20 v2
January 20 2020

Investment Committee's 2020 View

20 v2

Macro Economic Summary

US-China trade tensions dictated the market’s narrative in 2019. These tensions will likely continue to be a headwind to the trajectory of markets in 2020. The lack of certainty and low levels of predictability as to the outcome of negotiations has weighed on sentiment and to an extent on trade data. In fact, global trade growth in 2019 is expected to be up 2.5%, with global GDP growth expect to come in at 2.7%. Trade growth below GDP growth is a concern but we think it is temporary. Notwithstanding, markets were driven, in part, by accommodative central bank policy, which propelled global equity indices to close the year up double digits. This was coupled with supportive fundamentals.

An under-rated risk to the markets is the 2020 US presidential election cycle. Should a more left-leaning less centrist democratic candidate win the nomination it could spell trouble for markets in 2020. It’s too early to rely on polling data as to who will win the nomination, but we don’t think markets have priced in probability of any Democratic candidate yet.

Consequently, as of now, we think that equity valuations are lofty, though fair, due in large part to multiple expansion in 2019 rather than due to earnings growth following a stellar price return for almost all major global indices. We think certain sectors have room to benefit as we potentially exit a late cycle global economy.

Record low interest rates pushed bond yields down in 2019, and prices up, especially as recession conversations heated up in the third quarter and investors searched for safety. Gold went on a run in the second half following changes to interest rate expectations. However, the US Federal Reserve’s (Fed) indication in October that they had completed their 2019 cycle of interest rate reductions tamed investors’ fears. Consequently, bond yields perked up a bit from their lows and the curve steepened.

Generally, developed market central banks have paused their rate reduction cycle, but maintain other levers such as quantitative easing - most notably by the European Central Bank (ECB) and the Bank of Japan (BoJ). China has been using several monetary and fiscal tools, in light form, to re-angle its slowing economy. We think greater action will soon be needed to prevent a sub 6% GDP growth for example.

Globally there are indications that the economic cycle may have bottomed according to a global PMI composite of manufacturing and services as measured by IHS Markit; it ticked up in December to 51.7. The ECB and Fed are undergoing policy reviews with a particular focus on inflation. There is risk the Fed may move to an average inflation arrangement which could, in effect, allow inflation to rise above 2%. Emerging market central banks still have maneuverability for monetary action and thus we think this is supportive for EM equities in the first half of 2020. We think fiscal policy levers will start to become part of the global narrative in 2020.

2020 is likely to be a challenging year to navigate. Uncertainty remains: is a phase 1 trade deal enough? Who will be the democratic nominee? Has manufacturing data sustainably bottomed?

We continue to monitor markets to be defensive and re-weight to quality, but increasingly look to cyclicals in the event economic data truly shows a bottoming. As always, prudence, diversification, and rational decision making are an investor’s best approach to weather current uncertainties. We are overweight equities and alternatives, neutral fixed income and commodities.

Asset Class Commentary

Equity

Global equities had a stellar 2019. We think 2020 is likely to be more moderate but interspersed with corrections and a spike in volatility that is likely to test investors’ patience. We think the macro environment continues to drive equity returns and accommodative monetary policy is likely to continue to press stocks higher in the first half. Multiple expansion in 2019 also drove stocks higher. And while we feel that earnings growth has been resilient, it’s too low - sub 5% annually. While we’d like to see a greater focus on fundamentals by investors, the reality is that corporates and multi nationals have simply been weathering the trade tariffs uncertainty rather well by managing expectations. We think that the roll-off of interim trade tensions, even if temporary, is likely to remove this small overhang that contributes to stock volatility.

We think valuations in the US and Europe are lofty but not outsized. Better value was had only 1-2 years ago. Historically, price-to-earning (PE) ratios are about 2x below cycle peaks as implied by macro drivers. Notably, S&P 500 forward PE is nearing 20x as investors continue to buy up stocks for fear-of-missing out.

Laterally, value is coming back as an attractive option not just for momentum investors, but tactical investors who wish to play the early cyclical stocks. Growth stocks, on the other hand, have been in a grind in the second half of the year. Historically value stocks outperform earlier than growth stocks following a macro bottom. We suggest building exposure in stocks not reliant on momentum or growth but on P/B multiple expansion.

In Europe, TINA (there is no alternative) prevails when it comes to stocks. Low rates and lack of serious alternatives have shifted funds to the stock markets and created momentum and a fear-of-missing-out mantra. Thankfully, earnings have been supportive in 2019 to support prices and substantiate dividend yields. Fundamentals have held up similar to S&P 500 peers, but EPS growth still remains muted. A rebounding European economic growth outlook, evidenced by PMIs ticking back up, and supportive monetary policy is likely to continue to press European equities upwards in the ner term. But we feel there is a more supportive outlook for US stocks given the macro backdrop and, broadly, more upside in emerging market (EM) equities. We like the healthcare sector across regions, but Europe’s overweight to consumer discretionary and automotive are two out of favor sectors at the current point in the cycle.

For conservative strategies we continue to suggest defensiveness, although such sectors and stocks are more expensive now than a year ago. For more aggressive strategies, we’d suggest considering increasing quality cyclical exposure in sectors such as industrials and financials, in the event of a lull in the trade war is seen and PMI data, for example, sustainably rises. We favor the US market. In Europe it’s far too early for cyclicals since the ECB may not increase rates until 2021 at this juncture. While PMI data has rebounded it’s too early to call a bottom. Consumer data must be watched more closely here given Europe’s index overweight to consumer discretionary stocks. Markets are likely to look for more guidance from the ECB thru 2020 following its policy review.

We think emerging markets (EM) are likely to continue to offer yield and returns that are more attractive to investor risk appetite. Though we do think a weaker USD will prevail in 2020; this helps foreign companies remain competitive versus American and European counterparts - especially in a higher tariff environment. In a global trend of inward looking, populism, protectionism and even isolation, domestic manufacturers are looking more attractive on a thematic basis. Accommodative EM central banks are also likely to be supportive to EM stocks.

At this point in the economic cycle, we still think equities offer a more attractive return than the return that bonds offer. We remain overweight equities, especially the US and emerging markets.

Fixed Income

A lower for longer environment in 2019 questioned the sustainability of the asset class for long term investors. In 2019, to attain yield, investors reached on the maturity spectrum, increased duration and moved down the credit risk spectrum. Thankfully, the perceived culmination of the conclusion of the Fed’s rate reduction programme has generally lifted yields from their bottom. Continued rhetoric in Europe of intentions to tick down interest rates by another 10bps, for example, could be a catalyst for the ECB’s new leadership to persuade members to more seriously consider fiscal initiatives to encourage sorely needed inflation. After all, Japan has acquiesced and finally launched a USD 120bn plan to attempt to help stimulate inflation, growth and prevent rates from going too negative.

We think Investment Grade (IG) credit will be resilient in 2020 though the amount of BBB-rated debt is still bloated globally. More attractive issuers are likely to be those that have flexibility to pre-empt the risk of a downgrade and in effect solidify their membership in the IG class. Value is likely to be found in this dispersion even though it might be curtailed by earnings which are likely to still be under pressure but grow modestly again in 2020. We still suggest an up-in-quality move and this doesn't necessarily mean a shift from high yield (HY) to IG.

In the HY segment due to continued lack of fundamental upside in the lower end of the spectrum, such as B and even some BB-, higher credit quality high yield bonds that have a path to be upgraded can be attractive. However, we prefer equities over HY simply given that the dividend yield equation is showing a more competitive average than most bonds when considering the risk for reward/quality. In fact, the S&P 500 average yield is higher than the 10-year yield by some 20bps currently.

In China, easing tactics, pointed policy and structural adjustments are likely to pickup in 2020. EM Asia credit largely follows China’s lead. While trade tensions and tariffs spoil upbeat outlooks, there is support for a weaker dollar in 2020. In light of this, EM corporates are attractive as they offer greater yields and generally have lower leverage than developed market (DM) peers. Rate differentials may decrease as EM Asia cut rates due to domestic conditions, such as in India, Malaysia, Philippines and Thailand. While this could lessen the attractiveness of currency carry, it could make EM hard currency debt more stable on a risk-return basis. Furthermore, monetary easing could support supply in both corporates and sovereigns and moderate spreads.

EM corporates still offer the best risk-reward, even with the earnings impacts from reduced global trade and increased operating costs.

Extremely accommodative central banks, rising leverage through greater issuance and active M&A, keep us on alert in 2020 when it comes to fixed income. In a portfolio strategy lens, an option could be a barbell approach, in the event the curve steepens. This might achieve a satisfactory blend of yield, maturity and duration in a flatter and lower rate environment. We remain neutral fixed income.

Commodities

Despite the desperate pleas of central bankers to stimulate inflation, we don’t see this happening in material form in 2020. Traditionally, inflationary environments are helpful to commodities and hard assets such as real estate. However, real asset prices have been stagnant. In addition, slowing global growth, recession fears and dismal outlooks tend to shift asset flows to safer and tangible assets such as gold.

Gold traded on 2019 interest rate expectations and less so on its safe haven status. A more moderate 2020 macro outlook and weaker USD could portend a correlated strength in gold prices but only to a certain level. Gold remains a moderately attractive asset and we continue to suggest minor allocations.

We think that oil is increasingly sentiment based and less fundamentally supply/demand focused than markets are pricing. In fact, in November 2019 the US exported more oil and oil by-products than it imported. Nevertheless, flare ups in the Middle East such as oil tanker hijackings, rocket firings, or shipping blockades are likely to roil markets. For traders these are opportunities, but for long term investors oil’s contribution to inflation is waning. Thematically, green initiatives, reusable straws and the plastic free revolution sweeping society are further pressure on crude oil and its by-products.

We are neutral commodities. Oil continues it decline of importance to the global economy as the green revolution takes momentum.

Alternatives

In the face of what we expect to be an increasingly volatile market in 2020 versus 2019, we think certain alternative investments can reduce overall portfolio volatility while increasing the probability of achieving expected returns.

Specifically, we prefer non blind pools of concentrated investments in sectors such as: business services, technology services, healthcare services, education and real estate. Convertible or hybrid debt and equity arrangements can be attractive to give investors options as the life of a fund matures. We prefer specialty managers who are proven generators of alpha in their area of expertise.

Real estate

Hard assets such as real estate are typically correlated with rising inflation. Though the prospect for a sustainable increase in inflation for 2020 is muted. Trend-wise on a longer term basis it’s inevitable asset prices increase over time. Specifically, certain categories of real estate are attractive: multi-family housing, student housing, and diversified multi-tenant warehouses. We’re not in favor of commercial real estate, specialty use properties or trophy properties that rely on unique uses or specific buyer-tenant profiles. While REITs are an alternative liquid or yield-bearing strategy they are exposed to market risk and have expensive valuations.

Hedge funds

We prefer niche or specialist strategies that add valuable expertise to our asset allocation models. We like merger arbitrage strategies in the face of economic uncertainty and volatility in the stock market as deal terms are a largely predictable element. We are neutral in respect to the type of fund structure employed so long as it fits a particular investors’ portfolio circumstances. Furthermore, we are also neutral in respect to the size or length of the track record, so long as the manager has a proven track relative to similar strategies at other fund houses. We are underweight long/short and special situations.

Private credit

In the face of dislocation of the banking system globally, we find direct lending funds to be an attractive opportunity across Europe, US and Asia, where we feel the small business growth fundamentals are trending higher.

Private equity

We feel private equity has been overbought with expensive valuations. Style drift is an increasing risk in the late economic cycle as managers reach to match historical returns. However we think value can be found in well capitalized companies that add cushion to a manager’s scenario testing. We are neutral private equity and think better options are found elsewhere in this asset class.

Venture capital

For riskier portfolios, we suggest to diversify overall technology exposure with venture investments. We like technology as a long term overweight and this can be implemented in portfolios in several ways. Global mega tech is well played and over owned. To truly take advantages of the next several decades’ mega-trends, opportunity can be found in early stage transformative solutions that change human behavior. In this instance, we would recommend diversifying away from traditionally liquid tech and considering early stage venture funds or fund of funds that have proven reputations and investment records.

Overall, alternative assets are an important diversification mechanism in portfolios which can withstand the illiquidity, terms and fees for the reward of lower volatility and potentially higher probability of achieving expected returns.

Sources: Bank of America Global Research, Bank of America Private Bank, Bloomberg, Blackrock Investment Institute, Goldman Sachs Investment Research, Jeffries Group, JP Morgan Investment Research, Julius Baer, Lombard Odier, Neuberger Berman, Pictet, Reuters, Sandler O’Neil & Partners Investment Strategy Group, S&P Global, The Financial Times, The New York Times, The Wall Street Journal and UBS Investment Research.