Macro Matters – December 2019

 

(Merlea Investments)

Summary

Consensuses forecasts is for global growth to recover from the first quarter of 2020 onward as trade tensions and monetary policies ease, reversing the downward trend of the past seven quarters.  Easing trade tensions (the key factor in the global downturn) will reduce business uncertainty and make policy stimulus more effective.

 

Much will depend, however, on the outcome of U.S.-China trade talks and whether the Trump administration’s next round of tariffs, scheduled for Dec. 15, go into effect. If those tariffs are activated, global growth in the final quarter of this year will slow to 2.8% and a recovery will be delayed until the third quarter of 2020. The idea of easing-off on tariffs has divided the White House, and Trump has said publicly that he has not committed to lifting any of his administration’s duties against Chinese exports. Beijing is also reportedly reluctant to commit to purchasing $50 billion in U.S. agriculture goods, a key demand from Trump.

 

Regarding the trade war, our view is that both China and the U.S. have incentives to reach a “phase 1” deal soon. U.S. President Donald Trump would like to declare victory in the trade war ahead of his 2020 re-election bid. He also needs to lift the economic threat that the trade war poses to the near-term outlook.  Still, trade tensions and monetary policy are easing in tandem for the first time in seven quarters, with 20 out of 32 central banks that major central banks slashing interest rates with more easing on the horizon.  Fed Chair Jerome Powell, during testimony before Congress on Wednesday the 11th December said rates are unlikely to change anytime soon so long as the economy remains on its present path. Some leading economists expect the Fed to hold rates steady in 2020 but forecast two hikes in the second half of 2021 once inflation hits 2.5%.

 

Inflation poses the biggest risk in 2020 — or at least it is what investors don’t seem to have on their radar. We don’t want to paint a picture of dramatic inflation, but employment reports, European economic figures and wage pressures at peak expansion levels all indicate that inflation is one of the underappreciated risks for 2020.  The push toward de-globalisation will push prices higher because of supply shocks while economic growth slows. If these materialise against a weaker growth backdrop, it would be a bad combination for risk assets.

 

Bonds

Bull markets in bonds are usually associated with economic or geopolitical troubles somewhere in the world. Yields fall in anticipation of the troubles being severe enough to warrant interest rate cuts, cheering holders of bonds, since bond prices rise as interest rates and yields fall. However, despite 2019 seeing a continuation of falling bond yields, the world according to equity and corporate bond (or credit) investors was in relatively strong health. Equity markets rallied strongly, and credit spreads (yields on corporate bonds relative to lower risk government bonds) compressed to near their historically tightest levels.  So, if investors in these riskier assets were sufficiently cheerful to chase prices higher, why did bond yields continue falling?

 

 

 

All three of the following factors could be cited to explain the decline in bond yields in 2019, but only one can explain the resilience of risk assets:

  • Ongoing uncertainty over US-China trade – clearly suppressing global manufacturing confidence and investment
  • A lack of inflation
  • Despite near or record low levels of unemployment, central banks are cutting interest rates and adding fuel to the fire via lower interest rates and keeping economic expansion going

 

All other things remaining equal, trade uncertainty should reduce investor appetite for riskier assets like stocks. Low inflation is arguably good for some, but not all risk assets.  Only ever-lower interest rates really explain why both bonds and risky assets had such an enjoyable year.  However, a growing list of central bankers have suggested the stimulus from interest rate cuts and in many places, the pursuit of unconventional policies such as quantitative easing (QE) is largely exhausted.

 

The yield curve is no longer inverted (with short-term rates higher than long-term ones), which isn’t a surprise. We knew that it wasn’t signalling anything more than the fact that we were in the late phase of the economic cycle.  I believe the Fed and central banks around the world are more willing to let their economies run a little bit hot with higher inflation before they start to raise rates and we’re not near that point yet. With the Fed on hold an improving economy should lead to higher Treasury yields and a steeper yield curve. The 10-year Treasury yield could rise to around 2.25%.

 

With the economy showing resilience and core inflation edging up, inflation expectations should move higher, potentially adding 50 to 75 basis points to 10-year Treasury yields. Breakeven inflation rates are low, so TIPS (Treasury Inflation-Protected Securities) are attractive relative to nominal Treasuries for those looking for inflation protection. Despite signs of economic stabilisation, we see risks in the more aggressive segments of the bond markets, like high-yield bonds, bank loans and emerging market bonds. We suggest reducing exposure to high-yield bonds, while moving up in quality in the investment grade market.

 

Are low interest rates that bad?

One thing almost all participants in institutional asset markets can agree on is that long term interest rates are the cornerstone of assessing the relative value of assets. Market participants typically use long term interest rates, most commonly the ten-year government bond yield, as the starting point for considering asset prices. The logic is remarkably simple, if a (theoretically) risk free asset yields a rate of return, what should a riskier asset yield above that? This applies right across the spectrum, from investment grade bonds, high yield bonds, property and infrastructure yields (which have a double impact through a high use of leverage), to dividend yields on shares.

 

Setting interest rates at a low level discourages low risk investing. Retirees, pension funds, insurance companies and banks who all rely on normal interest rates for steady, low risk income are pushed to take greater risk when interest rates are set artificially low.

What we have seen in recent months is merely a continuation of what has happened all over the world over the last eleven years. Central banks have hoped that extraordinary monetary policy would kick start economic growth, but they have instead only created asset price growth. In applying their monetary policy hammer to problems that need a screwdriver they have created the preconditions for the next and possibly greater financial crisis. The effects are now starting to show with increasing regularity. Venture capital investors are flush with cash to put to work, with insane valuations being ascribed to businesses like Tesla, Uber and Lyft. There’s been a pullback in recent months as investors realise these companies are unable to demonstrate a pathway to generating meaningful profits.

Banks are hit particularly hard by lower interest rates, which eliminates the arbitrage banks used to get from accepting savings that receive no interest and lending those funds out at a much higher rate. There have been three regional bank failures in China in the past months, likely an early warning of the bad debt crisis brewing in China’s banks and debt markets. Europe’s banks aren’t in much better shape, there’s still a list of weak banks in Germany, Greece, Italy and Spain that haven’t fixed their problems that first surfaced a decade ago. Deutsche Bank is both fundamentally weak and the world’s most systemically important bank, a highly unstable situation.  These are just a few examples of situations where low interest rates have provided cover, while at the same time forcing investors into taking greater risk.

 

The most recent round of rate cuts and guidance towards future monetary policy easing is likely to kick the can a little further down the road, but the inevitable correction of excesses cannot be postponed forever.

 

Listed Property

With interest rates at record lows and continuing low inflation, there are not many options for investors seeking a healthy yield. A-REITs are one sector that investors will focus on. Dividend yields on listed Australian trusts investing in property are averaging about 3.5 times the current 10-year bond yield and 4.5 times the cash rate and if central banks further loosen monetary policy over the next 12 months, leading to lower bond yields, the case for investment in those AREITs that are taking advantage of global tailwinds and which offer the security of long-term income streams will become even more compelling. All signs are that cash rates will continue to fall, which should also attract capital flows from domestic and global investors.

 

Over the past financial year Charter Hall, the top performing AREIT, posted share price gains of more than 72 per cent in the 12 months to June, with the company claiming the “lower for longer” yield environment drove more capital into its property funds.  Goodman Group, which owns and develops commercial and industrial property, posted price gains of nearly 60 per cent over the same period thanks to its office property portfolio and booming industrial logistics.

 

The worst performer for the same period was Australian-listed global property giant, Westfield, whose share price slipped more than 27 per cent as investors grew increasingly nervous about exposure to the troubled global retail sector. Scentre Group, the nation’s largest retail landlord, was the second-worst performer, down nearly 8 per cent.

But the huge performance gap between best and worst begs the question as to whether this level of investment returns can be continued and who can deliver. Last year’s top performers might not be next year’s winners. Both top and bottom performers are mispriced. Charter Hall Group is overvalued and could fall by up to 38 per cent based on its share price valuation for the next 12 months. Scentre Group is the most undervalued, and I believe, with a 12-month potential return of 34 per cent.

At the end of August, AREITs were trading on a 51.7% premium to net tangible assets (NTA) on an index-weighted basis. This measure implies the sector is expensive, with a limited upside in asset valuations remaining in this cycle. However, AREITs’ earnings yields continued to be attractive relative to interest rates.

 

If the RBA is reducing rates because of a major economic downturn, that would be detrimental as financial markets might freeze up, restricting funding for REITs and constraining cash flows. Overall though, A-REITs are trading above their valuations, limiting the potential upside.  Putting things in perspective, the current A-REIT dividend yield is 3.5x the current 10-year bond yield and 4.5x the cash rate. The greatest risk to the sector is a rise in bond yields, which would negatively impact pricing. This seems unlikely now, but as the past year has shown, not all A-REIT are equal, and there will be winners and losers. This is a market for active stock-pickers.

 

When investing in REITs investors should focus on factors such as the location of the properties and their weighted average lease expiry, with blue-chip tenants on long rental terms favoured.

 

Australian Equities

The good news is the Australian economy is just about to notch up another quarter of economic growth, now in the 29th year of its record-breaking expansion, in part due to good management, in part due to good luck, and in part due to happy accidents of timing.  We’ve also had some pretty good luck as a country. The most obvious piece of luck has been the economic awakening of China. To have a billion people on our doorstep rapidly and radically transitioning from subsistence farming to sophisticated manufacturing and commerce, hungry for natural resources, sure helped. Australia was able to mask a housing bubble with a once-in-a century mining boom. So, not only have we had a “China boom”, we’ve also had a “China hedge”: a source of economic growth not fully synced with, and at times offsetting, housing booms and busts.

 

In the three months to the end of September, Australia recorded a seasonally adjusted $7.9-billion current account surplus, according to the Australian Bureau of Statistics. That’s good economic news.  China’s economy continues to expand at a very healthy pace and so demand for Australia’s iron ore and LNG remains strong. With a surge in exports, the Federal Government’s coffers also grow and, for the moment, it’s spending much of that windfall gain. General government final consumption expenditure increased by $817 million, or 0.9 per cent, in the quarter, and is expected to contribute 0.2 percentage points to growth in the September quarter. Again, that’s good economic news. But that’s where the good news ends.

 

Business investment is quite weak, interest rates are very low, but we’re just not seeing Australian businesses invest. Analysis by the Centre for Future Work shows that, if the drop-off in job ads continues into next year, Australia’s unemployment rate could climb above 6 per cent. Research by National Australia Bank also points to rising unemployment. The reason rising unemployment worries economists so much is that people without jobs find paying the mortgage extremely difficult and tend to spend less. That puts huge pressure on the property market and on one of the sectors of the economy — consumption — that generally needs to keep growing to prevent Australia from slipping into recession.

 

Areas like consumer spending and retail, building and construction and household incomes — the areas of the economy directly touching most people — are either going backwards or growing very weakly. With economic growth, it’s generally accepted, comes rising standards of living. So, the stronger the economic growth, the better off we should all feel.

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Monetary policy can be helpful but fiscal stimulus is also clearly needed to halt Australia’s flagging economy. Such was the latest message from the Reserve Bank Governor Philip Lowe as the Morrison government stubbornly clings to its budget surplus.

 

But the story of the Australian stock market is another thing altogether. Looking to next year, we’ll see “tentative signs” of a shift in manufacturing cycle and a long-awaited impact of the RBA rate cuts coming into effect – and this should mean higher economic growth. But not much higher and maybe not enough to justify the expectations that are priced into the equity market. This doesn’t mean we expect a collapse in the equity market but see very limited upside to equities that have come so far this year. However, stronger global conditions and an eventual pick-up in Australian growth through the second half of 2020 – along with further monetary easing – are likely to see Australian shares make it to around 7200 by the end of 2020.

 

The ASX200 has seen returns of over 20 per cent this year so far, and the experts are saying the Santa rally – (the tendency for shares to climb up during silly season) – is still to come, but that we shouldn’t be banking on the same figures going into the new decade. The outlook for the Australian economy remains soft. We expect consumers will remain cautious given high debt levels and slow wage growth. I think it’s going to be a tough 2020 for the Australian economy. And that Phillip Lowe will cut another one or two times down to somewhere between 25 and 50 basis points. This will result in a continuation of weak consumer spending, poor consumer confidence, and weak GDP growth.

 

Global markets

One “golden” rule of investing is: buy the rumour, sell the fact. For contrarians, it is a well-travelled road, but the question is what follows after you have the facts: should it revert to buying the rumour again?  Markets have fretted over China’s trade war with the United States, the possible impeachment of US President Donald Trump and the threat of a hard Brexit in Europe. It is less clear what happens next.

 

If 2019 was the year of living under a cloud, 2020 could be the year stock markets prove pessimists wrong. The elephant in the room is that every single asset class is up double digits this year. I think we’ll get dispersion of asset classes next year. It would be very unlikely to have two back-to-back years where literally every asset class works. Not to be the bear in the room, but there is this risk that a lot of the earnings we’ve seen over the last 10 years have been manufactured, by companies either buying back shares to pump up their EPS growth, or cost cutting. The next leg of this bull market must be driven by a real economic recovery.

 

We might even be past the worst of political and economic risk factors. Markets have been thick with speculation about global recession, but this hardly resonates with stock markets hitting fresh highs and rising risk appetites. The world is awash with central-bank-generated liquidity after the 2008 financial crash, but there is more in the pipeline. Monetary authorities in the US, China, Europe and Japan all seem committed to easier credit conditions in the coming months to put more vigour into recovery prospects, which will improve next year as the new stimulus gains traction.  Easier monetary policies should also be complemented by more expansionary budget policies, especially in the United Kingdom and Europe, as governments call time on fiscal austerity with political priorities changing.

 

Markets might seem expensive from a price/earnings perspective, but with financial surveys showing investors relatively underweight on outlook concerns, investors could end up squeezed back into the market for fear of missing out on higher returns.

If economic, political and market factors manage to work in harmony next year, the recovery in risk appetite could spark a major shake-up in asset allocation perceptions. The demand for safe-haven protection should diminish, with risk reversals out of cash and government bonds giving an additional boost to equity and credit markets. It would be the prelude to a major surge in government bond yields.

 

What does this mean for markets? We see the monetary stimulus delivered to date operating with a lag. We are likely to see the German economy – Europe’s largest – remain flat for another quarter. We still view the protectionist push as a key driver of global markets and economy. The U.S. and China appear to call a short-term truce, but a comprehensive trade deal as unlikely. Persistent uncertainty from protectionist policies is likely to remain a drag on corporate confidence and business spending. Robust consumer spending in the U.S. is key to our view that this long economic expansion is likely to remain intact.

 

Stocks in 2020 may return to single digit returns. There are still no signs of the US entering a recession, though the global economy seems to be slowing. The Fed may also stop pumping liquidity into the market, leaving stocks to appreciate based on market principles. Still, the bull market may continue at a flatter rate, extending as the longest running upward climb of assets in history.

 

Bottom line: We see moderate risk-taking likely rewarded – even as recent events reinforce our call for a greater focus on portfolio resilience.

 

 

 

America

The Federal Open Market Committee lowered the federal funds rate by 0.25% at its September meeting. The dot plot in the quarterly Summary of Economic Projections revealed a board with no interest in a prolonged cutting cycle. In the press conference following the meeting, Fed Chair Jerome Powell gave no indication of the Fed’s next step, reverting to guidance that decisions will be “data dependent.” With valid arguments both to hold and to cut, we expect the Fed to hold rates steady absent any further economic deterioration.

 

Sluggish business investment remains the greatest risk to U.S. economic growth. Burdened by trade battles, the manufacturing purchasing managers’ index (PMI) fell to 47.8 in September, indicating contraction (the PMI for services still shows expansion). The final estimate of second-quarter gross domestic product (GDP) showed business fixed investment falling by 1% on an annualised basis. At worst, this could signal the start of layoffs and contraction that would impair consumer spending; more optimistically, healthy consumer demand may help heavier industries bounce back.

 

Europe

The European Central Bank (ECB) welcomed its new president, Christine Lagarde. Lagarde will have to wait till 12th December for her first policy meeting but has already made a few official speeches. So far, she has avoided any firm statements on monetary policy, and instead has centred her comments on big-picture challenges to the global economy and what governments can do to boost the effectiveness of monetary policy. Bond yields broadly rose slightly across Europe, leading the euro government bond index to fall 0.9%. With the political and macroeconomic climate improving, Europe should be able to overcome the structural handicap of excessive exports and avoid recession. Germany may be less fortunate, because its dependence on export and its misguided budget consolidation. Until then, Germany will be stuck in its new role as the laggard of Europe.

 

United Kingdom

We expect to see flows back into UK equity and credit now that some of the Brexit uncertainty has been removed. The ruling UK Conservative Party won a large outright majority in Thursday’s election, giving Prime Minister Boris Johnson a stable government and mandate to deliver Brexit in January. The pound and domestic-focused UK equities should benefit from greater political certainty after four years of wrangling over leaving the European Union, negotiating a trade deal will be difficult and could take many months to play out. Uncertainty could spill over into the second half of next year. Yet if more time is needed to strike a deal, we expect Johnson to find a way of extending the deadline – at least for ratification. A larger parliamentary majority will likely give him a freer hand to negotiate with the EU and make some concessions without materially changing what will be a relatively hard Brexit – leaving the single market and customs union. That should benefit UK goods more than services. The result in Scotland will be a source of tension and up pressure for an independence referendum, but we don’t expect this government to grant one.

 

Japan

The economy expanded in the July-September quarter at a much faster pace than initially reported, driven by stronger capital investment and private consumption ahead of the Oct. 1 consumption tax increase. While the updated figures show domestic demand is continuing to power growth in Japan despite a global slowdown, front-loading of spending before the tax hike could amplify a contraction expected in the October-December quarter as the economy contends with the fallout of the higher tax and typhoon damage. The government last week announced ¥13.2 trillion in fiscal measures to support growth and the recovery from typhoon damage. While domestic demand has kept the economy expanding this year despite falling exports, gross domestic product is expected to contract 2.6 percent in the last three months of this year as consumers stay home following the consumption tax hike. Looking ahead, the government said its fiscal package will boost growth by 1.4 percentage point over time. Economists have cast doubt on that figure and the speed at which spending will reach the economy, but they largely agree that the package makes it easier for the Bank of Japan to hold off on extra stimulus.

 

China

China and the United States have made a breakthrough in trade negotiations, with a consensus agreement reached for a phase one deal that will halt further tariff increases and lower some already in place.  I have noticed the Chinese have been much less precise in confirming what they’ve agreed to. Even if it goes through, the real thorny structural and market access issues around subsidies, cyber, non-financial services have yet to be addressed, meaning that phase two will be more likely than not to quickly return us to a tense environment. Of course, also any number of external geopolitical issues can derail the train, such as Hong Kong, Taiwan, Xinjiang and the South China Sea.

 

Emerging markets

In our view, the balance of risks looks to be tilted in favour of EM, in terms of the trade conflict and potential dollar weakness. We see EM growth improving in 2020 as a function of monetary, and in certain cases fiscal, easing and there is scope for a moderate industrial cycle. Valuations are reasonable and earnings expectations for 2020 could be met. On the other hand, the relationship between the US and China remains uncertain and Chinese economic growth remains soft. Furthermore, the global environment remains one of excess debt and secular stagnation, with underlying growth slow; and markets in general have had a strong year as a function of the pivot to policy easing. We also believe that the recovery in growth will be moderate. Hence, we are positive on the outlook for EM equities in 2020, albeit cautiously.

 

Gold

The bull rally in equity markets, triggered initially in October following healthy third quarter US earnings and economic data, continued as cautious optimism developed in markets regarding a potential phase one trade deal between US and China. Both gold and silver retreated during the month as net speculative positioning pulled back slightly following meaning accumulation since May. Despite the pullback, gold’s speculative positioning is relatively elevated reflecting a recognition among market participants of the value of holding gold to hedge against a range of geopolitical and macroeconomic risks. These include US-China trade wars which are far from over, upcoming UK elections and Brexit uncertainty, potential impeachment of President Trump and fragile global economic growth.

 

WTIS

The growing consensus of a global supply surplus in the first half of 2020, is likely to be a catalyst for the Organization of the Petroleum Exporting Countries (OPEC) and its partners to at least extend current supply cuts if not deepen them when they meet to decide on policy over 5-6th December 2020. Saudi Arabia – the largest member of the cartel – is on the cusp of floating part of its national oil company. Even though it has vastly reduced the estimated valuation of the company, it can’t afford for oil prices to slip further and hence will apply pressure to all OPEC members to continue to cut. Perhaps more significantly it’s because the U.S. has joined Saudi Arabia as the swing crude producer, able to rapidly increase output to compensate for problems elsewhere in the global crude oil supply chain. Non-OPEC supply is expected to rise especially from Brazil, Norway and Guyana. While the International Energy Agency and Energy Information Administration expect US oil supply to continue to expand, we are sceptical that this can be achieved if WTI prices do not rise substantially. Under current weak prices, rig counts in the US are falling. Production is only able to remain stable because more drilled-but-uncompleted wells are being utilised.

 

 

Sector 12 Month Forecast Economic and political predictions 2020
 

AUD

 

67c-70c

 

The Australian Dollar bears have been battered over the last 3-months with the recent spike in the Aussie – driven largely by investor risk appetite seeping back into the market – pushing spot AUD/USD higher by 4% since its October swing low. A plunge in currency volatility and rise in relative attractiveness of the carry trade have also helped facilitate the rise in spot AUD/USD. The Australian Dollar still has potential to keep rising with US-China trade deal cheerfulness likely to provide the Aussie with a positive tailwind.

 

 

Gold

 

US$1,400/oz – US$1,500/oz

 

The precious metal may exhibit a bullish behaviour over the remainder of 2019 as market participants hedge against fiat-currencies.  The weakening outlook for global growth has pushed major central banks to shift gears this year, and the Federal Reserve may continue to alter the course for monetary policy as the US-China trade war drags on the economy.

 

 

Commodities

 

WTIS US$50 -US$61

 

Base metal complex will benefit from easy money policy.

 

 

Economic conditions in 2020 are expected to remain unfavourable for commodity markets – with global growth at sub-trend rates and uncertainty around the global trading environment persisting. At the time of writing, the “Phase One” trade deal between the US and China has not been concluded, and the US has introduced new trade measures against other countries. Chinese infrastructure investment could provide some support to commodity markets next year – albeit not enough (in our view) to drive prices higher.

 

 

Property

 

This is a market for active stock-pickers.

 

 

 

With interest rates at record lows and continuing low inflation, there are not many options for investors seeking a healthy yield. A-REITs is one sector that investors will focus on.

 

The sector benefits from solid operating fundamentals, low gearing and strong interest cover, good dividend coverage and demand for institutional grade real estate. A continuation of low interest rates, reasonable consumer confidence, and corporate activity (M&A) will support the sector. The lower Australian dollar adds to the appeal for offshore investors.

 

 

Australian Equities

 

5932 – 7105

This is a market for active stock-pickers.

 

 

 

I believe the Australian equity market not only remains good absolute value but great relative value. Market valuation levels, at 17x price earnings ratio are above long run averages of around 15x but earnings quality is much better than average, corporate balance sheets are strong and with very low interest rates today’s valuation multiples are more than justified. A fully franked dividend yield of around four percent also makes it a very hard asset class to ignore. While I’m positive on the overall Australian equity market, stock selection as always will be crucial.  I continue to look for great companies at reasonable prices and tend to have less sector over-weights and under-weights preferring to back the best companies in each sector.

 

 

Bonds

 

1% – 2.5%

An inflation-linked bond fund might be a good addition if looking for more inflation protection.

 

2019 saw both equity and fixed income markets generate remarkably strong returns for investors. Such strong returns for both asset classes are unusual given the backdrop of weaker global economic growth, lower earnings growth, elevated geopolitical uncertainty and trade tension. Credit spreads are tight in this late phase of the economic cycle. In this environment, high-yield bonds are asymmetrically susceptible to losses, suggesting those looking for enhanced income should think more broadly.

 

 

Cash Rates

 

0.25% – 0.50%

 

The RBA’s outlook for the economy continues to be driven by concerns over slowing economic growth and their view that rate cuts can continue to support lower unemployment without increasing inflation. RBA rate cuts have different impacts across the economy. Some groups and areas benefit while others are disadvantaged. Borrowers benefit because lower interest rates, provided they are passed on by the banks, reduce mortgage repayments and improve borrower spending. Savers are disadvantaged because they receive less interest income. This affects retirees and people with large amounts of cash held in bank accounts or conservative investment portfolios

 

Global Markets
 

America

 

S&P 500

2800-3000

The percentage of companies issuing negative earnings guidance is 78%, which is above the five-year average of 70%

 

 

We have re-affirmed our view, U.S. equities underweight. Rising uncertainty around the 2020 election and a wide range of potential policy outcomes may weigh on sentiment and prevent a repeat of outperformance.

 

Europe

 

Buy European Index

UK – Preferred sector

 

Even without potential help from monetary or fiscal policy, there are pockets of the European equity market that we think could do well in 2020. Eurozone shares remain more cheaply valued than their US counterparts overall. The MSCI EMU is on a 17.5x price to earnings ratio compared to the S&P 500 on 19.1x (FactSet, as at 29 November 2019).  Our view is that we are at a turning point in the cycle, with a more synchronised global recovery expected in 2020.

 

Banks are another area we think look compelling. Many have become lowly valued by the market owing to the argument that low interest rates (and correspondingly low bond yields) are squeezing profit margins beyond all hope of a near-term return to significant profitability.

 

 

 

 

Japan

 

Hold

 

 

 

While a modest pick-up in inflation and wages will imply some higher costs, corporate profits are generally responding positively to the improving domestic conditions as companies begin to regain some pricing power after almost two decades of deflation.

 

The Bank of Japan remains a large consistent buyer of equities via ETFs. Although this may be an effective route for its asset purchase programme, it also carries an increasing risk of distorting market prices. For 2020, however, there is no reason to expect the scale of buying to fade, and it is definitely much too early to worry about the potential impact of the central banks holdings being unwound.

 

 

Emerging markets

 

Prefer Asian markets

Emerging markets bonds and equities attracted an estimated $37.7bn in non-resident net inflows in September after investors pulled $13.9bn during the previous month, reflecting the “pendular nature of flows during 2019”.

 

 

A dovish U.S. Federal Reserve (the Fed), continued China stimulus and trade-war normalisation have seen managers looking beyond trade-war noise. Conviction has increased to exporters and high-growth technology sectors that lagged in China and Korea.  Current valuations remain attractive and dollar weakness resulting from looser Fed policy could provide a further tailwind.

 

China

 

Hold

The first quarter offered the best opportunity for buying Chinese stocks in 2019. Stocks might give up some of their gains during the rest of the year as growth continues to slow.

 

 

The Chinese economy also continues to slow, with the manufacturing sector feeling the most pain. Employment indicators are pointing to a slowdown in hiring, which increases the imperative of the Chinese government to either negotiate some form of trade deal or introduce new measures of stimulus.

 

 

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