Exhibit 1: 2019 – A banner year for equities
In our view investors have proved a little over eager to jump on the positive narrative of declining political risk in recent months. This has led to a sharp reduction in the risk premium for both global equities and credit markets. The situation is almost the reverse of 12 months ago when fears of a slowdown and overly tight monetary policy swept through markets. Then, at least cautious optimism seemed warranted, given the consistent track record of central banks in easing policy at the first sign of a slowdown. Now, market psychology appears to have swung too far towards optimism, as investors discount much-improved prospects for 2020 despite rather weak incoming economic data.
We certainly cannot take issue with the idea that there should be a positive response to the resolution of the US-China trade conflict, Brexit uncertainty or synchronised monetary policy easing. Not only have we previously highlighted that these fears were misplaced but each factor has steadily moved in investors’ favour during the past 12 months. Starting from an oversold position at the end of 2018, 2019 ultimately proved to be a banner year for global equities (Exhibit 1).
Exhibit 2: US high yield spread to risk-free rate – trading at cycle lows
However, the sheer extent of this rebound in global markets and the resolution of practically all of the commonly discussed risks raises the possibility that it may be the fear of missing out that is now driving markets. We believe that in addition to the known risks, it is important the ‘unknown unknowns’ should also carry a risk premium. Most recently this was demonstrated, for a 48-hour period in the first few days of January at least, by renewed tensions in the Middle East holding markets hostage.
It has become a popular view that passive investment is the only option. However, at various times during this extended economic cycle there have been opportunities to tactically adjust risk exposures where a gap has arisen between market valuations and economic reality. Passive investment certainly has a cost benefit but can also imply a loss of control over an investor’s risk/reward ratio if it means remaining permanently fully invested, regardless of equity valuations.