2019 A Surprisingly Good Year for Risk Assets: 2020 Outlook

January 15, 2020

Equity returns were strong in 2019 with major markets rising between 25 - 30% in US$ terms. This was despite an aura of despair regarding the strength of the global economy at the start of the year. Growth beat Value again and Large beat Small by a little bit.

In major markets the composition of returns was mostly comprised of price/earnings multiple expansion and negligible profits growth. In the United States a total return of 28.8% comprised 1.1% profits growth, 1.8% dividends with the balance provided by an expanded valuation taking the prospective P/E multiple to 18.5x for 2020. Market expectations for 10% profits growth in the United States in 2020 are likely to be downgraded to low single digits. China was one of the few markets where earnings and dividends generated the entire return of 16.8% and the earnings multiple contracted. China on a prospective P/E of 12.1x and Asia as a whole, on 14.4x offer a more sustainable mix of profits and dividends to generate returns in 2020. We are likely to find attractive stocks in these markets in 2020. We especially like smaller companies.

By the way, we recommend, again, that investors do not use GDP forecasts to predict equity returns, nor try to frequently trade asset class exposure up and down.

Despite or because of, such a strong year, we expect 2020 to be less buoyant. With more than 1/3rd of the world's sovereign bond market providing negative yields, the relationships between equities and bonds, and discount rates for profit and dividend growth, remain anything but 'normal'. In 2020 focus on decent balance sheets and be wary of locking your money away in illiquid assets. The WeWork/Softbank saga and the Woodford Investments fiasco in the UK show that the real risk of illiquid assets should not be calculated based on their price volatility; the true risk of illiquid assets is MUCH higher than liquid assets.

At some point the experiment of zero interest rates for all (ZIRP) will come to an end and someone will be found to be 'swimming naked'. Debts have risen enormously and not all of these can be honoured or repaid. At this time illiquid assets will suddenly not look so good. Bear in mind just what a large % of USA IPOs that are loss making when they list. This is rather strange and reflects very high-risk tolerance by investors for unproven business models. The era of ZIRP has created hidden investment traps for everyone. We use Bucephalus based in Hong Kong to help us identify these.

We believe 2019 was the start of a multi-year re-appraisal of Japan and its problems. They are NOT the same as the problems in the Anglo Saxon West even though the media uses the phrase 'turning Japanese' to describe all struggling economies. Japan's low nominal GDP is actually caused by poor demographics and not poor productivity from labour and capital investment. Australia has the reverse problem. Japan has adopted, quietly, a more thoughtful approach to immigration. Australia has not yet adopted a more thoughtful approach to total factor productivity. Japan's low nominal GDP growth is irrelevant for the risk premium to be placed on Japanese corporate profits. Japan's risk premium should be lower - in other words the market should be higher. It will get there.

If the West is "turning Japanese" it is only to the extent that zero interest rates have prevented the necessary clear out of bad capital allocation decisions - Japan had a similar problem for many years with the so called 'convoy system' preventing bad companies from going to the wall, or with shareholders not changing management. This attitude looks like changing and much M&A and corporate re-structuring is probably going to continue in Japan as a consequence. As for Europe and its "extend and pretend" attitude to their banking system? It is not going to end well. In that regard they are 'turning Japanese'; just as Japan changes for the better.

Brexit is now likely to happen in some form or other and the withdrawal (probably reduction) of UK net contributions and the likely shrinking of its trade deficit (removing a much-needed source of demand for the Rest of Europe) may wake up policy makers in the EU? Ironically the EU could be worth joining if it reforms; but it will only reform if the UK leaves. This is a sort of reverse Groucho Marx situation - "I would want to join a club I had just left"?

We invested more in the UK before the election but will wait to see the exit terms, and the EU response, before we consider reducing a large underweight in Europe.

Hong Kong protests are understandable and with luck there will be pressure brought to bear on China to be more 'democratic' in its treatment of its outer regions. China is now more reliant on inward capital and global investors can make a difference. We can't sign off without making the remark that if ESG is going to be effective and not just a 'parroted phrase', then much more work needs to be done to define what spheres it reasonably influences; how to measure success or change as a result of its implementation, and whether there can be one universally agreed set of principles. For example, even if China agrees to change as a result of global investor pressure (led by everyone's most hated administration, the USA!), up pops India (everyone's favourite emerging market economy but not ours) with its own brand of discrimination which should actually be triggering investment sanctions if ESG is to be more than 'words'. Don't get us started on Westpac.

Maybe 2020 is the year that ESG becomes more than a box ticking exercise? We hope so. We don't manage (yet?) enough assets to make a real difference but do let companies know if we are unhappy with their Governance which we continue to believe is the root of all capital allocation decisions.

Best of luck for 2020 in your investing and we wish to thank everyone with whom we have had contact in 2019 for their interest in Delft. Don't hesitate to get in touch if you wish to discuss any issue with us.