-term view of financial assets, although we recognize that the risk of an unexpected shock is always present. In the year ahead, we will be monitoring six key issues: trade tensions, global industrial growth, US labor markets, monetary policy, the evolution of the global technology ecosystem, and US politics.
Read the full paper to learn about how these six issues could shape the global economy and financial markets next year.
The challenge investors face at this point in the cycle is weighing short-term performance considerations against long-term investment objectives. The temptation to make decisions based on short-term market dynamics can lead to taking positions that can be very damaging. For example, buying a 100-year, low-coupon bond might be a very good trade for an investor who thinks rates will decline by 50 bps, as profit on the trade would be the duration multiplied by 0.5%. However, if rates back up by 100 bps, the same investor would incur large losses.
The reason we highlight this divergence between long-term investing and short-term trading is that the current market environment poses particularly difficult decisions to capital allocators. Rates are likely to stay lower than expected for longer than investors expected even one year ago. As a result, we believe managers will feel pressure to extend duration and take on more credit risk for higher yield. This trade may work for a few months or even a year or more. However, we believe the risk-reward of extending duration is asymmetrically negative at current rates. Moreover, we see increasing signs of underwriting sloppiness in the US corporate credit universe.
Looking through the year, our base case view is that the US 10-year yield stays in a range of 1.25%−2.25%. A break above 2.25% is most likely if the US and China resolve a meaningful portion of the trade dispute, but this is a questionable scenario. A breakdown of trade talks amid further escalation that leads to weakness in the service sector of the US economy could easily take the global stock of negative-yielding debt to $20 trillion and US 10-year yields below 1.25%.
Given our view of rates and credit, it should be no surprise that we are more bullish on equities. However, we believe the easy money of 2019 is behind us and expect a slow grind higher driven by earnings growth rather than valuation expansion. As we survey global equity markets, no major market is inexpensive relative to the last 10 years, and the US and Europe ex-UK are particularly expensive. The UK is the only market close to the median of the last decade, as Brexit risk continues to weigh on prices (Exhibit 2).
Exhibit 2: Equities Range from in Line to Expensive Relative to History
As of 30 November 2019
Median and percentiles calculated based on month-end values.
The figures above represent expected returns. Expected returns do not represent a promise or guarantee of future results and are subject to change.
Within markets, we remain positively disposed toward companies with high, sustainable returns on capital that aren’t currently reflected in their valuations. In our analysis, these compounders tend to outperform throughout the market cycle and defend particularly well in down markets. The challenge more recently has been finding compounders at an attractive valuation. That said, in a market that is likely to be driven by earnings growth rather than valuation expansion, we also believe that security selection is likely to be a much more important driver of total return than in recent years.
Overall, we believe equity market returns in 2020 are likely to be confined to the mid-single digits with fixed income total return between 0%−5%. Going forward, it is critical that investors right-size their expectations for returns, as it isn’t safe to assume that multiples will expand further. While fixed income offers a diversification benefit, it does not offer much of an income advantage over cash. It might be time to reallocate money away from debt toward cash, even if it means a bit of a drag against quarterly benchmarks. It also could be a good idea to allocate away from debt toward compounding equities, as the risk-reward profile is at least more balanced for companies that can sustain high returns.
In summary, investors should expect slower growth and very accommodative monetary policy in 2020. We believe the global economic backdrop will continue to be challenging as we enter 2020, but recession is not our base case. Rather, our base case is that the global industrial slowdown will find a bottom without spilling over to the service sector. Factors to watch in the year ahead include trade tensions and their impact on the economy, the resiliency (or lack thereof) of US labor markets, the evolving global technology ecosystem, and US politics.
Taking stock of the situation, we see modest upside for equities driven by earnings growth. We would caution that at this point in the cycle, investors should take opportunities to upgrade the quality of their holdings with a focus on valuation and fundamentals such as high returns on capital, strong balance sheets, and robust cash flow. In fixed income, while we see no reason to worry about a sharp backup in rates or a spike in defaults in the near term, we are wary of reaching for yield by taking on duration and credit risk. Finally, we believe this is a market environment in which security selection is likely to be a much more meaningful portion of total returns, as equity market appreciation is likely to be capped in the mid-single digits and bond returns may well be even lower.
The preceding is an excerpt from What to Watch in 2020. Read the full paper to learn about six key issues that could shape the global economy and financial markets next year.
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1 IMF World Economic Outlook. As of 15 October 2019.