Geopolitical risks are likely to continue to weigh on global corporate earnings, which, from these valuations, is likely to limit the extent of further upside in risk markets. At the same time, central banks are likely to remain active to limit the downside.
Given this backdrop, investors may wish to consider
1) An equity allocation that is neutral but inclined towards more defensive stocks.
In our view, an equity portfolio more focused on large cap, quality stocks is likely to prove more resilient should the downside risks materialise. Perhaps more controversial is our view that value stocks will also prove more resilient. This is less about value stocks suddenly getting uprated, which would require a reacceleration of growth and the prospect of higher interest rates to lift the financials. Instead, it is our assessment that tech-heavy growth stocks may prove more cyclical than currently expected and thus more vulnerable to a downgrade in earnings expectations. However, if economic growth remains positive but sluggish, then the scarcity of growth may continue to favour the tech-heavy growth markets. Given this two-way risk, and the fact that the US market is tech-heavy, we don’t see an argument for a particular regional bias in 2020. It seems more likely that global factors will either lift all boats, or provide equal challenges.
2) A broader approach to diversification
Despite historically low yields, we believe government bonds will still serve their purpose in a portfolio, which is to go up in price when stocks are falling. One of the key lessons of 2019 was that government bonds can still offer robust returns even when the starting yield is low. In October 2018,the euro government bond index yield, at 0.9%, was 2 percentage points lower than the US, but offered a similar return over the coming year (see below). The 1% yield on the Austrian one-hundred year government bond is the clearest reminder to challenge ourselves when we think yields can’t possibly get any lower.
Yields and total return of US and euro government bond indices
While government bonds still provide insurance, they no longer provide real income. Indeed, negative yields in much of the core market in Europe mean that investors have to pay for the insurance core bonds provide.
This leaves investors in a difficult quandary. Higher yields can be found, but only with increasing risk. On this basis it is noteworthy that the income on offer in core global infrastructure has remained robust, while yields on investment grade and high yield bonds have been compressed. The income from infrastructure investments has a better chance of cushioning total returns in a downturn, although investors do have to accept the liquidity risk that comes with real assets. Macro hedge funds may also have a role to play in portfolio diversification, given that their dynamic nature means they tend to adapt well in periods of heightened volatility (see below).
Global core infrastructure returns Macro hedge fund relative performance & volatility
%, rolling 4-quarter returns from income and Index level (LHS); % change year on year (RHS)
3) An eye on the upside
While our base case is more pessimistic, it is not outside the bounds of possibility that the geopolitical backdrop could improve in 2020. In which case, it makes sense to have some allocation towards areas of the market that would be the biggest beneficiaries (much like how an allocation to core bonds would work if the downside risks materialised). In our view, emerging Asia would see the most significant upside in the event of a trade resolution.
Even if this short-term view doesn’t play out, investors may need to consider the investment opportunities in parts of the emerging world to bolster long-term returns. Quite simply, very few parts of the developed world have the capacity to deliver growth in excess of 2% because of demographic headwinds. The emerging world – particularly China – is not exempt from population pressures, but incomes are rising more rapidly and increasing numbers are reaching middle income status. More households are buying their first homes, cars and appliances, and using financial services. Investing in emerging economies requires careful selection, and even then investors should expect more volatility. But our assessment, as seen in our Long-Term Capital Market Assumptions, is that the emerging world offers returns well in excess of those seen in the developed world (see below).
2020 Long-Term Capital Market Assumptions expected returns in coming 10-15 years
%, annualised returns in EUR
4) How inflation could upset returns in 2020
Many of the key geopolitical risks have been discussed. But there is one scenario not yet mentioned that could truly upset the applecart in 2020: the return of inflation. While this isn’t the most likely risk we face in 2020, it is worth considering because it would limit the ability of the central banks to continue to pursue aggressive pre-emptive supportive monetary policy. If you believe, as we do, that central bank activism has been the rising tide that has lifted all boats, then a return of inflation would be analogous to the tide going out. This would leave us in the worst of all worlds: one in which bonds and equities are falling in price. For this reason, we will be especially vigilant for any signs of returning inflation. This could be another reason to consider some allocation to global infrastructure or other real assets, which not only provide favourable income and diversification characteristics, but also offer a buffer against inflation risks.