A less defensive positioning in 2020
The potential de-escalation in a number of 2019’s geo-political hotspots sees us ‘leaning into risk’ from a less defensive portfolio position for 2020. We are closing our moderate underweight to equities (emerging markets and Europe), and instigating regional overweights in the UK and emerging markets, funded by an underweight in Australia. We are maintaining our underweight to fixed income and moving neutral on credit, and expect that a rise in interest rates could drive equity sector rotation. The macro cycle is not irreparably damaged, but it is mature, arguing for an ongoing over-allocation to defensive alternative assets. Risks for 2020 centre on a re-escalation in the US-China trade dispute.
‘Leaning into risk’ as geo-political tensions ease
The economic cycle in 2019 has clearly been damaged by the escalation in geo- political tensions and associated business uncertainty. Global growth has slowed and leading indicators suggest further slowing is likely into early 2020. Until recently, and after a stellar first half for risk assets, markets have spent most of the second half of 2019 drifting sideways.
However, as 2019 draws to a close, we believe that although the economic cycle is mature it is not irreparably damaged. A trilogy of positive drivers remain in play, from low unemployment, low inflation to low interest rates—these are cornerstones that support an ongoing robust economic cycle.
Much will depend on whether our judgement proves correct, that 2020 will start on a less tense geo-political footing. Can a potential ‘phase one’ US-China trade deal be signed and a majority UK Conservative Party government close a Brexit deal? Will this provide enough visibility soon enough for companies to forestall a signalled hiatus in global capex? The recent flood of global central bank easing— the most since the GFC—also holds the prospect of additional liquidity to support global activity as 2020 gets underway, notwithstanding that easy monetary policy has now largely reached its limits.
Tempering this emerging optimism is that if geo-political headwinds were to lift, we are still left with an economic cycle that is long and assets that are fully valued. More structurally, both in Australia and offshore, medium-term growth remains challenged by elevated debt levels, demographics that are deteriorating and a political environment that is less conducive to productivity enhancing reform, which is the true driver of real wage growth.
On balance, recent macro and political developments have reduced the likelihood of a sharp near-term correction in risk assets. However, relatively full valuations at the later stages of the cycle also argue against a risk stance that is too aggressive. This is particularly relevant as we remain closer to the end of the cycle than its beginning. Reflecting this, our key tactical asset allocation themes as 2020 gets underway primarily embody a decision to lean a little more into risk, albeit from a relatively neutral portfolio position.
Recent macro developments—further slowing into early 2020
As 2019 draws to a close, recent data reveal a continued slowing in global activity. Consumer sectors and jobs markets have so far remained resilient. But data on industrial production and exports across both developed and emerging markets have continued to weaken in H2 2019, and in some cases sharply. More concerning, capex intentions have fallen, notably in Europe and the US, while the drop in October’s JPMorgan composite purchasing managers index (PMI) to a new cycle low flags further weakness ahead.
Still, most forecasts centre on a stabilisation of growth in early 2020 ahead of a moderate recovery through 2020 that builds momentum into 2021. UBS expects global growth, currently 3.0%, to trough at 2.9% in H1 2020 before recovering modestly to 3.2% by end-2020 and 3.6% by end-2021.
Recent developments support such notions of weakness giving way to stabilisation, particularly a rebound in financial conditions through Q4 2019 partly due to global central bank rate cuts and renewed US Federal Reserve (Fed) quantitative easing (QE). Rising hopes of more stimulatory fiscal policy being put to work in Europe (where Germany narrowly avoided recession), China, the US, many Asian countries and Australia have also lifted sentiment.
On the data front, a stabilisation in November’s manufacturing PMIs (the epicentre of H2 2019 global weakness) across a broad range of countries is also positive, as is the recent rebound in US jobs data and unfolding strong recovery in US housing. Even in Australia, a recent drift up in business conditions and consumer confidence—in tandem with a strong recovery in housing activity—has supported the Reserve Bank of Australia’s (RBA) dual contention that the economy is experiencing “a gentle turn” and that the “threshold for undertaking QE in Australia has not been reached”.
PMIs still flag slowing growth into early 2020
Recent geo-political developments—de-escalation risks rise
Progress around some of the key geo-political risks also supports a more stable outlook, though outcomes remain far from certain:
US-China trade war—In late November, Reuters reported President Trump saying that the US is in the “final throes” of a ‘phase one’ deal with China. This follows China’s decision to increase penalties on intellectual property theft, likely an effort to accommodate US demands for greater progress. Key will be whether China’s demand for a wind back in tariffs or the cancellation of the mid-December tariffs (a potentially positive outcome) can be delivered.
Brexit—Based on current polling, a mid-December election is expected to deliver a majority Conservative Party government, allowing Prime Minister Boris Johnson to pass his ‘new’ Withdrawal Agreement Bill agreed with the European Union (EU) by the extended 31 January 2020 deadline.
Elsewhere, geo-political hotspots including oil and Iran, Turkey and Syria and the North Korean Peninsula appear calm for now. However, the recent re-escalation is the Hong Kong democracy demonstrations continue to weigh on sentiment globally, most evidently in the Asian region.
Positioning for 2020—our new tactical asset allocations
Since early August, we have positioned portfolios defensively, with moderate underweights in equities and bonds balanced by overweights to alternatives, credit and cash. Recent geo-political and macro developments have chipped away at the rationale for being underweight risk. As we move into 2020, we return our overall equities position to neutral, closing underweights in Europe (where cyclical value could find relief on stabilising growth) and emerging markets (now supported by an improved global trade backdrop). We have closed our cash overweight to reflect the persistence of low yields and the likelihood cash will not outperform even moderate gains in equities.
We have moved underweight domestic equities
The domestic market is on track for its best calendar year performance since the GFC, and fourth best since 1993. However, with a 17.7x one-year forward price to earnings (P/E) ratio—its highest since the 2002 Dot Com bubble—valuations have become stretched. Australia also now trades at parity to the rest of the world on a P/E basis, with prior peaks occurring during commodity price booms and only for short periods of time. This suggests the outlook for capital gains in Australia is muted in the absence of stronger earnings per share (EPS) growth over the course of 2020.
Unfortunately, over the latter half of 2019, EPS revisions have turned sharply lower, deteriorating at a time where the rest of the world has shown some stabilisation. EPS growth for the domestic market in CY 2020 is 3.5%, less than half that of Japan, which is the next weakest region and considerably less than world EPS growth of around 9%. Large parts of the domestic equity market are exposed to growth that is potentially below average:
Banks are suffering from historically low interest rates and the inability to reprice deposits to offset margin pressure.
Miners have had a year marked by positive one-off supply shocks for iron ore. An expected rebound in supply growth is likely to hamper earnings.
How this plays out in terms of growth versus value and Australia’s relative lack of high growth alternatives (and heavy exposure to defensive bond-proxies) will likely be an important driving factor behind returns in 2020.
We have moved underweight domestic equities to reflect a relatively low earnings outlook, absolute and relatively expensive valuations and an only a moderate (though improving) macro outlook.
Relative valuations support an overweight in UK and emerging markets
We have moved overweight international equities
For international equities, modest earnings growth should see markets grind higher. The UK is now a key overweight. With a Brexit resolution likely in early 2020, the UK market offers investors a rare combination of valuation support with dividend yield, P/E ratios and other valuation metrics screening cheaply in both an absolute and relative sense. In addition, stronger corporate confidence is already driving higher capex intentions. According to Credit Suisse estimates, the post-Brexit fiscal boost looks set to be the largest since the GFC, providing a positive backdrop for economy-wide sentiment.
Elsewhere, there is growing optimism that a ‘phase one’ US-China trade deal is close at hand, with markets pricing in a high chance of success. From here, for equities to push higher, there will need to be evidence that permanent damage to corporates’ willingness to invest has been avoided and that supply chains have not been structurally impaired. Additionally, for US equities to push higher—given valuations are historically expensive—it may require a more optimistic rebound in profitability. This suggests that other regions, such as Europe and emerging markets, may be of more interest. Emerging market valuations are only at long- run averages and this is the region with the highest beta to global trade. Similarly, Europe is the region next most correlated to stronger global growth. With a much greater sensitivity to higher bond yields, investors will closely monitor whether any rise in bond yields can provide a much-needed boost to that region’s financials sector.
We have moved overweight UK equities (a multi-year positive view in the wake of a likely Brexit deal) and overweight emerging market equities on better growth, supportive policy and corporate ‘self-help’, particularly in Asia. Both the UK and emerging market present relatively attractive valuations.
Underweight fixed income but overweight credit to high grade
2019 saw global central banks ease significantly, while inflation remained below their target bands. The Fed may push the cash rate lower in H1 2020 and the ECB will persist with supporting the economy via QE and negative interest rates. We forecast a more volatile time ahead, with the risk of stronger data supporting the end of easing cycles. But the tug-of-war between inflation and weakened growth, as well as uncertainty surrounding the US-China trade dispute, may create volatility in high-grade bonds with a likely emphasis on higher yields. Domestically, the RBA has the ability to ease further to help stimulate the economy but, with early signs of improving jobs data and a stronger housing market, moving further long duration could prove to be the wrong strategy.
While interest rates are expected to remain around historically low levels, we see credit spreads well supported and default rates remaining low, even if we do witness a gradual rise in yields. Floating rate, as opposed to fixed rate diversified income strategies with the emphasis on capital preservation, have been a strong theme in H2 2019 and we see this as gaining further momentum in 2020. Investors should focus on best-in-class global fixed income managers who can source the best risk-adjusted returns hedged back into Australia dollars to help support a well-diversified portfolio.
We remain underweight high-grade bonds as stabilising growth is expected to lead to more neutral central banks by mid-2020 and higher bond yields. We have a relative preference for domestic over international as the RBA is likely to lag any future rate hike cycle globally, and closed our domestic credit overweight, taking an overall neutral stance toward credit. Spreads are tight and unlikely to outperform as interest rates rise, and there is also the risk of a rise in default rates following weak earnings.
Overweight defensive hedge funds and real assets
We remain overweight alternatives as the cycle matures, given relatively expensive valuations for traditional assets and the relatively low expected return outlook. Tactically, within a diversified alternatives portfolio, we favour increased allocations to defensive hedge funds and higher quality credit and real assets (property and infrastructure). While we believe that private equity vintage risk can be minimised via manager selection, full valuations in public equity markets (though less evident to date in private markets) suggest private equity is modestly less attractive in the current environment.
Two additional portfolio topics to consider
Rotation risk—The collapse of bond yields from late 2018 has fostered a number of strong equity sector and style themes over the past year. These include the outperformance of growth sectors versus value and defensive bond proxies. The prominence singular macro factors has also contributed to the underperformance of active managers globally and in Australia. If a de-escalation in geo-political risks gives way to better growth and rising yields through 2020, a reversion in style is likely to be a key contributor to portfolio performance in the coming year.
Currency risk—Over the past two years, the Australian dollar has fallen 10% against the US dollar, providing a return tailwind for unhedged international equity positions and companies earning offshore. If global growth becomes less US-dominant and geo-political tensions ease, the US dollar may engage a weaker trend. Despite the potential for commodity price falls to weigh, more stable rates and an improving current account position could support the Australian dollar higher in 2020 (potentially to the mid-USD 0.70s), arguing for an increased focus on currency exposures in 2020.
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Scott has more than 20 years’ experience in global financial markets and investment banking, providing extensive economics research and investment strategy across equity and fixed income markets.