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When we talk about risks to our investment outlook, we always warn of the threat of ‘unknown unknowns’, events that come seemingly out of nowhere that can’t be predicted or planned for. All we know is at some point they will arise. As all readers will be aware, two have already arisen in the early stages of 2020, firstly with the tragic incident in Iran when a civilian plane was shot down and secondly with the outbreak of the new coronavirus in China. Understandably, we have received numerous queries from clients, notably on the latter, and this Global Matters Weekly seeks to clarify our current stance on recent events.

As the year began, so it ended, with yet another strong month for risk assets in December, capping one of the best years for markets since the financial crisis. Equities again led the charge, but leadership for once slipped from the US to emerging markets, which returned 7.5% in the month, well ahead of the US and MSCI World with 3.0% returns. This resulted in full year returns for the US of 30.7%, MSCI World 27.7% and MSCI Emerging Markets 18.4%. The ‘risk on’ environment led to safe haven government bonds weakening while high yield and emerging market bonds produced gains of 2.0-3.0%, with annual gains of 14.3% (US high yield) and 12.6% respectively.

In 1998, researchers at the Weizmann Institute of Science in Rehovot, Israel, showed that electrons passing through a membrane behave differently when being observed. In a similar way, investors looking for the next bear market are affecting its timing. Bear markets are typically preceded by a period of irrational exuberance, which seems a quantum leap from where the collective mood in markets is today. Traditional indicators such as the shape of the yield curve and the level of equity market valuations have proved ineffective thus far in this latest cycle; little surprise perhaps given the changing rules of the game, with risk free rates (here thinking about US Treasury Inflation Protected Securities) having declined to zero over the past 23 years. Instead of adhering to any single rule of thumb, we have preferred to stay invested on behalf of our investors and broadly diversified, to good effect in 2019.

While high growth/momentum stocks have performed well for some time, they have historically been susceptible to momentum crashes which have tended to coincide with bear market periods. As stock markets reach all-time highs and the US enters its tenth year of economic expansion, we think that having exposure to value stocks still makes good sense. We have long been of the view that having balanced factor exposure is the best way to achieve excess returns, and now does not seem the time to abandon this philosophy.

Following the worst year for equity markets since the financial crisis, 2019 was one of the best. Many risks failed to materialise: US-China trade wars moved towards a phase one deal, the UK did not fall over the Brexit cliff edge, the World economy slowed but did not enter recession, China’s debt bubble was contained and geopolitics caused ripples but no dislocation. Most important was the policy pivot by the Fed, from a restrictive stance to much looser policy. But corporate earnings were flat, so returns of 28% from world equities leave valuations materially higher than a year ago. Can this bull market, the longest in history, continue?

Markets are heading into the final weeks of the year with some extraordinary gains for the year to date. November proved
to be another strong month for risk assets, led by equities and in particular the US, up 3.6% for the month, taking its return so far this year to 26.9%. The contrast with the fourth quarter of last year, when Wall Street fell 20%, could not be more stark, and reflects to a large degree the policy pivot by the Fed, followed by other central banks, from tightening to easing policy. Markets have shrugged off the sharp downturn in global trade and manufacturing, as well as a tough year for corporate profits, which have been broadly flat, and have recovered all the ground lost in that sharp setback of Q4 2018. While the US has led the way and has reached a new all-time high other equity markets have also performed well: Europe ex UK gained 2.6% in November, 25.1% this year so far, while even the laggards among developed markets, Japan and the UK, have gained 16.4% and 13.3% respectively this year, after solid returns in November. The MSCI World index, dominated as it is by the US, was up 2.8% in the month, 24.0% year to date.

2019 proved to be a fantastic year in the financial markets with almost all major investment types posting very strong gains. Markets continued to make good progress in December, in stark contrast to the same month of the previous year. Equity markets led the way while major bond markets were mostly flat or down over the month. Emerging market equities outperformed, much of which came from the 5.8% gain for the Asia ex Japan region, while the global developed markets index returned 3.0%.

Slow economic growth, subdued inflation, mature business cycle, political risks, unfavourable demographics: the backdrop to today’s equity markets is challenging and adding convexity to portfolios can prove to be a highly valuable defensive solution. Be it via options, convertible bonds, tactical tilts or any other method and tool available, this must be managed carefully though. Increasing convexity imprudently can prove ineffective and expensive, but making wise use of it can reduce risks, smoothen the journey towards the investor’s objective and enhance returns over time.

The fact sheet update for Sanlam Managed Risk UCITS (SMR) Fund of November 2019.

Risk assets made further progress in October, with equities leading the way. Wall Street gained 2.1% and reached a new all-time high, but, as in September, the best returns came outside the US: Japan was up by 5%, Asia ex Japan by 4.5% and emerging markets by 4.2%. Among the major markets only the UK was down (-2.1%) as a strong rally in sterling put pressure on the big overseas earners, which dominate the UK stock market. The improved appetite for risk was reflected in bond markets, with safe haven government bonds flat or down while credit markets produced positive returns, led by US corporate bonds up 0.6%.