KJ Harrison’s Investment Outlook for 2020
Investors entered 2020 riding a wave of relief. The concerns that garnered headlines through much of 2019 – from the threat of a global recession and the impact of the U.S.-China trade war to the inversion of the bond yield curve – seemed to dissipate by the end of the year, and markets responded by barreling through to new all-time highs. Yet a closer look at last year suggests that markets were in many ways making up for lost ground, and several of the macroeconomic risks that were in play at the beginning of 2019 remain potential headwinds in 2020.
At KJ Harrison, our No. 1 priority is the preservation of our clients’ capital, based on a customized approach to financial management. Our commitment to capital preservation and our reading of macroeconomic factors led us to raise our cash levels near the end of 2018 and adopt a more generally conservative stance – which, as it turned out, helped us largely sidestep the market correction of Q4 2018, when benchmarks lost an average of 20%. This conservatism carried through into the first half of 2019, and contributed to our funds’ generally lagging behind some of the broad indices. However, it’s important to see those returns in the context of the late-2018 correction; much of 2019’s gains were simply a case of making back what was lost and over the last two years our funds participated in the upside while experiencing significantly less downside volatility.
In 2020, some of those risks have eased; others, however, remain in play. The largest might be that we are now entering the 11th year of an expansionary cycle – the longest in history. Given that no cycle lasts forever (or at least none has yet!), this reality weighs heavily on our approach to capital allocation in 2020. Yet while our general stance remains conservative, we also see opportunities for investors. Again, these stem from our reading of macroeconomic factors, but also from what we see as secular areas of interest based on industry, demographic, technological and other trends.
In this outlook, we explore further the macroeconomic landscape we expect will inform market performance and therefore our capital allocation strategies, as well as those secular areas of interest that may present opportunities for our clients in 2020 and beyond.
- Looking back, looking forward: defining the macroeconomic environment
When attempting to identify the forces that will impact markets in 2020, it’s useful to look back. In the context of last year’s equity and bond rally, one really needs to go back to the fourth quarter of 2018 and the market correction that upended what had been until then a relatively strong year. The salient point is that the correction was driven almost exclusively by U.S. Federal Reserve policy.
We cannot overstate how radical the Fed’s regime of rate hikes was in 2018. Consider the history: Ben Bernanke as Fed chair took rates down to zero during the financial crisis of 2008/2009, and they stayed at zero for five years. In each of 2015 and 2016 under his successor, Janet Yellen, the Fed raised rates by 25 basis points; in 2017, she raised by a total of 75 basis points. In 2018, under new chair Jerome Powell, the U.S. central bank hiked rates four times and began to wind down its quantitative easing (bond-buying) program. This would have profound consequences for the global economy and for markets.
Hiking into a slowdown
This monetary tightening occurred just as economic fundamentals in the U.S. and elsewhere were deteriorating and fears of a global recession were mounting. Concern and uncertainty over the escalating U.S.-China trade war were mounting. Between early 2018 and early 2019, the manufacturing purchasing managers’ index – a forward indicator of economic activity in the sector – dropped from higher than 60 to 47; any number below 50 indicates a contraction. Although manufacturing comprises only about 10% of U.S. GDP, it figures larger as a predictor of general economic health, and the sector appeared to be in a recession by the first quarter of 2019.
For investors, another key area of concern was U.S. corporate earnings. In 2018, U.S. tax cuts helped fuel earnings growth among S&P 500 companies of more than 25%, but in 2019 it fell into the single digits. That effectively meant the only way for equity prices to climb was through higher valuations. Given that 2019 marked the tenth year of an economic expansion, lower earnings growth presented a substantive headwind to equity returns.
Meanwhile, in U.S. fixed income markets, rates for long government bonds briefly went lower than rates for short-duration bonds – a yield curve inversion. Every recession over the past 50 years has been preceded by a yield curve inversion, and last summer’s inversion was a clear yellow signal for a downturn.
Globally, the evolving economic picture was even more gloomy. Growth in China was slowing, as it was in Europe and Japan. In an attempt to stimulate their economies, policymakers increasingly adopted negative interest rate policies. In fact, at peak in 2018, US$17 trillion worth of sovereign debt – a third of the total – had a negative yield. Among other factors, the spread between global and U.S. rates helped support an exceptionally strong U.S. dollar, which not only raised the debt servicing costs of many emerging market countries, but also bit into earnings for U.S. corporations. (Half of S&P 500 company earnings are generated overseas.)
The Fed pivots
It is now clear that, in raising rates through 2018, the Fed had committed a policy error, and in July 2019 it began one of the more remarkable pivots in central bank history. Between July 31 and October 31, it lowered rates three times and reinstituted its quantitative easing program.
The renewal of QE was one of the key factors in the market resurgence of late 2019. Through its bond-buying program – mimicked by other central banks in Europe and Japan – the Fed effectively injected trillions of dollars into the economy. That money has to go somewhere, and the gush of liquidity helped to boost asset prices, including equities. Combined with lower rates globally – 60% of central banks have cut rates over the past year – the Fed has contributed to the most synchronized easing cycle in a decade.
In this context, the equity rally of late 2019 was hardly surprising. With bond yields low – a result both of low rates and increased money supply – investors allocated more and more capital to stocks. While corporate earnings growth stagnated, equity prices rose by 25% to 30%. In the wake of that rally, valuations soared. At the end of 2018, forward price/earnings of the S&P 500 was 14; today it stands at 18. Given that the long-term average p/e of the S&P 500 is 16.2, current stock prices might not look extreme, but they do look expensive.
Consumer fundamentals offset pessimism
While the Fed’s reversal on rates and QE was certainly timely, it was not the only factor in helping allay recession fears in 2019. The U.S. consumer – whose spending accounts for 70% of GDP – also played a big part, as historically high employment rates and a generally robust labour market boosted confidence and spending stayed resilient. The American consumer was also given a hand from lower rates, which not only help Wall Street but Main Street, too. The 30-year mortgage rate dropped to 3.5% from 5%, saving the average American mortgage-holder about US$4,000 a year.
Lower borrowing costs in turn supported the U.S. housing market, which directly and indirectly comprises 20% of the U.S. economy. Housing starts in 2019 rose from 1.3 million in January to 1.6 million in December – the highest number since 2007. In our view, the knock-on effects of improvement in the housing sector were a large and underappreciated driver of economic and market performance.
Implications for asset allocation in 2020
The macroeconomic landscape that has evolved over the past several months has important implications for asset allocation as we look forward.
On monetary policy, we believe the Fed will likely stay on the sidelines at least until November, and probably for the rest of 2020. In an election year – which in itself could spark higher volatility and uncertainty in markets – the Fed will be reluctant to make any significant moves. While some fundamentals in the U.S. economy should continue to be robust, GDP growth remains on the low end of its historical range and inflation expectations are subdued. Those factors support a continuing low-rate environment and correspondingly inflated asset valuations.
Meanwhile, investor unease over the U.S.-China trade war has eased substantially, thanks to the signing of a Phase 1 agreement that saw some tariff reductions and implementation delays. We do not expect a Phase 2 deal this year, or perhaps ever, but at the very least it appears that escalation in trade tensions between the world’s two largest economies has been put on pause.
Still, risks remain. One is suggested by the inversion of the yield curve last summer. While it is not a perfect predictor – the curve has inverted twice before without a recession – we should remember that its timing is neither consistent nor well understood. Recessions can occur within weeks, months or years of an inversion. Particularly in this unique period, characterized by a long expansion supported by accommodative monetary policy, we cannot begin to guess whether or when a recession will follow the latest inversion. On balance, however, our view is that the likelihood of an imminent recession is low.
Given those factors, we remain conservative in our approach to asset allocation, but in the past several months we have reduced our cash positions and become more invested across mandates. In doing so, our goal is to stick to the KJ Harrison playbook. In times of uncertainty, robust diversification is essential. So, too, is our commitment to investing only in “best of breed” companies, and ideally those that pay high and growing dividends.
Of course, there is always the risk of a so-called black swan event – something that is by definition unpredictable. The recent coronavirus epidemic might prove to be one. It does not, however, change our basic approach, and our goal is to deploy “barbell” strategies that hedge against risk while continuing to generate alpha. For example, the uncertainty created by the coronavirus outbreak suggests that increasing our defensive positions is prudent; on the other end of the “barbell,” however, opportunities may arise in the form of oversold stocks in companies that may end up being only marginally affected by the epidemic, or might in fact see some benefit from it. In short, our approach to tail risk is to position portfolios to limit downside exposure while actively seeking opportunities.
- Sectoral outlooks and secular themes for 2020 and beyond
Low rates and a flattened yield curve have presented significant challenges for banks globally. Since banks borrow at the short end of the curve and lend at the long end, the shape of the yield curve has a direct impact on profitability; an inversion is particularly problematic, as it may mean banks are lending at lower rates than they are paying. Globally, short-term rates at or below zero present a more enduring issue; in Europe in particular, depositors are being charged money to leave cash with banks. Meanwhile, suppressed rates at the long end of the curve push down the level at which banks can afford to borrow. The net result in 2019 was that banks underperformed the broader market – even in Canada, which is something of a rarity. Our view is that the current accommodative rate environment will continue to present headwinds for financials, even while economic fundamentals for consumer spending and housing remain strong.
Following a very challenging Q4 2018, credit markets rebounded in Q1 2019 and again in Q4 2019 as credit spreads (the rate differential between corporate and government bonds) fell. In 2020, however, already low credit spreads present a headwind for returns, limiting opportunities in the absence of a market pullback.
There are several bullish indicators. The so-called “central bank put” – investors’ belief that policymakers will continue to lower rates should a crisis occur – remains in play. Some macroeconomic concerns, such as the U.S.-China trade war and uncertainty over Brexit, appear to be receding. Corporate bond supply looks like it will contract from 2019 – a tailwind for prices. Bond demand is strong, as capital inflows into investment-grade funds are at or near an all-time high.
On the downside, spreads are tight, and the credit quality of the fixed income market, in general, has deteriorated. Debt to EBITDA (earnings before interest, taxes, depreciation and amortization) in the corporate bond market has soared over the past 10 years; the market dominance of high-quality bonds has shifted to lower-quality issues. Companies are more leveraged, and if recession hits, many will not have the capacity to service their debt effectively. Meanwhile, last year’s yield curve inversion is an obvious negative.
Still, we are cautiously long on corporate credit, with an emphasis on liquidity and quality of investments. A pullback in credit markets in the short term seems unlikely, so we are focusing on high-quality, short-maturity and very low volatility with a view to preservation of capital.
In the United States over the past decade, there has been a structural deficit in homebuilding, as the number of new household formations has lagged behind the replacement rate. Yet the trend might now have reached an inflection point. Driven by robust consumer confidence and low rates, there is now consistently strong demand for homes, reflected in resurgent housing starts. As the post-recession period of underbuilding seems to be ending, stock prices for U.S. homebuilders have outperformed the overall market, but we remain constructive on the sector, and are pursuing opportunities in apartment real estate income trusts (REITs) and building suppliers, for example.
In Canada, apartment REITs look particularly appealing, given demographic trends and geographical realities. The Greater Toronto Area, for example, is among the fastest-growing regions in the world in terms of population and is experiencing massive net immigration. Homeownership might well be out of reach for many of those newcomers, and many will rent out of necessity. Meanwhile, regulatory caps on new building and the limitations imposed by the provincial greenbelt policy mean that there are significant barriers to new rental units. For these reasons, REITs with significant exposure to the existing stock of rental housing in the GTA could present compelling investment opportunities.
As valuations of high-profile technology stocks have soared, many investors think back with skepticism to the dot-com bubble of the late ‘90s. We are not among those. Today, many high-quality tech stocks, even with their high valuations, occupy a very advantageous economic position, boast strong profits and generate positive cash flow – unlike their predecessors of two decades ago.
Inarguably, some well-known tech names funded by private equity and venture capital are or have been in bubble territory. WeWork, whose long-awaited IPO collapsed under the weight of poor governance and excessive debt, might be the poster child of this group. Yet the bursting of these bubble unicorns could be good news for investors in public markets. For one thing, it means profitable public companies face less competition from (unprofitable) private ones; for another, failed or undersold IPOs could present buying opportunities.
Two areas within the tech sector merit particular focus. One is electric vehicles (EV). We expect EV will be a larger part of the car-buying cycle, owing to government regulation and subsidies that are lowering prices, and to falling battery prices that are making EVs more affordable. The other is artificial intelligence, which is making the leap from machine-vision (think self-driving cars) to natural language AI (think phone calls from machines that are indistinguishable from human beings). Though we expect AI to develop into a concrete opportunity for investors over decades rather than months or years, the potential applications for natural language AI in customer service and sales are compelling, and could bear fruit in the shorter term.
The Millennial generation is the largest demographic cohort in North America, and with an average age of 30 is now entering peak earning and spending years. Yet what Millennials will spend on requires a different approach for investors to capitalize on. The defining psychographic characteristic of Millennials is that they value experiences over possessions. For them, owning the most stylish clothes or flashiest car is less important than having (and sharing via social media) one-of-a-kind experiences. We believe that public companies that offer those experiences are poised to capitalize – for example, tour and resort operators, sports franchises, ticket companies and event venues.
One industry enjoying substantial growth is esports – basically, video games as spectator sports. Esports events are attracting young audiences – highly desirable to marketers – whose size often rivals those attracted by traditional sports. While investing in esports teams and operators is currently challenging, given limited opportunities and the youth of companies in the sector, established and large video game developers also stand to reap the benefits of what could well become the equivalent of the Super Bowl in the not-too-distant future.
For Canada’s fledgling cannabis industry, nothing went right in the public markets in 2019. After the initial fervour leading up to the legalization of recreational cannabis, the reality of retail bottlenecks, poor quality and, in some cases, corporate mismanagement bit investors hard, as inflated cannabis company valuations came crashing back down to earth. Today, our view is that many Canada-focused cannabis stocks remain overvalued and will be subject to more volatility to the downside. We do believe the market and some companies have significant potential, but for now, we are adopting a wait-and-see approach as the smoke clears. The U.S. cannabis market, however, may present more exciting opportunities for investors, though the regulatory landscape is complicated, and we are actively researching the sector.