4Q 2019 Quarterly Investment Forum Investing in the 2020s

Normally, the macro presentation for QIF takes a tactical look at markets over the next three and 12 months, but with a new decade coming up, this is a good time to consider how the investment environment could change in the 2020s, especially in a downturn. 

When the next recession hits, whether it's next year or five years from now, the US Federal Reserve will not have much room for easing. Historically, the Fed has cut an average of 5.5% during recessions. As of today, the federal funds rate is 175 basis points, and some ex-US central banks already have negative policy rates.

Instead, we expect the focus to shift to our elected leaders, who will have to implement aggressive fiscal stimulus, such as middle class tax cuts along with infrastructure and other spending. Significant fiscal stimulus could finally boost nominal GDP and potentially yields.

The question is what will central banks do as GDP rises? Will they continue to keep interest rates suppressed, or will they let some repricing happen as inflation begins to rise? The markets are going to have to deal with this interaction between monetary and fiscal. If successful, this would be positive for environment for more cyclical economies and markets, positive for inflation-linked assets and negative for duration. 

The case for value:

Steve Magill

Value has performed poorly since the Global Financial Crisis of 2008/2009. It's worth taking a look at what we mean by value. Stocks that fall into the value category change over time. Currently the category is dominated by cyclical stocks, in particular financial stocks, and includes minimal exposure to consumer staple stocks.

The recent poor performance for value relative to growth has been driven by slowing economic growth, geopolitical events and sustained high levels of monetary stimulus. This has led to an extreme 'flight to safety' amongst investors, which is visible in both bond yields and the performance of value stocks relative to growth stocks.

Value stocks are now on very low valuations relative to growth stocks. Historically, where valuations are so polarized, although the timing is hard to predict, the snap back is large and sustained.

The case for growth:

Albert Tsuei

We continue to see favorable conditions for growth. While the global economy has decelerated, DM households remain a resilient buffer to industrial slowdown. Additionally, we see a cooperative Fed in risk management mode, a force we see potentially extending the current cycle.

Most importantly, we believe that value faces secular challenges. Traditional value moats have eroded as new technologies have disrupted historic sources of competitive advantage. Deteriorating fundamentals among many value names trump their P/E discount to growth. Increased investment in intangible assets are inherently harder to encompass to assess through traditional equity value measures. Software allows companies to harness increasingly powerful compute to address new adjacencies. Finally, platform economics inherently favor scaled growth companies over their value brethren.

The bear case:

Jonathan Davies

On all measures of real exchange rate strength, the USD is trading at a high level compared to the average over the last 30 years. Using the Federal Reserve's measures of the real effective exchange rate¹, we would have to go back to the early part of this century to find a situation where the USD was more expensive than it is now. Another gauge of overall USD strength, the JP Morgan Real Effective Exchange Rate measure based on Producer Price Indices (the measure of inflation rates used to convert nominal exchange rates into real exchange rates) indicates that the USD is already as expensive as the peak reached in 2001 and that one would have to go back to the mid-1980s to find a situation where the USD was dearer than is currently the case.

USD strength over the past few years has been underpinned by US economic growth outperformance and a rising interest rate differential in favor of the USD compared to other G10 nations. These supportive factors are more likely to wane than increase from here on. Since 2015, US growth has been boosted by a significant easing of fiscal policy: as the US budget deficit is now moderately large, further loosening is unlikely. In contrast, fiscal policy has been quite tight in other parts of the world, such as Europe and more likely to be eased moderately from here on. Thus, global fiscal policy will likely no longer be boosting US growth versus the rest of the world and may start to act in the opposite direction.

While there is a growing consensus that monetary policy has reached its limits in areas where interest rates are already close to zero or even negative, the Federal Reserve still has scope to cut rates if further stimulus is deemed necessary. Thus, should a negative global economic situation arise, it is likely that interest rate differentials between the US and other G10 countries will be eroded. While it is true that the USD tends to be a currency that investors seek in times of heightened risk perception, there are other "safe haven" currencies such as the JPY, that are likely to outperform in such circumstances.

The bull case:

Lionel Oster

Compared to its long-term history, the USD may appear to be overvalued. However, this assessment fails to capture two changes in the US economy that may justify a higher valuation for a longer period.

First, the USD is the economy of the digital world in the 21^st century. The big names in technology are all in the US, and to a lesser degree in China. Second, the US has become energy independent due to its shale revolution, and is now a net oil exporter. If commodities perform well over the coming year, it will further boost USD valuation.

Catalysts that could further enhance USD value or trigger a decrease depending on how they go include the potential for slow-growth economies to engage in large-scale fiscal spending to drive economic growth. The main candidate is Germany, but for now at least, Germany is unlikely to move unless bad economic news continues.

Another potential catalyst is the US Federal Reserve's guidance for rate cuts in 2020. Should they stick to their view that these are just insurance cuts, this will guide the market to expect continued growth.

Last, tensions between the US and China on trade are here to stay, and should continue to provide support to the USD into the next 6 to 12 months as challenging China and its practices is a consensus on both sides of the political divide in Washington.