3 lessons from 2019

As per tradition, we use this final In Focus publication of the year to reflect on the lessons of the latest trip around the Sun. As always, there was much to absorb, but here are three messages from 2019 that the team thought particularly important. 

1. The art of the deal

There has been much to distract investors this year. The UK’s attempts to leave the EU and the on-off trade negotiations between the US and China have spewed a daily diet of jarring, often contradictory headlines. 

At times, these talks have been most clearly viewed through the prism of game theory: the game of chicken to be precise. If two cars speed towards each other, one strategy is to throw the steering wheel out the window. Surely the other will swerve? 

The question “what if they don’t?” has preoccupied investors for much of this year. For Brexit, the discarded steering wheel is perhaps represented by calls for an exit without a deal. Happily for investors, the potential damage of a no-deal divorce has been easier to ignore, because relatively few global assets care about what happens to the UK economy. Those investments that do have struggled by comparison for much of the year. Unfortunately, the US-China trade tensions have been harder to shelter from. Perceived safe havens, such as US government bonds, gold and the sturdier parts of the corporate sector, already well liked, have attracted further support.

The problem for those of us trying to work out what next remains what to listen to? How literally can we take the words and deeds of the protagonists in these epochal battles? To what extent do negotiating postures conceal a desire to come to a deal, to avoid a head-on collision?

So far, we would argue that the desire of all parties in these negotiations to avoid the worst case has been underestimated. Accidents can surely happen, but the approaching campaign trail in the US and the sheer uncertainty of an exit without a deal for the UK and Europe, seems to have incentivised compromise so far. In such a context, the daily torrent of headlines can mostly be dismissed as white noise. Of course accidents can happen, however, we continue to invest on the basis that they are less probable than many asset prices currently imply.

2. Markets don’t need an economic boom

We’ve long noted that the relationship between economic growth and the path of stock and bond market returns can be a loose one. Corporate earnings often bear little relation to the fluctuations in output growth reported by the national statistics agencies (Figure 1). 

Of course, the trend level of global and national output growth does matter, but more as a means of understanding the general climate for businesses, governments and consumers rather than in the precise, month-to-month way suggested by much of the commentariat.

Figure 2 illustrates that there is certainly a relationship between trend nominal GDP growth, bond yields and the Fed funds rate, but it is a long way from strict. The same applies for equities, where Figures 3 and 4 illustrate that higher GDP growth does not necessarily translate into higher earnings growth or even more impressive stock market returns. 

Part of this story is that Governments can get in the way, as has been the case in China, where the state-owned sector tends to consistently underperform relative to private enterprises (Figure 5). But we also see it in Europe, where regulators have certainly been influential in keeping bank earnings from rising (Figure 6). 

This year has been a case in point: the global economy has limped along, assailed by the usual cohort of doomers, yet stocks and bonds soared. The depressed starting point was certainly helpful, but the lesson is to get invested and stay invested, especially when everyone seems to be moping and fretting. 

3. Take stock

The world has changed dramatically in many ways over the last few decades, but one of the more important changes is more boring than you might think: it’s stock rooms. 

Much of the violence of past boom-bust cycles can be explained by swings in inventory levels. As companies became worried about demand from consumers and other buyers, the presence of large quantities of stock tended to amplify downturns in production. However, improved technology and supply chain management techniques have more recently enabled companies to more accurately forecast final demand. This means they need to hoard less stock, cash flows rise and companies are able to be more resilient to the inevitable ebbs and flows of final demand. This has helped dampen some of the worst excesses of past economic cycles.

This effect has been magnified by changes in consumer behaviour. There has been a surge in leasing goods that we used to purchase outright, from cars to phones to houses. Firms have developed expertise in managing the risks of financing and storing these durable goods, pooling this risk, and reducing exposure to the vagaries of consumer confidence. 

Nonetheless, while inventories play a lesser role in the economic cycle, a rundown of corporate inventory this year has both fed off some of the concerns around Chinese domestic demand and global trade, and amplified the effects. 

The sense that inventories are now running at a relatively low level may also be helpful next year as worries about final demand and the next recession continue to dissipate a little. 

Conclusion

These are obviously not the only lessons to be learnt this year. Markets are always teaching us humility for one thing. However, these three are likely to be helpful for us all to remember as we go into another year watched by the ever-coiled doomsayer community.

This publication now takes a break and will resume in the week of 6 January 2020. As always, this issue comes with the team’s best wishes for the festive period. 

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