La croissance est meilleure, mais les rendements restent faibles
Lower global interest rates and renewed central bank balance sheet growth helped deliver great returns across bonds and equities in 2019. While rates are on hold, balance sheets are still growing in Europe and the US. This should continue to support the momentum rally in markets, aided by the improved sentiment on the near-term economic outlook. Event risk could come back – it is the year of the US election after all – and growth might disappoint. However, the real signal to turn bearish would be if there were any signs that central banks were shifting away from their current dovishness. That is not likely anytime soon. With bond yields low and spreads narrow, the best expression of the risk-on momentum is in equity markets, while short-duration fixed income should be the focus for investors wanting a low-risk income strategy.
What a year
Last year was a stonking year for financial markets. The S&P500 had its second best year of index returns in the last twenty, as did the US corporate bond market. Most liquid top-down indices that I track had total returns that were in the top quartile of the last two decades. I’m sure many of my readers will look back over the last year and conclude that it never really felt like a huge bull market. For much of the year investors were concerned that the escalating trade dispute between China and the US would push the global cycle into recession, while in Europe the UK body-politic seemed to be heading towards a disastrous hard Brexit. In the end there were two sets of important developments. The first was the shift in global monetary policy towards lower rates and more balance sheet expansion. The second was the partial (but critical) resolution of some of the uncertainties around trade and Brexit. Cash became more unattractive and the late year rally in bonds and credit was surely partly driven by the capitulation of some investors putting their money to work at last. The year before had seen negative returns across everything except for the safest government bonds, 2019 saw this reversed and some. And for all the effort that goes into devising complex investment strategies there are two principles that continue to be the most important – time horizon and diversification. Looking at my set of bond indices as well as the S&P, there have been very few examples where the cumulative 3-year return has been negative over the last twenty years (the exceptions being in the early 2000s coming out of the tech-bust and the 2008 period). Moreover, 3-year holding periods for a balanced (50:50) exposure to bonds and equities in the US delivered double digit returns in 14 of the 18 three-year holding periods since the end of 1999. For a combination of US Treasuries and high yield, the record is double digit three-year returns in 16 of those periods.
Balance sheet bonanza
The consensus for 2020 is for a modest rebound in economic activity in the first half of the year but for the annual average GDP growth for the major economies to be not that different to the outcome from 2019. A derivative of that view is that central bank interest rates are largely on hold for the time being, especially as no-one really sees any change in the outlook for inflation. Indeed, there is a view that even if inflation is a little higher, central banks are happy to allow that to happen if it improves the chances of inflationary expectations rising back to levels consistent with central bank long-term inflation targets. A cut in rates is more likely in the US than anywhere else and a cut in rates is more likely in the US than a hike in rates. The market expectation on Fed Funds is still below the Fed’s own DOT plots for this year. No change in European interest rates are expected and the market does not really have a strong view either way on the UK. It’s safe to say, rates on hold. This will be a major influence on the level of bond yields. They may rise a bit but that rise will be limited. Importantly, central bank balance sheets are growing again. The decline in central bank balance sheets as a percentage of GDP in 2018 and early 2019 was met with a break in the equity market rally (the MSCI World Index essentially went sideways between end-2017 and August of last year). When the ECB announced QE2 coming on the back of the Fed’s early year pivot, markets took off. The hurdle to central banks becoming more hawkish is higher than ever given their lack of success in generating a sustainable rise in inflationary expectations. So don’t fight the Fed (ECB).
Sentiment about the macro outlook has certainly improved. In December we had an agreement between the US and China to sign a Phase 1 trade deal (although it is not signed yet) and the UK election which returned a Conservative government with a strong majority, paving the way for the Withdrawal Act to be passed and ensuring that a less market friendly government was not to be realised. This was certainly evident in market price action in December and, even though a little bit of a skirmish in Iran in the first few days of January challenged that, to me sentiment remains positive for credit and equities. Indeed, that has been borne out by the equity market response to the de-escalation of the tensions with Iran following President Trump’s acceptance of Iran’s “tit-for-tat” response to the initial US attack. The strength of returns in 2019 and the absence of any reasons to be immediately bearish on markets suggests that sentiment will remain positive and momentum will continue to be a strong factor in market returns. Our interaction with economists and strategists in the first week of the year suggest that positive sentiment is a common theme.
Yet few people are overly bullish about market returns following the strength of markets in 2019. Valuations are the problem. Bond yields and credit spreads are a lot lower than they were last year. Unless yields fall a lot, total returns from fixed income will be significantly lower than they were in 2019. One only has to look at a chart of the price action of most bond indices to be reminded of how strong the rally was last year and how much potential there is for a sell off. Our recent review of the outlook for fixed income markets revealed a range of views on the near-term direction of bond yields, so essentially I guess we are in a range. Central banks are on hold (neutral), macro data is looking to be a little better (higher yields), supply is likely to be significant in the first half of the year in both government and corporate bond markets (higher yields) but demand remains strong from the ECB in Europe and duration-short institutional investors everywhere (lower yields). We have been in a very modest bear market in government bonds since last September (US 10-year Treasury yields have moved from 1.4% to 1.85%) and at some point a test of the 2.0% level is likely. This will keep returns subdued in fixed income markets. For equities, the key will be the liquidity backdrop and how corporate earnings hold up in a world of relatively subdued, although cyclically better, growth.
A modest risk-on tone prevails. That means credit should outperform governments bonds and within credit, high yield should outperform investment grade. The demand for yield will remain a major driver of markets. However, again valuation is the issue as “quality” spreads have narrowed a lot. The difference between yields in the lowest rated investment grade bucket (BBB) and the highest rate high yield bucket (BB) in the US is around 65bps at the moment. At its 2019 widest this was double that. The exception remains in the weakest credit buckets in high yield and in the leveraged loan market. There has been some stabilisation in the spreads between CCC and BB rated tranches in the high yield market and this may provide some speculative opportunities for investors. However, as the energy and retail sectors remain a big chunk of the problem, especially in US high yield, it is not clear there is room for a lot of re-rating. Nevertheless, credit seems to us to be an asset class that will do reasonably well in the near term but without matching the total returns seen in 2019. That view is very much tied to the view on equities as well. One of my favourite charts is a plot of the US high yield spread against the VIX index. Current levels for both indicate a very benign environment with volatility close to its lows and spreads close to their tightest. History would suggest that there is only one way they can both go but I am not going to try to be a Cassandra for the sake of it. Assets are valued like they are today because there is plenty of liquidity, interest rates are really low and fundamentals are stable. Only if any of those changes would we need to start recession proofing our investment strategies.
Short duration bonds for income (high yield and emerging)
The upside for total returns is limited to some extent by valuations, especially in fixed income. So maybe the current market environment warrants thinking about what income strategies are likely to work best in a world where significant capital growth may be challenged. Looking at the disaggregation of income and capital returns across a range of asset classes over the last decade, the absolute best income returns have tended to come from high yield, emerging market bonds and leveraged loans. On the equity side, European and UK equities have tended to deliver the most income return. Adjusting the income return for the price volatility of the asset class gives a clear steer that short-duration fixed income strategies provide the best risk-adjusted income returns. Keep in mind that the absolute level of income return over the last few years has been declining across most asset classes, there is still a surprising good result from short duration investment grade, high yield and emerging market strategies – especially in US dollars and sterling, and less so in Euros. High yield remains the best asset class for delivering income return and should continue to remain that way given expectations that default rates will remain very low. On the equity side, there is a clear distinction between the UK and Europe on one hand, and the US and Japan on the other. The latter remain markets driven much more by capital gains rather than income (low yields and dividends in Japan, structurally more growth in the US).
Brace yourself for future events
It will be an interesting year, starting off with solid momentum in markets but I suspect morphing into a more event-driven volatile environment as the year progresses. The big thing will be the US election and this will increasingly become the key market focus as it has implications for global trade policies, additional fiscal measures and regulatory developments in the US which could impact on global equity markets. It is far too early to make any calls on the outcome and, as this week’s events in Iran reminded us, lots of things can happen before Americans go to the polls in November. Other risks to consider are the changing political dynamics in Europe, concerns about the leverage loan market in the US and the insidious effect of negative interest rates in Europe. But for now, enjoy the momentum and the positive sentiment and don’t fight the Fed.
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