Risk assets took an optimistic view of the world in 2019 with strong returns for most equity markets after the declines seen late in 2018. At the same time, earnings have stagnated in most geographies. As a result, valuations, on a forward price-to-earnings basis, are considerably less supportive than they were as we entered 2019, and credit spreads considerably tighter.
Is earnings growth likely to reaccelerate in 2020? We struggle to see it. A key global problem is that tight labour markets are pushing up wage costs, but companies still have slow sales growth as pricing power remains elusive in most industries. As a result, margins are under pressure.
A re-escalation in trade tensions or margin pressures may lead firms to cut jobs, and the global economy could take a turn for the worse. But we are also mindful that the higher wages that have been squeezing profits in 2019 could in turn lead to higher sales. Declining interest rates may also help ease margin pressures and boost sales. So there are risks both to the downside and the upside in 2020.
Given this uncertain outlook, investors may wish to consider:
1) An equity allocation that is neutral but inclined towards more defensive stocks
An equity portfolio more focused on large-cap, quality stocks is likely to prove more resilient should the downside risks materialise. Value stocks might 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 financials. Instead, tech-heavy growth stocks may prove more cyclical than currently expected and thus more vulnerable to a downgrade in earnings expectations.
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. US Treasuries probably offer more upside than UK or European government bonds in an economic downturn.
While government bonds still provide insurance, they no longer provide much income. 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.
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 if the upside risks materialise (just as it makes sense to have an allocation to core government bonds in case the downside risks materialise). In our view, emerging Asian equities would see the most significant upside in the event of a trade resolution.
Even if this more optimistic outcome doesn’t play out in the near term, 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 per cent 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, particularly in a downturn. But our assessment is that, over the long term, the emerging world offers returns well in excess of those seen in the developed world.
Mike Bell is a global market strategist at JP Morgan Asset Management. The views expressed above are his own and should not be taken as investment advice.