What a difference a year makes. When we sat down to write down the risks and opportunities for 2019, we were amid a sharp market drawdown. The US earnings season had raised concerns about an earnings recession, the market was worried the Fed was too hawkish and the trade war had injected fear into markets. Fast forward to today and earnings have been resilient, the Fed is on hold and the trade war, which did escalate during 2019, looks to be coming towards an end. Equity markets have delivered returns well into the double digits with S&P 500, MSCI World and S&P/NZX 50 all reaching historic highs.
Now, as we approach the new year with stock indices at a higher point, we also need to recognise that valuations are also at a higher point. The forward P/E ratio of the New Zealand market has increased from 18 times to 22 times 12 months forward earnings so far in 2019, and the global market has gone from 14 to 18 times. This is expensive in absolute terms, but when compared to bonds a healthy equity risk premium still exists.
We are also seeing early evidence of a positive uptick in global activity. While it is far from a synchronised global upturn, it is encouraging. We do not foresee aggressive interest rate cuts supercharging equity returns in 2020 but monetary policy should remain supportive. However, there are many events which can tilt the pendulum. Here are the top 10 for 2020:
1. Will monetary policy find a friend?
Global economic policy uncertainty remains high. Will stimulating growth fall to fiscal policy in 2020 as monetary policy runs out of ammunition? Japan recently announced a fiscal stimulus package, equivalent to roughly 2% of GDP. Speculation continues that Germany may do the same to stave off recession. China, however, is likely to continue prioritising a reduction in debt/GDP.
Note: Economic Policy Uncertainty (EPU) measures the frequency of news articles that contain words related to economy, policy and uncertainty. The Global Economic Policy Uncertainty Index is a GDP-weighted average of national EPU indices for 20 countries: Australia, Brazil, Canada, Chile, China, France, Germany, Greece, India, Ireland, Italy, Japan, Mexico, the Netherlands, Russia, South Korea, Spain, Sweden, the United Kingdom, and the United States. Source: Baker, Bloom & Davis. Bloomberg.
2. US election 2020 - Warren breaks up big tech:
If President Trump is the epitome of the President who is focussed on increasing the S&P 500, then Elizabeth Warren is the antithesis. Warren has made no secret of her desires to go after big tech. This could be a problem as the FAANG’s alone (Facebook, Amazon, Apple, Netflix and Google, ie Alphabet) contribute over 14% of the S&P 500’s earnings and have consistently delivered high earnings and revenue growth to investors. While Warren’s odds of getting the presidential nomination has diminished in recent polls, some pundits give her a real chance of snaring the nomination.
Source: Real Clear Politics. Bloomberg
3. Inflation inconveniently returns:
Supply-driven inflation poses a risk to equity markets if it drives a hawkish turn from global central banks at a time where demand remains weak. Global capacity pressures have increased in recent years and supply shocks have a greater impact in this environment. Swine fever in China, for example, has pushed global meat prices almost 30% higher this year. Weather-related supply disruptions are happening at a higher frequency and manufacturing supply chains are changing due to increasing costs of production and trade disputes.
In NZ, capacity pressure is most obvious in the construction sector and labour market. Minimum and living wage increases are adding further pressure to wage inflation. If inflation goes above 2% and inflation expectations follow, the market will likely start to contemplate the RBNZ shifting to a tightening bias.
Source: Bloomberg.
4. Trade developments:
The US-China trade war has weighed on global activity but a “phase one” deal between the US and China has now been signed and tariffs reduced. Will the de-escalation continue as Trump shifts his focus to supporting the US economy ahead of his 2020 re-election bid? Alternatively, will Trump harden his stance on China again or possibly turn his focus to Europe.
Source: Reserve Bank of New Zealand.
5. China deleveraging goes too far:
Chinese policy maker commitment to deleveraging the economy (reducing debt as a proportion of GDP) has been unfazed by the trade war and associated slower rates of Chinese economic activity. What if they overdo it?
Note: Goldman Sachs activity indicator and Bloomberg credit impulse estimate. Source: Bloomberg.
6. Unconventional monetary policy heads down under:
Recent weakness in Australian data has increased the probability of the RBA implementing unconventional monetary policy. The NZ economy is in better shape and has a larger amount of conventional monetary policy available. Downside risks to the outlook in both countries remain, however, and unconventional policy stimulus can’t be completely ruled out in 2020.
Source: Bloomberg.
7. NZ housing hubbub:
Are house prices about to accelerate again? Mortgage rates have reached record lows and recent changes to capital requirements have increased banks’ incentive to lend for housing. But NZ houses are expensive with the median house price almost 7 times median gross household income. Will poor affordability combine with lower rates of immigration and increased housing supply to cap house price gains? 
Source: Reserve Bank of New Zealand, interest.co.nz.
8. NZ political fragmentation:
Could changing demographics manifest themselves in greater levels of political fragmentation and NZ following the global trend towards populism? Large amounts of young immigrants in recent years means the NZ population is no longer strictly “ageing” with the 20 to 39-year olds outnumbering those between 40 and 59. These two groups face different challenges and have different preferences. For example, housing affordability and climate change is a much more important issue for younger age groups.
Source: Statistics New Zealand.
9. Private Equity Peaks:
There are few assets globally which have benefitted more from the low rate environment than private equity. The flood of money to this sector has seen valuation multiples, within US Private Equity at least, expand above the valuations of public equity markets. The high valuation levels have made it difficult to unload private equity holdings onto public markets. So far in 2019 we have seen twice the amount initial public offerings (IPOs) withdrawn in the US than in 2018, including the high profile failed IPO of WeWork and its subsequent write-down.
Source: Pitchbook. McKinsey.
10. Value finally turns the tables on growth:
2019 (to date) has been another torrid year for the disciples of value investing with the MSCI World Value index returning a little over half the MSCI World Growth index. These indices, first constructed in 1974, now have growth outperforming value over the period to date. We see secular forces, such as the move away from bricks and mortar retailing and growth in mega tech continuing to create a tough environment for value stocks. There are some potential tailwinds that could favour value, the largest of which is higher interest rates and the risk of regulation to the large technology companies. Can 2020 be the turning point for value?
Source: Bloomberg, MSCI.
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