GLOBAL REVIEW (Q4 2019)
IMCO Global Market Outlook: Choppy waters ahead for 2020
After more than 10 years of strong market performance across asset classes, we believe investors should be heading into 2020 with a much more cautious view regarding risk. The unprecedented coronavirus pandemic, lingering geopolitical concerns and fears of escalating trade tensions between the world’s two largest economies all pose significant headwinds in the year ahead and beyond.
We believe that all of this will result in an environment of lower and more volatile long-term returns. To be successful, investors will have to stay disciplined, truly diversified and prudent with respect to using leverage and managing costs.
Coming out of a strong 2019
As the U.S. and China successfully concluded phase-one trade deal talks and the Fed delivered three rate cuts amid further monetary stimulus from China and Europe, markets stayed buoyant and risky assets including public equities and high-yield corporate credit did not disappoint.
Developed equities were up by 21.9% in 2019. Emerging markets lagged the broader markets but still gained 12.4%. The Bloomberg CAD high-yield corporate bond index also delivered strong returns of 9.5% as credit spreads continued to tighten. These strong returns have led some investors to feel understandably confident that the years ahead should continue to drive bullish momentum.
At the same time, bond yields fell across the world. This is normal, as it is an indication of lower expected future economic growth. Canadian long-term benchmark government bond yields dropped by 42 basis points and the return for the year on the Canadian long bond index was 12.7%.
As a result, our view has become more cautious as the early months of 2020 unfold. Even without accounting for COVID-19, we believe some of the very forces which supported the returns over the recent years could turn into significant negatives and risk drivers in the year ahead.
Four key risks of 2020
Without a doubt, the coronavirus pandemic is the single biggest risk facing investors. In late 2019, we were concerned about the impact of the coronavirus on Chinese equities and neighbouring financial markets. But as new virus clusters cropped up in countries around the world, the impact has been larger, more sustained and more widespread than previously considered. The virus has led to widespread economic shutdowns across most developed and emerging markets, driving stock markets sharply lower and turning fears of a recession into a grim reality. We believe the coronavirus will have an impact on virtually every asset class for months if not years to come and investors will have to keep the pandemic front and center when positioning their portfolios for the future.
Next is the heightened geopolitical risk. While events like the Hong Kong protests, developments in the Brexit saga and U.S.-Iran conflict added uncertainty and volatility to the markets in 2019, they were not enough to derail the equity bull market. However, it’s important to note that in 2020 none of these have dissipated. They’ve merely paused. The protests in Hong Kong began to weigh on regional growth in mid to late 2019, only to be subsumed by the coronavirus pandemic and it’s possible they’ll return as a headline consideration – especially if they were to spill into the rest of China. Post-Brexit economic and policy considerations are far from settled and could return to haunt growth in Europe later this year. Finally, there is always potential for renewed tensions between the U.S. and Iran, though these now have to be seen in the context of the oil price war between Russia and Saudi Arabia, which began in early 2020. Whereas previously U.S.-Iran tensions would have been seen as a potential price support for oil, they are now more likely to act as an offset to the price war, with the former pushing oil higher and the latter continuing to drive it lower. Between this dynamic and the potential for new challenges emerging from the aftermath of the coronavirus pandemic, our expectation is that heightened geopolitical risks are going to be with us for the foreseeable future.
Next is the U.S.-China trade war. While a phase-one deal calmed markets and investor nerves globally, it’s important to remember that global trade still contracted over 2019 and that the trade conflict has been a key contributor. With the first-phase agreement signed in January, the way is clear for phase-two talks to begin. However, these negotiations are expected to be significantly more difficult than before. That, combined with the ever-present potential for market-moving and sometimes inflammatory commentary from the White House (especially in a Presidential election year), could create a drag on markets.
There is also reason for concern about U.S. corporate earnings, which were revised downward in the fourth quarter of 2019 even as the equity market kept rallying. Investor expectation was that the negative earnings trend would reverse after the fourth quarter. However, while we too were expecting a rebound in corporate fundamentals, we believed a downside surprise in earnings going forward (even without the impact of the coronavirus) was possible. Corporate borrowing is running at an all-time high, while the average rating of outstanding bonds has declined, which should give investors a legitimate reason to worry. Now, with the coronavirus pandemic impacting the earnings profiles of most businesses regardless of sector or geography, the risk of further downside cannot be ignored.
Where do we go from here?
Against this rather cloudy backdrop, it’s obvious that 2020 will not unfold like 2019 did. Indeed, the factors above add a significant negative load to the existing set of long-term secular considerations – none of which are particularly rosy either. These include high debt, declining productivity, challenging demographics and others. In addition, our economies have become addicted to the unprecedented monetary stimulus since the financial crisis and looking forward the ability of governments to respond to a potential recession is much more limited than in the past.
Those considerations all must be weighed in the context of the COVID-19 crisis. The pandemic has created additional burdens for governments and companies at an already vulnerable time and promises to fuel significant global uncertainty for the foreseeable future.
We believe that in this environment, investors have to expect heightened volatility and lower returns across most major asset classes. To build a more resilient portfolio, investors should ensure they’re truly diversified to reduce reliance on single-factor exposures. Leverage can also be a helpful tool, when used prudently, and can be used to increase expected returns while controlling risk. Active management (i.e. alpha) will also become more meaningful as return expectations trend lower. However, active management is also expensive, and costs matter more than ever in a lower-for-longer environment.
Above all, we believe that strong and consistent discipline will play a key role for investors throughout 2020.