January MAST Asset Allocation Outlook: 2020 Visions: Re-Acceleration after Resilience

We maintain our overweight to stocks versus bonds, hedged with a small overweight to duration as we continue to expect a constructive environment for stocks while seeing little upside to interest rates.
January 2020
  • We don’t expect rising military tensions in the Middle East to lead to larger military interventions or oil-supply disruptions. War is not a popular topic for Trump’s election campaign.
  • Global growth is experiencing a soft landing and central banks will continue to support growth in 2020, notably via liquidity injections by the Fed and a bias for more easing, if needed.
  • Canada’s economic outlook has surprisingly softened into year-end while the currency appreciated; we doubt the Bank of Canada will be pleased at its next meeting. U.S. growth outlook remains well supported by strong income growth. More optimistic businesses should help re-ignite business investment later this year.
  • We remain overweight stocks versus bonds while keeping a small overweight to duration as we believe there is little upside to government yields. We continue to prefer U.S. stocks versus EAFE. Value stocks look cheap, but we are mindful of a potential value trap.

For stock investors, 2019 was about resilience. Trade uncertainty was buffered by the synchronized pledge of major central banks to act pre-emptively against the economic slowdown and engineer a soft landing, which boosted stock valuations. However, investors’ New-Year celebrations were short lived as U.S.-Iran trade tensions escalated sharply. If the situation escalates further, it could dent capex plans by businesses that were beginning to feel more comfortable given more clarity on the U.S.-China phase one deal (Chart 1).

Chart 1: Earnings vs. Economic Policy Uncertainty

2020 Visions Re-Acceleration after Resilience Chart 1

Source:  Bloomberg, BMO Global Asset Management

As we outlined in our 2020 outlook, this year should see economic and earnings growth re-accelerate as President Trump turns more focused on running a strong economy and labour market to secure his re-election in November.

2019: What a year for stocks and bonds

Global stock markets had a solid year (MSCI ACWI, +27.3%), but it came almost entirely from a P/E expansion as interest rates collapsed on dovish central banks (Chart 2). Earnings, business investment, and consumer confidence were down, yet stocks have managed to climb that wall of worry. For 2020, we believe stock appreciation will require improvements in economic fundamentals rather than lower interest rates, although we continue to think that monetary policy will remain supportive of risk assets. Meanwhile, balanced-fund investors also benefited from solid fixed-income returns with the FTSE TMX benchmark returning nearly 7% in 2019. Although we are optimistic for 2020, we doubt 2019 performance will be easily repeated in 2020 for stocks and bonds.

Chart 2: P/E Expansion Drove SPX Returns in 2019

2020 Visions Re-Acceleration after Resilience Chart 2

Source: Bloomberg, BMO Global Asset Management

More Good News in December

Global stocks ended the year on a strong note (MSCI ACWI, +3.6%), led by solid gains in emerging markets (MSCI EM, +7.2%), U.S. (S&P 500, +3.0%), and some broad USD weakness which helped EAFE stocks (MSCI EAFE, +3.2%). Canadian stocks registered modest gains (S&P TSX, +0.5%) and ended the year well behind the U.S. (S&P TSX, +22.9% vs S&P 500, +31.5%) in a year when commodities were significantly up (WTI, +34.5%; Gold, +18.3%).

Year-end optimism helped push yields on 10-yr government bonds higher in Canada and the U.S., up by 24 and 14bp, respectively. For Canada, the rise in yields looks overdone given how weak recent Canadian macro indicators have been, notably the labour market, which showed a big surprise drop in employment (Source: Bloomberg),  and weak retail sales (Source: Bloomberg). Global optimism took the greenback down (-1.9%) while the Canadian dollar benefited (+2.2%) despite rising evidence that the Canadian economy might be struggling to expand in the fourth quarter.

Equity Factors: Is Value still worth anything?

When the sky is blue, equity dispersion is usually pretty subdued and this is what we observed in December. Most equity styles performed in line with the global benchmark (MSCI ACWI, +3.6%), with the exception of Low Volatility (Low-Vol) stocks (+1.6%). Quality finished the strongest for the month (+4.1%) and the year (+35.1%).

In Canada, the BMO Canadian Low-Volatility Equity ETF (ticker: ZLB, -1.7%) struggled in December while the broad market BMO S&P/TSX Capped Composite Index ETF (ticker: ZCN, +0.4%) registered a small gain, bringing its year-to-date performance nearly equal (ZCN, +22.8 vs ZLB, +22.0%)1. We continue to prefer Low-Vol stocks in Canada, but further upside in oil prices, which would support the energy sector, would likely mean Low-Vol lags the broad market.

For Value, its significant underperformance versus global stocks (-6.7%) or Growth (-12.1%) in 2019 illustrates the challenges of potential value traps and how some structural drivers of returns may have changed. One potential reason is how intangible investments, which can be quite significant in tech companies, are typically expensed rather than capitalized, thereby not showing up in book value and misleading investors about the financial health of a company. The second, and perhaps most important reason for Value underperformance in recent years, is increasing industry concentration that has led to greater pricing power and higher profit margins that came along with higher growth for firms who captured market share.  We recognize that the valuation spread (i.e. Value vs Growth) remains very wide and that this has historically been a good indicator for value outperformance. However, there are reasons to think many of these drivers have changed. We would argue for patience in calling for the great rotation.

Cheap Money is feeding the Zombies…and the Value Trap

The context of the stock value-trap may also be explained by the rise of moribund firms since the 2008 financial crisis. With falling long-term interest rates, a key economic and financial-market implication has been the rise of zombie firms, or mature firms that do not generate sufficient earnings to cover interest payments on debt (e.g., an interest coverage ratio below one).

The willingness to lend to non-viable firms and the lack of pressures for firms to restructure or exit has been exacerbated by cheap money and the hunt for yield. The increasing number of low-productivity zombie firms is diverting resources away from highly productive firms, in turn lowering economy-wide productivity. According to one study (Source: Deloitte), Canada has a high share of zombies: 16% vs the global average of 10%. Recall that Canada also ranks low on productivity, currently running close to zero compared to roughly 1.5% in the U.S. Without a significant uptick in interest rates or acute macro stress, zombie firms could keep going. While corporate credit spreads appear tight, they might stay anchored.

Fed Policy: Rebuilding the balance sheet and monetizing debt

A less dramatic trade environment and a soft landing for growth means the Fed may be on pause this year. While the Fed is sounding more confident about the global outlook and signalled rates on hold for this year, it’s also aggressively rebuilding its balance sheet (Chart 3). By next summer, the Fed will purchase nearly 60% of U.S. Treasury net debt issuance for F2020, which means the Fed is effectively monetizing the debt. With other global major central banks joining in the buying effort, we expect liquidity to remain a tailwind for assets into the first half this year.

Chart 3: Central banks are back into the buying business

2020 Visions Re-Acceleration after Resilience Chart 3

Source: Bloomberg, BMO Global Asset Management

Outlook and Positioning: Could the Commander in Chief spoil the party?

We maintain our overweight to stocks versus bonds, hedged with a small overweight to duration as we continue to expect a constructive environment for stocks while seeing little upside to interest rates. Our regional positioning for stocks also remains intact with an overweight to U.S. versus EAFE.

Although we were bullish for the loonie last year, its year-end rally breaking through $0.77 appears overdone. While trade related uncertainty has receded, the domestic backdrop has softened materially. We expect the Bank of Canada to sound concerned about that and the strength of the loonie at its January meeting.

Finally, recent events between the U.S. and Iran are a good reminder that President Trump is never shy to use bold, risky actions to handle international affairs, but we doubt we’re about to see a major military escalation in the Middle East such that oil markets would face major supply disruptions and prices would spike. War and high gasoline prices are never popular during an election campaign.

1 The performance for (ZLB) for the period ended December 31st, 2019 is (as follows: 21.82% (1 Year); 9.56% (3 year); 8.82% (5 year); and 13.40% since inception (on October 21st, 2011). The performance for (ZCN) for the period ended December 31st, 2019 is (as follows: 22.80% (1 Year); 6.86% (3 year); 6.25% (5 year); 6.32% (10 year); and 7.07% since inception (on May 29th, 2009).

Related articles
No posts matching your criteria