Asset allocators found themselves on the wrong side of market returns in 2019.
Equities went gangbusters around the world much to the surprise of many market participants. US stocks were up 31 per cent in total returns, the MSCI World Index climbed 28 per cent and emerging markets posted a healthy 19 per cent return. In the last 90 years of US equity returns, 2019 ranked 16th just behind a some very strong years in the 1930s and 1950s and 2013.
While incredibly impressive, the rally which has extended into the new year, hides the stark contrast between the forces that shape equity markets: earnings growth and discount rates.
Based on fundamentals, last year was not meant to be spectacular for risk assets. The International Monetary Fund reported global growth of 3.2 per cent with muted inflation, in line with its forecasts. Corporates followed this muted trend with most equity markets posting low single-digit revenue growth, just in line with inflation, and earnings actually fell in many markets, albeit marginally. This was no surprise to the analyst community whose forecasts were mainly in line with realised earnings growth from the start of the year. The pervading story for equity strategists was one of a dispassionate “hold” for the asset class. With no obvious disasters nor surprises on the horizon, 2019 was expected to be a “soft year”.
So what happened?
Central banks were proactive to weak market expectations, lowering the cost of capital and offering to do more if required. This saw interest rates nose dive, moving down 1 per cent across the curve and dropping by nearly a half to 1.6 per cent in the US and 0.8 per cent in Australia. Asset prices rallied aggressively, especially those with leverage, and equity valuations ballooned by 20 to 30 per cent around the world regardless of industry or market.
The magnificent equity returns of 2019 have emerged as a poster child for asset inflation caused by central bank policy and their promises. It also serves as a reminder of the disconnect that monetary policy can cause between asset prices and economic fundamentals.
The powerful rifts in market returns will continue to carry deep implications for the asset management industry, carrying some strategies out to sea while helping others indiscriminately. For Australia’s superannuation industry, aggressive allocation to equities and credit clearly paid off handsomely. For asset management, this may be another nail in the side of active managers, as they try to justify their fees when the passive alternative are not only cheaper but are performing unbelievably well. For factor allocation and quantitative strategies, smart beta and quality-based strategies tend to lag market returns and growth beat value yet again (by 10 per cent in the case of the US).
We face 2020 with a sneaking suspicion that we are living in a managed economy and that many of the classic relationships between fundamental and market prices are creaking if not lie broken.