Paul O’Connor, Head of the UK Multi-Asset Team, considers whether or not markets can continue to defy gravity in 2020, as we move into a post-stimulus era.

 

An eventful but rewarding decade for financial investors ends with a boom year. In 2019, government bonds delivered mid-single digit returns, with corporate debt, emerging market debt, gold and most equity markets registering double-digit gains[1]. The resilience of investor risk appetite throughout the year has been fairly impressive, against the backdrop of continued downgrades to global growth and a broadening range of adverse geopolitical developments: the ongoing Brexit saga, the US-China trade dispute, civil unrest in Hong Kong, the attempted impeachment of President Trump and more.

[1] At the time of writing, on 16 December 2019.

Still, many of these issues first emerged in 2018, and began to be priced into financial markets during that year – a disappointing one for investor returns in most asset classes. Taking the two years together, we see that much of the rise in financial markets in 2019 has just been compensation for losses in the previous year (see chart 1). The bigger picture here is of a tiring equity bull market, with many regional indices making little real progress since the end of 2017.

Chart 1: Many regional equity indices have made little progress since 2017

Source: Bloomberg, Janus Henderson Investors, 31 December 2017 to 15 December 2019. Notes: MSCI World ex US, MSCI EM and MSCI US indices, total returns, rebased to 100 at start date. Past performance is not a guide to future performance.

Weakening tailwinds, stronger headwinds

In broad terms, there are certainly some fundamental reasons why the equity bull market should now be expected to show signs of fatigue. For one thing, the great monetary easing that defined the post-crisis financial market environment has more or less come to an end. While we foresee more quantitative easing and more interest rate cuts from central banks around the world in the year ahead, the incremental impact from here will be modest compared to that seen over the past decade. On top of this, global growth continues to slow. It has been slowing since the end of 2017 and is expected to slow further in 2020 (see chart 2). Just as some of the key tailwinds that propelled the bull market are now beginning to tire, geopolitical headwinds are intensifying.

Chart 2: Growth is expected to slow further in 2020

Source: Bloomberg consensus forecasts, Janus Henderson Investors, as at December 2019.
Notes: Chart shows how forecasts for each year were revised across time. Past performance is not a guide to future performance.

Lower but longer

While this might all seem rather gloomy, we would argue that it would be unrealistic to expect sustained strong growth so late into the global economic expansion, with monetary policy looking fatigued and global unemployment already at historic lows (see chart 3). Indeed, it is notable that the mood among businesses and consumers is unusually sober for this stage of the expansion. This means that central banks are under very little pressure to take away the punchbowl and bring the party to an end. Rather than the usual late-cycle boom in animal spirits, we are now seeing subdued levels of economic sentiment that seem consistent with moderate rates of economic growth but, more positively, offer up hope of an unusually elongated economic expansion.

Chart 3: Unemployment rates are already at historic lows

Source: Bloomberg, OECD, Janus Henderson Investors, December 1983 to December 2019.

Expect mini-cycles

This lower-for-longer economic scenario does support the case for an unusually extended bull market in risk assets, but age should nevertheless still be expected to take its toll on market conditions. We regard the broad market environment of the past two years as a reasonable guide to what can be expected in 2020: modest investment returns and occasional flare-ups in market volatility. Instead of expecting big sustained swings in macro momentum, policy and investor sentiment, it is probably right to prepare for an environment of mini-cycles that last just a few quarters. While buy-and-hold investing is an effective strategy in a world of strong, trending investment returns, these sorts of choppy, rotational market conditions demand a more active approach to asset allocation to boost returns and to manage risk.

Sentiment rebound

As 2019 draws to a close, investors are toying with just the sort of thematic rotation that we would see expect to see in this kind of market environment. While global markets in the first eight or nine months of the year were dominated by the themes of slowing global growth, central bank monetary easing and concerns about trade conflict, the year’s latter stages saw investors wondering if these themes were now fully priced into financial markets. Accordingly, we have witnessed a rotation away from the growth-sceptical strategies that performed strongly earlier in the year, towards more reflationary, growth-positive themes.

Tentative signs of macroeconomic stabilisation and emerging optimism for a ceasefire in the China-US trade conflict have been the key catalysts for this market rotation. In the summer, consensus sentiment on the global economy was so gloomy that even the modestly better economic news of recent months has had a fairly sizeable impact on market performance. The rotation so far has been as much about a normalising of investor sentiment as it has been about improving fundamentals. However, now that investor expectations and positioning have adjusted more optimistically (see chart 4), the reflationary rotation will probably need more convincing signs of improving global growth for the market leadership trend to be sustained.

Chart 4: Has optimism replaced fears of a recession in 2020?

Source: Google Trends, Janus Henderson Investors, January 2004 to December 2019.
Notes: The chart tracks “interest over time” for the search term “recession” on Google. Numbers represent search interest relative to the highest point on the chart for the given region and time. A value of 100 is peak popularity for the term. A value of 50 means a term is half of peak popularity.

Macro stabilisation

As the year ends, the balance of evidence seems to supports the view that economic data are evolving in the way required to extend the pro-growth rotation in financial markets into 2020. While we do not yet see clear signs of the prerequisite upgrades to consensus forecasts for global growth, we do at least see some evidence of macro stabilisation. Manufacturing has been the key area of disappointment globally over the past couple of years but lead indicators in most of the major countries are now turning up in this sector.

Beyond this, some of the effects of monetary policy easing in 2019 should still be feeding through to support growth in 2020. While central bank rate cuts have been fairly modest this year, their impact on growth has been amplified by flattening yield curves and declines in private sector credit spreads, leading to easier financial conditions for both corporate borrowers and households. Fiscal policy is giving another modest boost.

A ceasefire in the China-US trade negotiations is probably a key precondition for this scenario to be sustained – it is hard to see a meaningful recovery in business confidence in the manufacturing sector without some easing of trade tensions. At the time of writing, press reports suggest that some sort of “phase 1 agreement” has been established, although the evidence remains patchy. While it seems clear that China and the US look set to engage in strategic economic disputes on a number of fronts for years to come, the messaging from both sides seems to favour some sort of de-escalation of hostilities, for a few months at least.

A big rotation in 2020?

As things stand, it is hard to predict how far the developing pro-cyclical themes in markets will run. The most optimistic outcome would be if global macro momentum strengthens decisively in 2020, inspiring a big rotation of funds from fixed income and money market funds into equities, reversing 2019’s investor flows and energising these emerging market trends. However, we see this as being an upside risk scenario rather than our central case for 2020, which remains based on our expectations of a fairly uneven economic recovery, more hesitant market leadership and occasional setbacks in investor confidence.

Clouds on the horizon

Until the data convincingly improve, it is going to be hard to dispel general concerns about whether the cyclical upswing will be strong enough to sustainably revive the aged economic recovery. Our near-term optimism on this front is counterbalanced by the recognition of the following vulnerabilities of the global economy that loom over the longer-term outlook:

• Inflation has been surprisingly weak throughout the post-crisis recovery. With the global economy looking set for another year of sub-trend growth in 2020, it is far from obvious why the recent downshift in inflation and inflation expectations will be reversed. Low inflation remains an enduring symptom of central bank policy ineffectiveness and a threat to corporate profit margins as labour markets tighten.
• While we remain hopeful that the uncertainty surrounding China-US trade relations will ease somewhat in 2020, this will not fully clear the fog of geopolitical uncertainty overshadowing the outlook. Indeed, the US presidential election is probably a new potential risk for 2020 that markets have only partially priced in. It is hard to calibrate how political uncertainty will influence business sentiment, but it is possible that it will remain a persistent drag on confidence and activity.
• The Chinese economy continues to slow, reflecting both global and domestic developments. While we expect that further Chinese policy stimulus in the months ahead will lift macro momentum, there are notable risks to this view. China’s strong growth over the past decade was supercharged by the rapid accumulation of private-sector debt. However, with policy makers now prioritising financial stability over large-scale stimulus, both debt accretion and economic growth might slow further in 2020.

Bullish, for now

We see plenty of risks but nevertheless enter the New Year optimistic that economic recovery will sustain investor appetite for risk assets into the first quarter of 2020, extending the reflationary rotation that began in late 2019. Reflecting this we currently favour equities to credit, with a particular focus on more economically sensitive regions such as Eurozone, Japan and emerging markets. Beyond this, we are less positive about the prospects for defensive assets that have performed strongly, such as gold, investment grade bonds and duration more broadly.

The unfamiliar combination of an elongated cyclical recovery fighting against some powerful structural headwinds sets a complicated macro backdrop for financial markets in 2020. We will remain vigilant to the risk that the anticipated modest cyclical recovery is overwhelmed by some of these adverse influences, but we see scope for upside surprise scenarios as well if the recovery does gain traction. The risks to our central scenario seem both sizeable and symmetric as we enter the new decade.