Outlook

24 Jan 2020

The past year has proved to be a very rewarding one for investors and was achieved against a background of political and trade uncertainty and with little or no help to equity markets from rising corporate profits. 

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As we noted in our opening section, investor returns still look highly appealing if the period is extended back to encompass the very difficult Q4 that occurred in 2018.  The chart below illustrates the inflated levels to which global policy uncertainty rose in the past year, compared with the majority of the post financial crisis period.  Bulls might argue that, if capital markets can generate those magnitudes of returns when concerns are elevated, what might they do if investors were to become a lot more relaxed?  They might also point to the amount of cash sitting uninvested on the market sidelines in the expectation that reduced uncertainty would prompt investors into buying assets, thereby driving market prices even higher. 
 
Though the headlines in recent weeks have been along the lines of “Trump agrees deal with China” and “Boris gets Brexit over the line”, both messages belie the detail of what still remains to be done.  Nevertheless if both go at least partly according to plan with the outstanding negotiations and Central Banks remain on their current path of supportive monetary policy, then it is logical to expect the reading on this chart to drop much further in the months to come.  There has been a strong correlation in the past between this reading and the level of global corporate profits - the recent decline in uncertainty indicates an improvement of about 5-6% in corporate earnings, which should rise further if uncertainty does revert towards the norm.
Global Policy Uncertainty Index
Global Policy Uncertainty Index

Source: Policyuncertainty.com Dec 2019

Bears of risk assets, especially of equities, argue that such a rise in profitability is necessary to substantiate the rise in share prices already achieved.  It is certainly fair to say that equity markets are not cheaply rated, but ratings are in part about a balance of investor judgments of the future and the probability of a poor outcome due to policy error feels to have diminished.  The preceding paragraph provides some comfort that at least some corporate earnings progress will be made in the year ahead.   However there is a US Presidential Election in sight and historians will note that the third year of the US electoral cycle is the most propitious for equity investors, as evidenced by the exceptional returns in the year just ended, and that the final year of the term is less good, though not usually poor.
At least in the near term, the path of least resistance for risk assets remains a gradual uptrend.
Global financial conditions are once again very supportive of risk assets (and not much of a headwind for bond prices) and Central Banks are expected to err on the side of looser policy rather than risk premature tightening.  This should mean that, at least in the near term, the path of least resistance for risk assets remains a gradual uptrend.  That gradient is less obvious for bond markets, given their stretched pricing, the potential for inflation expectations to rise once global growth has improved and the prospect of greater sovereign bond issuance if fiscal policy is loosened and not offset by renewed Central Bank purchases.  Nevertheless in the near term the scale of downward correction appears modest.   However the art of effecting a portfolio balance that facilitates appropriate exposure to the potential rewards of equities, whilst holding other assets (to offset the volatility stemming from equities) that are also capable of generating positive returns, remains a challenge.  

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