"Prove it." We expect to be repeating that phrase often in the early days of this new decade, the Twenties. After two years of repeated spikes in volatility, markets can finally, it seems, take a breather with two key sources of risk off the table: trade war and Brexit. Or at least, that's how the media story goes.
But are these risks off the table? We certainly expect the U.S./China "Phase 1" trade deal to be signed on January 15, as announced. But even after the agreement was confirmed by both sides, signs of a strategic geopolitical struggle have continued, manifested by fights over sensitive technology exports and continued jabs about Hong Kong and Xinjiang. As for Brexit, Boris Johnson's Withdrawal Agreement is set to be implemented by January 31, 2020, giving the U.K. and the EU only 11 months to draft the rules of their future relationship. We believe the "crashing out" storyline will continue throughout the year.
Pushing optimism to the edgeWe are willing to concede at this point, however, that the risks are reduced enough for markets to look through, if only due to the behavior of risk assets in Q4 of 2019. The S&P 500 Index rose at a 60% annualized rate since October 2 and at a greater than 100% annualized rate from December 3 to year-end.
What is not quite so clear-cut to us is the idea that the global economy is set to return to a growth trajectory that will make equity valuations less demanding. After failing to produce positive earnings growth in the third quarter, large-cap U.S. companies may see similarly lackluster results again in the fourth quarter. This would push both the forward price-earnings multiple and the price-to-sales multiple of the S&P 500 back to levels only exceeded at year-end 2017 in the post-global-financial-crisis era — which is to say, really expensive. Equities are not alone here: High-yield valuations, as measured by credit spreads per unit of leverage on corporate sector balance sheets, are also in the lowest decile of their historical range. This means investors are being paid next to nothing to own default risk.
Previous slowdowns ended with stimulusIt is important to remember that this current global growth slowdown was driven by a retrenchment in capital expenditures in response to policy uncertainty and low capacity utilization that had led to a buildup in inventory levels. While some of that inventory has now been worked off, capacity utilization is still well off the highs seen in 2014 and 2018. The current global macroeconomic environment critically lacks a catalyst for recovery that was present in the past two mid-cycle slowdowns in 2011/2012 and 2014/2015. Following the first of these — the European sovereign credit crisis — the world's major central banks engaged in coordinated and large-scale quantitative easing culminating in Mario Draghi's famous "whatever it takes" speech in July 2012. And in the second case, following a collapse in commodity prices in 2016, China responded aggressively with a stimulus package aimed at property and infrastructure spending at a time when China was consuming close to half of all the world's major industrial commodities.
Risk assets appear overvalued entering 2020
- Stocks and high-yield bonds rallied in Q4, but without the hoped-for earnings recovery.
- Stimulus efforts like those that solved slowdowns in 2011 and 2015 are not on the horizon.
- We favor reducing risk as we look for proof that earnings can support asset valuations.
No rescue this timeAt this juncture, we find it hard to believe that incremental purchases of U.S. agricultural goods by China in exchange for some partial tariff relief and a very timid round of incremental central bank balance sheet expansion will be enough to jump-start a third growth spurt in this decade-plus expansion. We are reminded of comments made in March 2000 by Rick Pitino, who at the time was head coach of the NBA's Boston Celtics. After the team started the season 23–34 (and after a 19–31 record in the previous lockout-shortened season), he famously said to the media, "Larry Bird is not walking through that door, fans." The obvious implication was that no magical panacea was ready to come to the rescue and fix everything. Similarly, while we cannot completely rule out the possibility that the reduction of risk in Q4 will, in and of itself, unleash a wave of corporate animal spirits, it strikes us as unlikely.
Without proof of profits, reduce portfolio riskIf the 4Q19 "melt-up" continues without the corroborating proof of a bounce in the global economy, we'll be tempted to increase the size of our underweight to risk assets. At the same time, we have a healthy amount of respect for the combination of risk asset momentum combined with a friendly, or at least neutral, Fed. We remember what that combination was like in 1999 and 2006, experiences which taught us a lesson that such environments can last for longer than you would think.
As the final days of 2019 drew to a close, the sentiment indicators that we follow were pointing to signs of froth. So with implied and realized volatility as low as they are across the landscape of risk assets, markets appear to be priced for perfection to start this new decade. We think a prudent amount of caution is warranted while we keep a close eye on the incoming high-frequency macro data over the next month or two.
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