Knowledge. Shared Blog

March 2020

Market GPS: Client Considerations Copy

2020 Vision

• Suny Park, CFA, CPA
  
  Head of Institutional Client Strategy, North America

Following the Market GPS: Investment Outlook 2020 provided by our heads of Equities, Fixed Income and Alternatives, Suny Park, Head of Institutional Client Strategy, North America, explores key considerations for institutional clients in 2020. Topics of discussion include the risk of a potential U.S. recession, ongoing U.S.-China trade tensions, the path of central banks’ policy rates and why we believe the outlook for investors in 2020 must be one of caution, selectivity and patience.

What a difference a year makes: in 2018, most risk and safe-haven assets underperformed cash, as represented by the 3-month U.S. Treasury bill; conversely in 2019, almost all strategic assets outperformed cash. One could say portfolio diversification failed in both 2018 and 2019 because all major return-enhancing and risk-reducing strategic assets fell and rose in tandem. In a recent research meeting, Julian McManus, one of our international equity portfolio managers, casually observed:

…companies are reporting slowing orders and declining profits, and yet stock prices seem to look beyond these negative company fundamentals and continue to go up based on an expected trade resolution between the U.S. and China.”

His observation highlights one of the macro issues top of mind for institutional investors, and one that has been a major driver of recent market returns.

Explicitly or implicitly, during 2019, most institutional investors have been grappling with the following major issues:

The mid-2019 yield curve inversion potentially signaling a recession in the U.S.

The impact of the ongoing U.S.-China trade war on financial markets.

A possible “Japanification” of developed Europe and the U.S.

A Recession Waiting in the Wings?

Despite evidence to the contrary, because the Great Recession of 2008 and the resultant equity bear market is still fresh in their minds, most investors heuristically equate recessions with equity bear markets. A slowdown in the economy should translate to slow sales; slower sales, in turn, should translate to lower profits; and lower profits, in turn, should result in lower stock prices. But, as shown in Exhibit 1, the U.S. financial market’s history does not necessarily support this causal relationship between recessions and equity bear markets.

Exhibit 1: A U.S. Recession in the Cards?

Source: Federal Reserve Bank of NY. Note: The first figure in each set of two shown is the cumulative return of the S&P 500 Index during recession; the second figure in each set of two shown is the cumulative return for the last four months of recession.

Between 1959 and 2019, there have been eight recessions in the U.S., as defined by the National Bureau of Economic Research. In half of those recorded recessions, the S&P 500 Index generated positive returns (the first figure in the set of two shown in Exhibit 1) during the recessionary periods in 1961, 1980, 1982 and 1991. In addition, in seven out of eight recessions, the S&P 500 Index generated strong positive returns in the last four months of a recession (the second figure in the set of two shown in Exhibit 1). Some attempt to predict future recessions in hopes of avoiding equity bear markets; however, as Exhibit 1 shows, it is not a foregone conclusion that recessions automatically trigger negative equity returns. Further, one runs the risk of missing out on strong positive equity returns by completely sidestepping the last four months of a recession.

Therefore, attempting to tilt or time equity allocations based on whether a recession will materialize is a low-success investment strategy. It demonstrates why George Maris and Alex Crooke, our Co-Heads of Global Equities, de-emphasize macro issues such as a potential U.S. recession, the ongoing U.S.-China trade war, or other geopolitical events with binary outcomes, and instead choose to focus their research efforts on company-specific fundamentals. Albeit important to be informed, it is just too difficult to make company-level investments based on prevailing macro issues.

Jim Cielinski – our Global Head of Fixed Income – recently highlighted that the 2019 yield curve inversion has correctly signaled a fragile global economy, and noted that it would be courageous to say the inversion is not important. Jim Cielinski is absolutely right. However, in our view, recession, whether it eventually materializes or not, is not important to how investors should view their strategic allocations to equities or fixed income.

The Ongoing U.S.-China Trade War

Had it been fully implemented, about $550 billion worth of Chinese imports (roughly 2.6% of U.S. GDP) would have been subject to U.S. tariffs. Given the size of the U.S. economy, it is not necessarily the magnitude of the Chinese imports that investors are concerned with but, rather, the associated negative externalities and the pall it casts over investor and business sentiments. In his 23 August 2019 Jackson Hole speech, Jerome Powell remarked:

In principle, anything that affects the outlook for employment and inflation could also affect the appropriate stance of monetary policy, and that could include uncertainty about trade policy. … There are, however, no recent precedents to guide any policy response to the current situation.”

Despite the low unemployment rate of 3.5% in November 2019 and actual GDP continuing to grow at a faster clip than potential GDP, the Federal Reserve Board (the Fed) preemptively cut the federal funds rate by 25 basis points to a target range between 1.50% and 1.75% as an insurance against uncertainty from the ongoing U.S.-China trade war because, as noted, “there are…no recent precedents to guide any policy response…” Clearly, even the Fed is concerned about the ongoing U.S.-China trade war; however, the Fed’s concern is over the trade war’s impact on its dual mandate for price stability and maximum employment, and not necessarily over the impact on the price of financial assets.

Just like our view on a potential recession and the related impact on equity markets, reading tea leaves on which way the wind will blow on the U.S.-China trade war also represents a low success investment strategy, even if it impacts investor sentiment and financial markets over shorter time periods.

As shown in Exhibit 2, the average return around both positive and negative news surrounding the trade war has been 0.21% between June 2016 and October 2019 – meaning, investors were better off ignoring news surrounding it. Sure, one could have generated meaningful alpha by timing the news, but that alpha would have accrued only to clairvoyant investors with perfect foresight.

No bottom-up, fundamental investor can fully divorce oneself from market-moving, uncertain macro events; however, lacking perfect foresight, the key to success in any investment strategy is relating how macro uncertainties will impact the fundamentals of individual companies in the investable universe, as opposed to relating macro events to the direction of broader financial markets.

Exhibit 2: Timeline of the U.S.-China Trade War

S&P 500 Index returns (%)¹

 

Source: Reuters – “Timeline: Key dates in the U.S.-China trade war”, 10 October 2019, Janus Henderson Investors and Bloomberg. Periodic returns shown span key moments in the strained trade relationship between the U.S. and China from June 28, 2016 to October 10, 2019.
¹ Periodic returns shown are cumulative, spanning from 3 business days prior and extending to 3 business days after the announcements.

Exhibit 3: Paths to Negative Policy Rates

Source: Christensen, Jens H.E. “Yield Curve Responses to Introducing Negative Policy Rates.” FRBSF Economic Letter 2019-79, 15 October 2019.

Are Europe and the U.S. Fated to Repeat the Japanese Experience of the Past Three Decades?

For the past 30 years, Japanese equities, as proxied by the local currency MSCI Japan Index, failed to surpass the high watermark reached on 29 December 1989. To put it more bluntly, if local investors had bought and held the index, they would have made no money for the past three decades.

Separately, the paths of policy rates shown in Exhibit 3 illustrate how the European Central Bank (ECB), the Swiss National Bank (SNB), Sweden’s Riksbank (SR) and the Danmarks Nationalbank (DNB) have followed the Bank of Japan (BoJ) to the zero and negative interest rate netherworld since 2015. And consider the following ECB interest rate policy guidance from September 2019:

The Governing Council now expects the key ECB interest rates to remain at their present or lower levels until it has seen the inflation outlook robustly converge … close to, but below, 2%.”²

Given the open-ended nature of the foregoing statement, as long as the ECB remains steadfast to the foregoing policy statement, and inflation outlook fails to converge to 2.0%, interest rates in the eurozone may remain stuck in the nether region of zero to negative for the foreseeable future. The harsh implication for investors and pensioners is obvious. They must meaningfully lower their expected returns on all strategic assets because, as remarked by Jim Cielinski:

With risk-free rates measured in basis points … and negative in swaths of Europe, it is a meager foundation on which to build returns”

No one knows whether we are fated to repeat the Japanese experience of the past three decades; however, despite strong and rising equity markets in 2019, it behooves all of us to set our long-term return expectations lower, meaningfully lower than those realized since the nadir of the Global Financial Crisis in February 2009.

What Does it All Mean in 2020?

There are plenty of macro uncertainties, however, we caution against making investment decisions in reaction to macro events with binary outcomes such as a potential U.S. recession, Brexit, or the eventual outcome of the U.S.-China trade war. Their impact on asset prices tend to be ephemeral and soon forgotten after their eventual resolution. Instead, there is long-term merit in adding alternative diversifying sources of returns, especially in a world where traditional portfolio diversification may no longer work as witnessed in 2018 and 2019.

In our opinion, of the three macro issues delineated in the opening paragraph, a possible ‘Japanification’ of developed Europe and the U.S. represents, by far, the biggest secular threat to investors and pensioners because of its impact on future expected returns on both risk-reducing and return-enhancing assets.

Many believe the current equity bull market is long in the tooth, the credit cycle is in the latter stages and valuations across both risk-reducing and return-enhancing assets appear stretched. As a result, the dearth of assets or investment strategies (both at strategic and opportunistic levels) able to generate returns high enough to meet spending needs represents the biggest challenge facing all investors. Coupled with that, given the current yield on U.S. Treasuries, many investors do not believe they can count on Treasuries or other risk-reducing assets to provide the same level of protection they once did prior to 2008. Given this asymmetry in the range of outcomes – lower expected returns and elevated risk of loss – the outlook for investors in 2020 must be one of caution, selectivity and patience.

 

² ECB press release, 12 September 2019.

Charts and graphs are for illustrative purposes only and do not represent the performance of any investment.

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