Goodbye 2019, and our guide for 2020 in global equities
Head of Equity Strategy
Summary: The return in global equities have been much higher than even the wildest fantasies of market participants back in early January. Significant positive impulses from central banks and commitments of fiscal spending seem to have stopped the bleeding with global leading indicators suggesting the global economy moved into the recovery phase in October. What does that mean for equities in 2020? We also talk about the signs of rising inflation expectations and how this should be played in global equities.
With less than two weeks to New Year we are leaving 2019 with a feeling of bewilderment and a sense of “can this really continue?”, as the year shaped up very differently from what we expected a year ago. In early January before Powell’s famous U-turn consensus was that the Fed had made a gigantic policy mistake hiking the rate in December 2018 paying no attention to signals coming from financial markets. What endured was the second worst December for US equities since 1927. The Fed’s U-turn and subsequently easing of monetary policy followed by the majority of the world’s central banks lifted sentiment and equities erased the Q4 2018 losses by April 2019.
Since then the US-China trade war hamster wheel turned multiple times causing markets to be driven by tweets and trade news headlines frustrating market participants. During the second half of the year many countries (South Korea, Japan, Netherlands etc.) planned higher fiscal spending in 2020. The combination of stimulus from central banks and governments extended the momentum in global equities despite falling profit growth, which is currently negative for emerging market companies, and as of yesterday the NASDAQ 100 is up staggering 39.5% on a total return basis. In this impressive rally for the technology sector lies also the culprit to the short-lived outperformance of value stocks that occurred during the year. In a low rates and growth environment technology companies with monopolistic power is the preferred segment. But this trend could easily be challenged as we will see in our guide for 2020.
One of the interesting developments the past month is the steepening of the US yield curve (10-2Y) reaching the highest levels observed in 2019. The rise in the yield curve can be decomposed into multiple parts where one of them is inflation expectations and this factor observed through break-even rates is clearly a major explanation. Our head of commodity strategy, Ole S. Hansen, has lately talked about food inflation is also coming to live across many food categories. What are the implications for investors if inflation is finally picking up?
If 2020 becomes the year of higher inflation and nominal growth then the most recent reaction function during the 2016-2018 nominal growth acceleration is a good guide. In this period nominal growth in the US rose from 2.3% y/y to 6% y/y and the 10-year yield rose from around 1.5% to 3.1% before the wheels came off during Q4 2018. If a similar scenario plays out but with the add spice that the Fed keeps the short-end of the yield curve under control despite rising fiscal deficits then we will see a massive steepening for the yield curve. In this scenario investors should overweight financials and under the inflation trade overweight the materials sector.
One thing is for sure going into 2020. Global equities have discounted a significant rebound in economic activity and profits inflating equity valuations to the high end of the historical spectrum. This means that even under good conditions in 2020 equity returns could be muted despite higher activity in the real economy. The only case for double digit equity returns again next year is a melt-up scenario as in 2000.
As we have been writing about lately the global leading indicators from OECD showed in December that the global economy turned a corner in October transitioning into the recovery phase. Historically this phase has been the best phase for equities on a relative basis against bonds. The excess total return in USD has been 9.4% during the business cycle phase. One possible path next year to this historical relationship is bonds down 10% during the recovery phase and equities unchanged. This could happen as inflation expectations creep higher and with it yields. This would in turn reach an inflection point where high duration growth assets such as technology stocks are hit on valuations as the discount rate suddenly becomes too high to justify the valuations.
As our business cycle map indicates the big trade right now is emerging market and Asian equities. This trade would also fit with a lower USD as the Fed does everything to keep rates low despite a rising US deficit which naturally leads to another round of QE and increasing balance sheet. On a sector level investors should overweight cyclicals and as a joker consider the energy sector as a supply constraint could force oil prices higher next year; this is by no means a consensus view.