2019 Review - Easing Monetary Policy Boosts All Asset Prices
In 2019, the Fed quickly ended its tightening cycle, cut interest rates three times, and reversed its balance-sheet normalization plan. China's credit crunch also shifted to a modest expansion, the European Central Bank restarted asset purchases and emerging market central banks entered into a rate cut cycle. Driven by abundant liquidity from global policymakers, a stark contrast to the environment in 2018, asset prices rallied across the board with handsome returns from stocks, bonds, commodities, precious metals and real estate in 2019.
2020 Macro Outlook - Goldilocks 2.0 vs. A Politics-Induced Bear Market
Looking ahead in 2020, our global economic leading indicators point to a potential rebound of global economic growth in the next six months. Although its momentum and sustainability remain uncertain, the current inventory destocking has been close to the previous levels when the cycle bottomed, suggesting limited room for further deterioration of manufacturing activities in the short term.
The bottoming of year-on-year growth in global semiconductor sales, which are most sensitive to the business cycle, was seen in July 2019. Based on the historical length of semiconductor cycles of 3-4 years, the coming upturn is unlikely to peak before the end of 2020.
China's economic cycle is now at its bottom. The current low inventory level has started to drive a rebound in manufacturing activity. The trend where corporate's return on invested capital has improved compared to financing costs will continue to facilitate moderate credit expansion under the assumption that the trade war will not escalate further in 2020 and economic policy remains moderately proactive.
Leading indicators of the US economy still point to a continued economic slowdown. The uncertainty caused by the trade war will continue to weigh on US business sentiment, which is also exacerbated by the fading effect from fiscal stimulus. Without a major breakthrough on trade, it may be difficult for US economic growth to accelerate again in the first half of the year. If the trade dispute does not escalate further, however, the current extremely low household debt service burden and high savings rate are still expected to sustain the strength of consumption and housing activities and achieve a soft landing for the US economy.
The economies of the Eurozone and Japan have demonstrated impressive resilience in the last 18 months, despite the trade war, slowing demand from China and major disruption in the automotive industry. Despite the deterioration of manufacturing activities, service industries continue to prop up their economies, job markets remain stable, and consumer confidence still hovers at high levels. Assuming a stable trade environment, Europe and Japan would recover in 2020. In addition, fiscal stimulus has been increasingly implemented by many governments in a low interest rate environment. China, Japan, South Korea, and the Eurozone are expected to further increase fiscal spending to stabilize economic growth this year.
As a lagging indicator, core inflation pressures in most countries will continue to decrease in the year ahead. Several survey-based indicators point to a slowdown on job growth due to the global manufacturing recession, and the pressure on wage growth will remain moderate for most of 2020. Therefore, monetary policies of the majority of global central banks are expected to remain accommodative this year. With major central banks such as the Federal Reserve, the European Central Bank and the Bank of Japan resuming or maintaining their asset purchase programmes, the global liquidity environment should continue to ease.
In a normal year, the macro setup indicates a "Goldilocks" environment that is most conducive to risk assets - the economy is neither too cold to cause the deterioration of demand, nor too hot to trigger the acceleration of inflation. With concerns over low inflation, geopolitical risks and insufficient room for future interest rate cuts, global central banks would prefer maintaining monetary accommodation until wage growth and inflation pick up significantly. If political risks can be effectively contained, global equity markets, which are still more attractive than government bonds, are expected to record strong performance as corporate profits recover.
In the past 30 years, the Fed successfully achieved a soft landing of the economy three times by quickly adjusting its monetary policy, in 1995, 1998 and 2016 respectively. In the following 12 months, equity markets delivered solid performance with US equity prices surging by an average of nearly 20% and Hong Kong equity prices by over 30%. In addition, emerging markets USD bonds also had decent returns in the same period.
In a US presidential election year, however, the political assumptions on which an optimistic scenario is based are fragile. Investors need to pay close attention to the evolution of geopolitics and US elections. The shift from a liquidity-driven bull market to a politics-induced bear market, which monetary easing is unable to offset, could simply be the result of some sudden incidents or miscalculations from political leaders.
The neglected problem may lie in the job market. Even if the US economy achieves a soft landing, the weakening of the job market, a lagging indicator, is still a high probability event in the next six months. Besides, Trump's main supporters are the very group with the weakest job competitiveness, and any marginal deterioration in the job market may have a far greater impact on his voter base than that showed by overall data. When Trump's popularity drops rapidly, whether he has enough patience to maintain market-friendly policies or instead choose a populist strategy to provoke greater conflict for re-election will be a big question mark.
In addition, there are many political risks that would significantly impact financial markets. Once Democrats' current leading left-wing candidate, Warren or Sanders, is elected, their Robin Hood economic policies are expected to have a major shock on the profit prospects of US multinationals, Silicon Valley giants, energy and financial behemoths. A bear market will then prevail and even central banks cannot offset the downturn. For now, the flood of liquidity has supported global equity markets. Nevertheless, investors' optimism run counter to the increasingly significant global political risks.
Even if a trade agreement is reached, it will not change the fact that the US economy is already in a late cycle. The latest reading from our proprietary US cycle dashboard shows that we are currently in the 93% quantile of the cycle, compared to the 84% quantile twelve months ago. In particular, the significant deterioration in the bond market, such as yield curve and credit spreads has sent a strong late-cycle warning.
A number of indicators suggest that the decade of the US equity bull market is coming to an end. Despite abundant liquidity, the risk appetite in the credit market has not meaningfully improved. The CCC ratings in leveraged loans and high-yield bond market have significantly underperformed higher-rated bonds. Historically, the divergence between a weak credit market and a strong equity market usually occurs right before major equity market drawdowns. Some other quantitative models that we constructed also pointed to a similar conclusion. Even in an optimistic scenario, the US equity market is likely to rise further this year, similar to 1999 when the global equity markets rallied after the Asian Financial Crisis. However, as the case in 2000, a liquidity-driven rally in the late cycle is likely to facilitate excesses building up in the financial market, paving the way for an eventual bear market.
2020 Investment Strategy - Odds Matter in An Uncertain World
We expect that the probability distribution of return on risk assets in 2020 will present a typical "fat tail" shape. That is to say, improved macro-economic fundamentals and loose liquidity will be particularly beneficial to equity markets; but if political risk is out of control, it will also cause a bear market that monetary policy can do little to rescue.
We don't believe that it is a good idea for investors to bet on the direction. Instead, investors should consider investment opportunities from the following perspectives:
First, seek certainty to generate excess return. For example, in an environment where global central banks maintain easing policies and the non-US economies have bottomed out, the US dollar should start to weaken, and non-US assets are expected to have better relative performance. Based on foreseeable geopolitical trends in the medium and long term, the competition of technology investment, supply chain restructuring and the self-reliance agenda in various countries will also bring long-term benefits to Europe, Japan and Southeast Asian countries.
Second, investors should pick assets with the best risk-reward potential based on valuation, market sentiment, position, inventory and other indicators. The possible recovery of the global manufacturing cycle will benefit European and Japanese equity markets the most, given their cheaper valuations and stronger cyclical attributes. Record-high speculative net short positions, extremely-low inventories and insufficient/unstable supply should make copper highly attractive in the Goldilocks scenario. Even in a pessimistic scenario, these assets should drop less than US equities.
Third, risk assets now lack protection against downside risks. Equity, interest rate and forex volatilities are currently at historically low levels, which means the portfolio can be protected at cheap prices via out-of-the-money options. The market's mispricing of tail risks has provided a lucrative opportunity for option investors to capture significant upside/downside potential. And the yen and precious metals are also excellent alternatives to reduce portfolio volatility and diversify risks.
Finally, we believe that Greater China assets, which are now at the bottom of the economic and profit cycle with cheap relative valuations, still remain in the early stage of a long-term bull market. In the short term, the upside and downside risks for Chinese assets are roughly balanced as uncertainty remains due to rising geopolitical pressure. Equity investors should stick to bottom-up stock-picking to capture opportunities with greater certainty at the micro level. Macro risks, if materialized, are likely to mark an end of the decade-old cycle and bring the dawn of a new era in the long run.
Money Never Sleeps, Good Luck Trading!
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