The Great Divergence
| 08 Jan 2020
The past year was an extraordinary combination of disappointing economics and exuberant markets – equities remain our preferred asset class for 2020 but lower returns and higher volatility should be expected…
2019 was a year of astonishing contrasts. For the financial markets, it was a ‘vintage’ year, with almost all investable assets that we measure generating returns above inflation (many by a substantial margin). The breadth of assets that saw gains was extraordinary: government bonds, investment grade credit, high-yield, global equities, commodities, private equity, listed real estate, infrastructure and gold. For world equities (up 22 percent in sterling terms), it was not only one of the strongest years since the rebound from the credit crisis in 2009, but also a year where the volatility of returns was exceptionally low. A similar calm was seen in other markets. In currencies, for example, the euro/dollar rate traded between just USD $1.09 and $1.15 all year, a trading range just a third of the average seen since the European currency launched two decades ago.1
By contrast, in the real world, economic conditions worsened for most of 2019, with the IMF forecasting global growth of just 3% for the full year in purchasing parity terms, the lowest in a decade. Over the summer, measures of economic and policy uncertainty surged2 even before the current Middle Eastern crisis. Trade disputes, presidential impeachment and a UK election that threatened a unique economic downside all impacted business confidence. Two of the strongest Asian and emerging world economies, Hong Kong and Chile, saw mass demonstrations, while growth slowed in both the regional giants of India and China. Even in the US, the respected ISM manufacturing survey recorded a 10-year low of 47.2 for December (below 50 implies contraction) as the backwash from the global slowdown and a strong dollar hit American industry. Yes, unemployment remains low and in general the global consumer is in good shape, but growth is fragile and arguably close to stall speed, outside of the US.
So why was life for those on Main Street so much tougher than on Wall Street?
The explanation for this ‘Great Divergence’ between the real world and financial world lies first in the actions of central bankers. Last year opened with Federal Reserve (Fed) Chairman Jerome Powell’s dramatic reversal of course in the language used to describe the central bank’s balance sheet reduction. Six months later, this evolved into the first of three US rate cuts (and the first America had seen since the crisis of 2008). Other central banks around the world followed suit via various routes – the Chinese central bank steadily reduced reserve requirements (and has done so again in the first days of 2020), central banks in India and many other emerging market countries cut rates directly while the ECB controversially restarted its asset purchase programme (QE) in November.
Second, this freedom to loosen policy has been made possible by inflation that still remains stubbornly low, with all G7 economies reporting core prices below 2%. The final reason for the buoyancy of financial markets has been strong thematic trends that have supported earnings in some key market sectors – the rapid adoption of the Cloud, AI initiatives and potentially 5G have benefited companies at the forefront of automation and digitalisation while the imperative of climate change has boosted renewable and selected industrials.
Pleasingly these trends have broadly matched our strategy across portfolios at Sarasin and Partners. Our asset allocation preference has been for an overweight to global equities where our core manager team have broadly managed to outperform global equity indices by focusing on powerful secular themes – among them automation, climate, new consumption models and ageing. Alternative assets, including infrastructure, renewables and meaningful positions in gold, also contributed strongly to returns. Finally, we were alert to the investment flows that looked set to return to UK assets in the event of a political resolution to Brexit and so hedged a significant portion of our foreign currency exposure. Sterling ended 2019 as the second best performing G10 currency.
Better news on trade, still generous central banks and higher government spending promise a modest economic rebound in 2020
So what of the future? Our broad assumption is that President Trump will need to maintain economic momentum well into the 2020 election (even more so since his actions in Iraq) and this will require de-escalating international trade disputes. Already it appears that a Phase 1 trade agreement with China is largely complete - “That’s a done deal, put that one in the bag” Peter Navarro the White House trade advisor stated last week. Note though that the deal is bare bones only – the actual reduction in current tariffs is small, with the average tariff on Chinese imports still 19.3% versus 3% before the dispute began.3 Meanwhile the White House has also succeeded in getting the US-Mexico-Canada Agreement (USMCA), the successor to the 1994 NAFTA, signed by all parties in December after major changes demanded by US House Democrats.
We also believe that global monetary conditions will likely remain generous in 2020. The Fed’s December meeting saw 13 of its 17 members forecast no change to rates this year, with Jerome Powell stating it would take a material reassessment in the outlook to warrant a shift in policy. In Europe, Christine Lagarde, the new ECB chair, announced a wide-ranging policy review but no change to the current monthly programme of 20 billion euros of bond purchases or the negative 0.5% deposit rate. Meanwhile, in Asia, the People’s Bank of China will continue to support liquidity in the local banking system. Expect other Asian and emerging world banks to continue to loosen.
In addition to generous monetary conditions, we also see continued fiscal expansion as governments look to mitigate populist pressures and buttress domestic growth. The Trump administration is already running a massive 4.6% of GDP deficit, Japan ran a 2.9% deficit in 2019 (with a commitment to further stimulus) while the UK’s new government has committed up to £80 billion for regional infrastructure spending. European fiscal spending continues to creep higher, with further funding likely under the banner of ‘Green Budgets’ (even in the face of German opposition).
Bond yields will trend modestly higher, volatility will increase while equity leadership could slowly pivot away from the US…
In principle then, trade, monetary and fiscal policy should act together to support a fragile world economy in 2020. If we are right then this should trigger a modest firming of manufacturing data, a recovery in global trade volumes and, in time, a gradual rise in bond yields. To some extent this already began last quarter; the inversion of the US yield curve seen over the summer has reversed, the mountain of negative-yielding government bonds has fallen from a staggering $17 trillion to around $11 trillion today4, while the US 10-year yield has risen by 35 basis points from its summer lows. Copper, a good bellwether of economic activity, has also rallied strongly from its August base.
Even modest rises in bond yields will likely alter equity market leadership, and if the moves are significant could trigger a rise in financial market volatility, as we saw in the first and fourth quarters of 2018. There is already some evidence of the former – high valuation Silicon Valley IPOs have suffered recently, with Lyft and Uber both trading around 34% below their IPO prices, global value indices have rallied since the summer, while bank stocks – particularly in the US – have climbed strongly as the yield curve has steepened. There has also been a catch up in non-US equity indices versus their US equivalents, notably in the markets of Japan, Germany and France over the last quarter of 2019. These trends are likely to continue and while not significant to a thematic investor like ourselves suggest a possibly less US-growth-dominated backdrop for global equity investors.
What could go wrong – security threats, debt and continued environmental risk?
Military and security threats are a rising risk to financial markets in 2020. The recent US drone strike that killed the Iranian Quds Force commander marks a pivot towards direct confrontation with Iran and a decision that other administrations have previously shied away from. It is worth noting that an Iranian/Iraqi coalition is not impossible given around two thirds of the latter’s population is Shia. Meanwhile, a more belligerent North Korea that promised a “Christmas gift” for the US has left defence officials across the Pacific prepared for the worst. Finally, US-Soviet relations continue to deteriorate with a series of military and nuclear arms control agreements now void or soon to expire. This is in part the reason for our continued holdings of gold, higher than normal cash positions and rolling programmes of portfolio insurance.
Another concern relates to the continued build-up of global debt and the steady deterioration in the quality of corporate bond issuance. Both the World Bank and the IMF issued warnings last year highlighting the rise in private sector debt and in particular the accumulation of emerging world borrowings. We have acted by reducing almost all our exposure to high yield, emerging world debt and leveraged loans or related products with overall debt quality now averaging A to A+ across our balanced funds.
Finally, Environmental, Social and Governance (ESG) issues were a key focus for us in 2019, led by significant deepening of climate risk. Today we see additional ESG challenges in the area of Extended Producer Responsibility (EPR). This is where producers are held liable, at least in part, for the treatment or disposal of post-consumer products. Fast fashion could become the next ocean plastics as the industry is forced to confront the disposal (via landfill or incineration) of around 70% of all clothing produced today.5 We will be looking across supply chains, scrutinising commitments to recycle/re-use, and watching for new liabilities particularly in the retail, food, fashion and clothing industries. The impact for shareholders could be considerable.
In summary, 2019 saw just enough growth to support corporate earnings but with downside risks that still caused central bankers to ease. This fragile ‘Goldilocks Scenario’ which was so rewarding for markets in 2019 will not easily be repeated in 2020. We will continue an overweight to global equities to reflect their superior yield and dividend growth potential but be increasingly cautious across other asset classes – deploying portfolio insurance, positions in gold, higher cash levels and a cautious credit strategy. In our equity mandates, we will continue to focus on recurring earnings from long-term secular themes, strong and integrated ESG to reflect the increasing climate imperative, and recurring dividend growth.
1 Wall Street Journal 4/1/2020
2 Global Economic Policy Uncertainty Index posted a 5 year high in August 2019 – Bloomberg
3 Gavekal Jan 2019
4 Bloomberg Barclays Global Negative Yielding Debt Aggregate – Jan 2020
5 Circular Fibros Initiative analysis