Navigating uncertainty

8 minute read

12 November 2019

By Gerald Moser, London UK, Chief Market Strategist

If 2019 was a tough year, then 2020 may be an even choppier one. So what investment strategies are worth considering to withstand the potential squalls that lie ahead?

A look back at 2019

The year has been a turbulent one for financial markets. After a strong bounce from risk assets in the early part of 2019, to recover from the growth scare that shook markets in the last three months of 2018, financial markets have been particularly volatile while trending modestly higher.

Geopolitics, rather than fundamentals, has affected markets. While manufacturing has been slowing meaningfully, akin to what has been seen in previous “soft” recessions, this seems to reflect political uncertainty delaying investment rather than a genuine broad economic slowdown.

Growth has been lacklustre but resilient, with consumers’ strength offsetting investments’ weakness. Although returns have been muted at the index level, widely diverging returns have been plentiful underneath the surface depending on the end-market (consumer versus business) and geographical exposure (domestic versus international). The dovish turn from major central banks, notably the US Federal Reserve (Fed), helped fixed income in general to enjoy a double-digit return in 2019.

The dovish turn from major central banks, notably the US Federal Reserve, helped fixed income in general to enjoy a double-digit return in 2019.

Uncertainty levels to climax in 2020

Our expectations for 2020 can be summed up in two words: “more uncertainty”. The economic cycle is getting older, a US presidential election is nearing, Brexit continues to linger and central bank heads (Bank of England and European Central Bank) and framework (Fed) are being replaced. So economic policy uncertainty is likely to rise further, after peaking at its highest level in more than 20 years in 2019.

Economic policy unvertainty index close to a 20 year high

Economic policy is a paramount parameter for investors: it sets the rules of the game. The level of taxation, the ease of doing business, the cost of borrowing, the openness of an economy and the like are factors that affect the value investors assign to a company, even though companies have no control over such factors. Economic policy has typically been relatively stable with only minor changes occurring over the years. But trade tensions, geopolitical sanctions, Brexit and unconventional monetary policy are changing those rules, or expectations of them, much more often than in the past.

And this not only affects investors, but also companies. It is increasingly difficult for companies to know where, and in which area, to invest. As highlighted in the third-quarter reporting season, companies have given little guidance to investors, blaming the “rampant uncertainty” as a reason for their relative silence.

Policy uncertainty also explains why growth in investments almost turned negative. Shifting rules make it almost impossible to take long-term decisions, which is what investments entail. The trend observed in 2019 looks set to continue in 2020, with consumption holding up economic growth while investment continues to be anaemic, except in certain areas such as technology.

Investment grwoth set to be anaemic again in 2020

Still prefer equities, but be select

With a recession still an outside chance but growth remaining lacklustre, we continue to prefer equities over fixed income investments, especially at this late stage of the cycle. But there is a caveat: index level performance is unlikely to diverge meaningfully between the two asset classes given the aforementioned geopolitical and economic backdrop. In both cases, we expect returns to be limited considering stretched valuations, low growth and increasing uncertainties.

Equity selections are likely to be an even more powerful way to add more value in 2020 than they were in 2019.

In commodities, the additional uncertainty should strengthen the benefit of allocating to gold as a diversifier asset in a portfolio context.

In the oil market, supply should outpace demand, but the unpredictable geopolitical landscape is likely to keep the oil price in a range. Other alternative assets, such as private capital and uncorrelated hedge fund strategies, are likely to become even more valuable from a portfolio perspective. With uncertainty on the rise, investing in strategies with less short-term volatility and a focus on long-term fundamentals, would make sense and add value to a portfolio.

With uncertainty on the rise, investing in strategies with less short-term volatility and a focus on long-term fundamentals, would make sense and add value to a portfolio.

Volatility as an asset class

So far, uncertainty has been approached with a negative bias in our discussion. But investment opportunities will arise from higher uncertainty. Namely, volatility is likely to increase significantly at times and should be considered as a stand-alone asset class, particularly as it is negatively correlated with risky assets.

Systematic selling of volatility is a strategy which makes sense in a portfolio context. Indeed, we believe it should be among the main alternative strategies. With uncertainty rising, the risk premia, or the compensation received from selling volatility, increases to compensate for the murkier outlook. On a more opportunistic basis, there are likely to be occasions to go long volatility to protect the portfolio when volatility levels dip, perhaps after a period of more optimistic news.

We believe (that the systematic selling of volatility) should be among the main alternative strategies.

Positioning for four investment themes

We identify four investment themes for 2020 worthy of consideration when looking at what to expect in the markets next year:

We expect the main asset classes to only return modest index gains in 2020.

Looking for yields:

We continue to like this investment theme. We expect the main asset classes to only return modest index gains in 2020 (though heightened volatility could lead to large swings during the year). So looking for sustainable yields, either in equities or fixed income – notably emerging market (EM) fixed income – as well as through alternative strategies, is a vital element of our investment strategy.

Globalisation 2.0:

This is set to be a pivotal year for the global setup in which countries interact. The US presidential election, the Brexit outcome and moves towards more or less cooperation in the European Union will affect whether the geopolitical backdrop is market friendly in the medium to longer term. This will create tactical opportunities. However, for the time being we maintain our preference for US and EM consumer exposure and mitigate exposure to trade and supply-chain exposed companies.

From monetary to fiscal policy:

Fiscal policy is unlikely to be accommodative in 2020. This investment theme is not about a strong fiscal incentive, such as that seen in the US in 2017 with a significant tax cut. However, we see potential pockets of fiscal expansion, especially linked to green initiatives in Europe. And once uncertainties surrounding the UK and US political background are lifted, we think that some areas could benefit from fiscal stimulus, through tax cuts and/or additional spending (for instance, infrastructure or environmental transition).

Time to hedge and diversify:

With heightened uncertainty, assets such as gold and volatility should be used in a portfolio context to diversify away from risky assets. Volatility could also be used to hedge opportunistically when the costs/benefits make sense. And other alternative strategies which are market neutral or fundamentally driven, or not being influenced by geopolitical events, should be considered.

Potential major risks

On the downside, we think that the biggest risk in 2020 will come from an unexpected event rather than a severe economic downturn. An event-driven sell-off, such as the EM debt crisis and the collapse of Long-Term Capital Management (1998), the plunge in energy prices and fears regarding China’s economy (Q4 2015) or the trade tensions and rates hike from the Fed (Q4 2018), could trigger a market sell-off of 10% or more without the global economy going into recession.

The trigger could be higher yields, an inflation surprise, trade tensions flaring up or additional tensions in the Middle East. In the current environment, there are more candidates than usual that could trigger market disrupting events. That said, it is worth keeping in mind that equity markets regularly see a 10% sell-off at some point in any year outside of a bear-market (when the fall can be larger).

On the positive side, a resolution of US-China trade tensions and, more broadly, market-friendly outcomes to geopolitical tensions could create upside to our base case. Also, a more decisive fiscal stimulus would lead to a better economic outcome than we currently expect.

We think that the biggest risk in 2020 will come from an unexpected event rather than a severe economic downturn.


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