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November 2019

Barometer: The investment landscape in 2020

The dollar's bull run should come to an end, weighing on US equities. Emerging market debt, European equities and value stocks have the potential to outperform.


Overview: diverging fates

Luca Paolini's Outlook for 2020

Could 2020 mark the end of the bull run for the US dollar? Luca Paolini, Chief Strategist at Pictet Asset Management, looks at the factors driving the global economy.

Tread carefully. The path to strong investment returns in 2020 won't be a smooth one. Global economic growth is lacklustre and valuations for most major asset classes look stretched. Add in the risks around trade wars and the US presidential election, and we believe global equities will only manage to deliver single digit returns, while most developed market bonds will fare even worse.

Investors should expect a significant divergence in the returns of individual asset classes.

We believe 2020 will mark the end of the bull run for the US dollar – and with that the leadership of US equities. In contrast, value stocks, European equities and emerging market debt have the potential to outperform.

This view is supported by our business cycle indicators. On a global level, they suggest that growth will slow slightly next year, to around 2.7 per cent annualised – 20 basis points below potential. But this masks widely different regional prospects (see Fig. 1). Most developed economies, particularly the US, will see a slowdown in growth. We forecast that the US expansion will slow to 1.5 per cent in 2020 – the weakest in a decade, and do not rule out the possibility of a very shallow technical recession in the first half. In contrast, emerging markets such as India, Brazil and Russia should see an acceleration.

As a result, we expect that the difference in the pace of growth between developed and emerging economies will reach 340 basis points – a seven year high. The US slowdown will also erase the North American economy’s advantage over Europe, to the benefit of European equities and the euro.

Fig.  1: EM in the lead
Expected change in the pace of economic growth, 2020 compared to 2019, ppts
growth differential chart

Dark colour denotes emerging market, pale colour developed markets. Data as of 29.10.2019. Source: Pictet Asset Management, CEIC, Refinitv.

Inflation should remain contained, enabling major central banks to continue monetary stimulus, albeit it a slower pace than in recent years. We expect central banks in US, Europe, Japan and China to increase liquidity provision by a total of USD1 trillion next year – an attention-grabbing amount, but 20 percent below the average injections of the past 11 years.

Some of that shortfall may be filled by fiscal stimulus. Notably, in traditionally frugal Germany, there are signs that the political mood is slowly shifting towards increased spending. However, we believe that globally the peak in fiscal stimulus was reached at the end of 2018. Current budget projections in both China and the US do not leave room for any significant new measures.

The prospect of slowing US growth and limited scope for stimulus bode badly for the dollar, whose valuation looks very stretched. According to our models, the greenback is about 20 per cent overvalued and we expect this premium to be steadily erased over the coming five years. That in turn should benefit emerging market assets. 

The US is also one of the most expensive equity markets in our model – something that will become harder to justify against a backdrop of virtually flat corporate earnings, a slowing economy and a rate-cutting US Federal Reserve.

In contrast, we see some value in US Treasuries (especially in inflation linked paper), emerging market currencies and in value stocks – companies that trade at a lower price than implied by their dividends, earnings or sales. 

Technical indicators show that investors are already in a relatively cautious mood. In the first 10 months of 2019, investors pumped a net USD400 billion into global bonds, while withdrawing USD221 billion from equities, according to EPFR data. Equity allocations remain close to their lowest levels in a decade. While we believe the caution may well be warranted, such positioning should put a floor under the equity market over the coming months, ensuring that while returns will be modest they will mostly still be positive.


Equities: uneasy markets

It’s been a good year for equities. But stocks are likely to run out of puff next year. We see single digit returns for global stock indices, with a broadly positive run from emerging markets and European shares likely to be offset by flat or marginally negative returns for the US. Meanwhile, after underperforming for the past decade and more, value stocks are at long last likely to do better than growth [see Fig. 2].

We think that, on the whole, earnings for listed companies will be roughly flat in 2020 on a global basis, as they have been this year. That’s down to the slowing pace of global economic growth and the rolling over of net profit margins, which we believe peaked at end of 2018. Indeed, all the sources of margin growth during the past decade – stronger economies, falling cost of capital, tax cuts and weak wage growth – have started to dissipate.

Nonetheless, equites are likely to make gains thanks to a modest expansion of valuations on the back of fresh infusions of central bank stimulus. But the risks, particularly in the US, are on the downside, not least because we estimate there is a 30 per cent probability the US sinks into recession during the year – much higher than the market is pricing in. The US market also looks the most likely to see a contraction in profit margins. Meanwhile, we are  very cautious on cyclical stocks, given their high valuations.

Fig. 2: Value going cheap
MSCI World value/growth price index, average level and one and two standard deviations since 31.12.1974
outlook 2020 equities

Source: Refinitiv. Data as of 31.10.2019

The picture isn’t uniformly bleak, however. Globally, value stocks are trading at their cheapest relative to growth companies since the Nifty-50 of the 1970s (which was that era’s frenzy for megacaps) and the dotcom bubble of the late 1990s. We think that a bottoming of bond yields will give value stocks a boost next year.

A defensive bias is also warranted, particularly in the US. Cyclical stocks there have outperformed by around 100 per cent since 2009, where as in the euro zone they’ve more or less stayed in a range. Given that European growth rates are converging on the US’s, something is bound to give. UK equities are a relatively good buy – both sterling and British stocks have been dragged down by Brexit worries and we figure that once the political situation becomes clearer, the pound has scope to gain up to 10 per cent while UK shares could see up to a 20 per cent re-rating relative to the rest of the world.

Elsewhere, emerging market equities are likely to benefit from more stable growth, a weaker dollar and low valuations. Russia is particularly attractive – the government’s fiscal and monetary policies are prudent, equity valuations are exceptionally cheap and the country seems to have weathered US sanctions. Hong Kong is another market beaten down by recent events but with scope for significant recovery once conditions settle a little. Its equities trade at a 15 per cent discount to the global market, near a 16-year relative low.

For global stocks, there’s a possible saving grace in the fact that the past decade has been the most unloved bull market in history. Over the past 12 months, investors have poured much more of their capital into bonds than equities and investors still hold a very high share of assets in cash. The result is that, relative to bonds, equities are priced at levels typically only seen during recessions, which could lend them further support if bond yields remain compressed.


Fixed income and currencies: dollar's demise is EM's gain

Fixed income investors should brace themselves for a challenging year. Not least because, with a record USD14 trillion of debt yielding below zero, attractively-priced assets are in short supply.

Developed government bonds are likely to deliver losses in 2020 while corporate bonds will also be vulnerable at a time when central banks seem unwilling to provide the same amount of monetary stimulus as in  recent years.

Prospects for emerging market (EM) debt, in contrast, are bright. The main reason is the dollar. We expect the US currency’s bull run to come to an end in 2020, a development that should benefit emerging market currencies the most.

Fig. 3:  Dethroned

Trade-weighted dollar and US growth relative to the rest of the world

US dollar and GDP growth chart

Source: Refinitiv, IMF, Pictet Asset Management. Data covering period 06.11.1986 – 06.11.2019 (and estimates for period until 06.11.2027)

A faltering US economy will be the main cause for the greenback’s demise.

Although the US has outpaced other developed economies in recent years, its advantage is shrinking fast. Next year, we expect it to grow by just 1.5 per cent, its weakest since 2009.

The Fed is likely to cut interest rates once again in the early part of 2020. Also weighing on the dollar, the US has the worst twin deficit – current account gap plus public budget shortfall – among major developed and emerging economies.

EM currencies are well placed to benefit from the shift in the dollar’s fortunes, not least because we estimate they are undervalued by up to 25 per cent against the US unit. We expect this gap to begin closing in 2020; the dollar should depreciate by around 5 per cent against a basket of emerging currencies in the coming 12 months.

The prospect of currency appreciation and a favourable growth backdrop are not the only reasons for favouring EM bonds.

We see a scope for interest rates in the region to fall further as inflation ebbs. Within EM, we particularly like bonds in Mexico and Russia for valuation grounds.

Separately, investors should lighten up on corporate bonds. At a time when growth is slowing, corporate earnings and margins are likely to fall.

This could make it difficult for many companies to service the debts they have accumulated. Worringly, the number of "zombie companies" – or businesses in industrialised countries whose interest costs are in excess of their annual earnings – has hit 548, a level not seen since the global financial crisis, according to Bank of America Merrill Lynch.

Corporate bond spreads are already beginning to rise from multi-year lows hit in 2018 as credit quality deteriorates.

The US yield curve suggests that the default rate among the riskier part of corporate bonds is likely to double over the next five years to near 6 per cent.


Appendix: forecasts

Pictet Asset Management's growth and inflation forecasts, %, year-on-year

Growth and inflation forecasts

Data as of 29.10.2019. Source: Pictet Asset Management, Refinitiv Datastream.