Many of the world’s leading economies face monetary, fiscal and economic policy uncertainties.
Having taken a more cautious stance on risk assets while emphasising liquidity, we continue to believe that navigating the challenges presented in the year ahead will require nimble management.
Heightened Financial Market Volatility Likely to Persist During 2020
Many of the world’s leading economies face significant monetary, fiscal and economic policy uncertainties as slowing global growth has become a rising concern. Trade tensions, weaker manufacturing activity, declining business sentiment, and rising political tensions and polarization are all risk factors we see carrying over into 2020.
Key central banks responded to slower growth by delivering an abrupt change in monetary policy throughout 2019, one which we believe should continue to buoy investor sentiment as the cost of capital has been reduced to historic lows. The danger going forward is that interest rates are already negative in many areas, and so the scope for central banks to stimulate activity is vanishing.
The US economy has appeared to be most resilient due to the support of consumer spending, favorable labour market conditions, the US Federal Reserve’s (Fed’s) pivot to rate cuts and declining long-term interest rates.
Key US-centric areas we will be watching as 2020 progresses include election-year proposals involving corporate and personal income tax rates; health care, including “Medicare for all” and drug-pricing controls; fossil fuel restrictions; banking regulation; and technology sector antitrust actions.
Meanwhile, fragile and potentially recessionary conditions in the eurozone complicate the 2020 picture, as does sluggish Japanese growth and the uncertain path for Brexit in the United Kingdom. Another nascent area of potential risk is the consumer, which has been a key support to the US and global economies.
We continue to see US job and wage growth, as well as strength in spending and sentiment indicators, but we also think any further deterioration in trade relations could weigh on consumer and business confidence to a degree that causes cracks to form.
The cumulative impact of strained trade relations on capital investment, hiring plans, supply chain rerouting and rising input costs leaves us concerned that growth prospects remain skewed to the downside.
We still view the US economy as having only a moderate risk of dipping into recession in 2020. However, the collateral damage from trade headwinds — underscored by a noticeable year-over-year decline in Chinese exports to the United States (through September 2019) — is spreading from country to country, and, increasingly, manufacturing weakness has begun to infect the much larger services sector.
Several emerging market economies are a possible bright spot, with some (notably Vietnam, Taiwan, South Korea and Mexico) looking to benefit from supply chains moving out of China, while others, such as Turkey and Argentina, may remain mired in political dysfunction.
Broad-Based Global Slowdown in Industrial Production During 2019
World Trade, Industrial Production and Manufacturing Purchasing Managers’ Index: New Orders
January 2015 – August 2019
Sources: CPB Netherlands Bureau for Economic Policy Analysis; Haver Analytics; Markit Economics; and International Monetary Fund staff calculations. International Monetary Fund, World Economic Outlook, October 2019. Three-month moving average; year-over-year percent change, unless noted otherwise; deviations from 50 for manufacturing PMI. Important data provider notices and terms available at www.franklintempletondatasources.com.
Our Multi-Asset Strategies Reflect a Tactical Adjustment Away from Riskier Assets
Against this backdrop, we have grown more cautious and selective in our multi-asset strategies, but we are not overly bearish. We have valuation concerns across a variety of asset classes.
Equities as a whole are not cheap, in our analysis, and we have tempered our enthusiasm for them. Corporate fundamentals remain relatively strong, and corporate earnings still support global equities. But we believe profit margin expansion will be tougher to achieve as the ability to pass on higher costs to consumers appears limited.
As a result, we believe profit margins have peaked across major economies and may decline further in 2020. This seems to be contributing to ebbing business confidence and curtailed investment plans. And if inflation picks up, markets could be in the difficult position of contending with less leeway for monetary accommodation than expected.
Recurring equity market selloffs seem likely again in 2020 as untested policy measures such as tariffs and restrictions on listing and capital flows are being considered. The US presidential election also could complicate the uneasy US-China relationship.
The US equity market’s attention in 2020 will probably focus on valuations, margin pressures and whether Fed interest-rate cuts are effective in stimulating demand.
Elsewhere, China’s equity market gives us pause despite attractive valuations and recent stabilisation enabled by stimulus measures. US-China trade disputes are only a symptom of broader tensions as the rhetoric between both countries has hardened.
In the credit markets, bouts of equity weakness have driven ongoing demand for longer-dated assets such as US Treasuries and high-grade corporate debt. We have seen a major upswing in issuance as companies have been able to access longer-term capital at incredibly low borrowing rates.
The sharp downdraft in interest rates globally has strongly benefited higher quality, long-duration fixed income assets, which leaves markets with very little room to maneuver. Consequently, we remain concerned about stretched bond valuations.
With these assets unlikely to repeat their 2019 performance in 2020, we are biased toward shorter duration exposure and assets such as short-term US Treasuries, mortgage-backed securities, and higher-quality corporate debt (both investment grade and non-investment grade). Overall, we have moved to a truly neutral view of bonds at the asset allocation level given the balance between reasons for optimism and valuation concerns.
We are also being extremely selective within lower-rated fixed income sectors such as high-yield corporates — default rates appear to be rising toward historical averages, and bank loans have experienced outflows.
The investment-grade corporate bond market should find ongoing support from strong fundamentals; however, leverage was high heading into 2020 and technical conditions may prove challenging. Although some widening of yield spreads is likely as growth slows, yields remain attractive to us in a global context.
We retain a more optimistic outlook for emerging market debt given dovish global central bank policy and real yields that have been running higher than historical averages, both of which could help mitigate exchange-rate risks in local-currency bonds.
A key caveat here is that we think selective positioning is important as investors continue to worry about protectionism and deterioration in geopolitics.
This article is contributed by Edward D. Perks, CFA, Chief Investment Officer, Franklin Templeton Multi-Asset Solutions.