AN OVERVIEW OF 2019 AND OUTLOOK FOR 2020
Australian shares produced very strong returns in 2019, but despite a strong year, a key observation has been weaker earnings across most market segments. With continued downgrades to earnings forecasts for companies, earnings have gone backwards in many sectors – with the Resources sector a key exception, driven by the performance of iron ore. Nonetheless (and in spite of various macroeconomic influences), markets have continued moving up – as have valuations, primarily driven by falling interest rates. The market is now looking more expensive as we head into 2020.
The Australian economy has shown signs of weakness over the last year, leading to a lowering of interest rates to all-time lows. Given its position as a smaller, more open economy, ongoing macroeconomic factors such as trade negotiations and central bank policy stimulus could very well continue driving market conditions in 2020 and determine whether the Reserve Bank of Australia cuts rates again. In addition, the Financials sector contributes a significant portion to Australia’s share market. Next year, we anticipate that the ongoing scrutiny and significant regulatory changes to Financials will have an impact on the performance of the share market and total returns will be more challenging. Corporate earnings will be a key driver of returns in 2020 as there needs to be justification of the higher valuations of 2019.
Despite ongoing trade tensions and their impact on global company earnings, global and emerging market indices have produced returns in excess of 15% over the 12 months to November 2019. However, returns at the regional and country level were significantly different. The year has also seen a continuation of a preference away from the value investments style, with quality and growth investment styles outperforming. This is why style and regional positioning has been an important driver of outcomes produced by active fund managers.
Growth across Europe continues to be challenged despite record low interest rates – partly due to higher than historical average levels of unemployment and weakening trade with other regions, particularly China. This has been further impacted by ongoing political tensions and events such as Brexit. As a result, the environment for companies in European markets has been weak.
In Japan, economic growth has continued to slow but has remained positive despite slowing trade in the region. In particular, trade with China has slowed due to China’s slowing economic activity and escalating trade issues with South Korea. Equity returns in Japan were low, however there have been some promising signs of improving corporate governance for Japanese domiciled firms.
In China, fiscal and monetary stimulus policies have yet to reverse the country’s slowing economy, which is currently experiencing low economic growth by Chinese standards. This is directly and indirectly impacting companies with exposure to US or China trade. Over the year, the Chinese market rose by much less than developed markets over the last year.
The US has been the strongest performing country over the year. Economic and company earnings growth has slowed, but to a lesser extent compared to other regions. The better performing US market reflects better economic growth relative to the rest of the world and the fact that this market has a greater weight toward growth companies and industries. Interestingly, the historically and relatively strong performance of the US market in 2019 was primarily driven by the strong performance of large US listed companies such as Microsoft and Apple.
Meanwhile, there has been considerable volatility across emerging markets. Brazil was one of the best performers for the year, while Korea was one of the weakest. Election outcomes were an important influence on returns in South America, with the market in Brazil responding very positively to policy changes following the election of a new president, while Mexico experienced a negative outcome largely as a result of policy outcomes following its presidential change. China has been an important driver of the overall emerging market index return due to its weight being a little over 30% of the overall emerging markets index.
Looking forward, the biggest macro considerations for 2020 include trade discussions around the world such as the potential for further deals between the US and China, and the exit of the UK from the European Union. In addition to this, economic health in each of the regions will be a significant contributor to market sentiment. In particular, China’s ability to stimulate the economy will be an important driver for the Asian and European regions through their trading links. Company performance will be influenced by the environments in which they operate. And while overall market valuation levels are not significantly above historical levels, some country and sector index valuations in developed markets are near historical highs.
Fixed interest markets performed strongly in 2019 as bond yields fell across the world. A combination of disappointing economic data and episodic but dramatic rises in geopolitical risks drove yields lower. The shift in investor sentiment has been dramatic – investors started 2019 concerned about how high global bond yields would rise and may instead end 2020 questioning where the bottom is in bond yields.
US 10-year bond yields have fallen considerably since 31 December 2018. Other countries, including Australia, followed the lead of the US, while two core European economies, France and Germany, have had their 10-year bonds trading at negative interest rates. Given the fall in sovereign bond yields and the disappointing economic data, it is somewhat surprising that the spread on investment grade (IG) corporates fell and that developed market IG bonds outperformed sovereign bonds.
We are cautious on the outlook for fixed interest markets in 2020. Given the current low level of nominal bond yields, most developed sovereign bonds are rich when measured by metrics such as real bond yields. However, we also believe that a significant and substantial rise in yields is unlikely in 2020 for several reasons. Firstly, global economic data remains mixed and a strong economic recovery is unlikely. Secondly, the main central banks retain strong pro-easing biases and are prepared to maintain low policy rates or continue the expansion in their balance sheets in order to stimulate economic growth. We expect the spread on IG corporate bonds to rise slowly or to remain steady in the absence of a recession. While IG spreads are trading close to historical lows and the level of leverage has increased over time, low interest rates and low defaults continue to support valuations. An additional reason to be cautious about returns in 2020 is that, for the first time in a decade, there is an almost total absence of any investors forecasting an impending collapse in fixed interest markets.
AUSTRALIAN AND GLOBAL PROPERTY
Residential real estate serves as a cornerstone of Australia’s overall wealth. In the second half of 2019, confidence returned to the Australian housing market – particularly in the country’s two largest cities, Sydney and Melbourne, which were both hit hardest by the earlier downturn.
However, not all property markets performed strongly in 2019. The retail sector continued its struggles, driven largely by a decline in consumer spending and the subsequent impacts of declining rental growth. The continued shift towards online shopping has also had a role to play and proved particularly challenging for weaker shopping malls. But while retail has underperformed, the industrials sector has experienced growth, influenced somewhat by the movement to online shopping and the demand for warehouses. Meanwhile, cracks began to show in office markets, with slowing demand and new supply coming on board.
Globally, property experienced similar challenges to Australia. Retail store closures in the US continued to trend upwards. However, with a broader market, investors have access and opportunities in niche sectors. Data centres and health care real estate have done particularly well – benefitting from technological advances and ageing populations. Despite some of the challenges, the declining interest rate and easing monetary policy conditions have continued to drive returns higher. Sufficient demand across markets has also continued to meet new supply and enabling rental growth.
Looking ahead to 2020, we anticipate a continuation of many of these trends. A question regularly posed is whether the performance of retail property will find its bottom next year? The reality is that online sales comprise only a small portion of total sales. We could see a survival of the fittest and a weeding out of weaker retailers and shopping malls. Industrial property could continue its upward trajectory, particularly if retailers continue to evolve their online offerings and look to solve the “last mile” problem for customer delivery. The wobbles facing co-working operators such as WeWork will be one to watch given they have driven leasing demand for office space and any change may impact demand and supply in 2020.
In 2019, volatility caused largely by macroeconomic factors (such as trade negotiations, Brexit and central bank policies) drove both successes and weaknesses in the broad space of alternatives. Over the year, we continued to observe dispersion in returns across various strategies in this asset class.
Macro factors began disrupting domestic economies, as reflected by dampening business and consumer confidence levels across the US, and a weaker Chinese Purchasing Managers’ Index as a result of US tariffs on Chinese exports. Some discretionary macro strategies were supported by macro factors such as the depreciating Chinese Renminbi and volatility in emerging market currencies. Meanwhile, systematic macro strategies remained more sensitive to volatility – particularly to the often news-driven, rapidly evolving nature of economics and geopolitics. Trend following strategies performed well when the unexpectedly strong trends across bond markets were captured.
Looking to 2020, we believe the alternatives asset class will continue to offer diversified returns to investors. The 2019 trend in bond markets reaffirms our belief that if there are strong trends in any market in 2020 (as we also observed in energy in 2014–15), they could be captured by trend following strategies. In our view, the macro environment should continue to present opportunities for investment managers to take directional or relative views across the bond, equity, currency and commodity markets.