By the Cross Asset and ETF Research Team at Lyxor Asset Management.
What’s going to move equity markets in 2020?
Another year has flown by, and what a year it’s been for equity markets. After a strong start to 2019, performance was affected again by political uncertainties around the world. Debates continue on whether we will see the fourth mini-cycle since 2009, or a mild recession in the US.
Looking ahead to 2020, the key market drivers will be any de-escalation of the US-China tariff war, Brexit progress, and a possible mild economic upturn. Appetite for ESG investments, regardless of regional equity allocation, will also likely remain strong.
US: Economic growth in the election year ahead
As we covered last week, we believe US economic growth will hold in 2020. Downside risks may be more prevalent in H2 during the US presidential election campaign.
In our view, the S&P 500 is likely to remain range-bound from here, with limited downside risks. US capex would benefit from diminishing trade tensions, favouring productivity gains. The anticipated cyclical upturn in H1 should act as a support for domestic equities.
However, margins will likely continue to erode over the year and we expect a slowdown in EPS growth to low single digits at around 3% in 2020. There is concentration risk within the S&P 500, too, as the top 10 stocks now represent close to 25% of the index’s market capitalisation.
History tells that US equity performance is usually positive in an election year. Yet we maintain a neutral stance on the market. Valuations may be vulnerable to a Democratic win, as this would likely lead to political measures more in favour of workers and consumers than shareholders. We also find the valuations of other developed markets more attractive.
Europe: Recent outperformance should continue in 2020
In Europe, sluggish economic activity has been a drag on EPS growth. However, we may have passed the worst – a cyclical upturn looks on the cards. The probability of a no-deal UK Brexit scenario has considerably reduced, leaving Europe less at risk from a severe negative growth shock. We believe the recent outperformance of value stocks that has started in recent months will continue in the year ahead.
As previously outlined in our blog on European equities, valuations and positioning remain quite extreme in Europe compared to historical standards. Our valuation models based on cyclically-adjusted metrics suggest European markets can deliver returns around 7-8% annualised over the next five years (6-7% is normal). Shorter term, a mild cyclical upswing along with fiscal and monetary policy accommodation would certainly act as a support. We maintain our preference for cyclical sectors such as consumer discretionary and industrials.
In the UK, fiscal policy should significantly expand to weather some of the negative effects on growth from Brexit. More domestic-oriented UK corporates would benefit from fiscal expansion vs large caps. Large caps will be also more sensitive to a stronger GBP.
Japan: Not too late to buy
In Japan, fiscal policy has already become more expansionary despite the sales tax hike in October 2019 – and we expect this to continue. Policy accommodation and the market rotation to value stocks have been supportive factors for Japanese equity performance in the second half of 2019.
Looking ahead, we believe Japanese equities have plenty of scope to provide further strong returns over the longer term, as they still look cheap on a cyclically-adjusted basis. The cyclically-adjusted dividend yield is currently around 1.5%, a level that has historically been consistent with future annualised returns of 13–15% (pre-dividends). Additionally, a lower level of equity-FX correlation suggests that a mild JPY upside would be manageable. The market also provides diversification benefits for Europe- or US-heavy portfolios.
EM: Selectivity will be key
Global liquidity conditions are set to remain supportive in 2020 and we expect the EM-DM growth gap to support EM equity performance, valuations and flows.
In Asia, we expect the 4Q cyclical upturn to extend into the first half of 2020. The EPS cycle, led by northeast Asia, is recovering. The context remains less favourable for the ASEAN markets of southeast Asia, amid sluggish growth and stalling momentum on reforms. In China, we expect additional stimulus measures to be implemented over the first half of the year. This should act as a support to the local equity market with room for higher margins and multiple expansions. However, we suspect that trade tensions will resume eventually in the second half of the year, putting a lid on local equity performance.
In Latin America, a rebound in Brazil’s GDP growth is expected while a little room for monetary policy easing remains. This should provide some support for Brazilian equities, our preferred market in the region.
Finally, a large fiscal stimulus in Germany would benefit eastern European countries (Slovakia and Slovenia in particular). One way to take advantage of fiscal easing in Germany is to get exposure to EU Europe equity markets (ex-Russia).
Overall, we believe selectivity will remain key in EM equities portfolio allocation over the year ahead. Take a look at our joint blog with MSCI to learn more on EM equity portfolio construction.
That’s it from us for this year. Thanks for reading and all the best for the festive season!
(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)