Fixed income returns have been excellent in 2019. Secular trends which have supported performance will remain in place – and indeed intensify – in the 2020s.
We view the Chinese economy as key to the global business cycle. Recently, Chinese leading indicators have improved. The credit impulse, for example, which measures the change in the flow of new credit to the private sector as a percentage of GDP, has turned positive. There is a correlation between the credit impulse and global business confidence, even if there are also other influences on the latter. Both the OECD Leading Indicator and PMIs have risen off their lows, too
While markets have become more optimistic recently, we expect the bounce in Chinese credit to be more muted than in 2012-13 and 2015-16. Ongoing corporate defaults suggest China stimulus will be both modest and ultimately ephemeral.
The overall picture for the European economy remains one of modest, though seemingly stabilizing, growth. Consumer spending is decent, but there are signs of slower momentum in the labor market. Weakness in manufacturing has already spilled over to the labor market and to services in Germany.
The US should benefit in the short term from a lift in sentiment in the aftermath of the headlines of the ‘Phase One’ US-China trade deal. Still, we see plenty of end-of-cycle characteristics, which pose downside risks to growth. Growth is predominantly driven by consumer spending. Business investment remains absent and CEO and CFO confidence surveys caution this could remain the case. Corporate profits are eroding as labor costs are on the rise and we see a growing risk that cost cutting could start to have an impact on the labor market. However, macroeconomic and market trends have been slow this cycle, so the pace of this process will probably fit that template.
The composition of the White House’s proposed December 2019 tariffs were self-damaging for US interests, as they would have hurt the US consumer ahead of an election year. So we should perhaps not be surprised by their recent repeal in the ‘Phase One’ deal. Yet for all the hoopla around the recent agreement, average economy-wide US-China tariff levels are still higher than the levels which so roiled markets in August 2019.
CEO and CFO confidence may well be linked to the challenge of making large long-term investment decisions amid such a fluid trade landscape. Their desire for stability will be hampered for most of 2020 by what looks to be a closer-than-usual White House contest. Uncertainty over who will win the November election may start to dominate markets from midyear. In the interim, we have the Democrat primaries in March. Who could go full steam ahead with corporate investment with both the geopolitical and domestic political windscreen so fogged up?
In the UK, the next election is now likely to be in 2024, following the convincing Conservative electoral win. This takes the rolling domestic uncertainty and parliamentary stasis of the last twelve months off the table. In terms of negotiating the future relationship between the UK and the EU, however, it is only the end of the beginning, to paraphrase Churchill. There is still scope for disagreement over the details and timing of trade agreements, and progress could be slowed by protectionist stances in front of specific domestic audiences and by insecurity in Brussels over large countries successfully leaving the EU. Still, we note that it took a hard deadline to concentrate minds – leading to compromise – in October 2019, so some tight deadlines are probably a harsh necessity in 2020.
The guidance from the Fed and ECB has been clear: both institutions prefer to remain on hold for the time being, and for both the bar to hike rates looks high. A pronounced rise in underlying inflation could spoil that outlook, but we expect core inflation in these economies to remain close to current levels.
Fixed income returns have been excellent in 2019, as they have for the last 3, 5 and 10 years. As yields have fallen and spreads tightened, the consensus view has consistently been to call time on the duration trade and look for higher yields.
But the consensus has missed the structural trends: the demand for duration-matching at pension funds and life insurers, the demand for income from an ageing society, and a need for capital stability in retirement. These secular trends will remain in place – and indeed intensify – in the 2020s.
With all that said, we do not expect the same total returns in 2020 as in 2019. That means a far more active approach is required – in curve, country and credit. We can identify areas that we like for 2020, but it is also important to choose areas on which to be cautious, following such strong total returns.
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