Why I’m sticking with stocks in 2020

The balance of probabilities suggests a higher risk premium in fixed income next year

Joseph Little

FILE PHOTO: European Union flags flutter outside the European Central Bank (ECB) headquarters in Frankfurt, Germany, April 26, 2018. REUTERS/Kai Pfaffenbach/File Photo
The global policy pivot — with more than 15 major central banks including the ECB (above) cutting rates this year — has been the single most important driver of strong returns © Reuters

The strong performance of financial markets in 2019 might seem counter-intuitive. After all, investor sentiment has been bearish for most of the year. But the key reason for solid returns — central bankers’ policy pivot towards further monetary easing — reveals an important truth about how markets work and provides some clues about what might come next.

The backdrop to 2019 has been what we call the age of uncertainty. Political instability and recession worries have dominated investors’ thinking and tempted them into cautious strategies, with large cash weights in their asset allocations. That has proved to be a costly decision as markets have performed strongly across the board, with positive returns in fixed income, equity and alternatives.

There is, of course, more than just one reason behind this impressive performance. A lot of the rhetoric from politicians, for example, was more about threats than action. What is more, many risk asset classes started the year at quite beaten-up prices after a sell-off at the end of 2018. However, it is the global policy pivot — with more than 15 major central banks cutting rates this year — that has been the single most important driver of strong returns.

This monetary easing, which was the opposite to what economists anticipated at the start of 2019, pushed interest rate expectations significantly lower — a shift that warranted a re-pricing of risk across the full range of asset classes.

So, what comes next?

Many of the key questions from 2019 remain unanswered as we head into the new year. Are we approaching the end of the economic cycle? Will political tensions continue to undermine growth and profits? That uncertainty creates an ongoing challenge for the economy today — and it continues to constrain the private sector’s “animal spirits”. It makes it difficult to predict a phase of strong, synchronised global growth emerging in 2020.

But it is not all bad news. The baseline scenario remains reasonably favourable: one of slow and steady growth, linked to robust labour markets and some carry-over from this year’s policy easing. What is more, sustained low inflation means that the prevention of recession is likely to continue to dominate policymakers’ decision-making, rather than concerns over cyclical overheating. If anything, policy is skewed towards further modest easing.

In this environment, though, investors need to be realistic. Based on our research, long-term investment returns already are set to be quite mediocre: for example, the expected return on global equity today, over the longer term, is only 6.5 per cent before inflation. That means asset class returns in 2020 could be some way shy of 2019’s bumper performance. One way around that arithmetic is if markets re-price themselves again.

There are two ways that such a re-pricing can occur. First, if we see a further round of unexpected policy easing, and second, if there is a compression in the risk premium — the required reward for taking risk — in asset classes.

Interest rates are where the action has been in 2019. It seems unwise to expect a repeat performance. That means better than expected market returns would need to be delivered from falling perceptions of risk pushing asset prices higher. However, the risk premium in many asset classes already looks low. It is negative when it comes to long-term government bonds and has compressed significantly in credit. If anything, the balance of probabilities suggests a higher risk premium in fixed income going forward, especially if policymakers begin to make more use of fiscal stimulus.

That leaves us with equities and equity-like asset classes. Perhaps surprisingly, after a year of strong performance in 2019, the global equity risk premium is still above long-run norms — we measure it at 4.5 per cent today versus a historic average of 4 per cent.

So, while overall prospective returns look low, equities still appear attractively priced, compared with alternatives. This is not a guarantee of success. But what it does mean is that if events play out more favourably than economists expect, stocks could do well again in 2020.

Strong performance in 2019 against a bearish news cycle might seem surprising, but it is not. The fundamental truth about how investment markets work has not changed.

Market action is driven by cash flows, interest rates and asset class risk premia. That disciplined way to think about expected returns remains really important in these uncertain times. As we head into 2020, we need to be realistic.

But sticking with stocks still makes sense.

The writer is global chief strategist at HSBC Global Asset Management

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