After a stellar 2019, investors are naturally asking themselves whether the strong performance can continue in 2020 or not. Trying to answer this is difficult as different perspectives provide different answers.
Our approach to this challenge is to start with a historical, quantitative lens before trying to figure out why the current situation might deviate from historical norms. From a quantitative perspective (or “Outside View”, for those familiar with the approach explained by Tetlock and Gardner in “Superforecasting: The Art and Science of Prediction”), our equity and bond market risk model is not flashing amber.
This suggests two things: one, the probability of outsized moves is relatively low, and, two, there is continued upside for both asset classes in the coming six months, with history suggesting that equities should continue to outperform bonds and gold.
Less diversity equals more volatility
Countering this to some extent are signs that the market diversity has fallen. What this means is that market behaviour is being dominated by a certain viewpoint or investor type. When this happens, the probability of a short-term reversal in equities is higher than normal.
This view is reinforced by the fact that many equity markets look overbought from a technical perspective, including those in the US, China and, to a lesser extent, the euro area. On balance, this suggests that we should not be surprised if equity markets experience a pullback of around 5-7 per cent in the coming weeks.
A different set of outcomes
However, if we extend our analysis to the “Inside View”, or a qualitative assessment of the outlook, we become more optimistic. Global growth is expected to stabilise, led by the emerging markets and the euro area. Meanwhile, after a challenging 2019, corporate earnings are likely to accelerate.
Current expectations are for just under 10 per cent global earnings growth and the risks to this outlook appear to be diminishing somewhat. Finally, monetary and fiscal policies are being eased, which should not only stabilise growth but, as importantly, reduce the downside risks to the economic outlook, encouraging risk appetite.
Watch out for euro banks
At the regional level, we believe the outlook for euro area banks, which are important to the region’s stock market, is improving as the European Central Bank has reduced the impact of negative interest rates on their earnings and an economic recovery should boost credit demand. With bank equities still very cheap, we see significant upside for this sector, which usually correlates with the outperformance of the regional market overall.
Meanwhile, in the US, while much of the commentary has been focused on the mutual fund outflows from US equities, this is being more than offset, by a wide margin, by companies buying back their own shares. We see this continuing in 2020.
Still pushing higher
Therefore, overall, we expect equities to perform well this year, especially in the first-half. Of course, this should not be viewed as an “all-or-nothing bet”. Any investment decision is best viewed from a probabilistic lens, which then results in approaching investments with a diversified asset allocation framework, and tweaking allocations depending on your own sense of the different perspectives.
While we continue to believe equities will do well in 2020, especially in the first-half of the year, there are good reasons why volatility will rise in the coming 12-24 months, especially with geopolitical risks, including the US presidential elections, on the horizon. Therefore, we would continue to have a preference for equity exposure, but this should be balanced with exposures to bonds and gold.
While bond yields remain relatively low, we do not think they will spike significantly (ie, push prices sharply lower) and as such we expect this asset class to generate positive returns in 2020. For gold, we remain positive, but we believe the markets got ahead of themselves in January, hitting our full-year target on January 8.
Therefore, we would look for dips to add exposure here, rather than chasing the market higher.