As a new decade looms ahead, let us take a peep into 2020 based on the trends observed over the last 18 months. The strong performance in bond and equity markets of 2019 have wiped away the sorry tale of investment markets just a year before. Much of this turn around can be attributed to a change in Central Bank policy, notably in the United States and Europe.
The disruption of 2018 has shown us that the road to monetary normalization is a sure way to hardship for asset markets. After 10years of world Central Bank accommodation, normalization could never be considered as just ‘watching paint dry’. In effect since 2009, Central Bank intervention has become too preponderant for it not to have an upsetting incidence on its way out. This point was clearly demonstrated in the Fall of 2018.
More of the same…
Looking into 2020, central bank accommodation is likely to be more of the same. But there are limits to this monetary approach. 2019 has revealed some of the undesired side effects of such a policy treatment. The US repo financing stress of September, as well as European bank profit warnings from negative interest rates are an indication of this collateral damage.
To counter balance these negative effects, central bankers have been pushing governments to engage in Keynesian fiscal stimulus. Japan has already announced its intention to go down this road with a 120 billion dollar package. In 2020, we could see a combination of continued monetary accommodation with fresh fiscal support in different parts of the world. Together, these interventions would join forces to juice assets markets even further, increasing the possibility of a financial ‘melt-up’.
With so much liquidity chasing too few investable assets, is this imbalance to be wished for? Not really. Ever higher asset markets funded by money printing and increased government deficits, is likely to bring back the great divide between holders of financial assets and the rest, invariably leading to social tension. This trend is already apparent with the unrest in Latin America, Europe, and the Middle East.
In addition, levitated markets require perpetual central bank intervention to sustain them. A highly valued financial system is inherently unstable and vulnerable to ‘Black Swan’ shocks. Therefore, markets could become even more monetary accommodation dependent. The persistent intervention by the Bank of Japan with its Quantitative Easing forever policy is already an example of this.
The Fixed Income world
The fundamental risks to fixed income instruments are Interest rate changes and credit default. Interest rates are unlikely to rise for the reasons already mentioned above. To add to this, monetary support gives the region implementing it a competitive advantage on the currency markets by keeping its value weak. In the current context of currency wars, it is increasingly improbable the accommodation policy of one Central bank will be modified all on its own.
Therefore, the central bank policy choices of 2019 are likely to continue into 2020. This could keep bond asset prices high and moving higher. As the returns from fixed income instruments remain meager, investors relying on the revenue stream from their capital investments will face an increasing conundrum, which could make the ‘chase for yield’ even worse next year.
Credit risk is likely to become an important investment theme for 2020. Up to now, many industrial economic models have been sustained by low interest rates, investor support and moderate growth. If the fiscal and monetary stimuli mentioned above where to be insufficient to prevent a generalized economic slowdown, low funding costs will not counterbalance losses in top line revenue for these same businesses. Investor support for weak problematic balance sheets could then disappear overnight.
Small is beautiful
Large credit funds in search of yield are desperately looking to invest. However, the fixed income instruments of quality issuers are highly sought after by every investor under the sun. Larger funds are having increasing difficulty in sourcing sufficient product in quality and quantity, under these circumstances. The result has been a tendency, on their part, to tiptoe into lower quality instruments or delve into niche markets. With an increasing probability of rising credit risk moving forward, due to a possible economic downturn, this new investment space is likely to be very uncomfortable place for the larger funds.
On the other hand, smaller credit funds have demonstrated a real competitive advantage to create value without taking on undue risk. Their size does not impose on them the sourcing constraint seen in larger funds. Therefore, their allocation can be made on their investment conviction. Their choice to acquire fixed income instruments is based on common financial sense criteria, rather than a mandate to accommodate a regulatory investment template. After all, this is how asset management should really function… Isn’t it?
Finally, the positive and negative impact of monetary and fiscal stimuli 2019/2020 requires management nimbleness to navigate through unknown consequences, in what are unchartered financial times. Only smaller funds have this flexibility still available to them.
Column by Steven Groslin, Executive Board Member and Portfolio Manager at ASG Capital