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2020 – the year of excitement?

We are threatened with excitement in 2020, from civil unrest and ongoing trade wars to political upheaval and market volatility. We believe global economic expansion will continue at a slower, less even pace across regions.

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We are threatened with excitement in 2020, from civil unrest and ongoing trade wars to political upheaval and market volatility. We believe global economic expansion will continue at a slower, less even pace across regions.

Against this backdrop of continued low growth, low interest rates and low inflation, we are aiming to tread a narrow path that balances risks to the upside – such as a sudden acceleration in growth – with risks to the downside, including the threat of a deeper recession. Our global approach and research intensity amid such an environment sees us well-positioned to navigate these macro and market movements.

Macro

In late summer we reached a critical point where leading indicators were at levels that have, historically, been a precursor to recession in developed markets. Indeed, in recent history when the US Treasury yield curve has inverted recession has followed more often than not. But although one could argue that recession still looks likely, it is not a given and as we have moved through the year we have gained greater confidence around a more subtle slowdown, whether that is low but positive or small but negative growth.

On a historical basis, when our proprietary recession indicator for the US reaches 30% it is likely recession will occur – we reached 24% in September but this risk is now flattening out. As it stands, perhaps it does not matter a great deal if we do enter recession because it will likely be shallow. Germany narrowly avoided recession this year, for example, and there is no sign of panic in markets, at least while unemployment remains low.

However, both hard and soft data are mixed: global PMIs have fallen; new factory orders in the US are deteriorating; German business expectations are poor; capital expenditure is down. So we are now standing at a crossroads. One path sees the industrial slowdown result in rising unemployment and a US consumer-led recession. The other sees the relatively full employment market propping up the consumer to the extent that it pulls the US out of its manufacturing slump (especially alongside a potentially more positive trade perspective) and embarks on a reflationary drive.

Our base case is that there is unlikely to be an acceleration in growth and we are equally unlikely to see a deep recession. In that environment, the long-duration element of markets – be that in fixed income or equities – remains relatively attractive. Geopolitics continues to unnerve investors as trade wars and Brexit rumble on against the backdrop of a late-cycle economy, but secular growth trends will provide long-term opportunity regardless of whether we see slight positive or negative growth.

It is this narrow path between the two outcomes that we must tread as investors, and our current asset allocation positioning – aggressively neutral – sets us up to do this successfully.

The excitement

So where is the excitement? Or more accurately, what factors might upset the apple cart? Trade is taking the headlines but my focus is on something different: civil unrest, which is occurring across the world, even though the reasons in each region differ markedly. At the beginning of the year the Gilets Jaunes protests, which centred around government austerity measures, gained greater prominence. We have seen protests in Hong Kong (initially centred around the Extradition Treaty), which have the potential to escalate tensions between the US and China, certainly in the context of the ongoing trade war, and have already resulted in a reversal of policy. We have also seen unrest in Chile over a hike in rail fares and in Lebanon a banking crisis, and there are many more instances around the world.

The question we must ask ourselves is whether protests that have inequality as a major factor will reach a tipping point? In Chile, we can look at the GINI co-efficient measure of income inequality and conclude it is as high there as anywhere else. In the US we can also state with some confidence that inequality is stretched. But in so many places we look, unrest appears to be spreading. Could this atmosphere of protest morph into something more extreme? Clearly this would not be positive for markets.

Inequality becoming stretched is in part a result of structural forces, such as underemployment (the rise of zero-hour contracts and a more flexible workforce), plummeting union membership, technology and disruption. The reaction to these forces is key and could even lead to a reversal of globalisation (given that globalisation has allowed corporates to source cheap labour from around the world). Indeed, this theme was harnessed by Donald Trump, whose election campaign was focused on protectionist policies designed to appeal to the domestic workforce, particularly in the steel and automotive industries. Trump’s trade war has carried the same populist flavour.

Unemployment remains low and yet we are still seeing unrest. If we were to endure a recession and unemployment were to rise, the response from people on the street could be equally robust. What is more conceivable is that ongoing civil unrest brings about policy change targeted at specific demographic groups but which is also to the long-term detriment of investment returns and corporate profitability.

The US has already signalled a reversal of globalisation by electing Trump, but in the UK an extremist possibility could come in the form of Jeremy Corbyn, which could equally hit corporate profitability, although at the time of writing it appears unlikely that Corbyn, if elected, would command a majority. Similarly so for Boris Johnson; although the fragility of our current political system means this can change very quickly. After all, five weeks before the last US election Donald Trump was “unelectable”.

So to Brexit, which will impact sentiment in and towards the UK, but is unlikely to move the dial on a global level and is arguably unlikely to result in a recession even if we get a perceived “unfavourable” outcome. While the Brexit outcome is important to the United Kingdom and its closest neighbours, the country contributes only 3% to total world GDP. [1]

Threats

As stated, our base case is that we continue to see low growth, low rates and low inflation; within this, global growth will be low but positive or small but negative, rather than soaring or collapsing. But what are the threats to that view?

The trade war remains key and could go either way. While recent noise on trade has given us reason for a more cautiously optimistic stance, we are mindful that events can take a sudden and dramatic turn, aided by the speed with which social media proclamations can spread. That said, with the upcoming US elections in 2020 the President will want to ensure the economy is on form, as it is most definitely not in the interests of Trump to risk a recession between now and then – to paraphrase economic strategist James Carville, “it’s all about the economy, stupid”. If anything, a swift trade war resolution is a risk to the upside for us, but should the rhetoric escalate once again and the situation deteriorate, it could equally result in under-investment and a hit to the downside.

More generally, a risk to the upside could come in the shape of a sudden acceleration in growth. Some believe this is likely because costs to businesses are currently low, with interest or borrowing rates low, as well as commodity and specifically oil prices. Also, the trade disputes could dissipate, while governments may increase or prolong fiscal stimulus. In this environment corporates can find themselves awash with excess cash and look to reinvest it, simultaneously injecting a shot of adrenalin into the economy. However, at present US corporates have been buying back their own shares rather than embarking on capital expenditure sprees. Equally, those structural forces keeping unemployment low are unlikely to shift and cause a spike in unemployment that hits consumers in their wallets.

Once again, we come back to the narrow path. But I like it when we can see stark risks to both the upside and downside, because it makes our centre ground positioning more likely to bear fruit.

Markets, themes and opportunities

What does all this mean for markets and our positioning? There is a wide dispersion of potential outcomes in 2020 that warrants us making smaller allocation tilts than we have done earlier on in the cycle, not least because late-cycle phases generally exhibit increased volatility. With that in mind, diversification should be prioritised amid the continued and significant uncertainty.

We believe long-term secular growth trends will provide opportunities for investment. It is about finding truly quality companies with sustainably attractive returns at reasonable valuations, companies that will ride these trends that we see dominating economies: from cloud computing to changing demographics and capital light businesses. Quality companies can be found across industries and around the globe, with the top 10% of firms capturing 80% of economic profits.

Worldwide public cloud services revenue has increased from $182 billion in 2018 to an expected $214 billion in 2019 and $331 billion by 2022 [2] , with growth exhibited by the likes of Alibaba in China and AWS and Azure in the US. As for demographics, we need only look to the explosive growth seen in Asia, where the number of people defined as middle class is now over 50% [3]; or to age distribution, where societies are ageing and changing the demand for products and services. We have seen an uptick in capital light companies that have high returns on capital (including the likes of Aon, IHS Markit and RELX) as well as those generating low or none at all. This has been due to the growth of service or knowledge-driven businesses which are very capital light but provide vital services to established companies such as software analysis and simulation. At the same time, disruptive innovation is occurring more rapidly with competitive forces eroding certain companies’ returns much faster.

Looking at equity regions of the world in isolation, we have already discussed the US, which is more expensive than other areas but has potential for greater growth. Europe is cheaper but is saddled with a challenged banking system, while in Japan valuations indicate areas of the market are cheap but it has unhelpful demographics which, while likely to change over the long term, will not change quick enough for us to benefit in 2020.

So to China, where growth has undoubtedly slowed. This is not a problem per se as lower growth should be more sustainable. At a growth rate of around 6%, consumption growth may remain attractive, but fixed asset investment may be more volatile. Indeed, consumption has been a stable contributor to China GDP in recent years and we do not see an industrial recession damaging that relationship in the short term, despite some areas of consumption, such as car sales, coming under pressure of late.

There is inherently more growth in emerging markets than in other places over the long term, and the growing middle classes in Asia (especially India) remain key, but regionally we favour the US, for the sheer number of companies that have the potential for growth. This makes it a difficult market to be underweight in.

On the fixed income side, ongoing uncertainty means opportunities will be as hard to find as they are in the equity universe, but quality or safe havens should again be a priority for investors. These may be rare, given the percentage of the bond universe that is yielding nothing or negatively, yet as with equities and other asset classes, our research intensity gives us the competitive edge and confidence we need to navigate markets successfully, albeit along a narrow path, for our clients. For example, we remain overweight in credit, while our skew towards quality companies is also an ongoing investment focus for us.

This narrow path, with risks to the upside and the downside, is a trail we’ve been following for the past decade. At some stage we will deviate from it one way or another, but currently we believe there remains a good chance of us continuing to follow the path of steady but low inflation, growth and interest rates.

William Davies , December 2019

Article also available in : English EN | français FR

Footnotes

[1] Bloomberg, 30 Sep 2019.

[2] Gartner Forecasts Worldwide Public Cloud Revenue to Grow 17.5 Percent in 2019, Gartner, 2 April 2019.

[3] The Emerging Middle Class in Developing Countries, OECD, January 2010.

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