2019 was a year when almost everything worked.
From the lows of December 2018, global equities staged a massive rally with many indices up over 20%. Long bonds enjoyed double-digit returns as yields fell across the world. Even commodities rallied, with oil, copper and gold all up more than 10%.
In modern portfolio theory, returns are related to the level of risk taken on by investors. In these models, bonds are supposed to act as a diversifier with a negative correlation to equities. They are seen as a low-risk and low-return asset.
Last year, bonds acted more like equities, providing more capital appreciation than income. In a low-interest-rate world, equities provide income and bonds provide gains. At least that was the case in 2019.
After a brief attempt to normalize interest rates in 2018 with three rate hikes, Federal Reserve Chairman Jerome Powell gave into market conditions and capitulated at the start of 2019. He was forced to move to a fully dovish stance to push off the recession fears that emerged as a result of a hostile trade war. The Fed reversed the 2018 hikes with three rate cuts, joined by central banks around the world, which cut rates more than 100 times in total.
While central banks were cutting rates, one of the more notable moves was the mid-year recovery in yields. The yield on the US 10-year Treasury fell below 1.5% in the summer, briefly inverting the yield curve.
The amount of negative-yielding debt topped $16-trillion by September. Then, the trend reversed. Global growth picked up and yields increased.
In a welcome sign of what may be a theme to come in the next year, the Swedish central bank announced an end to its negative-rate policy, even going as far to say it didn’t work.
By December, the US 10-year had recovered to 1.9%, the Japanese 10-year got back to zero after hitting -0.25% and, with that, the amount of negative-yielding debt globally declined to $12-trillion.
I was surprised by how big that number became, but it’s great news that it’s finally shrinking. Negative-yielding debt probably isn’t coming here anytime soon. That should be welcome news for all investors.
Equity markets took cues from bonds and ended the year with a similar rally, fuelled almost exclusively by multiple expansion as earnings remained flat for the year.
Traders like to use the common expression that markets ‘climb a wall of worry.’ The year began with fears around trade, yields and even impeachment. It ended with them all having been either resolved or brushed aside, resulting in all-time highs for equity markets. The wall was conquered in 2019.
As we turn the calendar to both a new year and a new decade, what does that leave for investors?
From a bond perspective, most market watchers are calling for a much quieter year ahead. Central banks are broadly signalling no changes in rates. Barring a flare up in trade tensions or an event that would cause yields to collapse, the curve should remain steep and bonds should go back to acting as the base in portfolios, not a source of capital gains. Overall duration should be shortened.
Equities are starting the year with optimism that earnings growth will return. We can’t expect another double-digit increase in multiples to drive markets higher.
What we may see is a change in leadership, either the long-awaited rotation from growth and momentum stocks to value. If global growth does emerge a more significant theme could see capital flow away from the over owned American markets to others.
An important indicator to watch will be the US dollar. A strong dollar weighs on earnings growth for most companies. As global growth picks up and money flows to other spheres of risk assets, the dollar should fade, providing some boost to earnings.
The prediction that feels the most certain is the expectation that volatility will return to most markets. US politics have come to dominate investing globally. Heading into a very contentious presidential election should make for many market-moving events.
The expectation is that the status quo will continue for another four years, given the strength of the US economy. Any change in that belief could rock markets.
If there’s one thing to say about the current environment, it’s that there seem to be more questions than answers. Things have been positive for the last year, but uncertainty continues to linger.
Many investors, including professional advisors, are asking us about how to position their portfolios for success. Here’s a sample of what we’ve been hearing and our thoughts on what to do:
Is it time to add alternatives to provide returns that are less tied to traditional markets?
Yes! We think alternative asset classes are tools that all investors should consider including in their portfolios. Broadly speaking, alternatives offer lower correlation to traditional markets and provide diversified, additional return streams. We especially like alternatives as a way to gain income in a world of suppressed yields. Yes, rates have rebounded from the lows of last year, but they remain low. Bonds likely won’t be providing the income foundation that their reputation suggests they should. Options-writing strategies are a favourite of ours for adding income while reducing overall portfolio risk.
If volatility returns how can we earn a stable return?
It can be easier than you think. The aforementioned options-writing strategy is a simple way to add a more stabilized source of return in the form of consistent, diversifying income. Another choice would be through the use of structured products, which can provide strong downside protection while churning out a consistent yield. Structured notes can be complex and time-consuming, so it may be easier and more convenient to access them through a portfolio which replicates the outcome. Lastly, a tactical asset allocation fund can also help provide more stable returns through periods of volatility, especially if it’s rules-based and can move quickly in response to the shifting market environment.
How do we position our fixed income portfolios if yields have finally begun to recover?
With a recovery in yields, its especially important to take an active approach to your fixed-income allocations. Passive bond indices do not capture a large enough portion of the fixed-income universe to be truly diversifying. Nor do they have the ability to shift stances with respect to the market. Investors are unlikely to get paid enough to take long duration credit and rate risks, and should stick to shorter duration and a more defensive credit position. If tax efficiency is a primary concern, consider the advantages of a corporate class structure for your core bond position.
We’re in the later stages of the market cycle with what’s sure to be a closely followed presidential election on the horizon. There are positive signs for continued gains, although we suspect we won’t see a repeat of 2019 and will see a change in leadership.
A cautious optimism for the new year feels appropriate, but investors will need to be positioned accordingly and not be caught taking on more risk by sticking with last year’s winners.
I know, it feels good to have big gainers like Apple and Amazon on your books, but the winners are often crowded trades, which carry some risk. Paring back a bit is wise. With RRSP season around the corner, now is the time to tweak portfolios.
— Greg Taylor, CFA is the Chief Investment Officer of Purpose Investments
All data sourced from Bloomberg unless otherwise noted.
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