The article above is Aon's Global Asset Allocation Team 2020 Outlook.
What can we usefully say about this year’s prospects and beyond? Will markets carry on rising
and how strongly? As usual, predictions for any given year are extremely hazardous, and what
may be wrong one year may be quite correct on a two to three-year period, and vice versa, so
this caveat needs to be borne in mind if thinking about 2020 alone.
Central to the 2020 market outlook is the way the global economy shapes up. We saw that central banks had gone on a rate cutting spree last year to stave off a sharp global economic downturn given the risks from an escalation in trade conflict between the US and China. In this way, they extended the already long expansion phase of the business cycle. In the normal course of things, lower interest rates ought now to produce a response in the form of better economic growth conditions. Is this happening? So far, we see more evidence of growth stabilisation than acceleration. We shall have to see what the trade truce between the US and China, now being worked on, might or might not bring in terms of any de-escalation of economic tensions (some scepticism is appropriate on expecting much by way of de-escalation!). More importantly, we should be a bit wary of the argument that lower interest rates will produce much faster growth, for two reasons:
- First, because interest rates were low to start with, cuts are less effective than if they were coming from higher levels. Japan and much of Europe already had negative interest rates, and even in the US, interest rates were cut from levels of only just over 2%. China has had more room to cut interest rates to be sure, but it has other agendas in trying to deleverage its already heavily borrowed corporate sector. In fact, China is trying to steer a soft landing for its economy with its policy easing, not to stimulate it. The China issue highlights in some ways the bigger difficulty. Interest rate cuts work by making borrowing cheaper. But a decade of low borrowing costs has already raised debt levels significantly among consumers, corporations and governments, which is why global debt has risen to such high levels. To be sure, debt levels can rise a bit more again in 2020 as interest rates have moved still lower, but given where rates are coming from, and the limited scope to cut, is it possible that the response to their moving lower still may be less strong than you might expect?
- Second, there is the difficulty that in trying to extend what has already been the longest US economic expansion in the last 150 years, it matters that the economy does not have much capacity left to sustain expansion without stress. Unemployment is at 3.6%, the lowest level for half a century. To be sure, the economy and jobs can keep humming away for a bit longer. However, even though such low unemployment rates are not resulting in significantly higher wages and inflation in the way it used to, there is still a logical barrier to the expansion that will emerge. Extending the cycle is not possible to do indefinitely. Something would have to give – either employment growth (and with it the economy at large) must slow, or wages/inflation need to rise as the labour market tightens further. Perhaps it is a bit of both? Of course, there is a timescale issue here in setting expectations for a specific period – so 2020 may not be where this economic barrier makes itself really felt, but it is not obvious that avoidance is possible much beyond that. Do we think these risks are priced into markets? It does not look like it, given where market valuations and interest rate expectations are today.
Which brings us nicely into a little debate on market valuations. Markets are expensive. This
matters to the outlook. They were arguably nearer fair value territory a year ago, but they are not as we look around us today. At the start of 2019, the US market was valued at 13.9 times next twelve month’s earnings. Now it is on over 18 times, close to the highest valuation level in the past two decades. High yield spreads over US treasury bonds were at over 500bps at the start of 2019, but now they hover at a lowly 350bps. Or take a longer look back and see how corporate bond yields have moved. Five years ago, UK corporate bonds yielded over 4%. Today they hover at around 2%.
With equities, the message is particularly clear. Unlike 2019, when gains were largely the result of higher valuations, this year, something else needs to go right. Profits. These need to deliver to sustain market gains. US market earnings were flat to slightly down in 2019, so the hope must be there is a big turn for the better coming. Here there are headwinds. Net profit margins for the US market had doubled in the past three decades from about 5% to well into double digits, a key driver of strong profit growth over many years. But margin pressure has been slowly building. The benefits of globalisation that pushed costs lower have peaked and domestic labour costs are now picking up. If economic growth really accelerates again (2017- style) the headwinds on profit margins can be managed for a time. If not, further market gains will really be on stony ground. It is also striking that rich risky asset valuations that we see are implicitly saying that the geopolitical and economic policy uncertainty caused by the upending of the post-war economic and political order in the past few years will not matter very much, if at all. Let us see if they are right. From a 2020 standalone viewpoint, there is also the other matter of a US Presidential election to contend with, which brings its own rich seam of uncertainties.
The final area up for debate is the message from bond markets and what that means for risky assets. This matters a great deal too. Markets have cheered bonds and equities together in 2019, a proverbial case of ‘having your cake and eating it’ since generally this is not supposed to happen. Wall Street strategists who have been equity bulls, to their credit, have been bond bears alongside. Though their calls have clearly been only half right since they have been wrong on bonds for many years, it is at least a consistent position! The only way to get around this parallel universe problem between equities and bonds is to argue that central banks will continue to do what they have done to boost all asset markets simultaneously – suppress interest rates and bond yields even more, while allowing equities to still prosper. However, current rock-bottom expectations of central bank interest rates as far as the eye can see cannot be good news for equities on an ongoing basis. Forward interest rate profiles of the sort we see in Europe, Japan, the UK and even the US are only consistent with weak growth and persistently low inflation, or in some cases, deflation. These are not conditions equities will like for very long. So, as we look at equities and bonds in current markets, it does feel as though something is askew and may well have to give.
Where does all this leave us? Here is a summary:
- All the central bank easing done and some reduction in economic tensions between the US and China count for something in having reduced near-term risk for the global economy and markets, but this does not amount to saying there is a clear-cut economic upturn coming that can be sustained in a market-pleasing way.
- Valuations are now significantly constraining market upside, especially if some of the underlying pressures starting to come through on corporate profitability seen in 2019 continue this year.
- Bonds and equities are still living in divergent worlds. This has been the best of worlds for both over the past decade, and especially in 2019, but tests are coming. Bonds ‘being right’ will not be helpful for equities, but equities ‘being right’ will not be helpful for bonds from here either. A parting of the ways may be one of the key risks investors will have to face, if not in the near-term in 2020, then certainly beyond.
- Money can still be made in 2020 but it is quite difficult to argue that last year’s rebound can carry on unchecked. The further we look out the more difficult it is to argue that return potential is anything other than seriously impaired by what we have already seen in markets. Return potential is now more difficult to find in markets than we have seen for a long time.
The view from the global asset allocation team that global markets are in a transition phase of higher uncertainty in which the going is harder for markets, stays unchanged.
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About Aon Global Asset Allocation
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Registered in England & Wales. Registered No: 4396810.
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