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Annual Investment Review – 2019


An exceptional year for the financial markets despite growing risks

Stock markets rose on average by 27% in 2019, bond indices between 7% and 14% and gold by 15% despite a difficult environment:

  • The rise of nationalism and protectionism.
  • A multipolar world with brutal leaders, Donald Trump, Recep Erdogan, Vladimir Putin, Xi Jinping, Jair Bolsonaro.
  • A WTO and a NATO, in a state of brain dead.
  • Military tensions with Iran and North Korea.
  • The US’s trade and technological war against its partners.
  • The inversion of the interest rate curve, signaling of an impending recession.
  • The acceleration of the extraterritoriality of American laws.
  • Britain’s difficult exit from the European Union.

However, the U-turn by the U.S. Federal Reserve with three Fed Fund cuts in July, September and October 2019 and large injections of liquidity, as well as the stabilization/improvement of manufacturing indicators, allowed the financial markets, and risky assets in particular, to perform well in 2019. The Fed was under heavy pressure from Donald Trump who wanted a rapid and significant drop in Fed Funds, calling into question the independence of the US Federal Reserve.

Main asset classes performances in 2019


Equity markets appreciates Donald Trump

The S&P 500 has grown more than 50% since the president was elected, more than the double of the average of 23% for the other presidents after 3 years in office. The index rose 28% in 2019, well above the average of 12.8% in year 3 for the other presidents. If history is a guide, since World War II, year 4 should be positive with a probability of 78% for an average increase of 6.3%.

The stock market appreciated the resilience of household consumption and an unemployment rate at 3.5% in the United States, the lowest level since 1969. In the 4th quarter of 2019, the interest rate curve normalized, moving away the risk of recession; moreover, according to the Fed’s model, the probability of a recession in the United States has gone from 40% to 20%. Manufacturing indicators in developed countries have entered into a zone of severe contraction, but the industrial component only accounts for 12% of GDP. The US stock market also benefited from the tax reform implemented in 2018 and its effects on major share buyback programs, which positively influence earnings per share.

In 2019, the evolution of stock market indices took place in 3 phases:

  • From January to April. Stocks and bonds rally after downward hype in Q4 2018. The Fed adopts an accommodative tone.
  • From May to August. Return of volatility on the financial markets. Inversion of the yield curve. The trade war is intensifying and the technological war is starting. Donald Trump threatens to launch a financial war against China. Falling interest rates: investors fear a recession.
  • From September to December. Powerful rally in equities thanks to injections of liquidity from the Fed and reduced fears of recession. Interest rates are rising (moderately).


Central banks’ U-turn

In December, the Fed announced that it will not raise its benchmark rate in 2020. After tight monetary policy in 2017 and 2018, it realizes that the exit from accommodative policy is critical. In order to avoid a bond shock, the Fed will remain very cautious. The new boss of the European Central Bank, Christine Lagarde, gave an optimistic speech on the state of the economy and encouraged the European Union to launch infrastructure programs, notably green, to take over from monetary policies accommodation deemed ineffective in stimulating economic growth.


An unloved bull market

2019 has once again confirmed that this 10-year-old bull market remains unloved. The positive performances of equities should not hide the caution of investors with a historically high allocation of cash and net outflows from funds and ETFs invested in US equities of $156 billion in 2019 into bond and money market funds. The main concern of investors was the US-China trade war, which could lead to a global recession in 2020.


Brexit, the endless story

After multiple postponements of the date of exit from the European Union, for lack of agreement in the English Parliament on Brexit, Boris Johnson had to organize parliamentary elections, which he largely won, strengthening his position both in Parliament and vis-à-vis to the European Commission. BoJo wants to exit at the end of January 2020, but the exit process will still be long, because if there is an agreement, the terms of the exit have still to be defined.



Asset Allocation: Markets ignore disconnects

  • Geopolitics: ahead of multiple deadlines
  • Fed: a – temporarily – powerful White Knight
  • Macro-land: a few green shoots…
  • … but reflation theme is premature
  • Currencies: a forever brain-dead market?
  • Risky assets: not so buoyant ex-equities

The sagas of US-China trade talks and hard Brexit no longer seem to frighten markets. In both cases, the worst-case scenario has been avoided. But the developments will take some time to result in concrete outcomes, possibly beyond 2020. Even if the odds of Trump impeachment are low, the US political landscape is growingly becoming corrosive, unreadable.

Massive liquidity injections by the Fed, essentially linked to the drying of the repo market, managed to inverse the negative mood of Q3 19. Financial repression will continue until risks of a recession completely evaporate. But the long-overdue normalization of monetary policy must wait after a genuine reflation is engineered. It would actually take a very unusual mix of extreme fiscal and monetary measures to reach it. Such a process, eventually non-coordinated internationally, would restore positive real interest rates, but also cross-asset volatility.

Commodities do not acknowledge for equities’ optimism. Emerging and heavy cyclical stocks do not confirm an upcoming reflation. Neither do the resilient Swiss Franc and US Treasury long bonds.



Secular stagnation, still and always…?

To paraphrase L. Summers, world is plagued in secular stagnation and suffers from a monetary policy ¨black hole¨. For him, without a major discontinuity, there is no prospect for policy rates returning to positive territory in Europe and Japan. The US appears to be one recession away from implementing negative policy rates. The odds of a significant cyclical pick-up in the next couple of years are low, due to the inevitable political stalemate linked to impeachment and to presidential elections.

Long-term taboos are gradually vanishing in Europe. New debates are mushrooming among key decision makers over contentious topics like green bonds, new / different ways of mutualizing risks (euro-bonds). The old continent is even seemingly moving towards the adoption of ¨monetary financing¨ (i.e. direct central bank financing of government debt). This is a seductive policy option when demand is chronically deficient. But such debt monetization requires explicit co-operation between (atrophied) fiscal and a politically disciplined (barely independent) central bank. It is one thing to set a new strategy / direction, but it is quite another implementing it in Europe, considering its huge political inertia. Hopefully it will not take a hard Brexit / bankruptcy of systemic banks / very aggressive protectionist measures for Europe to fundamentally re-engineer its policy mix.

Risks of a US recession in 2020 diminished recently, thanks to a hyper-active Fed and very supportive financial conditions. At best growth will approach potential (<2%)
Finally, mindset is changing for the better in Europe. But the clock is ticking loud


Gloom is contained… for now

Trade tensions have been fueling an industrial slowdown. World trade has relentlessly decelerated over last couple of years, following the outbreak of the protectionist policy of the US and its subsequent collateral developments. Indeed, in a first phase the retaliation occurred essentially from China and to a limited extend from Europe. Second round impacts are visible now, with Japan and South Korea also engaging into a bilateral trade conflict and the US threatening Brazil and Argentina etc.

¨Global¨ assembly lines have been delocalized on a very large scale in Asia – say China – during the heat of the globalization. Integration increased gradually, with China climbing the value-added ladder. The – often long-cycle – Tech chains have not been dismantled yet. But still, part of the trade volume, formerly produced in China, is starting to divert to-wards Vietnam, Thailand, Indonesia, etc. Among symbolic corporate moves, Nintendo, Sharp, Ricoh did it while Google, if not Apple contemplate making their smart-phones elsewhere. The expected broad-base of the reonshoring of manufacturing is just US politicians’ illusion. But still, new investment projects are put on hold. In a nutshell, global uncertainty, new regulations and tech disruption will continue to depress – current and future – corporate capex.

The key issue is whether a transmission of the joint gloom of trade / manufacturing towards services and consumption will occur or not? If history is any guide, it happened more frequently than not over the (very) long term period. But in most cases, it was due to either to over-capacities or to macro imbalances that do not exist currently. In the current circumstances, only a slow contagion process might unfold through a) an intensification of trade tariffs and barriers b) massive layoffs. Except for very specific situations (German cars, Brexit consequences), it seems unlikely so far.

The odds of a significant revival in 2020 in trade / capex / manufacturing cycles are low
But consumption should continue to remain relatively immune


China transition is well-engaged, but far from completed

The integration of China into the WTO in 2001 accelerated the decline of its primary sector (agriculture). The resulting quickening of globalization helped China take-off, with real estate / heavy industries / manufacturing and services essentially benefitting from it. Services have now become prominent, namely in terms of number of employees. This expansion has been largely financed by credit. On the one hand, it is theoretically less cyclical, hence more resilient. On the other hand, the excessive leverage renders it more fragile.



Low FX volatility

This year the main surprise was undoubtedly the very low level of FX volatility. The anomaly here is that the various sources of worldwide risks, like the trade conflict and Brexit, should have led to much higher volatility. Nevertheless, main currencies have remained confined within tight trading ranges. Why has this happened and, major critically, can it continue? A key factor behind this modest volatility has been an unexpected restart of ample liquidity by central banks in an already ultra-loose environment.

Ample liquidity dragged down yields and a lower propensity to take FX risks reduced the hunt for protection and thus demand for volatility. This phenomenon tends to be self-fulfilling: low realized volatility calls for low implied volatility, which hints that currencies will likely stay stuck. This does not provide incentives to pay extra hedging costs, even if such strategies are cheap. In addition, economic cycles remain largely synchronized worldwide. Consequently, monetary policies tend to be similar, accommodative and synchronized, explaining why major trends have failed to materialize.


Limited volatility favors carry trades

The Fed has prematurely and sharply reversed its quantitative tightening – due to money markets stress. The BoJ balance sheet is still growing and the ECB has re-started its QE program. After $600bn of balance sheet shrinkage since 2018, G3 central banks’ balance sheets could grow by $1trn by 2020 year-end. So, the case for a volatility pick up on a liquidity withdrawal is therefore limited, undermining those bull cases for both JPY and CHF. Typically, low volatility sup-ports carry trade strategies – suggesting continuing demand for high yielding currencies – largely at the expense of Europe.

EM FX decently performed this year. This is quite an achievement in a year where declines in trade volumes and global growth have not been EM FX supportive. If trade and growth stabilize/improve next year, the EM FX segment should offer even better returns, with the carry component being also coupled with some positive contribution from potential price gains. However, if there are limited negative USD factors, EM FX appreciation is unlikely to be aggressive. The carry component will remain the key part of the return.


Search for undervaluation

Within the G10 segment, there is clear divergence between the rich USD valuation, the European cheap low yielding currencies (EUR, GBP, CHF) and the growth dependent currencies (NOK, CAD, AUD, NZD). The only exception remains the JPY. All the procyclical currencies show a neutral to positive output gap and inflation close to target. This is positive; these central banks may be less prone to ease more aggressively. These currencies are still offering relatively good yields. All this makes most of the G10 procyclical currencies an attractive bet. Most of EM currencies are cheap against the USD in real terms.



Stimulus are already well in place

Somewhat more positive signs emerged in the trade talks, and lower probabilities of a no-deal Brexit and of a recession have all contributed to higher yields. All-in-all supportive central banks, but less than market expectations have also pushed bond yields higher. The Fed has lowered 3 times its Fed Funds this year and is now on hold. There is still a chance for another last cut. The ECB cut its deposit rate to -0.5% and resumed its QE program. ECB members are divided over the effects of further monetary stimulus measures. The ECB is on hold too. Investors were expecting more from key central bankers. So, further stimulus measures look unlikely. Since then, expectations for further rate cuts should stay contained.


Inflation will not only be about base effect

While US headline inflation surprised to the upside in October, the core component weakened. The 2020 base effects may drive higher readings. Investors are not worried yet as tariffs have not driven prices higher. The Euro area inflation is set to bottom as the base impact of falling energy prices will drop out of the annual data.

After a decade of monetary stimulus including bond purchases and/or zero/negative interest rates, central bankers have been unable to reignite inflation. They are more and more talking about tweaking their inflation targets. Over the medium term, it would have the advantage of removing any pressure to start tightening as soon as price growth moves up. Ideally, it would also boost expectations – a critical factor for generating actual inflation – by creating room to overshoot. Another solution could be to revisit the inflation baskets. For example, the ECB acknowledges that the EU harmonized index – based the 19 members states inputs – dramatically underweights housing costs.


Mixed bag conditions for corporate bonds

Default rates are at historical lows, companies have good interest coverage but higher leverage. During this lengthy period of low yields, many companies have taken the opportunity to extend their debt maturities and thus reduce interest expenses, which is beneficial. However, the refunding will not be easy. The wall of redemption will reach its peak over the next 2 years. Default rates are expected to rise from current low level (2.6%) to 3.6% in 2020, given the growing share of companies with a negative market outlook. Even if global financial conditions remain supportive, banks have started to tighten their lending standards. Usually, it is a leading indicator of wider high yield spreads.

Because of the low-yield environment, many investors will continue to favor safer corporate bonds. Higher demand for investment grade bonds, together with the fact that the ECB remains a buyer, may further support investment grade bonds. Furthermore, a lot of companies are already mentioning that they will do whatever it takes to avoid downgrades into the junk category.


EM bonds are the best of all possible worlds

More stable government finances, i.e. better current account balances and lower inflation have lessened the financial vulnerability of many emerging countries. Despite numerous interest rate cuts in 2019, yields are still much higher than in developed markets, which makes good returns possible. There are prospects of further rate cuts in several markets, which can lead to higher bond prices. The fact that the Fed and other central banks are still providing stimulus should be beneficial for EM assets for a while longer. Risks still include political risk/protectionism and potential investor risk aversion. Uncertainty about emerging currencies is both a risk and an opportunity.


The (very) long-term connection of equity markets and corporate earnings is well-documented. In the short-to medium term, however, it is far from stable. Indeed, for instance 2018 was a (very) good earnings vintage, globally, that translated into mediocre market performances, while 2019 will prove disappointing earnings-wise, but buoyant in terms of equity prices. This apparent disconnect comes from several factors. Namely the evolution of the discounting factor of earnings, i.e. the level and the trend in interest rates (both long-term and policy ones). And several other – more elusive – factors can also play an important temporary role, like investors’ risk appetite, capital flows, regulation, geo-politics, etc.

The – never-ending – financial repression in developed countries adds to the classic factors of distortion. This makes forecasts particularly challenging. In this specific context, equities have lately become the reference asset class (by de-fault) for lots of investors, including naturally risk averse ones. By over-simplifying, what PE ratio are investors willing to pay, when the PE ratio of long sovereign bonds has become extremely expensive, i.e. 50x for the US 10y benchmark (stuck below 2%)? In such a context, dividends (and their growth) fulfil a substituting function. They gradually replace the absence of securities generating positive cash-flows in the fixed income sphere. This could in theory continue some time in a fixed income world, where borrowers are paid by lenders to park / dispose of their cash. But for how long? Is it actually healthy (no) and sustainable (who knows)?


Benign macro perspectives

Long term earnings’ trends remain dependent on developments of nominal growth. The relentless decline of the pace of expansion observed over last decade will continue, if not reinforce over next couple of years. This ¨secular stagnation¨ regime should actually spell in 2020 and 2021 nominal growth rate of about 4% in the OECD (US 4,2%, EU Area 2,7%, China 7,7%, Japan 1,7%). Therefore, just like in 2019, the direct contribution of the macro factors into global corporate earnings is expected to remain subdued (more like 2019 than 2018). There are two ¨jokers¨ that companies can use to propel their EPS: margins and buybacks.

When it comes to margins their current level is very high in the US, compared to former cycles. This is even more the case, when compared to the broad spectrum of US companies, i.e. the NIPA, which includes non-quoted and small enterprises. Margins are less overextended in Europe, Japan and emerging markets, where a cyclical growth rebound could help restore higher profitability.

Buybacks have been very instrumental in fueling EPS growth in the US over last years, courtesy of a) 2017/8 fiscal reform and b) extremely accommodative financial conditions (very tight spreads used by CFOs to re-leverage B/S on cheap terms). This trend, though seemingly decelerating, will remain a positive contributor to EPS growth in 2019. This could change in 2020, were the Democrats – namely E. Warren – to be elected. A rise in interest rates or in spreads (with too hot or too cold an expansion) may also change the tack…

The tepid macro landscape should not provide corporate earnings with a strong / positive impulse


Earnings’ expectations and capital flows

After a short period of irrationality, long-term investors have healthily normalized their secular expectations for earnings growth. Indeed, the rare IBES secular survey of 5y expectations reached an alarming level of about 18%. This analysis is interesting, as featuring the sentiment (and propensity to take risks) of pension funds, life insurers, etc. Such a strategic level actually fueled very ample institutional capital inflows into equities from H2 2017 up to the end 2018. Surprise sur-prise, this complacency coincided with below average performances from the US S&P Index (lots of gyrations with a start of the period around 2’400 points, and a similar level at the end of it)! Good news is that this thermometer is no longer calling the heat. It actually normalized rapidly in H1 2019.

Equities outflows in ETFs and mutual funds just reversed last October. Long-term institutional investors have been reducing their risks accordingly. This is a source of comfort, confirming the financial adage that a huge pile of cash is on the sidelines, waiting for coming-back to the market. This caution is also valid for retail / private investors. They have been fleeing equities after the two / three warning corrections that occurred since early 2018.

Such an ¨unloved¨ bull market actually!? Very sophisticated investors, like Hedge Funds / CTA, have opportunistically increased markedly their exposure last months. These very nimble investors also tend to take advantage of uptrends to sell volatility related products (VIX). This is a dissonant sign of speculation / exuberance. This normally prefigures short-term corrections but doesn’t change the underlying trend of markets.

In spite of significant uncertainty, the global equity landscape remains rather supportive
We don’t see pre-conditions for a bear market


Emerging stock markets have suffered from US protectionism

Undoubtedly, emerging equities have suffered from the decline of the global trade volume because of the new US protectionist trade policy and the strength of the dollar. The underperformance was accentuated in May 2019 with the start of Donald Trump’s technological war against China. Will the next war be financial?

The MSCI Emerging underperforms the MSCI World, when the dollar is strong. If manufacturing indicators confirm their recovery, the emerging zone could catch up. The lag in performance and favorable relative valuations should allow emerging equities to resist rising volatility. In Q4 2018, the MSCI Emerging had much less corrected than the MSCI World.



EM central banks will remain structurally gold buyers

The dedollarization and growing importance of Asia, and China as a pivotal point in world trade, are pushing central banks to buy gold at the expense of the dollar. The attractiveness of gold is high as gold accounts for only 3% of China’s central bank’s foreign reserves, compared with 20% in Russia, 20% in Turkey and 7% in India. A mere doubling of gold holdings by China would account for nearly half of the annual gold supply.


In 2019, the average price of oil is 14% lower than in 2018, the fault of a smaller increase in demand and a sharp increase in US production which stands at 12.9 million barrels / day (+10% in 2019). With the continuation of the agreement to freeze production within OPEC+, Saudi Arabia is seeking at all costs to support prices. In the current reflationary bet played by investors, expectations of an acceleration of oil demand could resurface and push prices up. There may be a tightening of supply if US production decelerates, regarding the decline in the number of oil rigs observed in the United States. However, on the production side, efficiency gains partially offset the decline in the number of rigs.

Asset Allocation




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