Another year of living dangerously?

2019 was a terrific year for Australian investors. The median growth fund produced a 14.7% return for 2019: the eighth consecutive year of positive returns, according to Chant West.

Last year, there were very strong share market returns, especially in the developed world, particularly in the US, and in IT, that underpinned the result. Australian shares also performed strongly, albeit not as strongly as markets in the US and the Eurozone.

Both Australian and global fixed income benchmark returns were pretty solid for the year – better than 7% for domestic and (hedged) global fixed income – even though the last quarter saw yields rise sharply, and some of the very strong gains earlier in the year were given back.

Overall, 2019 was a challenging year for the whole world economy, despite it being the 10th consecutive year of post-Global Financial Crisis growth.

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MACRO ISSUES

The global economy has been slowing down since the middle of 2017. Even though consumer spending and services have held up well in most major economies, global manufacturing effectively fell into recession – particularly in the major developed economies. 

As a rule of thumb, if your economy and manufacturing sector was more heavily export oriented, more heavily exposed to capital goods and more heavily exposed to the auto industry the worse you fared, with Germany being a clear case in point. Inflation remained stubbornly low, and in most economies, lower than previous market forecasts and lower than central bank policy objectives.

Compounding all this, of course, was the trade war between the US and China and the ongoing debacle that was – and is – Brexit.

The tariff measures imposed by both countries have not been substantial enough in isolation to seriously derail the global economy. However, the second round impacts on business confidence, business spending plans, and the disruption of supply chains have been a significant drag on economic growth, although not enough to bring about a global recession.

INTEREST RATES

Slower global growth and low inflation has allowed the world’s central banks to maintain extraordinarily accommodative monetary policy settings. In the case of the Federal Reserve and our own Reserve Bank allowed them to move official rates lower.

Falling interest rates effectively allowed world share markets to defy the challenges posed by a slower global economy, ongoing trade tensions and Brexit. In other words, for many investors low interest rates meant that equities remained the only game in town.

2020 

As we start 2020, several concerns that have weighed heavily on market sentiment have abated, at least to some extent. 

US and Chinese trade negotiators delivered the so-called ‘phase one’ trade deal, an outcome which should limit further damage to world trade and economic growth.

In the UK, a decisive victory by Prime Minister Boris Johnson’s Conservative party in the December election ensured the passage through Parliament of a Brexit agreement.

There have been early signs that the world economy may be starting to stabilise. In particular, the worst of the downturn in global manufacturing may well be behind us.

There remain good reasons to believe that the global economy can avoid recession for another year. The traditional alarm bells that typically ring prior to the onset of recession are (mostly) not ringing. Monetary policy settings are far from restrictive, although the boost to growth over the coming year or two from easier monetary policy is likely to be modest. 

Financial market conditions indices and surveys of bank lending conditions remain pretty healthy, and there is some prospect of expansionary fiscal policy being brought to bear in a number of economies.

Here in Australia, economic growth remains below the economy’s growth potential, and inflation remains below the Reserve Bank’s target range. 

Private domestic spending growth has been weak, and household spending grew only marginally in the September quarter, despite income tax cuts boosting disposable income. 

While there has been some better news in recent retail sales data, that seems to reflect changes in seasonal spending patterns (associated with the fact that “Black Friday Sales” are now a thing in Australia) rather than a more durable improvement. House prices have begun to recover but housing activity continues to decline.

Despite solid gains in employment, indicators of both unemployment and underemployment are still elevated and this is casting doubt over the economy’s ability to generate faster wages growth.

We are likely to see some better economic growth as 2020 progresses – courtesy of lower interest rates and a pick-up in domestic spending. However, the immediate outlook has become more complicated with the ongoing bushfire crisis.

It’s too early to be overly precise, but there’s likely to be a negative impact on growth in the March quarter as well as an upward pressure on prices with hikes in dairy, and meat prices obvious examples.

The recovery work will be significant as both private and public spending is likely to be boosted over the remainder of the year and into 2021. 

There has already been pressure on the federal government to use fiscal policy to boost growth and both federal and key state governments are likely to step up over the year ahead, particularly given the recovery effort that will be required.

FINANCIAL MARKETS

While there are reasons for optimism about the world and Australian economies for 2020, what does that mean for financial markets?

A combination of improving global growth and very low interest rates should provide a healthy backdrop for corporate earnings and share markets. Notwithstanding the fact that the year ahead is likely to pose its fair share of challenges.

Tensions in the Middle East – most notably between the US and Iran persist and are likely to flare-up again at some point.

While US and China trade tensions have eased they have not disappeared. Trade is more costly and less free than pre-Trump, and there is bipartisan support in the US for the view that China has not behaved well in trade and in intellectual property.

While Brexit uncertainty appears to be off the table, we need to remember that a UK-EU trade deal needs to be worked out this year, and I don’t think anyone really believes a deal can be done by 31st December. The UK will almost certainly have to ask for an extension, but the EU will almost certainly agree to that extension and a deal will get done.

We need to acknowledge that geopolitics are going to be an ongoing source of volatility for financial markets over the years ahead, but over the coming years, shares should continue to perform well against bonds or cash.

However, that’s at least partly a reflection of the likelihood that bonds are likely to perform poorly.

It’s difficult to describe share market valuations as cheap in absolute terms. Even after the rise in yields towards the end of 2019, yields are still historically very low. 

While there is some scope to enhance fixed income returns through an allocation to credit, after a decade of sustained global growth, we are late in the cycle, where excessive exposure to credit is probably something to be avoided.

For alternative asset classes – such as private equity, unlisted property and infrastructure – there are still opportunities to generate the kind of investment returns that superannuation fund members need, and these assets remain attractive relative to public equity and fixed income. However, over the past decade these assets have also performed extremely well, and prospective returns are likely to be lower over the coming years.

Warnings were undoubtedly issued at the start of 2019 too. But rather than bemoan the inaccuracy of those warnings, it’s important to acknowledge that those warnings are not meant as short-term market predictions – which are mostly folly – but rather a genuine effort to ensure that investors have realistic and achievable expectations for longer term investment returns.

ADVISERS IN 2020

As for the adviser community, heading into uncertain times could mean getting back to the basics with clients and educating and managing their expectations around low growth environments and what to expect during a correction.

New ways of thinking about portfolio construction should also be top of advisers’ minds this year with the old ways ofen  thinking about asset allocation will not necessarily be the right approach in the current setting.

In the new decade, our prediction is that the way advisers undertake risk profiling and asset allocation will change.

For example, many advisers have historically shunned recommending diversified alternatives to clients due to the perceptions of high risk, but there are a broad range of unlisted assets that can be classified as “defensive”. 

As a case in point, Sunsuper invests in institutional-quality property assets, both within Australia and globally, and infrastructure assets typically characterised by several of the following key features: long duration, large initial capital outlays, monopolistic qualities, stable income, gross domestic product or inflation-linked earnings, and returns dominated by income, once an asset has matured.

There are still good opportunities for these assets to generate the investment returns super fund members need.

Not forgetting advisers have a fiduciary obligation to consider all the options on the table when constructing portfolios and, particularly in challenging times, needed to continue to recognise the power of diversification in helping clients maximise their retirement savings.  

Brian Parker is chief economist and Anne Fuchs is head of advice and retirement at Sunsuper.