The article above is Aon's Quarterly Investment Outlook for January 2020.
Summary of the article:
The strength in both risky and safe asset prices last year reflected a large easing in monetary conditions as central banks cut interest rates sharply and grew balance sheets once again.
Fears for the global economy have eased but we should keep perspective. Trade uncertainty remains and the limited interest rate cuts that were possible spell only a modest economic rebound.
The ‘lower for very much longer’ interest rate environment looks to be more deeply embedded than ever.
The lockstep move in assets with liabilities has protected US pension plans’ funded status from lower discount rates. This good fortune may not last as we look ahead.
Credit spreads are again on the wrong side of our fair values. With yields on corporate bonds now low, the margin for comfort on returns is thin. We suggest some coping strategies.
The secret sauce of the bull market, record high profit margins in the US, is not going to be as supportive of markets looking ahead.
Central bank actions have brought a respite for markets but it is still just a matter of time before unsettled conditions return. Portfolio actions need to remain focused on higher market risk and lower returns that will likely follow this period of strength.
An impressive few months for risky assets
Risky assets made impressive gains in Q4 2019, a move that has continued into the new year to date. At the time of writing, the MSCI All Country World Index has returned over 10% since the start of Q42. This is on a scale deserving of the description ‘market melt-up’, now being widely used. 2019 had begun well (after a disastrous end to 2018), but Q2 and Q3 were uneven, with bonds doing as well as equities. Sentiment turned dramatically in the closing months of last year, the market starting to resemble a normal ‘risk-on’ environment. Bonds began to underperform, cheap value names did better, and emerging markets performed well, as risk was embraced.
Is this a ‘liquidity’ driven market move?
The market story for 2019 overall was different. The key feature for the full year was just how well all asset classes did. Equities outshone, yes, but ‘safe assets’ were also strong. Even after a recent mild pick-up in yields, US long duration yields are still down about 1% on year-ago levels. Gold, a traditional safe- haven, rose 18% in 2019 and continues to climb.
The simultaneously strong performance of safe and risky assets for 2019 is best explained by changed monetary policy conditions. Though the Federal Reserve’s three interest rate cuts were the most market-impacting, it went far wider. Central banks globally turned to easier money, some 70% of the main global central banks easing by Q4 2019. This was slightly ahead of that seen at the time of the global financial crisis in 2008 (see chart above).
This is not all. Since September, the Federal Reserve’s balance sheet has swelled by 10% through asset purchases (akin to, but not formally labelled QE), boosting market liquidity, ostensibly to ease an earlier squeeze in overnight money markets. This was quite a turn, given that the balance sheet had declined by more than this through the previous eighteen months. All in all, liquidity improvement through rate cuts and central bank asset purchases, do appear to have supported risky assets through 2019.
Are global economic clouds lifting?
With equities up so strongly of late, how good is the fundamental support for this market rise? As of now, the jury is out. The market chatter, through the strong risky asset moves recently, has been about how central bank easing and the US-China trade agreement have lifted the big clouds hanging over the global economy.
Some circumspection is in order over these claims. The China-US agreement is only a truce in their economic conflict. Even in tariff- terms, average levels will remain high on their respective imports from each other (see chart) with uncertainty on future direction. Beyond tariffs, different views over the movement of capital and technology know-how between the two countries mean that the wider conflict remains. Additionally, spill-overs to other regions will continue to occur, so this is far from just a US-China matter.
Of course, the trade conflict was key to the economic slowdown last year, disrupting global production chains and trade flows. Here, the pause in escalation is encouraging. However, we should not count on a marked positive response to the cuts in interest rates. Europe and Japan are very constrained, but even in the US, rates were only cut from just above 2%. In this way, squeezed monetary policy room is constraining the size of stimulus, which limits the positive economic response too. China has had more cutting room, but it is not doing so to stimulate more growth but to ensure a smoother slowdown.
The message we take away from these developments is cautious – we see these as a reduction in risk rather than a spur towards rapidly improving global economic conditions. Still, conditions are better than where we were not so long ago, when global recession fears were commonplace.
‘Lower for longer’ global interest rate environment firmly embedded
The global trend towards lower interest rates and bond yields in the past few decades has been pronounced. Challenges have come, but the inexorable logic of lower interest rates has won out – an ageing population, slowing economic growth, strong demand for safe assets from all manner of investors, weaker capital investment, have all played a part. The US has tried on two occasions to begin normalising interest rates – once in 2013 when it had to reverse course immediately, and then again in the 2017/18 period. After some initial success, pushing policy rates above 2% in 2018 backfired. These failures make the ‘lower for much longer’ interest rate environment more deeply embedded than ever. Big economic policy shifts could change things but there must also be a willingness to raise rates and an ability for economies to withstand them. Both are currently low. This could alter too, but until those policy shifts start to happen low interest rates should be viewed as having staying power.
Falling discount rates and funded ratios
Discount rates for US pension plans keep falling. There have been only a few periods in the past decade when rates have risen. Last year, credit spreads and underlying US treasury yields were both down. 2019’s blockbuster gains in equities were offset by discount rates falling about 1%, leaving funded status largely flat for US corporate plans. The Milliman funding index for the 100 largest US corporate plans fell slightly and Aon’s pension funded status tracker for S&P 500 company pension plans was close to unchanged for the year.
This picture of asset and liability gains tending to move together is fortunate in that it has helped to contain damage from falling discount rates over quite a prolonged period. What is the outlook as we look ahead? In an ideal world, asset gains would continue with discount rates creeping up as US treasury yields rose but with credit outperforming, i.e. spreads declining further. This would materially improve the funded status of US plans. However, the likelihood of this looks low. Asset markets, both equities and credit, have done a lot of the heavy lifting already given the strength and high valuations of both. US treasury yields may creep up marginally but are unlikely to do very much above the modest yield rises already priced into yield curves, especially if risk assets flatten or fall. In such conditions, significantly underhedged positions with large duration underweights are likely to be taking too much risk.
Spreads on the wrong side of fair value
Credit spreads over government bonds have moved to unattractive levels again after better pricing during 2018. The US long duration credit spread is an illustration of how these are generally now well below our long-term fair value estimates (see chart). This signals that expected returns carry more risk since spreads are likely over time to gravitate to higher levels.
A reversion towards fair value will need economic and market conditions to alter, or an anticipation that they will. As credit quality has deteriorated worldwide, with higher corporate debt loads and weaker credit covenants, there is high vulnerability to this. 2018 saw just such a spiral of poor expectations. Strong central bank easing and liquidity injections have soothed nerves since then. Lower interest rates do buy time, improving the affordability and refinancing ability for companies carrying heavy debt loads. Even so, rickety credit fundamentals across credit universes leave limited room for a further reduction in spreads.
At some point, fundamentals will again make buoyant credit market pricing appear unsustainable, though timing the tipping point is difficult. For now, credit positions need to be watched carefully. Falling yields on corporate bonds mean that the margin of comfort preventing returns from going towards zero or negative is now thin. as in 2018. Two coping strategies could help. First, lowering duration of credit portfolios lessens sensitivity to market shifts. Second, focusing on areas where risk is better rewarded – selected securitised credit assets, to take an example, brings more return for credit risk taken.
Resilience to the earnings slowdown?
Strong gains in a year when company profits in all regions stagnated or fell, feeds the suspicion that liquidity, not fundamentals, are behind the strength. Even S&P 500 earnings appear to have dipped slightly in 2019. Markets now look expensive; the US is now at close to the highest valuation levels in the past two decades for all the major valuation metrics. ‘Deep value’ metrics, such as valuation versus cyclically-adjusted earnings, or capitalisation versus national income or corporate gross value-added, are even more stretched.
One reason why the market does not seem to mind high valuations could be profitability levels. Return on Equity (ROE), currently a little over 15%3 for the US market, is 1-2% higher than long term averages, but not markedly so. A more compelling one is the high net profit margin of US companies. This has doubled in the past three decades (see chart), to levels significantly higher than what we see elsewhere. It is no exaggeration that this rise in profit margins has been the ‘secret sauce’ of the two strongest bull markets of all time, the 1990s and the one we are in.
However, clouds are appearing. Some factors driving margins to high levels are no longer with us. Costs are now rising as globalisation-led cost declines turn into cost increases from trade disruption and more uncertainty on international flows of people and capital. Domestic labour costs are also rising. Other drivers, and there are many, though less important than costs, are also turning less favourable over time. If the economy slows, revenue growth will weaken, which pressures margins further.
A period of respite
How should investors react to current market conditions? Since equities are a part of portfolios rather than standalone investments, relative comparisons with other asset classes matter. Here, the importance of low interest rates and bond yields is clear since these improve the relative value credentials of equities. Lower interest rates tend to push valuations higher for this reason. Easier financial market liquidity, when it comes, as now, provides further support. But there is a catch. This condition only holds so long as economic and earnings growth conditions that drive market gains are not impaired. It is probable, however, that low bond yields and interest rate easing are signalling less good economic conditions, especially relative to current (optimistic) consensus views. This means that conditions for valuation multiples to stay high may not be met on an ongoing basis. Beyond the near-term support being offered by easy monetary and financial conditions, this makes for a much more challenging outlook for equity markets.
For the time being, lower rates and easy liquidity are offering a period of respite. This may last for several months if not all of 2020, which allows scope for laggards like emerging and small-cap equities and lagging styles like value to likely recover at least some lost ground.
Sooner or later, though, unsettled conditions will return. Our view of transition market conditions taken since mid-2018, moving through mini-cycles of optimism and pessimism amidst a gradual pick up in volatility, still looks appropriate. Reining in equity risk into diversifiers within alternative space, adopting conservative approaches in portfolios across and within asset classes and setting lower portfolio return expectations ahead are some of the more obvious coping strategies.
1 Past performance is no guarantee of future results. Indices cannot be invested in directly.
2 As of October 1, 2019. Past performance is no guarantee of future results. Indices cannot be invested in directly.
3 As of 12/31/2019. Past performance is no guarantee of future results. Indices cannot be invested in directly.
Market data source Factset
Unmanaged index returns assume reinvestment of any and all distributions and do not reflect fees or expenses.
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Appendix: Index Definitions
S&P 500 Index – The market-cap-weighted index includes 500 leading companies and captures approximately 80% of available market capitalization.
Russell 2000 Index - The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000 is constructed to provide a comprehensive and unbiased small-cap barometer and is completely reconstituted annually to ensure larger stocks do not distort the performance and characteristics of the true small-cap opportunity set.
MSCI EAFE Index $ - The MSCI EAFE Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in USD dollar terms.
MSCI EAFE Index (Hedged) - The MSCI EAFE hedged Index is designed to measure the performance of the large and mid-cap segments of developed European Australasian and Far East Markets. The index covers approximately 85% of the free float-adjusted market capitalization and is measured in hedged dollar terms.
MSCI Emerging Markets Index – The MSCI Emerging Markets Index captures large and mid-cap representation across Emerging Markets (EM) countries. The index covers approximately 85% of the free float-adjusted market capitalization in each country and is measured in USD terms.
Bloomberg Barclays Capital Aggregate Index - The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.
HFRI: The Hedge Fund Research, Inc. Monthly Indices (HFRI) are fund-weighted (equal-weighted) indices. Unlike asset-weighting, the equal-weighting of indices presents a more general picture of performance of the hedge fund industry. Any bias towards the larger funds potentially created by alternative weightings is greatly reduced, especially for strategies that encompass a small number of funds. All single-manager HFRI Index constituents are included in the HFRI Fund Weighted Composite, which accounts for over 2000 funds listed on the internal HFR Database.
CBOE VIX Index: Tracks the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.
ML MOVE Index - The Merrill lynch Option Volatility Estimate (MOVE) Index is a yield curve weighted index of the normalized implied volatility on 1-month Treasury options which are weighted on the 2, 5, 10, and 30 year contracts
Appendix: Data Disclaimers
BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively "Bloomberg"). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, "Barclays"), used under license. Bloomberg or Bloomberg's licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.
London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group [year]. FTSE Russell is a trading name of certain of the LSE Group companies. “FTSE®” “Russell®”, “FTSE Russell® are a trade mark(s) of the relevant LSE Group companies and is/are used by any other LSE Group company under license. All rights in the FTSE Russell indexes or data vest in the relevant LSE Group company which owns the index or the data. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group does not promote, sponsor or endorse the content of this communication.
The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)
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