Just over a year ago, in the midst of a market downturn, we wrote a note entitled, “Time to hibernate?”.  In reflecting upon this question at that time, we concluded that it was not the right moment to turn away from risk assets, on the basis that a further run into 2020 was possible if certain conditions were met.  We pointed to the following dependant factors and, a year on, we can reflect upon how events have transpired:

1. The Federal Reserve blinks and changes course from further tightening – tick.
2. China provides further stimulus - tick.
3. Trade tensions do not escalate and preferably ease - partial tick.
4. Stress in credit markets, particularly CLOs, stays in check – tick.

So, with the conditions largely met, the travails of 2018 have been quietly forgotten and we can now look back on 2019 as another banner year for risk assets.

“Excellent!” is the cry from many investors - more to go for in 2020!  That may be so, but it depends what floats your investment boat.  Those of us who still believe that price discovery in risk assets will eventually matter, do not share this confidence in the coming year.  Those who are content to ride the global central bank liquidity wave (or should we say, tsunami?) - keep on partying!

With this in mind, we lay out below some of the factors that explain the growing gap between the expectations built into asset prices and the economic reality on the ground.

In the beginning…and now

If we return to first principles, asset markets used to be all about raising capital for investment, through debt and/or equity. Today, we can argue that their primary purpose is to provide a return to yield-hungry investors, be they pension funds, other institutions or individuals. As such, central bankers and governments are obsessed about the risk of asset downturns and make every effort to prevent them.  This amounts to an extension of the “Greenspan put principle”, or, in other words, “they must not be allowed to fail”.

If you look at most IPOs today, they are either routes for business owners to capitalise, or fantasy stocks like Uber, whose investment case is based on hope and air.

Sadly, the perpetual band-aid applied to risk assets and the staggering shift by central bankers, from their traditional role of lender-of-last-resort to buyer-of-last-resort,  has driven bond yields, in particular, to very low (or even negative) levels, guaranteeing very subdued future returns from fixed income.

With regard to equities, in the absence of a slick Ponzi scheme known as US share buybacks to keep the show on the road, the harsh reality is that many core markets have been meandering aimlessly for years.  This may not be true of every stock, or indeed every index (the median stock has been pushing higher for years), but if you are a UK, European or Asian mainstream investor, your capital returns have been paltry (ignoring currency effects) for a protracted period of time.

This leads on neatly to our thoughts on the US stockmarket.  Most investors, ourselves included, have watched the sheer heights scaled by this market with something akin to bemusement and incredulity.  With this mind, we offer our thoughts on the prospects for asset markets over the coming 12 months against the following backdrop:

• Our expectations for fixed income returns have been shaped entirely by the scale of buying by central banks.  It’s easy to forget that the Bank of Japan owns over 50% of its own sovereign bond market, while the ECB come in with a more modest 35%!  It is simply astounding that we are witnessing the nationalisation of bond markets.
• For equities, prior to Trump’s tax bump, the earnings cycle had been largely about the ebb and flow of China’s activity levels.  In truth, corporate profits in the US have been flatlining for years, which is an inconvenient truth for those who obsess about the declared and, in some cases, fantasy earnings numbers.  By way of illustration, the graphic below shows US corporate profits before tax, as recorded by the Federal Reserve Bank of St. Louis (shaded areas indicate US recession).

^{Source: Economic Research, Federal Reserve Bank of St Louis}

But never mind, because, very conveniently, the leaders of corporate America will continue to borrow aggressively to fund share buybacks, with the result that we spread that lack of earnings growth across fewer shares.   (Let’s ignore the number of share options issued against this stock count, of course!)

• Unfortunately, the US Inc is now tapped out, as corporate free cashflow now amounts to 100% of share buybacks and dividends.  Whoops – are we in the season of peak share buyback?
• Finally, from a macro perspective, we don’t deviate from the, “It’s about China, stupid!” mantra and here, we fear that expectations for a repeat of the stimulus seen in 2016 will be frustrated.  The fact is that China simply does not have the luxury of re-engaging in such lavish manoeuvring.  Equally, unless and until the housing market goes into free fall, the authorities are likely to tinker, rather than roll out the bazookas.

What next?

As we stated in our thoughts a year ago, we suspected that another run for risk assets was on the cards, but that it would again be a sentiment and liquidity event, and not, as others felt, a secular economic renaissance.  Therefore, we were clear that bonds would still be valid investments and that gold would become more interesting (inflation expectations emanating from false growth expectations).

So, here we are today, looking at global central banks in full liquidity flush mode and asset prices responding to every new push of the accelerator pedal.  With this in mind, it is mystifying to see commentators on permanent recession watch, when the explanations for the extreme moves in bond yields (and US equities) centre upon monetary liquidity.  Indeed, we can indulge in many semantic debates about the path ahead, whether the Japanification of the global economy or a new reflationary/stagflationary boom, but the fact is that these debates do not matter while the liquidity taps are in full flow.

With all of that said, investors should not be in any doubt that this is a challenging environment for fundamental investors and will, at best, result in meagre investment returns moving forward or, equally likely, a far more volatile investment climate.

We will follow up shortly with our Monthly Viewpoint, which will feature a more detailed review of the year and our further thoughts on positioning for 2020.  In the meantime, may we take this opportunity to wish you all a happy and successful start to the new decade.