The global and U.S. economies maneuvered around tariff headwinds and structural challenges in 2019, albeit at a slower pace. Ultra-accommodative monetary policies already on the books, some additional fiscal stimulus, and a confident consumer should keep most developed economies growing moderately through at least 2020. Major central banks seem willing to safeguard the expansion by easing further if necessary; this posture combined with below-average GDP growth should keep sovereign bond yields near historically low levels. As long as U.S. recession risks remain in the distance, as they are now, we believe portfolios should maintain a Market Weight allocation to equities. Following are our thoughts about fixed income and equity portfolio positioning for 2020 by region, and our forecasts for currencies and commodities.
RBC’s annual GDP growth forecasts for developed markets
Global central banks will look to harvest the fruits of their labor in 2020 after a series of rate cuts and other stimulus measures were planted to close out 2019. While growth and inflation expectations for developed markets are now on the ascent, recession fears and geopolitical concerns are likely to linger. Markets mostly expect central banks to remain on hold for the next year, but the bias will remain toward further easing rather than a return to tightening, anchoring yields across the global landscape near historical lows.
As central banks seek to boost economic growth, will global yields also get a boost?
The Fed looks set to take a wait-and-see approach to policy and the economy in 2020 after delivering three rate cuts in 2019. However, we see scope for further cuts absent a stabilization in economic data and a sustained steepening of yield curves. Any chance for a resumption of the rate hike cycle is likely a 2021 event, at the earliest.
There is no doubt U.S. economic growth moderated through 2019; the question for 2020 is whether it rolls over into a recession. Recent yield curve inversions raise the risk of such an event, but the Fed’s rate cuts have achieved the goal of re-steepening yield curves and are likely sufficient to extend the economic cycle, in our view.
As economic risks remain slightly biased to the downside, so too is the outlook for yields. We believe the benchmark 10-year Treasury could establish a new all-time low—which stands at 1.36 percent from 2016—largely caused by the gravitational pull of negative global yields, slowing growth, and low inflation.
The global hunt for yield has driven yields on high-yield debt to near the lowest levels on record. With yields below six percent in this sector, and the economic cycle in its later stages, we believe investors simply aren’t being adequately compensated for risks. Therefore, we would focus on investment-grade corporates, and bank-issued preferred shares for income—where balance sheets remain pristine.
The Bank of Canada (BoC) has bucked the trend of global central bank easing as the domestic economy has been buoyed by a firm employment backdrop and a resurgent housing market. This helped quell some growth concerns that were reflected in lower bond yields in mid-2019. Current pricing does not fully reflect expectations of a 25 basis point cut in 2020 and suggests Canada will soon have the highest policy rate in the G7.
Given Canada is a small open economy with heightened sensitivity to global growth, we believe the BoC could shift toward easing to ward off an appreciating Canadian dollar if the Federal Reserve lowered rates further. We see short- and intermediate-term bonds as attractively priced and recommend locking in reasonable yields for the next few years. Inflation-protected bonds are a good way to source longer-term exposure as market expectations for inflation in Canada are near all-time lows. An accommodative policy stance could revive these muted inflation expectations.
Corporate bonds only offer modest yield enhancement versus governments. Accordingly, we continue to favour upgrading credit quality and liquidity within bond portfolios. Preferred shares are the one exception to this quality bias as we view it as the most attractively valued category in Canadian credit. Widespread investor pessimism has created an opportunity to lock in materially higher yields than what is available on longer-term corporate bonds from the same issuers. In our view, concerns about the impact of lower yields on the cash flow profile of rate resets are imbedded in current pricing.
With a new European Central Bank president, and a substantial stimulus package as a departing gift from outgoing President Mario Draghi, we expect monetary policy will be on pause for a while. Continuing soft economic data may warrant an additional interest rate cut or extension of quantitative easing.
There is an expectation individual euro area countries may provide a fiscal boost to their domestic economies. This depends on the appetite of each government for stimulus and the budgetary restrictions of the EU Commission. We remain comfortable with our Market Weight stance on government bonds and our Overweight view on corporate credit for Europe.
The outlook for the UK is largely conditional on the general election results and the subsequent policy of the next government on achieving departure from the EU. We believe a small majority Conservative government would prove to be better for delivering Brexit and for the economy in 2020. This outcome may lead to higher inflation and subsequently to tighter monetary policy. If the outcome is a Labour-led government, we see the risk of a possible second Brexit referendum in 2020, leading to a more uncertain economic outlook.
We anticipate the Bank of England may cut rates in the coming months. But for now, our Market Weight view for UK government bonds and corporate credit and short-duration positioning remains.
China’s economy is expected to continue slowing in 2020, with GDP growth likely to fall below six percent, based on the Bloomberg consensus forecast. We anticipate the policymakers’ response will be the same as in the past year: walking the thin line between keeping the country’s debt under control and using targeted fiscal and monetary measures to cushion downside risks.
This scenario extends the valuation case for Asia high-yield in 2020, in our view, and we remain Overweight the sector. Although fundamentals will be of concern and require close monitoring, the valuation case is comparable to 2019, where the yield pick-up over Developed Markets debt is attractive. Investors should, however, be prepared for volatility spikes on headline news or during global risk-off periods.
We expect idiosyncratic risk to be high for Asia fixed income and would maintain a well-diversified portfolio. Our investment philosophy is not to fight fundamental trends. There are two areas we would lean against. In terms of countries, we are cautious on India due to its challenging growth and fiscal dynamics. In terms of sectors, we are cautious on commodity names due to global growth concerns.
As we move further into the late stage of the economic cycle, capital preservation is key, and we would stick with quality names. We see the sweet spot in the higher BB-rated credits within Asia high-yield. We are Market Weight Asia investment-grade.
Our view for 2020 features moderate equity returns and earnings growth. Valuations in North America are not outlandish, while in Europe and Japan they are cheap. Alongside this, we see a continued need for vigilance given that the late-cycle economic phase brings with it particular challenges and often generates market volatility. Absent the prospect of a return to more robust economic and earnings growth, we have become less tolerant of portfolios carrying an overweight or above-benchmark commitment to equities, and recommend maintaining a Market Weight allocation.
Price-to-earnings (P/E) ratios of major equity indexes
|Forward P/E||10-yr Avg.|
|S&P Small Cap 600||18.5x||18.0x|
|STOXX Europe 600||14.6x||13.2x|
Note: Data represents forward P/E ratios based on Bloomberg consensus earnings forecasts for the next 12 months.
Source - Bloomberg; data as of 11/12/19
United States – Market Weight
After coming off of a strong run in 2019, we think patience will be a virtue for investors in 2020. Our key indicators are signaling the domestic economic expansion will persist, although there could be some hiccups as the 10-year-old cycle ages. Also, global growth could face headwinds due to structural economic challenges in China and Europe, and were some trade and tariff issues to go unresolved.
Anecdotal evidence among institutional investors points to muted expectations for S&P 500 earnings growth in 2020. The optimistic consensus forecasts by industry analysts do not yet fully reflect this view. We anticipate the consensus estimates for growth will come down closer to the mid-single-digit range that RBC Capital Markets is forecasting for S&P 500 profits.
A modest advance in earnings and revenues, combined with a still-expanding economy, should be “good enough” to provide a foundation for somewhat higher U.S. equity prices in 2020. Valuations are also on the market’s side. They are above average, but not unreasonable considering the ultralow interest rate environment and the more extreme valuation peaks reached in the two previous bull market cycles. We think a Market Weight allocation to U.S. equities remains appropriate.
Canada – Market Weight
We recommend a Market Weight allocation to Canadian equities. Domestic-specific challenges, including elevated household leverage, strained affordability in key housing markets, and insufficient oil & gas pipeline capacity, remain in focus. We view these issues as well documented and reflected in the valuations of the most directly affected industries.
Canadian banks are trading at a modest discount to their long-term average price-to-earnings valuation, which we believe is appropriate. We expect 2020 earnings growth at the low end of banks’ medium-term targets as weaker economic growth and rising credit provisions serve as headwinds. We are mindful that credit losses could rise materially if the economic outlook darkens as new accounting measures dictate a more forward-looking approach.
The outlook for the Energy sector continues to be clouded by a muted commodity backdrop and ongoing market access issues. While prospective new pipeline projects remain beset by delays, Canadian energy producers face a diminished investment appetite and the risk of wider price discounts. Tangible progress in advancing the Line 3 Replacement or Trans Mountain Expansion could help sentiment despite post-2020 in-service dates.
Europe/United Kingdom – Market Weight/Market Weight
We are upgrading Europe to Market Weight. The U.S.-China trade tensions-induced slowdown is showing signs of abating, and the economy could be close to bottoming. Political headwinds, such as a populist government in Italy and a hard Brexit have not materialized. A stabilization in global economic momentum would benefit the region, and we note rumblings regarding fiscal stimulus have become more persistent. Valuations are not demanding. We would seek opportunities in well-managed companies with strong business models and balance sheets, and whose prospects are buoyed by secular growth drivers.
Meanwhile, the upcoming UK general elections may yet alter the course of Brexit. Should the Conservatives gather a majority in Parliament, financial markets would likely react positively in the short term: the UK would leave the EU at the end of Jan. 2020 in an orderly fashion, and the government would likely increase fiscal spending and lower taxes to support the economy. But looking out further, the trade relationship with the EU after the transition period would still have to be worked out in detail. Should a free trade agreement not be in place by Dec. 2020, the UK may well have to fall back on unfavorable World Trade Organization terms, as per the withdrawal agreement.
At the other extreme, in the case of a Labour-led administration, uncertainty would resume, with the prospect of a second referendum and more left-leaning policies.
For now, weighing attractive valuations versus this uncertainty, we choose to be Market Weight UK equities. We would adopt a balanced approach to domestic and internationally focused stocks.
Asia ex-Japan/Japan – Market Weight/Overweight
2020 may prove to be another eventful year for Chinese stocks, as market participants will look for clues on whether the country can contain economic downside risks. Beijing may continue to support the economy through: (1) reserve-requirement ratio reductions, (2) tax cuts, (3) trimming borrowing rates, (4) reverse repurchase agreements, (5) propping up sectors most at risk, and (6) focusing on infrastructure projects. Policymakers will likely try to control risks by preventing the base rate for new corporate loans from falling meaningfully, as an over-extension of credit could expose the financial sector to systemic risks, in our view. As for the trade impasse, a full pact may not be reached until the U.S. presidential election draws closer.
The Hang Seng Index’s trajectory will largely depend on: (1) trade progress and (2) whether the unrest in Hong Kong ends soon. The city is now in a technical recession, and upcoming economic data may point to a continued deceleration. Despite the gloom, any alleviation of political tensions may bring about opportunities, particularly as the Hang Seng carries a price-to-book ratio of just 1.19x and an undemanding forward price-to-earnings ratio of 10.3x. Last but not least, Hong Kong’s IPO market has been staging a notable comeback and the trend may persist.
In Japan, we expect modest economic growth in 2020 following the hike in the consumption tax in October 2019. Monetary policy will likely remain accommodative. Further fiscal stimulus is available if private consumption declines more than economists’ expectations. Despite decent consensus earnings growth expectations for 2020, Japan remains one of the most undervalued developed markets. We maintain our Overweight stance for investors with 12-month or longer time horizons.
|U.S. Dollar Index||97.34|
Source - RBC Capital Markets, Bloomberg
USD – Carry on. The U.S. dollar continued to grind higher in 2019 despite a dovish Fed, thanks to safe-haven demand emanating from trade tensions and a resilient domestic economy against a backdrop of slowing global growth. Although U.S. economic growth could slow in 2020, so long as this does not derail the broad economic expansion narrative, the dollar should remain supported, in our view.
EUR – Growing pains. Euro weakness prevailed through 2019 as economic activity slowed and continued to disappoint. After delivering a comprehensive stimulus package, the European Central Bank could remain on hold through most of 2020, limiting downward pressure on the euro. But the challenging growth outlook points to little impetus for a material euro recovery for now, and we maintain a neutral outlook.
CAD – Fading support. The Bank of Canada hinted at an easing bias for the first time since 2015, flagging slowing global growth and trade concerns. While this could tee up a rate cut, it is not yet priced into the market. In the absence of support from positive rate dynamics, the Canadian dollar could trend moderately lower.
GBP – Brexit? The pound is still below its pre-referendum level and will remain hostage to Brexit developments, both in terms of the UK’s exit from the EU and of their future trading relationship, of which details are yet to be negotiated. With multiple outcomes possible, economic momentum weak, and the Bank of England on hold for now, we remain neutral.
JPY – Looking abroad. Concerns about the slowing global economy prompted the Bank of Japan to deliver dovish forward guidance, and ultraloose policy could persist through 2020. However, external factors could be key drivers for the yen. Notably, Japanese investors’ appetite for unhedged higher-yielding assets abroad could cap gains from safe-haven demand.
|Oil (WTI $/bbl)||$58|
|Natural gas ($/mmBtu)||$2.45|
Source - RBC Capital Markets forecasts (oil, natural gas, copper, and gold), Bloomberg consensus forecasts (soybean and wheat)
WTI – Range-bound. Despite turbulent intraday swings in 2019, RBC Capital Markets expects WTI crude oil to trade between $50 and $60 per barrel over the next 12–18 months, capped by excess global supply and slowing demand growth. The International Maritime Organization’s 2020 regulations are scheduled to take effect at the beginning of January, and aim to reduce maritime sulphur emissions by over 80 percent.
Natural gas – Inventory builds. Demand for cleaner energy continues to paint a favourable backdrop for natural gas over the longer term. However, we believe near-term upside remains limited due to larger-than-average inventory build-ups. RBC Capital Markets forecasts production to outpace demand through 2021. In addition, future demand growth may be more tepid if China slows further.
Copper – Supply surplus. U.S.-China trade uncertainty and a further deceleration in global manufacturing would impede any significant rally in copper, in our view. We also believe China’s monetary and fiscal packages are more likely to stabilize demand rather than spark a new growth phase. Supply and demand fundamentals are pointing towards a surplus position until 2021.
Gold – Consolidation. Gold rallied in 2019 as central banks eased monetary policies further. We expect less accommodation going forward. The outcomes of the U.S.-China trade dispute and Brexit, and the timing of these events, should be key drivers of gold in 2020. The impeachment process in the U.S. and investors’ risk appetites could also play a role.
Soybeans – Phase one. Soybean pricing has been volatile since the emergence of the U.S.-China trade dispute in mid-2018. The market is anticipating a “phase one” trade deal whereby China is expected to ramp up purchases of U.S. agricultural goods. U.S. exports remain below pre-trade war levels but should increase going into 2020.
Wheat – Record high. The U.S. Department of Agriculture is lowering its 2019/2020 global production forecast, driven by unfavourable weather conditions and reduced consumption rates. Global ending stocks hit a record high of 288 million tonnes in Oct.2019, with approximately half within China’s storage.