The Markets in 2020

By Ignacio de la Torre

Fred Schwed said that “asset classes considered as ‘better’ vary from time to time; the pathetic fallacy is that we end up thinking that the best are only the most popular, the most transacted, the most talked about, the most adulated, and consequently the most expensive at the time of their popularity. ”

Perhaps this quote should be remembered when considering the investment options we propose for the coming year.

If the main driver of bullish behavior in practically all asset classes has been monetary policy, in the form of low rates and quantitative easing, to always modestly predict how assets will move in 2020, a consideration of how central banks will behave is imperative. Well, today two-thirds of central banks are lowering rates (the most recent, Brazil and Russia) and most importantly, continued quantitative easing. If a year ago there was a risk that the reduction in the balance sheet of the Fed caused some convulsion in asset prices, today it is injecting about 60,000 million dollars a month, courtesy of the abrupt problems of its money market (REPOs).  At the same time, the ECB injects about 25,000 million dollars a month, the Japanese central bank another 30,000, and the Chinese central bank something similar. In other words, we can expect more than a trillion dollars injected in 2020 in a context of low rates. This to add to the twenty trillion already injected since 2008 with a world economy that reaches 90 trillion dollars. Then we wonder why Greece sell bonds at a negative rate today…

From this consideration we deduce that, if the upward inflation is not surprising, the short and long rates will remain low during the year, which will provide some support for most asset classes. By decree, sovereign fixed income has begun to correct downward (the yield of sovereign bonds goes up) despite the policy of central banks. The reason is the always feared step “from monetary to fiscal policy” (governments that implement fiscal policies can sometimes make hefty mistakes that we will all pay for) and the revival of the world economy, which began in November, and that will be underpinned with the least uncertainty associated with the trade wars and Brexit. I would not have sovereign bonds in my portfolio. Financing, for example, the French state at a negative rate, or the US at a PE 60 is a scam. The “risk-free” asset is very risky.

Corporate bonds are divided between those with the investment grade (BBB- and higher) and those considered “high yield” or “speculative” (BB + grade or less). The former move practically in line with sovereign bonds, for which one cannot expect very positive behavior for the reasons set forth for sovereigns. The latter, although they have high prices, still confer reasonable returns compared to those offered by sovereign or investment grade bonds. In my opinion, their behavior will be better than that of investment grade bonds, since the greatest risk they present is that of a rise in defaults as a result of a recession, and I believe that this risk is limited. However, as I have warned in the past, there are important problems in the liquidity of secondary bond markets, and lack of liquidity can often bring major surprises.

The stock exchanges are dominated by three factors. The first is the cost of capital, which moves inversely proportional to the PER multiple listed. Due to the arguments expressed in the two preceding paragraphs, the cost of capital should not rise alarmingly in 2020. The second is profit margins, expressed in terms of the margin obtained on sales. This factor worries me, since net margins have risen sharply since the 1970s, courtesy of the fourth industrial revolution. However, for the first time in half a century, we begin to observe how workers begin to obtain wage increases which are higher than productivity and inflation.  This results in a lower net interest margin, and also in the form of greater share of wages in a GDP. It is a slow but inexorable process. Therefore, when we affirm that we pay a PER 17 for a market, we do not really know if it is 17 or 20, or 23… it depends on the evolution of the margins. That is why it is so useful to contrast the PE ratio with the CAPE, a concept developed by Nobel laureate Robert Schiller, in the form of a tight PE ratio assuming that the margins revert to the average of the last ten years.  According to the CAPE, for example, we pay more than 30 times for the US stock exchange, a multiple that was only exceeded in 1929 and in the year 2000. If the margins fall then the potential of the stock market is limited (see the graph below). The third factor that affects the stock exchanges is the sectoral and geographical composition of the indices. When we buy “Spanish stock market” we actually also buy “Ibero-American” stock market, when we buy “European” stock market we buy a huge exposure to banks, whose price depends a lot on the ECB’s policy and when we buy North American stock market, we depend on the technology sector. Therefore, geographic and sectoral variables will play a fundamental role in determining stock returns. In my opinion, if we take into account all the factors reviewed, these will be modest.

CAPE 10 monthly, multiple

Source: Yale University, Arcano Economic Research

Finally, alternative assets (private equity, venture capital, infrastructure, private debt and real estate) should continue to benefit from the trend that shows how they gain weight in the portfolios of institutions and high assets. It is foreseeable that they grant returns higher than other assets, among other reasons, because they continue to quote with abnormally high spreads against “risk-free” assets. However, it is true that consubstantial illiquidity of these assets also requires greater profitability.*

Time to play ball, and if things go wrong, remember the other big phrase of market wisdom that says “a long-term investment is a short-term one in which you are losing money.”

Well, let’s hope that most long-term investments are not renamed in a better year.