A World in Transition
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A World in Transition T
he world is coming to terms with several factors that are significantly altering the outlook for the global economy, and the world we live in. How the world adapts to the challenges could have significant implications for financial markets in 2020 and beyond. The world is in transition and doesn’t know yet where it’s going to arrive.
Baby Boomers Hand Over the Baton to the Millennials Baby boomers are rapidly being replaced by Gen Xers (1965-1980) and Millennials (1981-1996) in the general population and workforce. The attitudes, aspirations and lifestyle of Baby boomers born in the aftermath of the Second World War and through to 1964 will no longer hold sway as other generations take hold. The marked change of very recent years is that Millennials have now moved in many cases to become the largest cohort in the labour force. Millennials are more likely to live with parents, marry later, adopt technology, but also to fear that technology will lead to them losing their job.
Chart 1: Millennials became the largest generation in the labor force in 2016
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A World in Transition
Pension and Healthcare Costs Become a Real and Present Problem With baby boomers moving into retirement, there is an increasing focus on the contingent liabilities of pension funds and government social benefits. There are already numerous examples of pension funds unable to meet their present-day commitments. However, the future looks even more worrying. In the US, the 2019 OASDI Trustees Report commented that the Social Security’s Old-Age, Survivors, and Disability Insurance (OASDI) trust funds alone have an unfunded obligation of $43.2 trillion. Another study showed that the Social security’s combined trust fund would be depleted in 2035. Policymakers will not be able to continually bury their heads in the ground. Already with recent protests in France, the disruption to political life could be considerable as governments try to address their deficits and the private sector owns up to hopelessly under-funded pension schemes.
The Waning Dominance of the United States The United States feels threatened. Trade wars have some foundation in unfair practices, but they also reflect an attempt by countries to slow the progress and reach of competing nations. The Chinese economy on a purchasing power basis is already larger than the United States and could surpass the United States on a current prices basis later in the decade. President Trump has taken up the challenge in his way. The trade war with China contrasts with his efforts to withdraw troops from several theatres of conflict. The dollar has been weaponized by the US government threatening to take dollars away from countries that don’t comply with their perspective. Such moves only increase efforts to propagate new means of global payments, including the use of cryptocurrencies.
Chart 2: China’s economy surpasses the US on some measures 40.0%
Forecast
35.0%
US GDP on current prices basis
30.0% 25.0%
20.0%
US GDP on PPP basis
15.0% Chinese GDP on PPP basis
10.0%
5.0%
Chinese GDP on current prices basis
A World in Transition
2024
2022
2020
2018
2016
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2012
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0.0%
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Environmental, Social and Governance (ESG) are Front and Centre In the past year, there has been a dramatic increase in awareness of ESG matters. We cannot overstate the degree to which the popular press and financial markets have taken ESG to heart. Every asset manager now has to have some strategy around ESG factors. Investment choices are being made with at least a half an eye on ESG matters. A recent survey by Aviva found that 90% of investors polled considered ESG important in investment decision-making. Companies that do not meet baseline ESG ratings will find themselves increasingly struggling to get access to funding at a reasonable cost. Already there appears to be discernible deterioration in the valuation of ‘dirty’ industry companies. Meanwhile, climate change issues are never far from the headlines. The issues have always been there. The difference in 2019 was that the topics were reaching the top of political agendas. While green parties still struggle to make a meaningful impact in elections, the green credentials of leading parties are increasingly being challenged.
Chart 3: Atmospheric carbon dioxide levels off the charts
Source: climate.nasa.gov
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A World in Transition
The ESG factors are morphing into new initiatives that catch the eye. The decision of by a large body of leading US CEOs to change, this year, their focus to stakeholders rather than shareholders marks a remarkable shift from the past. Capitalism is considered to have started in around the 16th/ 17th century. At its extreme, financial capitalism dominated through to the world financial crisis. Could it be that we are now seeing a form of social-capitalism developing where labour has a meaningful input to corporate decision-making and gain a fairer payout from gross profits?
A World in Transition
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The Reality of Slower Global Growth Real GDP growth has been slowing both in the developed and emerging world. Chart 4 shows that even in the United States, which has had the benefit of President Trump’s tax cuts, the trend in long term growth is way below that enjoyed between 1980 and 2007.
Chart 4: Trend in US 10-year average growth has materially fallen 4 3.5 3 2.5 2 1.5 1 0.5 0
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Source: Bloomberg
Unfortunately, the trends ingrowth in the emerging world are also downward. Weak Chinese growth due in part to the legacy of a one-child policy is bringing Asian growth down materially for the near 9% growth witnessed in the past. In Latin America growth is erratic but averaging close to half the rates achieved in the past. In the Middle East, the constraints on oil production to support oil prices has left growth a fraction of past levels.
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A World in Transition
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Table 1: Historic and Forecast Real GDP growth 2001-10
2019 (E)
2020 (E)
2020 - 24(E)
Emerging and Developing Asia
8.5
5.9
6.0
6.0
Emerging and Developing Europe
4.4
1.8
2.5
2.5
Latin America and Caribbean
3.2
0.2
1.8
2.7
Middle East and Central Asia
5.3
0.9
2.9
3.3
Sub-Saharan
5.9
3.2
3.6
4.2 Source: IMF
The Holing Out of the Centre of Global Politics There is an active debate amongst political analysts over whether global politics is moving to left or right, but one thing that is evident that the centre is fast disappearing. The politics of consensus seems to be increasingly on the wane. The US has Democrats and Republicans in entrenched positions either side of an argument. The UK election saw an increasingly entrenched electorate at opposite ends of the political divide. Many democracies fail to deliver outcomes for their economies or their people that offer fairness or vision for the future. The seeming lack of leaders and political parties that can garner the support of majority of the population risks leaving governments trying to manage their countries with difficult coalitions or wafer-thin majorities. The world faces significant challenges that need empowered leadership with vision. Few countries can easily say that they have such a political set up at this juncture.
A World in Transition
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Global Economy The Great Experiment
T
he global economy is not growing fast enough for the comfort of policymakers in most of the major economies. We expect future years to be marked by a grand experiment when governments become more significant contributors to global growth. We believe governments and central banks will, by hook or by crook, be working much more closely together. Heavily indebted governments will need central banks to buy into the new Modern Monetary theory that allows central banks to fund government largesse through printing money. The rest of the developed world is set for its Japanification – the proverbial liquidity trap.
Table 1: IMF forecasts for Global Economic Growth Average 2019-2024 Projected
Average 2001-2010
2018
2019E
2020E
2024E
World
3.9
3.6
3.0
3.4
3.6
United States
1.7
2.9
2.4
2.1
1.6
2.0
Euro Area
1.2
1.9
1.2
1.4
1.3
1.3
Japan
0.6
0.8
0.9
0.5
0.5
0.6
EM and Developing Economies
6.2
4.5
3.9
4.6
4.8
4.4
China
10.5
6.6
6.1
5.8
5.5
5.8
India
7.5
6.8
6.1
7.0
7.3
6.8
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Global Economy - The Great Experiment
Most of the world’s major economies are struggling to shake off the weak average growth rates of 2001-10 that incorporated a global financial crisis. Over the next five years, the IMF forecasts that growth rates in major economies will not be materially away from those experienced over the past ten years. However, in emerging countries, the IMF envisages a marked slowdown in growth. We would probably take issue with the IMF’s relatively rosy picture of developed market growth. But that being said, we believe that policymakers in developed countries will try to achieve growth rates that improve on those that were seen in the past ten years. However, in our view, the global economy is particularly vulnerable at this moment. The usual levers of growth are stagnating or are, at the very least, less effective than at any previous stage of the modern economy.
Population growth - Down Global population growth is slowing. The current 10-year growth rate of 1.2% is well down on the 2.0% plus growth rates seen through the 1980s and 1990s. The current population growth rate is also highly dependent on relatively poor countries. Over the next thirty years, nine countries will be responsible for half of projected population growth, with the United States (ranking 9th) the sole developed country on the list.
Productivity growth - Down Global productivity growth slowed to just 1.9% in 2018 compared with 2.9% between 2000-07. Even in emerging markets, productivity growth has slowed in recent times. China’s productivity growth has more than halved to 4.0% compared to 8.9% between 2000-07.
Globalisation - Going into reverse For the past twenty years, the global economy benefitted in many ways from globalisation. However, the challenges of Donald Trump’s trade wars through 2018/19 have put many of these positive effects into reverse, as have an outbreaks of populism in other parts of the world. The World Economic Forum has calculated that a persistent US-China trade war would take 0.7% off global growth.
Global Economy - The Great Experiment
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Consumer Spending
Governments to Spend More
Income growth is a critical component of the ability of consumers to increase their spending. The trends remain troubling. In 2017 global real wage growth slipped to the lowest level since 2008. Hence, despite growth and rising employment, wage-earners still struggled to gain a larger share of national income. 2018 and 2019 do not appear to have been too different, with wage earners struggling to negotiate materially higher salaries. The US has seen some improvement, with real wage growth most recently at around 0.6%, the most significant increase since 2016. But even that wage growth appears to lack breadth or momentum. In Europe and Asia, salary growth remains low. The old world is in sharp contrast with the new world where wage growth has been more vibrant and where consumer spending remains a source of significant demand growth in the future.
The structural challenges of ageing populations and highly indebted governments are likely to unleash government action on the back of a new wave of economic thinking in the global economy.
Investment Spending Investment spending plans were already hesitant even before the trade wars hit, with companies confused about future supply lines and customer bases. US companies, after the tax inspired splurge on capital investment in 2018, have markedly reined in their investment plans in recent quarters.
In 2017 Global Real Wage Growth Slipped To The Lowest Level Since 2008
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Global Economy - The Great Experiment
Given the lack of other drivers, an increase in government spending ends up being the default policy for driving growth in the global economy. Such spending becomes all the more likely when you consider that geopolitically, the world seems to be in a phase of populist governments. By design, populist governments try to be popular. One way for a government to be popular is to spend money. Governments can mask their expenditure increases as necessary under the headings of infrastructure spending and ‘green’ budgeting. The OECD launched the Paris Collaborative on Green Budgeting in December 2017. The aim was to encourage governments to align their expenditure and revenue process with climate and environmental goals. The initiative doesn’t per se encourage additional spending. However, governments can undoubtedly use the ‘excuse’ of trying to achieve climate and environmental goals to increase government spending. In September, for example, the German government announced a Euro 50bn spending package through to 2023 that would help the country meet their 2030 carbon reduction goals. However, the net impact on the economy is offset by a carbon dioxide emissions tax on transport and heating in buildings from 2021. The pressure for additional government spending may also come from the need for governments to cover contingent liabilities of social security, pension and healthcare in both the public and private sectors. Public and private sector pensions liabilities are woefully underfunded. Healthcare costs are likely to balloon. In our view, governments will be forced to make good the gaps by more substantial social and healthcare spending.
Modern Monetary Theory encourages central banks to support high spending governments. With government debts already very high relative to GDP, one could ask how they are going to fund spending? The simple answer is that central banks will increasingly be pressured to monetise government debts through quantitative easing. This may seem shameful; however, the new Modern Monetary Theory provides an academic framework/ excuse for doing just that. Put simply, the government spends money and runs a higher government deficit. This will require the government to raise funds from the market through the issue of bonds. However, in
the absence of investors buying the newly issued debt, interest rates would rise, nullifying some of the positive impact of higher spending. Hence, to keep a rise in long term interest rates in check, the central banks would need to print money to buy the bonds. We still fear that prolific government spending will at some stage end in tears. Conventional wisdom is that governments are not the best allocators of capital. Their spending does not typically have a multiplier that generates long term sustained growth. Hence spending in any one year often has to be followed by spending in another year as the benefits of the spending fall away.
Chart 1: Japan’s government deficit just never goes away Government aggregate deficit (before bond issuance) as a percentage of GDP
0.0% -2.0% -4.0% -6.0% -8.0% -10.0%
Jan-19
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-12.0%
Source: Bloomberg
The Bottom Line
The Japanification of developed countries is underway. Higher government spending helped by a supportive central bank is a hallmark of the Japanese economy over the past two decades. As Japan experienced, such policies can mask the underlying problems for only so long, if at all. But as a marker the Bank of Japan owns 97.1% of the Japanese Government Bond market, the Federal Reserve owns ‘just’ 11.2% of the US bond market.
Global Economy - The Great Experiment
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Three Elements of European Integration that Matter to Markets
F
rench President Emmanuel Macron recently announced that Europe stood ‘at the edge of a precipice’. He was trying to reinvigorate efforts by the European Union (EU) to take charge of its destiny and to leverage its economic power on a global stage. The backlash against his thoughts was intense. However, it highlighted the pressure the EU finds itself under to achieve progress on issues such as security, the environment, migration and trade. From December 1st the new EU government has a fresh Commission, EU Parliament and ECB President. The Merkel-era is quickly drawing a close. The EU electorate is demanding new strategies driven by fresh thinking. There is even, in typical EU fashion, a Conference on the Future of Europe. Grassroots participation is encouraged rather than top-down blue skies-thinking of an earlier era.
In this article, we look at three specific areas which we believe will play a role in determining the capacity for, and potential success of, further Eurozone integration in the next decade.
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Three Elements of European Integration that Matter to Markets
Banking union Capital markets union Fiscal union
01 02 03
Completion of these projects, we feel, is necessary, if not sufficient, in maintaining the EU as a global economic super-power. Fiscal union is essential to drive region-wide infrastructure projects that benefit all member states. The measures would take the region in the direction of a federated government - something that might be achieved by the end of the next decade.
European Banking Union Ever since the sovereign debt crisis, policymakers have aimed to establish a banking union that is resilient to external and internal shocks. The crisis highlighted the need for policymakers to reinforce confidence in bank balance sheets, and reduce the risk of capital flight and liquidity squeezes. In particular, there was a clear need to address the ‘death loop’ of the over-reliance on local sovereign debt in banks’ capital bases. Banking integration so far has taken three forms. 1. The establishment of a single supervisor (the ECB) with a clear mandate to intervene and establish adequate reporting standards; 2. The creation and application of a single resolution mechanism for failing banks. 3. The inception of an EU-wide deposit insurance scheme which ultimately brought progress to a virtual standstill. National governments have been hugely resistant to bailing-in senior debt holders in failing institutions and instead have sought to include participation by depositors. The wealthier northern European members are wary of seeing contingent claims on their banking systems should they fully insure the depositors of banks in peripheral economies who have had a reputation for poor quality lending. If financial markets, depositors and EU policymakers can have confidence that measures of the quality of a bank loan book and its reserves are accurate, then it will encourage mutualisation of risk. It will require root and branch reform that will undoubtedly be lengthy and painful. There is the no small matter of ensuring that individual country bank regulators are fully independent and informed. Likewise, there is a need to embed a consistent process around bad debt recognition. Decent audit standards are particularly important. None of these will be arrived at overnight, but they are essential if an EU banking system is fit for future purpose.
Three Elements of European Integration that Matter to Markets
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Capital Markets Union The capital markets union aims to dissolve the significant barriers to cross border investment across the EU. A project has been in place for almost a decade but has been given new urgency by global trade tensions and a stagnating regional economy. Success to date has been limited. Companies are still very dependent on their domestic banking sources. An IMF report* in September 2019 highlighted how “firms in, say, Greece, pay a 2.5 per cent higher rate of interest on their debt than similar firms in the same industry in France; Italian firms pay 0.8 per cent higher interest on debt than comparable firms in Belgium…. there is no level playing field”. The report highlighted deficiencies in capital markets regulation and insolvency regimes as just some examples of what might lead to companies disadvantage in accessing competitive funding across the region. It recommends a focus in areas such as transparency much as we mentioned under banking union with a genuine independent stance by European markets’ regulator in working to contain systemic risk. Measures proposed include large central clearinghouses and robust settlement systems.
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Three Elements of European Integration that Matter to Markets
Fiscal Union Six years ago, after the EU debt crisis, there was a greater focus on enforcing the well-known Maastricht criteria that are still the basis of the euro currency club. The Maastricht criteria set out targets for borrowing through an economic cycle as well as capping total outstanding debt alongside restrictions on borrowings for current spending purposes. As a way of ensuring a more cohesive approach to economic management, there has been much discussion in the interim about how the EU could take a path to fiscal union. By 2019, the context has changed markedly as the notion of a fiscal union is now seen as the framework for an integrated EU budget with spending directed at specific sectors that have union-wide relevance. At present, the EU budget is no more than 1% of combined GDP. Efforts to expand its reach and to attach a dedicated revenue stream to the budget (e.g. VAT receipts) has run into staunch resistance, especially from creditor Eurozone members. They
see any concession requiring establishing a vigilant oversight from an EU Treasury or Budget Department. Yet there is clearly a political need to provide a visible return to economies that have suffered as part of the adjustment to Eurozone membership mainly in the case of hardship linked to cyclical downturns. Support for automatic stabilisers such as unemployment benefits is one example. Yet increasingly, long term thinking is focused around a European Infrastructure Fund that would focus on projects that offer benefits to the union as a whole rather than individual economies. Examples include green or environmental investment or support for the digital economy and its connectivity. The added important aspect is that euro-bonds issued to finance such outlays, by carrying the guarantee of the union, would offer a ‘safe-asset’ to the regions banking system. It would also provide a means by which the ECB might provide monetary financing at times of stress in the eurozone economy.
By Bill O’Neill
Three Elements of European Integration that Matter to Markets
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Asia: Looking Through the Policy Volatility
T
he new decade starts with optimism. Inevitably the outlook for the year will be shaped by the evolution of Sino-US trade talks and the effect it has on sentiment. But the rebound in money supply growth in developed countries is a plus point. A return to quantitative easing in the US and European will end the need for Asian policymakers to consider raising interest rates or tighten fiscal policy. Inflation-adjusted interest rates in Asia are already positive outside of Australia and the US dollar-linked markets of Hong Kong and Singapore. Yields in Asia are higher than developed nations and equities are cheaper, making both an option for a balanced portfolio.
Chart 1: MSCI Asia Forecast PE v MSCI Developed Markets 1.30 1.20 1.10 1.00 0.90 0.80
0.70 0.60
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Source: Bloomberg
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Asia: Looking Through the Policy Volatility
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US-China: Tensions to Stay Washington and Beijing have engaged in a trade spat for most of President Trump’s term in office. Most professional observers are looking for some concessions in the early months of 2020. We expect some, such as allowing greater US agricultural exports, but little else. Trade tensions will inevitably continue to shock Asian financial markets periodically. The key considerations for investors are 1) does President Trump’s business style make a deal or an easing of tensions likely? 2) does China have any incentive to offer olive branches or even concessions? 3) what are the knock-on effects in Asia for trade and financial flows? In the first case, 2019 was a year in which President Trump largely delivered on threats but stalled on agreements. Trade barriers went up as expected but talks to begin normalising relations invariably fell through each time. By the end of 2019, it had become clear that re-negotiating USSino trade relations was only one of President Trump’s objectives and major moves forward were only likely when all adversaries, including European allies, started to give ground.
Chart 2: Exports to 1) US, 2) Japan and 3) Southeast Asia 800 700 600 500
400 300 200 100 0
United States
Japan
SE Asia
Source: Bloomberg
Asia: Looking Through the Policy Volatility
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In short, President Trump is pushing for a full package of concessions from the international community, thus making ‘the deal’ with China less likely in the near term. The trade war with China has not produced the onshoring of jobs to industrial sectors and states of the US, which are essential to President Trump’s re-election hopes. Trump’s incentives to settle are not high. If the US won’t blink, what about Beijing? President Xi doesn’t face any major leadership challenges in 2020. Could there be a unilateral move? We believe that social events in Hong Kong, Taiwan’s impending elections, the fact that mainland growth hasn’t slumped in 2019 as tariffs bite and the re-orientation of China’s trade towards Southeast Asia has given Beijing a need and room to wait. In short, with neither side needing to move, there is little chance of an early resolution.
Knock ons: Semis & Southeast Asia But this isn’t necessarily a market negative. This is not a materially different state of affairs to last year. South Korea and Taiwan benefit from having US political backing and a large, dependent customer base in China. They are well placed to gain better trading terms from China. Exporters and manufacturers in these two nations should be shielded from downside risk. That said, gains for semiconductor manufacturers are likely to be muted given US national security concerns and dependence of Taiwanese / South Korean manufacturers on American component suppliers. Also, Southeast Asia is gaining from being co-opted into a Chinese-centric trading block and China’s reorientation of its supply chain. This transition has intensified as tariffs have increased. Vietnam, in particular, has picked up market share from diminished US exporting activity.
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Asia: Looking Through the Policy Volatility
Japan: The High Jump An additional beneficiary is Japan. Inward tourism has rocketed in the last ten years. Just over 6 million people visited Japan in 2009. Little changed until 2011. Since then the number of visitors has broken the 30 million mark with the majority coming from China, Taiwan and South Korea. The Tokyo Olympics will be held in July and August 2020. Tourism, hotels, consumerism and demand for Yen will likely remain strong throughout the year.
Chart 3: Chinese 5-year CNY bonds v US 5-year government bond yield 4.50 4.00
China 5-year government bond yield
3.50 3.00
2.50 2.00 1.50
US 5-year government bond yield
1.00 0.50 0.00 Dec-14
Jun-15
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Jun-18
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Source: Bloomberg
Asian bonds: Yield Gap From an investment perspective, Sino-US trade tensions are less critical to potential returns than regional growth and capital flows from low interest yielding developed markets. While consensus forecasts expect China’s headline growth rate to fall from 6.1% in 2019 to 5.9% in 2020 and then 5.7% in 2021, growth in the rest of Asia is expected to bottom out in the next six months. Growth should return to near trend levels by 2021, providing there is no recession in the US (not our central forecast). As growth recovers, we could see the same sustained flows into Asia as 2013-15. Policy loosening by the US Federal Reserve and the European Central Bank is once again suppressing long-term interest rates in developed markets and improving spread returns for Asian currencies and bonds. Asian bond yields remain attractive relative to the US and Europe. Asian High Yield bonds carry an average yield of 7%. Asian 5-year government bonds yield 1-3% points more than in developed markets.
Asian equity markets are cheaper than developed markets, trading at a price-to-earnings multiple of 14x 2020 earnings for Asia ex-Japan index versus 16.4x for developed markets. The latter is priced at close to its 10-year high. Asian equities now represent a better risk-reward proposition than their developed market counterparts.
Asian FX: US Dollar Peak? Once again, the year’s outlook is heavily dependent on the direction of the US dollar. After substantial gains in 2018, the greenback has not moved a long way again against Asian currencies over the last 12 months. If US monetary policy remains loose as the Federal Reserve appears to be signalling, then another year of currency, reasonable stability is likely. That again is a positive for Asian bonds and equities as growth stabilises and currency risk diminishes.
By Mark McFarland Asia: Looking Through the Policy Volatility
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Global Interest Rates in 2020: From ZIRP to NIRP? • In a sluggish growth environment, there is scope for policy rates to drift lower • Without a growth spurt and inflation to accompany, long rates will have little impetus to rise • A supply surge won’t push yields higher either, if Central Bank remain the buyers of last resort
T
he global economic recovery, initiated with much ado by central banks around 2008 and fanned intermittently thereafter, is still with us. Despite the odd potential hiccup, it looks like it is here to stay for at least a substantial part of 2020, if not a bit longer. In this past decade, the market has witnessed an unprecedented policy experiment: Central Bank quantitative easing (QE) on an industrial scale, coupled with lower official interest rates than ever before. Some have described this as “Japanification”, in reference to the experience of Japan post the property and stock market collapse which sent interest rates – short and long – plummeting. Also, that proving to be insufficient to lift the economy, the government become a major holder of its own debt via asset purchases carried out by the Bank of Japan.
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Global Interest Rates in 2020: From ZIRP to NIRP?
In some form or another, this pattern has now played out in most of the major economies across the globe. The current stance of all the major Central Banks is to be on easing mode, and also to be considering further QE. For the year 2020, the outlook is for official rates to have a downward bias. If this is indeed the case, and if our presumption is correct that global inflation is likely to remain low, there is an important implication for rates expectations: prepare for even more negative rates. Where we were looking at a ZIRP before (zero interest rate policy), the next level might be NIRP: negative interest rate policy. The thought that more countries will see negative rates is not so shocking. First, many countries are already at or below zero rates. Second, to keep yield curves positively sloping, further reductions in official rates to even more negative levels cannot be ruled out. The Bank of Japan has been trying to do this: keep the curve positively sloped, and for a variety of reasons.
The Yield Curve, Then and Now One of the temporary drivers of growth pessimism in the second half of 2019 was the partial inversion of the US yield curve whereby long rates are lower than short rates. The market has a long-held view that an inversion triggers an economic recession in relatively short order: something like a year or so. This is one reason policymakers prefer not to run an inverted curve for too long (assuming they have control over it in the first place); another is the fact that an inverted curve, if embedded for a long enough time, can wreak havoc in the financial sector. “This time is different� is the usual way in which analysts preface an error. More often than not, it is a way to try to rationalise away the obvious: debt expansions are followed by default spikes, excessive equity valuations tend to deflate, etc. Mostly, things are never really that different. So, it is with caution that we hazard the statement that the 2019 inversion was in fact quite different from previous ones. The main difference, of course, was that there was a major new buyer in the market not seen in previous cycles: the neighbourhood Central Bank. Pointing out this difference, and claiming that there will not be a recession, is not the same thing. Undeniably there is evidence of global slowing from many regions. Most are avoiding it, and the US looks to be on a stable path at the moment. Avoiding a recession, however, may not be enough to return bond yields to the levels seen before the crisis, or even through the midpoint of the current expansion. Say’s Law: Supply creates its own demand. Or: You can create your own demand as long as you supply to the Central Bank.
Global Interest Rates in 2020: From ZIRP to NIRP?
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The Japan experience has taught that it is possible for governments to issue bonds to their hearts’ content without risking higher interest rates in the process. Those who are advocating a rise in the long end of the curve due to excessive issuance had best heed this lesson. The next step in this process is to expand the purchase programme to non-financial assets, a thing dismissively referred to in orthodox economic circles as “helicopter money�. The BOJ has dipped its toe in the water here by extending its purchases not just to government bonds, but also equities. From there it is a short journey to other assets. A further factor is the absence of inflation. Bond investors are well aware of the fact that a part of the return accruing to bonds is due to inflation risk. If there is no risk of inflation in the immediate future, it stands to reason that long bond yields should not carry much of a premium for this risk. A neat way for the market to signal its view on inflation is through the breakeven rate of inflation priced into the US TIPS market. In the period before 2008, the very rough rule of thumb was that the breakeven would generally average in the 2.25% to 2.5% band. Post-crisis, it has seldom been near these levels, and at the time of writing it is hovering closer to 1.6%. This is below the informal 2% target that the Fed has. It probably explains why the Fed has signalled that it would require something quite substantial to shift it back to a tightening mode.
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Global Interest Rates in 2020: From ZIRP to NIRP?
We Expect Low Rates in 2020 Thus, the core view for 2020 on rates short and long is that absent a big growth surprise (to the upside), coupled by a surge in inflation (not currently discounted by the market), we should not be too surprised if rates remained low. Government bonds are the prime source of duration in portfolios. Finding other sources of duration when the prime source is clearly as expensive as it has ever been will be a challenge for 2020, and maybe beyond. As a hedge against outright deflation, few other assets are superior. So selectively and into whatever weakness the market provides, we would suggest adding some duration in USD portfolios, or at least not to reduce duration too aggressively.
Other markets: Europe and Japan For the past years, neither European core government bond markets nor Japanese bonds have been high on the list of desirable investments for investors. In Europe, the occasional political hiccup creates entry opportunities, but right now even the one-time profligate Italy and Greece have seen yields plummet: 1.23% and 1.41% respectively, in the 10Y maturity. We see little reason to invest. These yields are too low to be taken seriously. Likewise, all the countries where yields are negative. With the ECB on standby to ease policy even further, the market expectation is for yields to remain low for quite a while. The same argument applies to Japan. More easing is likely, and to soak up the supply to keep rates low there is the Central Bank buying. According to Bloomberg estimates, the BOJ already holds a whopping 97% of issued government and agency paper in Japan.
Global Interest Rates in 2020: From ZIRP to NIRP?
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The Credit Story in 2020 • There is still ample opportunity to generate income streams of acceptable quality in global credit markets • Rising risks that accompany the end of a prolonged economic cycle appear to be priced by the market • Active management might be the way to go here, to avoid areas that are becoming too risky
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brief look back at 2019 reveals fixed income overall and credit bonds as an asset class specifically had a pretty decent year – using Bloomberg Barclays Total Return Indices as a guide. Globally, aggregate credit exposure would have returned an investor about 11.5%. Considering that US Treasuries gave 7-8%, the rest of the return came from the higher interest rates on offer on credit at the beginning of the year, with a smattering of spread tightening thrown in. As is usually the case when the economic backdrop is benign, the weaker parts of the credit spectrum performed better than the more defensive, safer
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The Credit Story in 2020
areas. US High Yield and Emerging Market bonds were above 12%, and in some parts of the financial subordinated market, returns were in the 15% range. Spectacular blow-ups also happened this year, illustrating the critical importance of diversification in portfolios where idiosyncratic risk abounds. Argentina dropped by 50% in a fortnight on adverse political developments, and closer to the end of the year, Lebanese bondholders were exposed to a shock of similar magnitude. At the country and regional level, Asia performed worse than most with a meagre 2.2% return, dragged lower by China and South Korea.
The Usual Mantra in Credit: No Defaults, No Risk? Credit investors know full well that the greatest source of risk for a long-term portfolio is defaults. Short term spread movements can cause temporary pain, but if no defaults ensue, then the damage is just that: temporary. Knowing what the default outcome will be, gives one an edge in the market. The downside risk of a series of corporate failures is far worse than the upside of even a strong credit rally. Best to avoid defaults then. As 2020 starts, default rates look to be well under control. Globally, Moody’s estimates that 2.6% of HY bonds are defaulting on an annualised basis. That compares to the average rate of 4.1%. In the US the rate has edged closer to the average: 3.6% compared to 4.6%. Keep in mind that the average can be a bit misleading as it would be dragged higher by the few recessionary episodes when it spiked. For non-recessionary periods, we are running around the expected average rate of default. Should this continue into 2020, credit markets promise to be a fruitful source of income for investors, for at least another year. However, caution is warranted. In most economies, growth looks like it will be lower in 2020 compared to 2019. It has been shown that historically, slower growth pushes defaults higher. It is thus no surprise to note that Moody’s is forecasting that default rates among corporate borrowers will be on the rise in 2020, possibly drifting upwards towards the historical average by the end of the year. A good source of return for credit investors is spread compression: when the risk premium demanded by investors for holding credit bonds over government bonds decrease. There is little reason to expect much of this phenomenon in 2020, as the premium is already quite small. Further compression is possible but the scope for it is limited.
Credit Positioning in 2020: The Key Issues While we still think the notion of holding credit for income is sound, the end of the cycle brings reason for caution. Some areas of the credit universe are showing the strain that is unavoidable given such a prolonged economic cycle, and also such a long period of easy monetary policy. The strain can be observed in certain sectors, or in some specific regions.
European and USD HY Credit Spreads 600 500 400 300 200 100 0 8/8/2012
8/8/2013
8/8/2014
8/8/2015
8/8/2016
8/8/2017
8/8/2018
8/8/2019
Source: Bloomberg EUR Crossover Index
US HY CDS
The Credit Story in 2020
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Too Many BBB Bonds? One specific area that keeps attracting comment is the “growing” amount of BBB-rated bonds as a percentage of the overall issuance of investment-grade bonds. This could be an issue because a very large proportion of the funds and ETF’s that hold BBB bonds are not allowed by their mandates to hold high-yield bonds. In theory, if there was a large number of downgrades, pulling many BBB bonds into BB, the fear is that the forced selling that will ensue, as funds offload junk bonds, will cause a dislocation in the market. This fear is understandable but possibly overdone. Looking at the proportion of BBB-rated bonds as a ratio of the overall issuance, it is now at 55%, much the same as over the last number of years. Furthermore, the rate at which these turn into so-called “fallen angels” is not excessive, even when looking only at periods of outright recession. During such periods, Moody’s data suggests that about 6% of these bonds will become junk on an annualised basis for as long as the recession lasts. The fact that at least some of them recover their status fairly soon (up to a quarter over the past 20 years) is not material to the argument: the concern is a short-term dislocation driven by forced selling. Given this risk is well-flagged and understood by now, the best idea is to remain invested, track developments but resist the temptation to be drawn into panic selling.
Leveraged Loans The overall view on credit also applies to loans: in the absence of a recession, the market should provide a good source of income. Loans are almost exclusively instruments that price relative to money market rates, and hence have no scope for capital gains under normal conditions. In this market, some developments warrant careful attention, as some of the errors of the GFC appear to be repeated. The two main ones are, first, a deterioration of covenant quality, and second, a growing influence of Collateralised Loan Obligations (CLO’s) as key investors keeping the market going. Déjà vu? Both these factors should remind those who survived the 2008 meltdown of the market of the dangers embedded in this otherwise docile market. Covenants are simply the terms and conditions that borrowers must abide by when they take up funding from banks or other lenders. Once covenants become looser, the risk to the end investor increases. Typically, where revenue targets are easier to meet, more balance sheet leverage is allowed etc., a so-called “cov-lite” situation arises. This is of little concern if the going is good; if businesses start running into trouble, investors will suffer the consequences in the form of poor recovery values on secured assets.
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The Credit Story in 2020
Assessing the CLO concentration risk is very difficult, as this market is not always as transparent as some other public markets. Anecdotally, the sense is that there are some large CLO manufacturers in the market at the moment, and also a quite select group of heavy buyers. This could potentially increase concentration risk and perhaps impair liquidity in the event of stress in the underlying loan market.
Emerging Markets The broad category had a mixed 2019, reminding investors that a strong bottom-up process pays dividends in avoiding some of the idiosyncratic issues that are simply part of the territory. This year brought us the collapse (again) of Argentine government bond prices, as well as those for Lebanon. However, even if the outlook for growth is somewhat less optimistic than what 2019 delivered, a non-recessionary outcome for 2020 should still be broadly supportive of the asset class. As always, there will be regional and sector-driven nuances that need to be monitored, but the level of income available in even the more conservative exposures is still attractive enough. As the Fed looks to have come close to the end of their easing cycle, albeit with scope to do a bit more, we do not view the USD as being particularly vulnerable against the broader complex of EM currencies. For hard-currency EM debt, this would be a further source of support.
The Credit Story in 2020
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Developed Equity Markets Momentum is Alive & Kicking Easy Money - A Continued Driver of Markets
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espite market reservations about the valuation of equities, particularly in the United States, global equity markets still look as if they have positive momentum as we move into 2020. Easy monetary policy, which likely becomes even easier in 2020, and relatively high dividend yields are two factors that could continue to support equities. Note that despite heavy selling by retail investors in 2019, equities still made good progress. Corporate buying of equities by way of share buybacks and institutional buying have supported the markets. Share buybacks were on track to be the second-highest on record in the US in 2019 at around $700bn although down on last year’s record.
Chart 1: Global markets rally through 2019
MSCI World Index, 2019 YTD 2400 2300 2200 2100
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Source: Bloomberg
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Developed Equity Markets Momentum is Alive & Kicking
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A reversal of policy by the Federal Reserve when they went from monetary tightening to monetary easing was the catalyst for the sharp rebound in equities in the early part of 2019. Subsequently, the cuts in interest rates and renewal of quantitative easing by the major central banks provided the impetus for further good returns. In 2020, we expect the central banks to continue with their easy money conditions. Indeed, we assume that the Fed, ECB and Bank of Japan will all be easing monetary conditions still further as we go through the year. Equities tend to react to changes in levels of accommodation, not just the level of interest rates or quantitative easing.
Renewal of Quantitative Easing Cuts in Interest Rates Dividend Yields
Retail Selling and Earnings Downgrades are Headwinds US retail investor net selling of equity mutual funds has shown no sign of abating. JPMorgan calculates that US retail investors have sold around $225 billion of US equities since January 2018, fully unwinding the inflows seen in 2016 and 2017. Analysts continue to cut their corporate earnings forecasts. Global growth has continued to surprise to the downside, leading analysts to trim their corporate earnings forecasts in most parts of the world. The drop in earnings forecasts would have been more dramatic were it not for the share buyback schemes in the United States. As always, analysts are expecting double-digit corporate earnings growth in 2020, something that looks unachievable Longer-term we have our concerns about equities. Too many commentators compare the valuations of equities with metrics for the past twenty to thirty years and conclude that equities are cheap. However, such an argument misses the rather important point that the next thirty years if not ten years will look very different from the past. Firstly, potential global GDP growth is falling. The past thirty years witnessed inflation and good growth. Demographics and lower
Equities
productivity have led to lower global growth, and growth is set to fall still further. Japan is a good case in point: the thirty-year average P/E multiple of the market is close to 26.0, and the current forward P/E multiple at a lowly 14.0. Japan used to achieve growth rates of close to 5%; these days they see a sense of achievement in anything above 0.5%. Secondly, investors are getting older and more riskaverse, and their allocations to equities in their pension funds and long-term savings are likely to continue to fall. Fidelity recently commented that more than a third of baby boomers had more than they recommend in equities. Indeed 10% of baby boomers had their entire pension plan in equities!
Developed Equity Markets Momentum is Alive & Kicking
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Equity Themes for 2020 Domestic growth over international growth While there may yet be some agreement between the United States and China, the trade spat has put globalisation on a much rockier path if not going into reverse. Supply lines have been disrupted, and we expect international companies to find increasing challenges in accessing markets and finding suppliers that won’t be caught up in the trade war. A second factor that sways us to look more at domestic plays is that we believe that governments are primed to expand fiscal policy through tax cuts and/or spending in the coming years. A focus on domestic growth will tend to help small and medium-sized companies over large companies.
Chart 2: Small-cap versus large-cap stock performances MSCI Global Small total return index versus MSCI World total return index
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Source: Bloomberg
Technology – still plenty of pockets of growth Despite some impressive returns in recent years for global payment companies, experts still believe there are excellent prospects ahead. MarketResearchNest.com thinks that the industry will grow revenues by a compound growth rate of 18% in the coming five years. Such growth is most apparent in the emerging world. Cashless payments increased by 55% in India last year compared to 48% in China and 23% in Indonesia. KPMG expects 299% annual growth in developing markets through to 2024. There is still much room for growth to remain exponential. Consider that there were only 18 cashless payments per inhabitant in India in 2018 compared to 142 in China and 529 in Sweden, according to the BIS.
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Developed Equity Markets Momentum is Alive & Kicking
Dividend yield plus growth The search for yield is likely to continue to focus on the equity markets, given that most equity markets yield more than their respective bond markets. However, we would be very careful not to buy yield blindly as you might do when buying a high dividend yield ETF.
Chart 3: Equity dividend yields way above respective bond yields Index Dividend Yield - 10 Year Gov't Bond Yield 5 -1
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Source: Bloomberg
Laggard countries – Has the UK’s time come? If the UK can get beyond Brexit, investors will have to find other excuses for not buying back into a market that has been a serial underperformer against global markets in recent years (chart 4). We expect the catalyst for better performance to come from some certainty about Brexit and a pending significant boost to the economy from an easing of fiscal policy through a combination of spending increases and tax cuts.
Chart 4: UK equity market markedly underperformed the global index MSCI UK total return index versus the MSCI World index ex UK total return 160 150 140 130 120 110 100 90 80 70 60
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Source: Bloomberg
Developed Equity Markets Momentum is Alive & Kicking
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Is this the UK’s moment?
U
K equities are begging to be bought. The equity market sits at a near thirty year low relative to the global index. The potential return for a foreign investor is potentially enhanced by a further rally in sterling.
BR
Chart 1: MSCI UK equity index net total return underperforms global ex UK index (1969=100) 180 170 160
150 140 130 120 110 100 90 80 70 60 50
69 71 72 73 74 75 76 78 79 80 81 82 83 85 86 87 88 89 90 92 93 94 95 96 97 99 00 01 02 03 04 06 07 08 09 10 11 13 14 15 16 17 18
Source: Bloomberg
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Is this the UK’s moment?
EXIT
The UK equity market’s poor relative performance was not just a reflection of 2016’s Brexit referendum result but also a reflection of listless policymaking in the UK in the wake of the global financial crisis. It has been an economy without purpose exacerbated by the dithering around its relationship with the EU. The equity market has suffered net selling by domestic institutions. The Investment Association reports monthly outflows from UK equity mutual funds since 2016. As we turn the year, some of the fog around the financial markets is clearing. The country has a majority government that will take the UK out of the EU. After years of austerity, the government is set to relax fiscal policy and pump prime growth through tax cuts and spending increases.
In our view, investors should focus on domestic plays probably through small/mid-cap indices such as the FTSE250. We expect returns from the equity market to be enhanced for foreign investors by a further rally in sterling against the dollar. UK equities have one particular attraction at this point – yield. Yielding equities are not just attractive to portfolio managers but also to private equity investors. There have been several private equity deals where PE firms buy out high yielding equities. The level of equity market yield is also quite remarkable relative to longer-term gilt yields. While off their high, UK equity yields are nearly 400bps higher than the ten-year gilt yield, close to the highest in twelve years.
Is this the UK’s moment?
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Chart 2: UK equity dividend yields high and very high relative to gilts 7.0% 6.0% UK equity yield
5.0% 4.0% 3.0%
2.0% 1.0% 0.0% UK equity yield less the 10 year gilt yield
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Source: Bloomberg
Even with Brexit by the end of January, the problems of Brexit do not just go away. The next challenge is likely to be the trade deal discussions between the EU and the UK. The current plan is that the UK and EU will discuss a trade deal over the course of the next year with a deadline at the end of 2020. On the UK side, there will be pressure for the discussions to be concluded as quickly as possible. During the negotiations, the UK will still have to make contributions to the EU, allow freedom of movement of people and abide by the European Court of Justice framework. The UK economy will have to re-establish its credentials in the post Brexit era. A good deal of damage has been done. The last five years have been lost to the Brexit debate. Consumers have been reticent to spend, companies have been even more reticent to invest, and the government has run tight fiscal policy. The next effect has been to reduce productivity growth to less than 0.75% from the 2.25% achieved before the Brexit issues. Fears over immigration and
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Is this the UK’s moment?
immigrants’ right of abode has slowed the pace of the growth of the labour market. The Bank of England forecasts a gradual recovery in growth through 2020 and 2021 boosted by consumers, industry and government all increasing spending. Monetary policy is likely to remain accommodating. Inflation has been tracking around 2%, and yet policy rates are at 0.75%, leaving the economy supported by negative (accommodating) real interest rates. Monetary policy should remain accommodating. An expected rise in the value of sterling should keep inflation in check. A rate change seems unlikely with risks to the upside or downside about in balance. UK gilts should be marginally attractive to international investors if they believe that sterling can rebound still further. A 10-year gilt yield of 0.69% compares to negative yields on equivalent bonds issued in France and Germany. A rise in sterling would reinforce the returns from the asset class as it would push inflation down, and with-it gilt yields. The one
factor that has some investors concerned is the decision by Moody’s to put the UK on negative watch for a potential downgrade. However, they comment that “no matter what the outcome is of the general election Moody’s sees widespread political pressures for higher expenditures with no clear plan to increase revenues to finance this spending”. It seems disingenuous to pick on the UK; every government in the developed world is likely to adopt such a strategy. Also the EU is awash with low-yielding bonds with much worse metrics.
In a global context, UK corporate debt on the surface looks attractive, given the nominal yields of 2.0%. Most of the concerns about the asset class remain macro with investors concerned about the damage to the UK economy from Brexit. Clearly, the issues around Brexit will continue well beyond the actual day that the UK leaves the EU. Sterling-based investors should be encouraged that unlike in 2011/12, corporate debt does provide a real yield that will protect the investor’s real wealth.
Chart 3: UK Corporate Debt yields – low in nominal terms, fair value in real terms 10.0% 8.0% 6.0%
Nominal yield to worst
4.0% 2.0% 0.0% -2.0% -4.0%
Real yield to worst
01 01 02 02 03 03 04 04 05 05 06 06 07 07 08 08 09 09 10 10 11 11 12 12 13 13 14 14 15 15 16 16 17 17 18 18 19 19
Source: Bloomberg
Is this the UK’s moment?
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India – Patience Required
I
ndian assets have the scope to deliver double-digit returns, but at the start of 2020, there is much to put you in two minds. Given the lack of momentum in domestic growth, we would advise equity investors to be patient and wait for some absolute weakness to add to holdings. Fixed-income investors can be bolder as we expect the central bank to remain on course to provide further cuts in interest rates over the course of 2020.
Chart 1: Nifty Equity Index maintains its uptrend 13000 12000 11000 10000 9000 8000 7000 6000 5000 4000
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Source: Bloomberg
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India – Patience Required
2015
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Indian asset markets, like global markets, have benefitted from the continuing easy monetary conditions around the world and generally good growth from the United States. However, India also had some very favourable domestic factors that should have led to maybe even greater returns than the equity market eventually achieved. 2020 is shaping up to be another year where investors see the long-term opportunity in India but may fear that the returns will slow to show through.
Chart 2: Indian 10-year government bond yield falls close to recent lows 8.50
(%)
8.00 7.50 7.00
6.50 6.00 5.50 2014
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2018 Source: Bloomberg
India – Patience Required
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Looking back at 2019 is instructive at framing how 2020 may work out for the Indian asset markets. Indian equities, like many equity markets, started on a strong note, rebounding from their December lows. As the end of the year approaches, they looked likely to outperform the emerging market equity index modestly. However, looking back, you might have expected much more. The central bank cut interest rates by 135 basis points. Long -term interest rates fell in line with short rates. Politics was very favourable with Prime Minister Modi achieving an even greater majority in the general election. The Indian Rupee was generally well-behaved tracking the general trends of the broad emerging market currency basket. However, all the good news was offset by the slide in growth. India was the world’s fastest-growing economy in 2018; however, by the fourth quarter of 2019, growth had slipped to below 5%.
Chart 3: Rupee holds its own against other emerging market currencies 110
73 Relative to EM currency basket (lhs)
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98 INR/USD (rhs)
96 94 Nov-18
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Source: Bloomberg
Domestic sentiment in the Indian economy is weak. Indian current affairs programs characterise the situation as a crisis. Could it really be that bad? For sure, the economic data is soft. Industrial production fell 3.7% in the third quarter, and the monetary system appears to have frozen over. Car sales fell 6.3% in October from last year, and motorcycle sales were down 14.4%, according to data released by the Society of Indian Automobile Manufacturers. The formal banking system has not been able to compensate for the marked deterioration of the shadow banking industry. Cuts in interest rates have had limited impact thus far because even if a company wanted to take advantage of the lower rates, it is a struggle to find a willing lender.
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India – Patience Required
3.7 %
This is certainly not the greatest crisis the Indian economy has faced, and one suspects it will just take time for things to be righted. However, it will take the significant intervention of the government to make things better. The BJP government has been reformminded from the start. Yet, the pace of government reform must follow the political cycle. As much as the Modi government may want to push ahead with reforms, they also realize that they must stay on the right side of the electorate. The BJP and partners still need to build a sufficient majority in the upper house to push ahead with more reforms. In the meantime, the central bank will be under pressure to provide further support for the economy. Encouragingly international investors have stuck with the Indian asset markets. Late in 2019, foreign investor inflows into equities had reached $13.4 billion and $4.4 billion into bond funds. The hope amongst foreign investors is that in the wake of slowing growth, the government will provide a further stimulus package.
6.3 %
The fact that the fiscal deficit is already at 3.3% and growing may limit the ability of the government to react. However, the government is expected to come back with measures to boost consumer spending potentially though tax cuts and/or payments directly to farmers. Government hand-outs, however, only paper over more structural challenges to the economy. The country needs to encourage households to save inside the formal banking system and not in gold or under the mattress. Secondly, and most importantly, the banking sector needs to work out its bad debts, allowing an expansion in credit. Industrial India is starved of the capital required to grow and to become competitive. If the government can relieve the credit crunch, this could provide a much-needed structural boost to the economy and then indeed the financial markets would have better grounds for high returns in the coming year.
14.4 %
India – Patience Required
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Singapore Outlook 2020 S
ingapore’s trade sensitive economy has been hard hit by global trade tensions with growth falling to six-year lows as the manufacturing sector has been impacted by trade uncertainty. The deterioration in the economy amid the trade war has also been felt in Singapore’s equity market, with the benchmark Straits Times Index (+9.1%) heavily underperforming global equities (+20.4%), when measured in Singapore Dollar terms. What cause then for optimism on the city state’s economy and markets in 2020? We see several reasons why Singapore could fare relatively better following progress towards a stage one deal in the trade war between the US and China. Singapore’s globalised economy stands to benefit more than most from any trade war détente. Accordingly, if a deal were to occur, Singaporean markets could come back into favour, supported by renewed investor interest, attractive valuations and a Government that is well positioned to offer an expansionary fiscal budget, prior to a likely 2020 election.
Chart 1: Singapore’s economy has suffered amid the trade war 6.0%
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GDP Growth (yoy) LHS
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Singapore Outlook 2020
Industrial Production Growth (yoy) RHS
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Trade War Détente and Sensitivity to Global Growth If there is a détente in the trade war, Singapore, with its high external exposure (trade over 300% of GDP)1, will be a chief beneficiary within ASEAN. Amid the recent thawing in the Trade War and following policy support from Central Banks around the world, the global manufacturing PMI has registered three consecutive months of increases and Singapore’s macroeconomic data are showing early signs of recovery with three consecutive months of increases and Singapore’s macroeconomic data are showing early signs of recovery. Abnormally low growth through 2019 in certain sectors such as semiconductors and electronics, should also lead to positive “base effects” heading into 2020, flattering headline growth rates. Growth in earnings may accompany any recovery in the economy. Given listed Singaporean companies' dependence on external demand, any global growth recovery should lead to positive revisions in earnings. Consensus growth earnings forecasts for 2020 are positive at 7.3% for FY20202. The unfavorable trade thematic and heightened geopolitical concerns have led to net outflows from Singaporean equities, of SGD 1.5bn in the year to October 2019, on top of outflows in 2018. Accordingly, investor positioning is light, and a trade deal (of any significance) could lead to a recovery in investor interest. Chart 2: Outflows from Singaporean Equities (by institutional investors) to October 2019
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Source: World Bank, as at end of 2018 Source: Bloomberg, MSCI Singapore (MXSG)
Singapore Outlook 2020
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Valuations are Reasonable Singapore is trading on FY20 consensus P/E of 12.5x, below its 10 year average of 13.1x. Viewed on a relative basis, this is the cheapest in ASEAN (a 13% discount to ASEAN overall)3. Alongside reasonable valuations is an attractive dividend story. Interest rate cuts and the chase for yield, alongside any receding in trade war related fears may drive attention towards Singapore equities which are among the highest dividend yielding in Asia and compare favorably to other developed markets. Real estate investment trusts (REITS), which are a key component of the Singapore market, may be a particular beneficiary of the search for income.
Chart 3: Dividend yields in Singapore are attractive 6.0% 5.1%
Forward Dividend Yield (%)
5.0% 4.1% 4.0% 2.7%
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FTSE Straits Times REITS
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MSCI AC Asia ex Japan
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Source: Bloomberg
Government & Monetary Support Increased domestic policy support from higher fiscal spending looks likely as Singapore moves into an election year in 2020. According to Singapore’s constitution, the Government is required to maintain a balanced budget over the course of its term. Having accumulated surpluses of an estimated SGD 15.6bn from prior fiscal years4, the Government has ample room to support the economy in the context of the election and any ongoing economic challenges.
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Source: Bloomberg, MSCI Singapore (MXSG) Source: Singapore Department of Statistics
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Singapore Outlook 2020
The economy may also be supported by Central Bank policy. In its October statement, the Monetary Authority of Singapore (MAS) reduced the rate of appreciation of the Singapore Dollar, given expectations for below average inflation and growth in output remaining below potential. The MAS also highlighted its willingness to adjust monetary policy in response to changes in the inflation and growth outlook. In a low interest-rate world, Singapore stands out among developed markets for still having meaningfully positive bond yields across its yield curve. Given the nation’s AAA-rated status, Singaporean Government Bonds may serve as a source of diversification and downside protection in 2020.
Chart 4: Singapore has higher bond yields than other developed nations
10-year Government Bond Yield
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Source: Bloomberg 10 year government bond yields as at 31 October 2019
Long-Term Prospects In the short-term the trade war has clearly had a negative impact on Singapore’s economic prospects, but in the long-term the situation could reverse. The trade war appears to have benefitted ASEAN nations, in particular Vietnam, as Chinese and US companies have shifted production to the region in order to circumvent the trade war restrictions. To highlight this point, trade between the US and Vietnam rose 34.0%5 in the first ten months of 2019, relative to the same period in 2018. Singapore could benefit from these shifts in global supply chains if companies looking to relocate production move their headquarters, or open offices in the country. Singapore’s favourable business environment, with low tax, a constructive immigration policy and access to Asian markets make it a strong candidate for firms looking to set up in the region.
5
Source: US Census Bureau
Singapore Outlook 2020
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Currency Comment Stable outlook for USD After firming across the board for much of 2018 and 2019, the USD is perhaps set for a period of consolidation as growth moderates in the US and interest rates remain low or decrease even further. The index levels below mask wide potential divergences across regions. The domestic situation in the US is such that the push and pull factors appear to be broadly in balance, and the possibility of a strong move in the USD in either direction, on its own terms, looks small. That does not mean that due to more specific factors, other currencies will be equally docile.
135 US
Dollar Trade-Weighted Index 1997=100
130
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110 105 100
Source: Bloomberg
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Currency Comment
Asia, the trade war and the CNY A key risk faced by Asian economies in 2020 will be the ongoing disruption caused by the trade war between China and the USA. Asia is in many ways an innocent bystander here. Overall growth in trade volume in 2018 was already slower than the year before, growing by 4% compared to 7.3% in 2017 – as reported by the Asian Development Bank recently. All indications are that the number will be lower for the full year 2019 again, as the impact remained noticeable and appeared, in fact, to intensify in the third and fourth quarter of 2019. Notably, the overall trade surplus run by China against the US still has not really moved in the
direction that Mr Trump would prefer. By the end of 2019 the trade surplus with the USA was close to $26.5 billion, virtually unchanged from two years earlier. The announcement of tariffs at the end of 2018 had a major impact, but only temporarily. The size of the Chinese surplus returned to earlier levels quickly, even though overall volume between the two countries has declined. For a long time the People’s Bank of China was viewed as having a “soft” limit on CNY depreciation beyond the level of 7 to the USD. This level was breached in July but after a period of weakening it has now returned again to levels just above 7. While
Currency Comment
45
the current mood in the market is optimistic about the prospects of a trade thaw, we do not rule out the possibility of the odd spate of renewed weakness in the CNY, should there be episodes of trade war
escalation – to be expected in the turmoil that will be the order of the day as we approach the US presidential elections at the end of the year.
EM Currencies: Selective Opportunities While the trade war has been a very clear dampener for the outlook for the broader emerging market complex, the impact is not expected to be uniform over time or across the various regions. The trade dependency of Asian countries on Chinese trade with the USA is very well documented and understood. The second half of 2019 has proved to be challenging for several of the economies in South-East Asia as trade volumes were very clearly negatively impacted. Economic growth has suffered, and in response monetary policy has been eased.
through foreign exchange: the carry play. Many investors have bad memories of taking exposure to emerging market currencies for the sole purpose of harvesting the local interest rate on these. The risk is seldom default of some underlying credit bond, the risk is simply that the local currency weakens more than the interest that the investors are being paid. So, the idea is not to overexpose portfolios to any one country, but instead try to take advantage of a stable dollar environment and add conservative exposure across some of the more attractive currencies.
In other regions, the trade impact has not been the main driver: domestic issues have been a bigger driver across Latin America, where Argentina grabbed headlines for all the wrong reasons by wiping out sovereign debt holders for the umpteenth time as political developments turned toxic.
A good example is the Russian rouble. Much the same as the GBP, the rouble stands to potentially benefit from several factors. First, the domestic equity market is pricing at interesting levels. Granted, it is up more than 20% so far in 2019, but it is still trading at a mere 6 times forward multiple and at a dividend yield of 6.2%. Such valuations could support a steady inflow of capital.
Even so, 2020 might provide an opportunity for investors to take some exposure to emerging markets
46
Currency Comment
Opportunity in GBP? Similar arguments apply to UK assets as to those in Russia. With a stock market that has performed poorly against global peers and an economy that has been partially paralysed by the Brexit-induced uncertainty, it is not much of a surprise that UK assets have become quite unloved in the global investment community.
GBP in recovery mode? 1.7 1.6
GBP/USD
1.5
1.4 1.3 1.2
Sep-2019
Jun-2019
Mar-2019
Dec-2018
Sep-2018
Jun-2018
Mar-2018
Dec-2017
Sep-2017
Jun-2017
Mar-2017
Dec-2016
Sep-2016
Jun-2016
Mar-2016
Dec-2015
Sep-2015
Jun-2015
Mar-2015
Dec-2014
1.1
Source: Bloomberg
In the run-up to the Brexit referendum, the currency was trading far stronger than today. The uncertainty and risk introduced by the referendum outcome caused an instant and sustained devaluation of sterling. As we argue elsewhere, there is no reason to expect the path to the proper resolution of all the outstanding issues between Britain and the EU to be smooth, or, for that matter, quick. Nonetheless, the process should gradually begin to clear the fog. It opens the possibility of a gradual but sustainable re-pricing of sterling. It is optimistic to suggest that it will recoup all of the losses suffered since 2016, but the direction appears to be for strength, not weakness. Currency Comment
47
Precious Metals an Asset Class for These Times T
he allure of gold has both fascinated and captivated humanity for eons. Given the current unparalleled challenges faced by the global financial system, precious metals deserve the same focus and close attention. During 2019, sentiment towards precious metals fluctuated as investors reacted to the ever-changing geopolitical landscape and economic outlook. Set against this backdrop some technical analysts believe that the pattern of substantial gains and subsequent downside correction is the continuation of a longer-term trend which indicates a strong advance in 2020, and beyond. We agree. We see short-term pullbacks in the gold price as an opportunity to initiate new positions or add to existing holdings.
Chart 1: Gold and Silver prices (USD per ounce) 1900
50 45
1700
40 1500
35 30
1300
25 1100
20 15
900
10 700 500
5 2007
2009
2011
Source: Bloomberg
48
Precious Metals an Asset Class for These Times
2013
2015
2017
0
Below we highlight three factors which we believe are vital in driving meaningful gains for precious metals.
Negative Interest Rates The global financial system has, in the recent years, faced unprecedented challenges, which have been met with extraordinary measures by major central banks. Declining consensus forecasts for economic growth, most recently exacerbated by the trade war between the United States and China, and the continuous expansion of global debt, has forced central banks to cut policy rates to zero, and then negative. During 2019 the global market value of negativeyielding debt peaked at US$17 trillion. Despite declining from this level, the sum still increased by over 50% during the year. By common consensus, where lenders have to pay a borrower to accept their money then it has reached the extreme point of absurdity, being devoid of any real commercial logic. Historically, periods of declining real US $ interest rates have been positive for gold.
Chart 2: Value of global negative yielding debt (USD trillion) Bloomberg Barclays Global Agg Neg Yielding Debt Market Value USD 18.0 16.0
14.0 12.0 10.0
8.0 6.0 4.0
2.0 0.0
Source: Bloomberg 2012
2014
Currency Devaluation Historically, a strong currency was a symbol of national pride, especially among the political leadership and popular press; however, the desire for this emblematic status has now been almost entirely
2016
2018
reversed. Indeed, most central banks and national governments have entered into a competitive devaluation, with a race to the bottom of purchasing power. During 2019, President Trump made multiple
Precious Metals an Asset Class for These Times
49
references or statements of intent and desire to devalue the US Dollar. Furthermore, the likelihood of the devaluation race becoming full-blown currency ‘wars’ arguably increased in 2019, as the Trump administration formally labelled China as a currency manipulator, after the People’s Bank of China allowed the yuan to fall to more than an eleven-year low versus the US Dollar. Meanwhile many financial analysts also interpreted the Swiss National Bank’s (SNB) 2019 intervention in the currency market to weaken the Swiss franc as a further sign of these potential currency wars. The SNB took the stance that they were acting “to keep
the attractiveness of Swiss franc investments low and ease pressure on the currency.” In such a scenario of active devaluation, we believe that investors will view gold as a better store of value. Investors need only look at Argentina to understand that extreme outcomes can happen when there is a complete loss of confidence in fiat currency. Over the past five years, the price of gold in Argentine Peso’s has risen more than 750%. Over ten years, the price change is over 1,800%! By way of reference, in US Dollar terms, the price of gold has risen 28% over ten years and in Japanese Yen terms by just over 55%.
Central Bank Buying While the recent trend for global central banks has been to pressure interest rates to extreme lows, many have been Can be increasing their holdings of gold on their balance sheets. When transacted in central banks were questioned by the World Gold Council for their large sizes 2019 survey to rank the relevance of factors underpinning their decision to invest in gold, both emerging and developing 9 economy central banks put “long-term store of value” and “lack of default” in first and second position respectively. The Is easily central banks of advanced economies, however, cited “historical valued position” as their primary reason. In recent times the most committed countries, in percentage terms, to increasing their gold reserves have been Russia and China. In a concerted effort to reduce its US Dollar reserves, The Bank of Russia has cut its holdings of US Treasuries over the past three years by over 88%. In contrast, over the same period, its gold reserves have increased in value 8 by over 75%. Russian gold reserves now total over US$107bn. Having gone through a long hiatus between October 2016 and December 2018, China is also buying more significant quantities of the precious metal again, raising reserves to over 1,948 tonnes. Although China is the world’s largest producer of gold, its overall gold stores have been anaemic compared to its competitors, especially in the context of the size of its economy. According to the World Gold Council today the People’s Bank of China (PBoC) has just 3% of its reserves in gold compared to 9% for the UK, 20% for Russia, 63% for France and 77% for the United States. We expect the PBoC to be a persistent buyer of gold from both domestic and international sources in the coming years. Should China continue to accumulate bullion at the current rate over 2019, it will probably eclipse Russia as the top buyer of the precious metal. Furthermore, we also believe the trend to diversify balance sheet risk by increasing gold and reducing the influence of the US Dollar as a reserve asset to continue. Without question, the dynamics of emerging economy central banks accumulating reserves as net buyers will play a crucial role in the directionality of the gold market for years to come.
50
Precious Metals an Asset Class for These Times
For today’s investor, the allure of gold and other precious metals is in their many attractive attributes, especially when viewed in the context of their total wealth (see exhibit below).
4
3
Typically performs well during times of crisis
Lacks any form of political risk
5
2 Has no default risk
Is a proven effective portfolio diversifier
Is a highly liquid asset
Physical Gold
Serves as valuable collateral
6
1
Is a long-term store of value
7
We believe gold and other precious metals, play an important role in investment portfolios and believe there is more upside to come in years ahead. We urge investors to take out the insurance policy against untoward issues in the near and long term. A world of ever declining real rates, currency devaluations, trade disputes, tensions in the Middle East, political uncertainty, and debt levels showing no bounds, is a world made for gold and silver.
Contribution from Aurian Precious Metals an Asset Class for These Times
51
Real Estate
low-interest rates provide ongoing support
W
ith the growing list of cash deposits and government and corporate bonds that offer negative yields, investors are looking into every corner of the investment universe for income. Real estate is an obvious asset class for income seekers.
Residential In the broad spectrum of real estate, to us, residential real estate still looks to be generically the more expensive and at risk of more burdensome taxation on returns in the future. As we wrote last year, governments remain short of revenues and taxes on wealth via the real estate market are a very real risk. In any case, residential prices remain beyond the means of many ordinary people, which must weigh down prices. However, the residential real estate area does offer some niche opportunities.
Build to Rent (BtR) BtR is described as “purpose-built units designed specifically for long term rental occupation”. The concept is hugely popular with younger generations due to the amenities offered such as fibre optic, smart home and home automation, to name just a few. These units are built with the target market in mind to push the properties for a specific consumer. The product is highly popular with Millennials and Gen Z’s who find the
52
Real Estate – low-interest rates provide ongoing support
old housing stock too expensive and lack the means to purchase housing and hence prefer to rent. In the UK, a first-time buyer would need to find a deposit equivalent to 71% of yearly income. As such, it is extremely difficult to get onto the housing ladder. Although a relatively new concept in the UK, the idea had its beginnings in the multi-family housing concept in the United States some two decades earlier. The concept has gained more traction in recent years given the preference of Millennials and Gen Z’s to live in urban areas with a sense of a community as opposed to Baby Boomers who prefer to live out of town. As an example, Grainger (the UK’s largest private landlord) signed a deal with Transport for London in April 2019 to build 3,000 properties above and around Underground stations. Greystar launched a £750m fund to target the UK BtR sector with around £2bn to invest in BtR projects. In the first quarter of 2019 over £1.0 bn was poured into BtR schemes, quadruple the amount invested in the first quarter of 2018. The BTR model attracted £2.4bn in 2017 and is forecast to grow by a further 180% over the next six years.
Commercial Real Estate In commercial real estate, yield-seeking institutional investors will continue to provide support. Indeed, we suspect there could be a new wave of money that is attracted to commercial real estate as investors recognise that central banks could be running zero to negative policy rates for some years to come. The experience of Japan, when monetary policy was set at zero to negative interest rates is that real estate, even through the form of real estate investment trusts, tends to outperform the broad equity market index. All major regions broad REIT Indices have yields comfortably above their respective 10-year bond yield to maturity.
Real Estate – low-interest rates provide ongoing support
53
Table 1: REITs offer significant income pick up over government bonds REIT 12-month yield
10-year government bond yield
REIT yield pick up
UK
3.81%
0.73%
3.08%
US
3.85%
1.75%
2.10%
Japan
3.41%
-0.12%
3.53%
Europe
4.44%
-0.34%
4.78%
Region/Country
Source: Bloomberg
European Commercial Real Estate With negative interest rates and bond yields in the Eurozone, there is a clear reason for interest in real estate to grow. Pension funds and insurance funds are desperate to invest in long term assets that can mitigate some of the challenges of having a bond portfolio that provides little by way of return. One of the anomalies in the asset markets at present is that an investor can invest in the corporate debt of a major German company at a 10 year yield of 0.4% or achieve a 4-7% return by leasing a building to the same company. It is, in a sense, the same credit risk but very different returns for around the same time horizon. Such a large gap between the yield on the long-term debt and the yield on a building where the
company is the primary tenant looks anomalous. On paper, there appears to be a lot of value; however, in reality, it is difficult to find quality buildings to invest in. Total real estate investment in Europe in Q3 2019 was â‚Ź69.5bn, a 4% fall over the same period last year. Analysts comment that there is a deep pool of available capital; however, there is a limited number of investment opportunities of scale and quality. One factor which could change the availability of commercial real estate in Europe would be a trend for companies to make a sale and leaseback of their buildings. Europe is relatively unique in having a large number of owner-occupied commercial properties last estimated at 60% compared to 30% in the UK.
Building New Communities While Baby Boomers may prefer to start their retirement in a remote part of the countryside, eventually, they begin to need a more supportive environment, they will seek to live closer to others and with door-step support. Millennials have already shown a preference for living in urban areas. This puts them closer to their work and allows them to live without the need for a car.
54
Real Estate – low-interest rates provide ongoing support
Developers have also been trying to find ways of tapping into the desire to build communities. As malls have struggled to keep footfall, developers are applying to re-zone areas such that residential property can be incorporated to build a community rather than just a barren retail development. Brookfield Property, for example, is transforming one of the US’s largest shopping centres (Ala Moana) into a small city with the addition of as many as ten The impacts of climate change have residential towers. The template that is building already influenced real estate markets at for mall redevelopment is based on providing a the global scale. 35% of REITs’ properties community of entertainment, health, eating out are exposed to climate hazards. Of these, and shopping experiences together with some 17% of properties are exposed to inland significant multi-family developments. flood risk, 6% to sea-level rise and coastal floods and 12% to hurricanes or typhoons
ESG – Ignore at Your Peril
Source: Bloomberg
One factor to keep in mind into 2020 is the impact of ESG on real estate companies. The sector is still searching for the right structure and metrics to analyse the impact of ESG on real estate investment. The sustainability accounting standards board (SASB) provides the industry with guidance on how to determine financial materiality concerning ESG factors. Another evident materiality comes from the fact that commercial and residential real estate companies account for approximately 40% of total global energy consumption. The real estate sector will increasingly be called to task to design buildings to the highest energy-saving standards. Furthermore, property owners may be pushed to refurbish buildings to meet new standards of efficiency. Further taxes on energy prices will have tenants looking for low cost, well-maintained buildings that are up-to-date with energy efficiency.
Real Estate – low-interest rates provide ongoing support
55
Be Active in Your Choice of Active Versus Passive
L
ooking at 2019 product net flows, passive funds have won the hearts and minds of investors. In 2019, passive funds again took in more net flows than active funds, generating inflows of $757bn in the year to October 2019, compared to outflows of $52bn for active.
Billions
Chart 1: Inflows to active funds vs. passive funds $1,200 $1,000 $757
$800 $600 $400 $200 $-
-$52
-$200 -$400
31-Dec-11
31-Dec-12
31-Dec-13
31-Dec-14 Index
31-Dec-15
31-Dec-16
31-Dec-17
31-Dec-18
2019 YTD
Active
Source: Morningstar, all worldwide funds excl. money market, feeder and fund of funds. 2019 data for year to Oct 2019
But are investors paying close enough attention to the nuances of active vs. passive management? 2019 saw a continuation of a trend established in 2015 where even asset classes favourable towards active management, such as emerging markets, saw higher inflows to passive funds than active. These trends suggest to us that investors are not differentiating enough between asset classes in their decision to go active or passive. Active management can lead to meaningfully higher returns across a wide number of asset classes and in a low return world, investors should leave nothing on the table (see charts on the following page).
Summary of active manager performance to October 2019 % of Funds Outperforming 66% 55% 41%
Year to Oct 2019
35%
Three years
Equity Funds
56
Be Active in Your Choice of Active Versus Passive
Year to Oct 2019
Three years
Bond Funds
Table 1: Alpha of the Median Manager by Asset Class (2019 to Oct)
Active Laggards
Active Leaders
Equities China China - A Shares Asia ex-Japan Small/Mid-Cap Global Emerging Markets Small/Mid-Cap US Mid-Cap US Small-Cap UK Flex-Cap Asia ex Japan Latin America Global Emerging Markets Europe Large-Cap Value Asia-Pacific ex-Japan Japan Large-Cap Global Small-Cap UK Large-Cap Europe Large-Cap Blend India Japan Flex-Cap Global Large-Cap Value Global Large-Cap Blend US Large-Cap Blend US Flex-Cap US Large-Cap Value US Large-Cap Growth Europe Large-Cap Growth Global Large-Cap Growth Global Flex-Cap
7.7% 7.1% 6.9% 6.1% 4.5% 4.5% 3.5% 3.2% 3.1% 2.4% 2.3% 2.2%
1.0% 0.9% 0.9% 0.2% -0.1% -0.1% -0.3% -0.4% -0.6% -0.7% -0.9% -1.5% -2.1% -2.3% -2.6% -4%
-2%
0%
2%
4%
6%
8%
10%
Bonds Global High Yield Bond
2.4%
Active Leaders
USD Flexible Bond
1.2%
Global Flexible Bond-USD Hedged
0.8%
Global Emerging Markets Corporate Bond
0.6%
Global Corporate Bond - USD Hedged
0.5%
USD High Yield Bond
0.4%
Global Emerging Markets Bond - Local Currency
0.1%
Active Laggards
Global Bond - USD Hedged
-0.3%
Global Inflation-Linked Bond - USD Hedged
-0.5%
USD Government Bond
-0.7%
Global Emerging Markets Bond
-0.7%
Asia Bond
-1.9% -3%
-2%
-1%
0%
1%
2%
3%
Source: Morningstar, for periods ended October 2019. Data represent a customised peer group of funds from the Morningstar Global Investment Fund Sectors. The customised peer group includes those funds with an inception date prior to April 2016 and are not tagged as index funds, or fund of funds.
Be Active in Your Choice of Active Versus Passive
57
2019 saw active managers underperform in key asset classes, such as US and Global Equities. However, across many niche asset classes, such as emerging markets and small/mid-cap companies, active managers generated returns above benchmarks for investors. When an investor takes into account the potential for alpha in asset class, they can come to a very different conclusion regarding the attractiveness of an asset class. To illustrate, Chinese equities are only up 12% in the year to October 2019, compared to 19.4% for global equities. Based on this data we would conclude that Chinese equities had a poor year. But when you consider that the median active manager of Chinese equities added 7.7% percentage points of extra return this leads to a very different perspective. We estimate the median active investor in Chinese equities has generated returns of approximately 19.0% (after fees) in 2019 YTD almost the same return as the return from the global equity index.
Key Asset Classes for Active Management in 2020 In 2020 we see the environment continuing to favour active funds in more niche areas of the market. Disruption arising from trade tension, policy uncertainty (e.g. such as that arising from Brexit) and technology will continue to create dispersion across sectors, creating potential for active managers to outperform. Set against these disruptive forces, global monetary policy will be a key variable, particularly for bond investors. Central Bank support may increase correlations across fixed income markets, reducing the opportunity for managers to be rewarded for active bets. Whether growth megacaps such as Alphabet, Microsoft and Facebook continue their strong run of performance in 2020 will also be influential as active managers tend to fare better when performance is more balanced across small, mid and large-cap companies.
58
Be Active in Your Choice of Active Versus Passive
01
We recommend investors adopt an active approach to UK equities in 2020.
Typically, UK equity managers outperform their benchmarks when small and mid-cap segments of the market generate higher returns than large-cap. UK mid and small-caps offer more opportunity for portfolio managers to add value versus the index. The fact that there is less analyst coverage by sell-side analysts (see chart below) and a greater dispersion of returns helps portfolio managers outperform. Risk to our View: A Hard Brexit or further UK political discord could lead to a change in this view.
Chart 2: Analyst coverage of UK Large-Caps vs. UK Mid-caps
Over 20
37%
4%
10 to 20
63%
41% 0%
5 to 10
38%
0%
Under 5
0%
18%
10%
20%
30%
UK large-caps
40%
50%
60%
70%
UK mid-caps
Source: Bloomberg. UK large-caps represents stocks in the FTSE 100, UK mid-caps represents stocks in the FTSE 250.
Be Active in Your Choice of Active Versus Passive
59
Active management in Emerging Market Hard Currency Bonds
02
Active managers in hard currency emerging market debt should fare better if, as we expect, the US Dollar weakens (or is at least flat) in 2020. Active managers are often overweight “riskier� segments of the emerging hard currency market such as countries which are reliant on external sources of financing (e.g. Turkey or Indonesia) or corporate issuers (rather than sovereign). These segments of the market tend to fare better, when the US Dollar weakens supporting the returns of active emerging market debt managers. Risk to our view: Positive US economic surprises, or a deterioration in the Trade War could trigger a change in our active vs. passive view on this asset class.
Chart 3: Emerging Market Bond Managers perform better in periods of USD weakness
EM Bond Fund outperformance
4.0% 2.0% 0.0% -2.0% -4.0% -6.0% -8.0% -10.0% -12.0%
USD Weakness
-14.0%
Emerging Market Bond Manager Relative Performance
US Dollar Trade Weighted Index
Source: Morningstar Hard Currency Emerging Market Bond peer group. Relative performance measured against the iShares USD Emerging Market Bond UCITS ETF
60
Be Active in Your Choice of Active Versus Passive
03
High Yield Bonds: Protecting on the downside
In this riskier segment of the global bond market we recommend active strategies, largely due to risk management considerations. Active managers in global high yield tend to fare better in “risk-off� environments characterised by low or negative returns to their underlying asset class. This arises as high yield managers tend to be underweight the very low quality parts of their market (CCC rated debt and lower). We are also conscious that fixed income indices tend to tilt towards the most indebted companies, as when companies issue more debt, they become a larger part of the underlying index. If the global economy does slow in 2020, investors could benefit from holding an active manager with a disciplined approach to evaluating fundamental credit risk, potentially mitigating any increase in defaults. Risk to our view: Positive economic growth surprises, supporting weaker companies, could change our 2020 outlook for global high yield.
Chart 4: Active vs Passive High Yield in a falling market
Average Return in a negative month
0.0%
Active High Yield Funds
iShares Global High Yield Corp Bond
-0.2% Active high yield managers outperform on the downside
-0.4% -0.6% -0.8% -1.0% -1.2% -1.4%
-1.03% -1.25% Source: Morningstar. Active High Yield Funds measured by Morningstar peer group
Be Active in Your Choice of Active Versus Passive
61
Defining the
2020s
01
Growth of big tech
Rise of women in business – A wave of pushback against racism/sexism with the rise of genderfluidity
02
Smartphones & Apps + Internet/4G & Smart tech
Falling prices of high-tech hardware
07
03
New ways of working – the cloud and technological revolution/ working from home
The rise of Software as a Service (SaaS) business models
08
04
Emerging middle classes in Asia
Increasing US energy independence
09
05
Geopolitical – Populism and nationalism re-emerge
Decreasing cost of capital as central banks maintain very loose monetary policy
10
62
Defining the 2020s
Looking back at 2010s, the defining trends included:
06
As we look into the 2020s, we analyse some of the potential evolutionary changes ahead of us.
ESG is a significant factor in asset class returns, and corporate and household behaviour The last decade saw the emergence of Environment Social Governance (ESG); the next decade should see the concept become embedded within government and corporate behaviour. We could see significant shifts in the allocation of capital away from dirty industries or companies with poor social and governance policies. Climate shaming – flight shaming is already impacting on global airlines. Austrian rail firm ÖBB is already reintroducing more overnight trains in reaction to demand from the public. Per passenger, a one-way trip from Zurich to Milan, for example, emits three kilograms of carbon dioxide if taken by train, compared with 104kg by plane.
Investment consequences ESG analytics will become embedded in all analysis of financial securities. There may be reduced access to capital for fossil-fuel-related businesses.
Stakeholders not shareholders
In a significant change from the past, a forum of the CEOs of some of the largest US companies alluded to the need to take into consideration all stakeholders in a company, not just shareholders. The second millennium has, to date, seen a further marked increase in the share of the added value of companies going to shareholders rather than the wage earner. Also, companies have continued to squeeze their suppliers as their profit margins have come under pressure.
Investment consequences A future with corporate culture more focused on the well-being of stakeholders over shareholders seems likely to lead inevitably to slower corporate profits growth. Indeed, taken with ESG, it should redirect companies away from a 100% focus on making profits. However, over the longer term, the move away from profit maximisation towards a greater emphasis on balance and sustainability could lead to lower volatility in equity markets.
Defining the 2020s
63
5G followed by the dawn of 6G 5G Data and communications will be shared across billions of interconnected devices. 6G will bring about wireless brain-to-computer interactions. 5G is currently estimated to have transfer speeds of over 1 gigabit per second while 6G will boast speeds of greater than one terabyte per second. This could be the end of the smartphone.
Investment consequences This disruptive innovation clearly provides a challenge for many industries to invest in the new era of communication and control systems. The one fly in the ointment is the attitude of the US that is using trade wars to undermine China’s efforts to seize the initiative on 5G. We could end up with a bifurcated world with those countries happy to do business with China being much earlier adopters of the new 5G and 6G technology while the second group is beholden to out-of-date US technology.
Learning to learn, unlearn and re-learn
It is already conventional wisdom that by the time you finish a degree/course, much of the material studied is out of date. The idea of a life-long career in one company or indeed in one industry was already on the wane. The future will be about an individual having to continually update their education and skill set to remain relevant in the workforce. The labour market will need careful handling by employers and governments to ensure that the workforce remains relevant to a rapidly changing world.
Investment consequences Education, in its many forms, should prove to be an attractive sector. However, most investment opportunities tend to be found in the private equity and venture capital field.
64
Defining the 2020s
No more leather wallets, cash disappears
Payments companies will become the future of money. Next generations will be much more tech-savvy, leading a move to the withdrawal of physical cash. Gen Z will make up 40% of all US consumers by 2020, relying heavily on payments companies.
Investment consequences Payments companies in their many forms take business from banks. Already at risk from new digital banks, the franchises of traditional banks are also at risk from any company that has a large consumer client base and decides to launch their own closed-loop currency. Starbucks Rewards, for example, already has 17.6 million active users. Similarly, Bitcoin and other crypto currencies have millions of active users. As Starbucks Rewards and Bitcoin are not attached to any country in particular, we will see the slow demise of currencies that are linked to countries.
Zero to negative interest rates become normal At various stages of recent years, analysts have tried to wish away negative interest rates as a passing phase. However, as we have seen in Japan, the fact that working populations in many developed countries are likely to start to decline in the next decade, if they have not already, suggests negative interest rates are almost a logical outcome.
Investment consequences This change is supportive of bonds and all yielding assets that don’t rely on the general well-being of the global economy for their credit quality. The clear winners are the digital financial services companies. They are set to overwhelm bricks and mortar encumbered businesses, such as traditional banks and insurance companies. Unless banks and insurance companies structurally change and substantially reduce their cost base, they will be overwhelmed by the digital financial industry.
Defining the 2020s
65
Government policies move sharply to the left There are already many signs that the decline of the baby boomers as a share of the electorate may lead to growing support for more leftwing policies being adopted by governments. We should expect a high risk of wealth taxes and more spending on social services.
Investment consequences We remain concerned about higher wealth taxes, particularly on residential real estate. Mass consumer products or retailers that appeal to lower-income groups should benefit. Healthcare will see more spending but with potential pushback on drug pricing.
Large scale involuntary migration
Whether through military conflict or natural disasters, large swathes of people could be on the move through the next decade. The mass migration of refugees from Syria that created an immigration challenge in Europe may, in some senses, have de-stabilised Europe and contributed to factors that led to Brexit.
Investment consequences The outcomes will tend to be random but clearly de-stabilising, and costly for the receiving countries with a higher risk of armed conflict between nations. Europe remains at risk from Turkey opening the door to allow refugees from Middle East conflict to pass through their borders. This has enormous implications for Central and Eastern European countries and hence the stability of the European Union. In Asia, the climatic challenges of flooding and freshwater scarcity in the Ganges Delta puts hundreds of millions of people at risk who may have to uproot and try to migrate through India, Bangladesh and potentially into Myanmar.
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Defining the 2020s
Increased discounting of the inadequate funding of developed market pension funds There are already increasing signs of the wheels coming off the pensions industry. Inadequate saving by individuals, crazily high assumptions being made by pension trustees and head-in-the-sand attitudes of governments are a big problem for the future. It is instructive that as 2019 ended, a report from the Group of 30 estimated that the world’s top economies would face a shortfall of $5.8 trillion in 2050 up from $1.1 trillion in 2017. The Dutch government has been forced to warn pensioners that their pensions may need to be cut.
Investment consequences Those individuals in the workforce will have to be encouraged to save more, thus reducing consumer spending. The government may be called to prop up more and more pension funds through direct guarantees but at the cost of ever-higher-government debt. People may simply have to work longer – maybe a decade longer. Does retirement become an obsolete concept?
Return to the concept of community
The mindset of future generations is already one of a sharing economy. Hence, we expect the idea of community and sharing to be more prevalent across all aspects of life. We have already seen that property developers are responding to the needs of future generations by developing sharing spaces whether for offices or homes. In the office space, sharing spaces are evolving into a wellness and office revolution – the work/life balance — the Google office impact.
Investment consequences Offices now have to be extensions of homes, eateries, nurseries and playgrounds to attract and retain talent. The concept of everyone having a desk will disappear, which has implications on office space demand. Homes will get smaller but will be couched in terms of communities rather than impersonal estates with limited facilities. Shopping malls and high streets will be redeveloped into spaces where people live, work and play, not just shop.
Defining the 2020s
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Risks
Economic U.S. economy loses momentum precipitously, and the policymakers are slow to react
T
he U.S. economic expansion is into its 11th year. Naturally, most economies slow when approaching full employment. However, if a slow-down were exacerbated by a marked loss of confidence amongst households, the economy could slip into a more marked downturn. Given the pending Presidential election and the toxic atmosphere on Capitol Hill, a government response to a possible economic downturn could be slow.
European Central Banks and governments fail to provide support for fiscal expansion in the eurozone European growth slumps without support from policymakers and asset markets sell off
Brexit trade talks go badly, and the U.K. leaves without a trade deal U.K. sterling and equities fall sharply
Surprise shadow banking industry collapse To some extent already seen in China and India but the problems could still deepen and cause problems for their respective governments.
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Risks
The rise of inflation? Never write off inflation. It is well known that the U.S. Federal Reserve is in the throes of trying to create more inflation. Recent employment reports showed the U.S. labour market pushing further into full employment as the unemployment rate fell to a historic low of 3.5%. While we have our doubts that persistent inflation will take hold, the global economy is extremely vulnerable to a spike in inflation. Record high levels of debt mean that the global economy would take a significant hit from higher interest rates with the consequent impact of raising debt servicing cases. Investors should be vigilant for any signs that the new sources of inflation risk don’t rear their ugly head namely -
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Trade wars that increase prices of goods and services.
The marked increase in global focus on Environmental Governance and Social (ESG) issues may have an inflationary impact. Saving the planet will cost money. Switching from to clean energy comes at a cost. Sourcing from more ethical/better governed/more social supplies will add to cost – while undeniably saving the planet in some small way. There is a clear risk that mainstream policies will become more left of centre. Populist governments typically redistribute wealth in favour of those on low incomes. Such a shift would put money in the pockets of the less well-off potentially unleashing a sharp increase in inflationary consumer spending. The adoption of the relatively new Modern Monetary Theory (MMT) risks seeing central banks fund inflated government spending. MMT advocates central banks funding governments as they push their economies to full employment. But if only economic policy was that easy or that precise. The higher risk is that central banks are politicised to support the policies of ‘populist’ political leaders. The world has never been so vulnerable to higher inflation. The IMF calculates that global debt to GDP was 225% at the end of 2017. In 1974 when there was the last burst of uncontrolled inflation debt to GDP was 110%.
Inflation strategy – reduce allocation to conventional bonds buy gold and indexed linked bonds. Risks
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Climate change • A localised disaster that sets the world into a panic about the potential devastation from climate change. • At least 21 cities in India, including capital New Delhi, Bengaluru, Chennai and Hyderabad, will run out of groundwater by 2020, affecting around 100 million people (NITI Ayog) • Bangladesh called a “planetary disaster” (November 2019) mindful of the risks in the Ganges delta – in the 1970 500,000 people lost their lives on the Ganges Delta when Bhola cyclone created a surge of 2535ft through the delta. Today 400m people live in the Ganges Delta. A belated acceleration in action to arrest climate change including potential drastic change in taxes, substantial increase in spending on mitigation to climate change.
Geopolitical U.S. elections • The country gets distracted by political fighting with the risk of policy paralysis. It may stop effective economy management as Capitol Hill fights about matters such as impeachment and not managing the economy • If President Trump gets re-elected the markets will be concerned about another four years of challenging global geopolitics. Conventional wisdom is that in the year of a Presidential election U.S. equities do well. Since 1928, out of 23 election years, only four saw negative returns from the stock market. However, we all know how unique Mr Trump is!
Elections in Central and Eastern Europe • Polish presidential elections, Romanian parliamentary elections and Slovak parliamentary elections may heighten tensions with the E.U. around areas such as the politicisation of the judiciary, environmental and migrant policy.
Trade tensions escalate • President Trump is under pressure due to the pending election may lash out on trade policy to re-establish his credentials around the “Make the United States Great Again” campaign. • The trade war between South Korea and Japan continues to simmer. Any further escalation could damage regional growth.
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Risks
Markets Flash crash in financial markets • The very sharp fall in the equity market in the fourth quarter of 2018 underscored the vulnerability of the equity market to a flash crash • We remain concerned that retail investors, despite some selling through 2019, remain overweight in equities. Yet, many cannot afford to see a significant drop in their wealth ahead of retirement. • Enough commentators are warning about the potential lack of liquidity in bond markets for us to write off the risks as doom-mongering. The structural changes in the markets post the world financial crisis leaves little capital committed to ensuring continuous dealing through a crisis.
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