If 2018 was ‘the year when nothing seemed to work’ in Equity markets, then 2019 was the year when everything seemed to, with many indices closing at all time highs and the villains of 2018 becoming the heroes of 2019. In fact 2019 was the best annual performance from equities of the whole decade. This was helped by a poor 2018 and low expectations and valuations in January, particularly around trade wars and Brexit uncertainty, both of which are now largely resolved. New uncertainties threaten in 2020, however, notably in the US policy arena and a rise in US$ volatility is probably one of the key risks to market dynamics.
- Short term Uncertainties.
GBP down, US$ up. Trade tensions ease, US policy risks rise.
For the year 2019, we began with a key uncertainty in Europe, which was of course Brexit. The year began with a supposed March deadline for Britain to leave the EU, which was missed and the subsequent European Elections saw sufficient damage to the Conservative Party that Prime Minister Teresa May stood down, producing months of further uncertainty as first there was the campaign for her successor, then new Prime Minister Boris Johnson was forced to miss his self imposed deadline for leaving by the end of October by some unprecedented behaviours and procedures in Parliament that led to a General Election being called at the close of the year on the campaign of “Get Brexit Done”. Won with a surprisingly large (to many) majority, the uncertainty about the UK leaving the EU has now diminished almost entirely and in $ terms the FTSE managed to end the year a respectable 21% higher on a total return basis.
As would be expected, almost all the market activity around this uncertainty has tended to be in the noise markets, mainly Sterling. As we discussed over recent months, in fact Sterling has been trading in a 10% band either side of $1.33 since before the original referendum results and the fact that it spiked on the result of the General Election to around $1.35 was a good reason to fade the rally. We would expect the volatility to drop now, perhaps to a 5% band as traders’ attention shifts elsewhere.
Another area of uncertainty for 2019 has of course been the trade war. While this was not a new issue, indeed it was arguably the key driver behind the weakness of Chinese and Asian equities during 2018 – not helped by the fact it was a year when everyone was very bullish to start with – the uncertainty around the likelihood of sanctions was conflated with the parallel issue of the new Sino US economic cold war. This tended to produce lots of drama and headlines, notably around Huawei and some volatility in Asian currencies including the Rmb, but actually little negative stock or bond market action. Indeed, the CSI 300 was one of the top performing markets in $ terms in 2019 with a total return in $ of over 38%. The main exception to that of course was Hong Kong, which saw a major rise in uncertainty during the summer, when mass protests against a proposed extradition law morphed into smaller, but more violent ‘pro-democracy’ demonstrations that seriously damaged both the Hong Kong economy and the valuations in the stock market. Even here though, a bottom was put in during August and the HSI ended the year with a total return in $ of around 13.5%. As discussed in recent posts, we hope we are not too sanguine in believing that this tension has now peaked and that pro democracy initiatives as well as actions to deal with the property bubble induced inequality will be a feature of 2020.
The most obvious place for uncertainty in 2020 is now the US, with the upcoming US Elections. Opinion polls, betting markets and indeed Financial Markets themselves all appear to be backing a second term for Donald Trump – even if the mainstream media are refusing to acknowledge the possibility. In that sense it is his to lose, which means anything that appears to suggest this might not happen could unsettle markets and probably the dollar. As noted in an earlier post, the weakness in the US $ at the very end of the year is something we are watching carefully as a trend that may already be underway. Meanwhile, as the impeachment circus threatens to disrupt campaigning, the first quarter will undoubtedly focus on who will be the Democratic Candidate and for markets the uncertainty could be around not only their campaign promises, but also the extent to which Donald Trump hijacks them. He is known to be a fan of lower drug pricing for example and holds no brief for the carried interest that makes the Private Equity Barons so extremely wealthy. Moreover, he is clearly no fan of the Silicon Valley Billionaire club. Just as Boris Johnson tore up austerity to offer more money for infrastructure, schools and healthcare in order to neutralise the Labour Party appeal, so a shift to centre left economic politics combined with centre right social politics could be the combination for Trump’s next term. In that sense some of the biggest stocks in the US may find 2020 a challenge.
2) Near term risks.
Rotation, liquidity and private market correlations
After a good year for almost every asset market in 2019 (equities were the best for a decade) there is likely to be a positive wealth effect in a number of economies, which should favour some of the luxury sectors and probably including residential property markets. Indeed, with the reduction in uncertainty over Brexit and Sterling still good value we would not be surprised to see some recovery in mid to high end London property. Within markets, with valuations high, especially in the US, asset allocators will be concerned about rebalancing their international exposure after another strong year for US equity markets, particularly if, as noted may happen, the US$ weakens. China is an obvious area of interest, although ironically this will likely be because, rather than in spite of, what turned out to be another great year in Chinese equities – the best of all major markets. While many will be wary of the ‘emerging market effect’, one good year followed by a bad year, the valuations and the breadth of the Chinese markets are now starting to be more ‘developed country’ like, as is the relative stability of the currency now that it is broadly pegged to an SDR basket and is back below 7.0 to the $.
The ongoing stress in the Repo markets due to the technical aspects of ‘not QE’ also threaten volatility in the short end of the bond markets and into the leveraged areas of so called alternatives. Indeed, these remain probably our biggest area of near term, as well as longer term concern. The rush for an illusory illiquidity premium and a continued focus on low volatility as the definitive measure of low risk has produced a meaningful misallocation of capital in our view, as well as the risk of a 2008 style shock when anyone or indeed everyone tries to sell. Moreover, with over $100bn of VC capital looking to select startups with the aim of selling to the over $1trn of dry powder in Private Equity funds, which in turn are further leveraged via Private Credit and Leveraged loans, the notion that alternatives are a form of diversification is seriously questioned. They might have historically performed differently, but now they are all dependent on the same, leveraged, eco-system. The way that WeWork failed to fund its IPO, which was intended to release more debt, will obviously have seriously impaired the expected as well as the actual returns for SoftBank and its future fund. Banks and private credit had to scramble to get their money out – helped by parent company SoftBank, but there is no guarantee that happens ‘next time’. Meanwhile, the fact that over $4bn of Mortgage Back Securities (MBS) were secured against property where WeWork were the tenant shows how interdependent both the MBS and the physical real estate market are with a lot of the rest of alternative space.
Rotation is another risk factor. We like to look at the world’s equity markets through the prism of factors, specifically the five key factors identified in academic research of Value, Quality, Size, momentum and minimum volatility. In that context, one of the more interesting aspects of December and indeed of the last six months has been the reversal/rotation between momentum and value. On a global basis, after under-performing momentum by 10% in 2017, 12% in 2018 and over 17% up until August 2019, value started to pick up relatively in the third and fourth quarter. It may be too early to call a full reversion, but risk managers will certainly be looking at some rebalancing away from more concentrated positions in momentum and minimum volatility stocks towards areas like Quality, Value and Size.
3. Longer term trends
By their very nature, longer term trends tend not to impinge too much on Market Thinking reviews and predictions – although of course we do discuss them in context. A look back at the last 12 months saw the all markets do very well, indeed, as noted, the best since 2009. The CSI300 in China was one of the top performing markets after a very poor 2018 and a good 2017. Given the up down nature of the China market, which tends to be the inverse of the year ahead popularity (ie everyone hated China in early 2017, loved it in early 2018 and hated it again in early 2019) the temptation is to be contrarian again, but as noted earlier, we think that the nature of the market is changing and that while still higher risk than developed markets, China should definitely start to come into portfolios as a strategic rather than a purely tactical allocation. Perhaps more significantly we continue to feel that China and Asia generally can and should start to take the asset allocation role previously held by ‘Emerging Markets’. In the US, at the top end of town, the fact that Apple is up 30% in the last three months alone and over 80% on the year points to some worrying crowding effects, as does a 55% return this year on Facebook, both way ahead of other FANG type stocks, although a basket of them looks better if you include the Chinese ADRs like Alibaba and Baidu. In an interesting twist, one of the strongest emerging markets in $ terms this year is Russia, up 43% on the MOEX Russia index helped by an 11% gain in the Ruble against the $. Seems like US sanctions help markets maybe?
Not unconnected with this is that one of the bigger longer term trends we see developing this year is the shift away from the $ based payments system towards a more multi-lateral approach. One of the ‘predictions’ we have for the year ahead (albeit conceding the time frame might be a bit short) is that the Chinese embrace the SDR as a means of raising offshore capital and effectively internationalising the Rmb without risking capital flight. This could include pegging the Hong Kong $ to the SDR, which would be positive for the whole Hong Kong/Greater Bay area story. It would also accelerate the trend towards paying for commodities in currencies other than the $. The new gas pipelines from Russia to Europe, Turkey and China are all likely to involve both customer and provider wishing to avoid $s for example. Russia in particular is increasingly trying to reduce exposure to the US$ and with $433 bn in reserves and a further $108bn in Gold is second only to China in large emerging markets in terms of reserves. Given the SDR is the currency for international reserve holdings, the idea of bilateral trade and investment in SDRs makes more sense.
The US of course continues to try and disrupt the pipelines – introducing sanctions on contractors at the end of this year- and to try and insist that Europe should buy LNG from the US rather than piped gas from Russia on the basis of what it refers to as ‘security reasons’. This is naturally putting relations with Europe under a good deal of strain. Sadly another aspect of this geopolitical fracturing is the perpetual conflict, particularly in the Middle East. The end year escalation of tension with Iran does not bode well and suggests that a firm bid will remain under oil prices into the new decade.