Taking a two- to three-year view of the world is challenging as economies around the world transition to quite a different economic backdrop to the past.
However, we believe interesting opportunities are there to be found if we remain focused on a mix of long-term market forces and how they interact with shorter-term drivers.
2019 saw economic and interest rate expectations go into reverse. A number of Purchasing Managers Indices (PMIs), which are used as a barometer of economic sentiment, have fallen below the crucial 50 mark, crossing the threshold between ongoing expansion and contraction.
To counter this slowdown in growth, interest rates have been cut by key central banks, which is a significant change from the start of the year. In December 2018, the market was still pricing in ongoing interest rate hikes by the US Federal Reserve (Fed).
Heightened economic risks have primarily come from concern and uncertainty over trade. Digging beneath the surface of global PMIs reveals that the weakest sectors have been those most closely associated with trade, such as Autos, but also commodity-related areas.
However, some tentative evidence has emerged over the past month that the slowdown has broadened out to the service area of the economy, with sectors such as tourism and commercial services now slowing.
This is by no means conclusive but leads us into the New Year with a huge amount of uncertainty surrounding how severe the economic downturn is ultimately going to be. Serious questions will now be asked of monetary policy and how effective it can be if growth and inflation expectations fail to improve.
These heightened risks to growth have seen a significant fall in US bond yields and expectations for Eurozone inflation have also fallen markedly. However, at the same time, equities have continued to rise, led by the US.
Some analysts appear to believe that financial markets have consistently started to price in an extended period of low inflation and low interest rates. However, we believe anomalies exist across markets and, in our view, this is what could define the investment landscape in 2020.
One simple example is that equities appear to have priced in low interest rates, however, given fairly stretched valuations, we do not see the asset class pricing in any kind of slowdown in corporate profits growth. The reason this is an issue is because there appears to be limited ammunition available following another round of interest rate cuts. The Fed still has some flexibility to cut interest rates from here, however, options for the European Central Bank are more limited as interest rates are already negative.
We believe the discussion around further monetary policy easing measures (beyond interest rate cuts), such as fiscal spending, is likely to drive differentiated performance across regions globally. This creates an incredibly interesting economic landscape for utilising more targeted investment opportunities such as relative value ideas, which pair a positive view of one part of the market with a less positive view of another.
There is also the sting in the tail that some longstanding relationships between asset classes have started to change. One reason for this could be negative interest rates in Europe and, in this context, currencies are an interesting case study.
For example, the US dollar has continued to perform well despite its ‘yield advantage’ over other places in the world, such as the eurozone, having been eroded in 2019. This means the difference between higher yielding US interest rates and Eurozone interest rates is narrower now than it was at the beginning of 2019. With interest rates so low, it is the absolute level of yield that matters and, therefore, this narrowing of the ‘yield advantage’ has not translated into a weaker US dollar versus currencies such as the euro.
Uncovering anomalies across the world has been an important source of returns in 2019, such as the convergence between bond markets around the world. A prime example of this and how far markets have moved are Australian government bonds, which are now yielding less than US bonds.
Elsewhere, we believe global equities are expensive. This is not an issue if corporate profits continue to meet expectations but we believe profit margins are coming under pressure. To date, global profit growth expectations have not really been revised down for the next couple of years and, without another significant move lower in bond yields, equities could struggle to make the same progress that they have made this year.
Given a number of markets have already moved, it is crucial to uncover the next implementation route for themes which have already driven markets for a number of years. So, if we expect interest rates to remain low, bonds are not necessarily the best way to reflect that economic view.
However, we believe we have identified a number of equity sectors that are yet to price in an extended period of low interest rates. Therefore, we believe one way to take advantage of a low interest rate environment is to look for relative value opportunities at a sector level within the equity market.
Having the ability to unveil these anomalies across regions and asset types globally is what gives us the confidence to navigate the uncertain investment landscape ahead.
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