UOB bank
Stepping back from the brink of recession and peeking into 2020
By Anthony Raza
Senior Director and Head of Multi-Asset Strategy,
UOB Asset Management
As we begin a new decade, our Investment Outlook Seminar at the beginning of this year took on a future-forward tone with several topics focusing on issues that look set to disrupt the asset management industry. Chief among them is the impact of technology where we looked at how digital disruption has shaken up the banking industry and we can similarly draw parallels in asset management. At a post-seminar masterclass, we also took an in-depth look at the use of artificial intelligence, machine learning and data science, and how they can be applied to investment management. A deep dive into blockchain and cryptocurrency showed how it is democratising finance, tying in with our exploration of Impact Investing where we looked at how as investors, we can help to shape the world for the better. The bricks and mortar topic on global property was also discussed. Turning back to bread-and-butter issues, I took investors through our assessment of the current economic and market conditions and where we see opportunities as we embark on a new year.
Dodging a bullet
I think it would be fair to say that 2019 was a near-miss as we were on the brink of tipping into recession. One of the most reliable indicators of recession, the yield curve, inverted in August 2019, setting off alarm bells. The US Treasury (UST) 10-year yield is normally above the 2-year yield, making for an upward-sloping yield curve. But in the past when the curve inverts with the 10-year yield dipping below the 2-year yield, it was always followed by a US recession – albeit sometimes with a time lag of up to one or two years. Watching this indicator, which has a near-perfect track record of predicting recession, flash red, we were naturally nervous and looked to other economic indicators for further direction.
Leading indicators: The US Conference Board Leading Indicators typically dip below zero when the economy tips into recession. But the indicators were very positive at the start of 2019, though slipping all through the year and only hitting negative territory at the end of 2019. This was at the same time that the yield curve righted itself back up, creating some sort of a mixed signal.
Consumer confidence: Concurrently, with the US economic expansion having lasted 11 years, there are signs of the consumer – a significant growth driver – being fatigued. Our ‘yield curve of the consumer', which measures the Conference Board Consumer Confidence Expectations minus their Present Situation, was constantly in the red for the year. This showed consumers being less optimistic about the future than the present, signalling that they were less likely to spend on big ticket items.
Jobless claims: Surprisingly, though businesses were struggling and had to cut costs and workers, there was no evidence of significant retrenchments with unemployment claims remaining very low. US initial jobless claims stayed at the 200,000 levels1, unlike in the period leading up to a recession where it would trend above 300,000 and spike up to 500,000 or even above 650,000 as was the case in the 2009 recession2.
Manufacturing: While manufacturing fell sharply to recessionary levels in 2019, it appears to be stabilising at the start of 2020 with Taiwan’s Purchasing Manufacturing Index (PMI)3, which tends to lead the global PMI, already bouncing up.
Hence as we start 2020, we conclude that it was a close call, but weak business conditions did not spread to the rest of the economy and appeared to be stabilising at the end of 2019. Industrial production, business investment, manufacturing and trade declined sharply in 2019 as they would before a recession. However, the weak business climate was supported by interest rate cuts and employers did not start to reduce labour supply significantly. With stable employment, consumers, which make up 70 per cent of developed market economies, continued to keep the economic engine humming. By the end of 2019, leading indicators appear to be stabilising and recovering with the economic expansion set to continue.
The curious investment case of 2018/2019 and what it means for 2020
With the murky economic outlook all through 2019 and corporate earnings growth coming in at or below zero, it seems strange that equity markets had such a good run, chalking up returns of 28 per cent for the year4. Conversely, in 2018 when economic leading indicators and growth were tracking well with corporate earnings growth at a strong 15 per cent, equity markets declined 9 per cent5 – the first time in history that both equity and fixed income returns were negative in a year where global growth was above trend, global earnings growth double-digit and inflation under control.
How do we explain the curious case of investment markets seemingly behaving in a contrary manner to economic fundamentals?
I think one way to make sense of this is to look at the average of the two years 2018 and 2019. Overall, the average equity returns over the period was 10 per cent6 – in line with average global gross domestic product (GDP) growth of 3.4 per cent, corporate earnings growth of 6 per cent7 and leading indicators pointing to continued expansion. Fixed income markets seemed to present a more logical picture with global fixed income returns declining in 2018 when US Federal Reserve (Fed) raised interest rates, and rising in 2019 with the US Fed cutting rates.
Another way to look at this is that the strong earnings base created in 2018 laid the foundation for equity markets to rally in 2019 even in the absence of earnings growth as valuations were undemanding then. In that same vein, we think earnings growth will be critical in 2020 in order for markets to continue to perform as valuations are now relatively stretched. By most measures such as price-to-earnings which are at or more than one standard deviation above their mean levels, markets are expensive. In order to justify these valuations, earnings need to catch up. Going by consensus earnings growth forecast of about 7 per cent8, we think this is a reasonable estimate of global equity returns for 2020. While valuations are extended, we see no cause for panic as the current low interest rates means equity yield is more highly prized, justifying their above-normal valuations.
Within global equities, we think there is a case for Asia to outperform in 2020. Asian equities are at the upper end of valuation ranges but they are not as expensive as global equities. Furthermore, earnings growth look more attractive for Asia in 2020 than for global stocks. We start the year neutral on Asia, having upgraded it from an underweight position, but keep a close watch on it as it has the potential to be a top performer particularly if trade stabilises.
Fixed income returns, we think will be muted as rates are already very low. We do not expect more rate cuts or hikes in 2020. Corporate bonds in general and Asian credits in particular look reasonably priced at current low rates, though credit spreads are still reasonable. With credit spreads, the higher they are, the cheaper are the bonds. While spreads are not as low as they have been, we are comfortable with where they are now. We expect fixed income returns to be anchored at about 3-4 per cent.
We think that alternative assets will be an attractive proposition in 2020. In an environment when stock markets rally, alternatives may not stand out. However, when stock market returns offer little upside and especially when there is significant dispersion in returns across markets, alternatives tend to outperform. We also expect the US dollar to be range-bound with a mildly softening bias.
Is our investment clock stuck at 11.59 and other burning issues for 2020
One of our burning questions for 2020 is: In this 11th year of expansion, how do we think about cycles? At UOBAM, we have been using our Investment Clock to guide our investment recommendations. The Clock takes us through four quadrants: slowdown at 12-3 o'clock, recession with the trough at 6 o'clock, recovery at 6-9 o'clock and expansion with the peak of the cycle at 12 o'clock. At the corresponding quadrants, we would expect cash, bonds, equities and commodities to outperform respectively. However, this current economic expansion has gone on for so unusually long without tipping over that I wonder if we are stuck at 11.59 on our Clock!
With no precedents on how to invest in such a long cycle, I think our approach is to be nimble and humble about leaning on historical examples. Markets will be anxious along the way and we expect greater volatility to challenge our positioning.
Another key issue that we have been evaluating is whether geopolitical risks will destabilise markets in 2020. The resurgence of Middle East conflicts such as between Iran and the US, Saudi Arabia and Iran, and Israel are areas of concern. North Korea's refusal to de-nuclearise, the shape of European politics after Brexit and any potential flare-up of trade tensions are also event risks that could haunt markets. Overall we think that markets tend to vacillate about these geopolitical issues but rarely do they turn out to have a material impact. For example in the Iraq war of the 90s when Iraq invaded Kuwait and the subsequent US invasion of Kuwait, markets fell by about 20 per cent, but returned to their previous highs within five months. Similarly, in the September 11 2001 terrorist attack on the US, markets plunged 20 per cent but recouped their losses in one month9. As we begin 2020, there are many issues that may cloud markets but we think there is no need to over-react to geopolitics.
The US presidential election is also a topic many clients are concerned about in its potential market impact. Interestingly, a poll we took at our Seminar showed that most investors, putting aside personal preference, expect President Trump to be re-elected. Indeed, incumbents have a big advantage in US elections. However, the complication is that President Trump's approval ratings at the time of writing is low at about 41 per cent10. While most investors seem to believe that Trump will be more market-friendly, we think that the currently leading Democratic candidate, Joe Biden, will be as good if not better for markets. In any case, it is difficult to get confident about predictions at the moment but we think that both candidates will likely be market friendly.
Overall, we think that these risks will not be unsurmountable for markets in 2020. With an expectation for muted growth amid improving economic conditions, we think it unlikely for most asset classes to replicate last year's strong performance. Hence we advocate a risk-based balanced income strategy to preserve and grow capital through bond yields and stock dividends.
Postscript: Following our Investment Outlook Seminar, the outbreak of the Novel Coronavirus (2019-nCoV) has caused markets to be volatile with sharp declines and a partial rebound and we think this adds another risk to our global market assessment. The rapidness of this outbreak gives us reason to draw a comparison with the 2003 severe acute respiratory syndrome (SARS) outbreak which saw market drawdowns of 5-15 per cent over 2-4 months. The risk to economic fundamentals is significant, but we expect markets to treat the weakness as transitory once the number of new cases of the virus peaks and starts to decline. Psychologically, investors’ fear of a potential pandemic has caused knee-jerk selling but as was the case in previous outbreaks, we expect that once the outbreak is on a downtrend, markets will fully recover their losses. We are still in the early stages of the virus outbreak and it would seem aggressive to buy into the market correction at this stage but overall, we recommend that investors remain calm and monitor the number of new cases for signs of a decline. Hence, we retain our asset allocation recommendation of staying neutral in equities with a slight overweight in fixed income.
Read our commentary and initial assessment on the Novel Coronavirus (2019-nCoV) outbreak here.
1 Source: Bloomberg, November 2019
2 Source: Bloomberg, November 2019
3 Source: Bloomberg, January 2020
4 Source: MSCI World index USD returns as at 31 December 2019
5 Source: UOBAM, Bloomberg, as at January 2020
6 Source: UOBAM, Bloomberg, as at January 2020
7 Source: UOBAM, Bloomberg, as at January 2020
8 Source: Factset, UOBAM, as at December 2019
9 Source: UOBAM, Bloomberg, MSCI World index
10 Source: fivethirtyeight.com, ABC News Internet Ventures