Fourth Quarter 2019 Market Review and Outlook

The article below is Aon’s Q4 2019 market review and outlook with perspectives on market activity and current investment trends. Continue reading to learn more about market trends in Q4 2019. 

Market Highlights

• Fading concerns over the U.S.-China trade war and economic deterioration bolstered equity markets. Despite the strong momentum, Aon takes the view that, given how far valuations have extended and with profit margins under pressure, the prospects for equities are less compelling.
• Bond yields globally bucked the downward trend observed through most of 2019, rising on the back of higher inflation expectations while increases in real yields were more muted, by comparison. Resurging risk appetite helped propel credit spreads lower and resulted in corporate bond outperformance over government bonds.
• Additional supply cuts proposed by OPEC+ as well as a less pessimistic outlook helped crude oil prices to rebound while commodity prices, in general, found firmer footing.

Macroeconomic and Political Moves

Geopolitical risk, principally the U.S.-China trade war, faded in the last quarter of 2019 but has not disappeared

Economic weakness continued to be predominately isolated in the manufacturing sector, with limited spillovers into the more resilient services sector. In the last of few months of 2019, fears of a global slowdown were soothed by generally positive economic data releases, whilst expectations of accommodative monetary policies from major central banks provided further support for risk assets. There remains a significant number of developed economies that have manufacturing Purchasing Managers’ Indexes (PMIs) under 50 (levels which are consistent with a contraction in activity) but the service sector, which tends to be a larger proportion of developed economies, has held up. Looking ahead to this year, we expect to see more evidence of growth stabilisation than acceleration.

Growth in the U.S. economy accelerated marginally in the third quarter – up slightly from an annualized 2.0% to 2.1%¹. Similar to the prior quarter, much of the growth stemmed from the resilience of the U.S. consumer offsetting contracting private investment. Meanwhile, unemployment dipped to a new multi-decade low while wage growth continued to outstrip inflation. Consequently, consumer confidence (as measured by the Conference Board) remained buoyant. All of this stands in contrast to the aforementioned contraction in the manufacturing sector.

Indeed, the uncertainty from the trade war has undoubtedly had an impact on the U.S. manufacturing sector with the ISM manufacturing index below 50 for nearly half of 2019. However, the apparent thawing of tensions with the announcement of a “Phase One” trade deal had a discernible effect on risk appetite and translated into strong gains in risky assets. The details of the trade deal, includes the reduction of some U.S. tariffs on Chinese goods (as well as the cancellation of Chinese retaliatory tariffs), boosting Chinese purchases of some American goods while also addressing complaints regarding intellectual property. The extent that this deal lays the foundation for further deals to be announced remains to be seen. With the U.S. Presidential elections approaching, a tough stance towards China (popular among the electorate) could lead to similar headwinds experienced over 2019.

Alongside this, the recent escalation in Iran and the threat from North Korea to resume nuclear tests suggest that investors in 2020 (and beyond) will have to contend with several potentially disruptive geopolitical flashpoints that could undermine risk assets. Whether these ultimately translate into full-blown crises is unknown but the presence of these risks adds to our belief that volatility will be higher. At the same time, the stellar returns of 2019 across most asset classes have made many very expensive again and vulnerable to disappointment, which merits a well-diversified portfolio.

Over the fourth quarter, we saw another Brexit deadline come and go, while yet another extension was granted, as we expected. The difference to prior Brexit rigmaroles was the calling of a General Election which culminated in a significant majority for the incumbent Conservative party; the result of which sent sterling up close to $1.35/£² reflecting greater confidence that at least the first stage of Brexit will be resolved. However, difficult negotiations lie ahead and most uncertainties that have dampened business confidence will persist. As a result, some important residual drags for the UK economy, sterling and sterling-denominated assets remain.

Monetary Policy

Lower for longer: central banks are likely to maintain current monetary accommodation amid market pressures

One of the puzzles in recent years is the failure for inflation to take hold despite unemployment at record lows. Annual consumer price inflation continues to hover around 2% (2.1% for the year to November 2019), while the Fed’s preferred measure of core PCE inflation remains well below the 2% target at 1.6%³ – failing to hit 2% throughout 2019. Amid this backdrop of decelerating economies and inflation failing to hit targets, central banks have eased policy while changes to inflation targeting policies have also been contemplated. As we discuss in greater detail later on, the risk of moving to very low or negative inflation similar to the Japan experience cannot be ruled out completely and therefore steps need to be taken by policymakers to avoid such a result.

As for the Fed, it cut its target rate for the third time this year to 1.50-1.75% in October. Following the tumult in money markets over September, the Fed also became more aggressive in their intervention in markets, purchasing $60 billion per month of Treasury bills to apply downward pressure on short-term rates. For now, it seems that extra monetary policy accommodation is not planned by the Fed but market participants are still expecting further easing in 2020. This will continue to be a source of market support but conditions and expectations can change very quickly, so this cannot be relied upon.

Equities

In spite of disappointing economic releases, equities surge to new heights.

While economic data continues to point to a worldwide manufacturing recession, equity markets have largely shrugged off concerns that the economic environment will deteriorate further, posting strong returns over the quarter. In local currency terms, the MSCI AC World Investable Market Index returned 7.9% ^* over the quarter but due to U.S. dollar weakness, the return was 9.2%^4* in USD-terms. Concerns about trade wars faded over the quarter with the announcement of a “Phase One” trade deal while also lifting the economic outlook. A more entrenched accommodative monetary policy environment also provided additional impetus.

The impressive return for equities was, however, devoid of any recovery in earnings. Indeed, aggregate trailing earnings for S&P 500 companies fell for a second successive quarter. With the absence of an earnings catalyst, what can explain the impressive equity performance? With the sheer amount of low or negative-yielding debt, there is a resurgent belief that ‘There Is No Alternative’ (commonly referred to as TINA), which has encouraged demand for equities.

Valuations move higher across the board. Shaky foundations for strong returns in years ahead if profits fail to materialize.

Most equity markets posted solid gains over the fourth quarter, but there were standout performers in U.S. and Emerging Market equities which returned 9.1%^4* and 9.3%^4*, respectively. Both benefited from greater exposure to a revitalized Technology sector as worries over trade-war induced repercussions on technology companies faded. With corporate earnings turning lower, the positive return for U.S. equities was driven by multiple expansion. In contrast to the prior quarter, more cyclical sectors outperformed largely thanks to the appearance of revitalized economic fortunes while less economically-sensitive sectors, such as Utilities and Consumer Staples, lagged. Technology stocks were the principal beneficiaries supported by the lower threat from trade war induced repercussions as well as expectations that interest rates would be lower for longer. The exception to Utilities sector underperformance was in the UK, where utility companies were buoyed by the election defeat of the Labour party who advocated nationalizing parts of the UK utility network.

Unlike 2019, when gains were largely the result of higher valuations, going forward we believe profits will need to be delivered to sustain market gains. There are headwinds, however. Net profit margins have risen substantially over the last few decades, but we now see margins coming under pressure. The benefits of globalization that pushed costs lower have peaked and domestic labor costs are now picking up. If economic growth accelerates again (similar to that of 2017) the headwinds on profit margins can be managed for a time. If not, the outlook for equity markets may not be that rosy.

Government Bonds and Yields

Developed market government bond yields arrest downward momentum for now but is Japanification becoming inevitable?

Government bond yields largely bucked the downward trend over the fourth quarter with significant upward moves in nominal yields. Looking at real and nominal markets in isolation it looks evident that yield movements were triggered not by growth expectations (which remain low) but instead by increasing inflation expectations. This follows sustained central bank easing, prospects of debt-financed fiscal stimulus and potential changes to inflation-targeting policies; all of which are supportive for higher inflation. There was a ‘bear steepening’ in the U.S. nominal yield curve with long-term yields rising more than their shorter-maturity counterparts. 10-year Treasury yields retraced most of the prior quarter’s fall with a 25bps increase to 1.92%^5* over the quarter, while 30- year yields rose by 27bps to 2.39%^5*.

With fairly large movements in U.S. yields, it was not surprising to see long-duration government bonds underperform over the quarter. The Bloomberg Barclays U.S. Aggregate Treasury Over 20 Year Index returned -4.2%^6* while the long-duration European government bonds also posted negative returns, with a -2.2%^6* return for the Bloomberg Barclays Euro Aggregate Over 10-Year Index.

Looking further ahead, we are cognizant that yields may not continue on an upward trend on a sustained basis back to precrisis levels. We believe this potential ‘Japanification’ of interest rates has become harder to avoid, but crucially not inevitable. Fiscal measures as well as the potential for ‘helicopter money’ could bring back positive bond risk premia that have eluded bond markets for some time but the consequences of such aggressive actions are clearly in uncharted territory. For now, Aon remains pessimistic on fixed income because of the low yield levels but with structural bond yield drivers remaining bond-friendly we would not advocate large underweight positions.

Credit

Similar to equities, albeit to a lesser extent, credit also benefited from the low-yield environment. Greater risk appetite saw spreads fall across the board but mostly in non-investment grade areas such as high yield and emerging market debt where greater yields are on offer.

The Bloomberg Barclays Global High Yield Index returned 3.5%^6*, while the Global Credit Index slightly underperformed with a return of 1.9%^6*, both in USD-terms. Were it not for the U.S. dollar depreciation over the quarter, global credit would have generated a far paltrier return of 0.7%⁶ with a still-healthy coupon return offsetting the negative price return from higher underlying government bond yields.

We remain cautious on credit in general. We mentioned in the prior quarter our concern relating to the high proportion of BBB-rated bonds in investment-grade indices and we believe that there are areas where current spreads are not compensating investors for the risks we see in 2020. We are especially concerned about high yield credit where spreads have moved back to near-2018 lows at around 340bps⁷. Underneath the headline move in credit spreads, dispersion remains elevated (the CCC-rated bond spread over BB-rated bonds is still over 800bps⁷), which suggests a less optimistic or fragile outlook for credit. Our preferred approach is caution and selectivity in taking credit risk.

Commodities

Commodity prices continue to ebb and flow with trade and global demand developments. Rising geopolitical risks may lead to periods of high volatility

Commodity performance in 2019 was bookended by two quarters of strong returns. In both occasions, energy and particularly crude oil prices rose significantly. Commodities found support from ‘green shoots’ of economic recovery while the U.S. dollar, which typically weighs on commodities, depreciated. Looking specifically at oil, there was news that OPEC+ agreed to cut output by a greater amount than expected. Alongside better economic prospects, which are positive for oil demand, these cuts should help tighten the oil supply-demand balance. WTI crude oil prices jumped by 13.0%⁸ over the period to settle at $61.10/bbl. A strong end to the year for copper prices (up 7.5%9) could not bolster overall returns for the Industrial Metals segment which returned only 1.8%10. Agricultural commodities also benefited from price appreciation, but negative roll returns led to a lower overall quarterly performance. Gold prices continued to oscillate with growth expectations and geopolitical risks, ending the quarter up 2%11 at $1514.75 per troy ounce.

^{Appendix: Index Definitions}

^{MSCI All Country World Investable Market Index
A capitalization-weighted index of stocks representing approximately 49 developed and emerging countries, including the U.S. and Canadian markets and covering all investable large-, mid- and small-cap securities.}

^{MSCI Emerging Markets Investable Market Index
A capitalization-weighted index of stocks representing approximately 26 emerging countries, and covering all investable large-, mid- and small-cap securities.}

^{Dow Jones U.S. Total Stock Market Index
A capitalization-weighted index of stocks representing all U.S. equity eligible securities.}

^{Trade-weighted U.S. Dollar Index (DXY)
A weighted geometric mean of the value of the U.S. dollar relative to a basket of foreign currencies, typically key U.S. trade partner currencies.}

^{Bloomberg Barclays U.S. Aggregate Treasury Over 20-Year Index
An unmanaged index considered representative of fixed-income obligations with maturities over 20 years from the current date, issued by the U.S. Treasury.}

^{Bloomberg Barclays Euro Aggregate Government Over 10-Year Index
An unmanaged index considered representative of fixed-income obligations with maturities over 10 years from the current date, issued by the European government.}

^{Bloomberg Barclays Global High Yield Index
An unmanaged index considered representative of noninvestment grade fixed-income obligations issued by global corporate, specified foreign debentures, and secured notes.}

^{Bloomberg Barclays Global Credit Index
An unmanaged index considered representative of investment grade fixed-income obligations issued by global corporate, specified foreign debentures, and secured notes.}

^{S&P Goldman Sachs Commodity Index (GSCI)
A composite world-production weighted index of commodities that is considered representative of the performance of the commodity market.}

^{J.P. Morgan Global Purchasing Managers’ Index™
The PMI® is a composite index based on the diffusion indexes of five of the indexes with equal weights across over 40 countries: New Orders (seasonally adjusted), Production (seasonally adjusted), Employment (seasonally adjusted), Supplier Deliveries (seasonally adjusted), and Inventories. Diffusion indexes have the properties of leading indicators and are convenient summary measures showing the prevailing direction of change and the scope of change.}

^{1U.S. Bureau of Economic Analysis, FactSet}

^{2WM/Reuters, FactSet}

^{3U.S. Department of Labor, FactSet}

^{4FMSCI, FactSet}

^{*Past Performance is no guarantee of future results. Indices cannot be invested in directly. Unmanaged index returns assume reinvestment of any and all distributions and do not reflect our fees and expenses. Please refer to Appendix for Index Definitions and other General Disclosures.}

^{7ICE Bank of America Merrill Lynch, FactSet}

^{8Commodity Research Bureau, FactSet}

^{9London Metal Exchange, FactSet}

^{10S&P GSCI, FactSet}

^{11London Bullion Market Association, FactSet}

^{The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. Information contained herein is for informational purposes only and should not be considered investment advice.}

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