If economic historians of the future look back at 2019, they might conclude that this was the year central bankers once again managed to reflate financial markets – if not the global economy at large. The year has been a tug of war between two opposing forces. At one end was the reflationary impact of central banks’ easing of monetary policies – implemented either through reductions in policy rates (e.g. US and Australia) or, in the case of the Eurozone, through an expansion in the central bank’s balance sheet (buying European debt and bonds). At the other end were the return-suppressing impulses originating from a slowing global economy and escalating geopolitical risks – in particular, trade tensions between the United States and China. At the time of writing of this article, the old saying that “an investor should never stand in front of a steamroller driven by a central banker” still rings true.
Investors started 2019 with anxiety after a sharp decline in share markets in the last quarter of 2018. In early 2019 Chairman Powell signalled that the US Federal Reserve (the Fed) had pivoted from a tightening bias to a more neutral, “data-dependent” policy stance. The Fed subsequently reduced policy rates by 75 basis points to a target range of between 1.5% and 1.75%. Other central banks followed suit. The Reserve Bank of Australia (RBA) reduced the target cash rate by 75 basis points to 0.75%. The European Central Bank (ECB) brazenly announced that it had reduced the interest rate on deposit facility by 10 basis points to negative 0.5% and would resume net asset purchases at a monthly pace of 20 billion Euro per month. It also wrote an open cheque by announcing that the asset purchase program would remain for as long as necessary.
Easing monetary policy comes amid deteriorating economic conditions, especially in manufacturing sectors. The Purchasing Managers’ Index (PMI) suggested that the manufacturing sectors in the US, Europe and China were all experiencing recessionary conditions by the end of 2019. This has been confirmed by official economic statistics. For example, Germany’s GDP grew only marginally by 0.1% (quarter-on-quarter) in the September quarter after contracting by 0.2% in the June quarter, while Chinese GDP growth of 6.1% (year-on-year) in the September quarter was the lowest level the country has seen in 20 years.
Chart 1 Source: Factset
As the tide of central banks’ liquidity lifted all asset classes, investors have been richly rewarded for taking risks in 2019. The year-to-date returns of the main asset classes are shown in Chart 2 – all of which returned positively. Australian bonds returned just over 9% as the RBA reduced policy rates three times during 2019. Global sovereign bonds lagged this level slightly, but delivered a very solid 7.3% to investors – impressive considering around one third of the global sovereign bonds universe comprises negative-yielding bonds. Further out on the risk curve, listed real assets benefited from falling bond yields and generated returns above 20%. Both global and Australian shares performed strongly despite concerns about economic recessions, lower earnings growth and expensive valuations, while emerging market shares have been a relative laggard.
Chart 2: Year-to-date returns as at 30 November 20191
However, the high year-to-date returns masked considerable volatility in markets, which were often driven by macro headline news on US–China trade tensions, Brexit and developments in the Middle East. As seen in Chart 3 below, the S&P 500 fell by 6.8% in May and by 5.8% in the first week in August. The US equity market recovered strongly and quickly after those falls. One of the factors supporting the recovery is the fall in US 10-year bond yield, which started the year at close to 2.7% and was around 1.77% in November.
Chart 3: US 10-year bond Yield and S&P 500 to 28 November 2019
We are cautiously optimistic in our investment outlook for 2020, which is based primarily on the easing of financial conditions by central banks. However, we acknowledge that risks are significantly skewed to the downside given the high level of geopolitical uncertainty and very mixed economic data. Below, we map out three possible scenarios for markets over the next year and expand on the most likely scenario we believe could come to pass.
In our view, the most likely scenario is modest economic growth and market returns:
- On the economic front, the main central banks have all eased monetary policy and this could translate into improving economic data towards mid-2020. In the US, the level of unemployment is still low at 3.6%, and the growth in non-farm employment remains reasonable despite the deceleration in job creation since late 2018. Furthermore, both US households and financials have de-leveraged significantly since the global financial crisis. Importantly, US consumer price inflation remains below the Fed’s target which, combined with the relatively high cash rate in the US, means the Fed has the ammunition to stimulate the economy if necessary. The key risk to the US economy is weakness in corporate sentiment and investment. Anecdotal evidence suggests that the dispute with China is a significant contributor. We do not expect a full resolution of the trade war, but we believe a ceasefire is likely which could improve sentiment.
- Outside the US, economic prospects appear cloudier. The main source of uncertainty under this scenario is the Chinese economy, which has suffered from US tariffs on its exports. The trade war has undoubtedly made the transition of the country’s economy from an exports and investment-driven economy to a consumer-oriented economy more treacherous. However, the Chinese economy is a hybrid market economy in which the authorities retain many policy levers – many of which the authorities began using in late 2017 and could continue using – such as lowering banks’ reserve requirement ratios to support the Chinese economy and avoiding a hard landing.
- Australian economic growth slowed in 2019 and the RBA responded by lowering its policy rate. The weaknesses in the Australian economy can be attributed to a mix of weak consumer spending, driven by low wage growth and the wealth effect from corrections in house prices, and deteriorating corporate sentiments. We anticipate that more accommodative monetary policy, the reduction in income tax in July 2019 and the recovery in house prices seen in the second half of 2019 may stabilise the economy, helping Australia maintain its record of uninterrupted economic growth since the early 1990s.
- The modest recovery in economic growth could benefit equities. However, given most share markets are currently trading at around fair value through measures such as forward price/earnings and price/book, we expect modest returns in the single digits. Stronger economic growth could also exert some upwards pressure on bond yields, but that trend should be constrained by low inflation and central banks’ dovish forward guidance. As at November 2019, the US 10-year yield is around 1.78% and could rise through to 2%. Spreads on investment-grade corporate bonds should remain steady.
1 Cash: RBA Cash Rate; Australian Fixed Interest: Bloomberg Australian Bond Index; Global Sovereign Bonds: FTSE World Government Bond Index (AUD Hedged); Global Aggregate: FTSE World Broad Investment Grade Bond Index (AUD Hedged); Australian REIT: ASX AREIT Index; Global REIT: FTSE EPRA/NAREIT Developed rental Index (A$ Hedged); Global Listed Infrastructure: FTSE Developed Core Infrastructure 50/50 (100% hedged to AUD net of tax)Australian Equity: ASX 300 Accumulation Index; Australian Small Cap: ASX Small Cap Accumulation Index; Global Equity (unhedged): MSCI All Country World Index (AUD Unhedged); Global Equity (Hedged): MSCI All Country World Net Index (AUD Unhedged); global emerging markets: MSCI Emerging Markets Index (AUD Unhedged).
If you would like to discuss further please contact Trent Doughty or Shane Hay.
Senior Client Director