Volatility back on the table for 2020 following benign 2019

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MEDIA RELEASE: Investors shouldn’t be lulled into a false sense of security following a benign 2019, with volatility and risk premia likely to reassert themselves in 2020, says Simon Doyle, head of multi-asset at Schroder Investment Management Australia.

“Central bank support, most notably the US Federal Reserve, made 2019 a better year than it had any right to be.  This pushed the many geopolitical concerns – including tariffs, Hong Kong, Brexit, US presidential impeachment – into the background.  

“A key lesson for investors is that, in the absence of recession, liquidity trumps growth and, as long as interest rates remain low, markets will be supported.  Furthermore, 2019 has shown us that asset prices are systemically important and policy makers (especially central bankers) are not yet ready to withdraw or materially temper their support.”

However, Mr Doyle said, 2020 is unlikely to be a repeat of 2019.

“While we do not expect a recession as a base case in 2020, we do expect volatility to pick up and, as a result, asset allocation will reassert itself as an important driver of active returns. 

“Geopolitics will feature heavily and, when set against optimistic asset pricing, this may test investor resolve. Capital preservation will need to be balanced against opportunistic buying opportunities.

“Valuations across almost all asset classes and markets range from “full” (such as Australian equities) to “demanding” (such as US equities). Sovereign bond yields have fallen markedly in key markets and across the yield curve, and credit spreads have also narrowed.”

Equity markets 

Within equities, Mr Doyle said that the outlook for Australia, Japan and selected emerging markets look the most attractive.

“While we remain cautious as valuations remain problematic, two major geopolitical risks – the US-China trade war, and the uncertainty of Brexit – have improved on the margin and markets are awash with central bank liquidity, providing an opportunity to add back to risk.

“Within equities, our preferred markets are Australia and Japan, based on expected returns and relative valuation support. Given the improvement in trade and a potentially weakening USD, we have also increased our allocation to emerging markets. 

“Australian equities are trading on full, but not extreme valuation metrics and, with high dividend yields still on offer, will likely benefit from investors seeking income against a backdrop of record low official interest rates, deposit rates and investment rates.  The market is therefore well supported.

“Japan has been a medium term underperformer and is still trading at  OK valuations, so we also see some good opportunities there.

“Emerging market equities, while still inherently riskier than their developed market counterparts, also offer reasonable valuations and potential outperformance should the US dollar weaken.  We continue to prefer value over growth,” Mr Doyle said.

Fixed income

Notwithstanding low yields, Mr Doyle says he continues to believe sovereign bonds (and duration) will be effective hedges against recession.

“Investors should continue to hold sovereign bonds as a hedge, even though yields are very low and the rewards in a steady state environment are likely to be modest. Investors should also consider their overall asset allocation in this low interest rate environment.

“While we remain attracted to duration for its return potential if and when downside risks to growth unfold, we believe yields could back up from here if manufacturing and global trade improve over the short-term. That said, the added uncertainty of the Corona virus means some hedging of bets here is appropriate.

“Credit remains expensive overall, and while spreads could remain narrow given ample liquidity the scope for spreads to narrow further is limited. We continue to search for relative value within the asset class and at the margin see Asian credit as offering better spreads and some diversification.”

Mr Doyle said that as a general rule, investors should be grateful, but not fooled by the strong outcomes across the board in 2019.

“Historically some of the best years for investors are very late in the investment cycle (1999, for example). We would encourage investors to remember the much more challenging environment of 2018. The bull market didn’t end in 2018, but investors did start to price in uncertainty and demand a premium for taking risk in their portfolios. This may provide a better roadmap for the year ahead,” he said.