As 2020 kicks off, let us begin by offering two famous quotations (variously attributed to Mark Twain or Yogi Berra among others) that we believe contain great and perhaps surprising wisdom for investors.
“Making predictions is hard, especially about the future.”
The dawn of a new year inevitably brings with it a slew of economic and market predictions for the year ahead. In aggregate these form consensus expectations that determine the pricing of financial assets. But these predictions are almost invariably wrong. New information challenges the consensus and the market adjusts, often significantly. For example, the dovish pivot from the Federal Reserve caught many by surprise and led to a very strong 2019 for both global stocks and bonds. Now just in January, the emergence of the Wuhan coronavirus and heightened tensions in the Middle East have already challenged many 2020 outlooks. The lesson here is that forecasting may be a necessary exercise for investors, but it is an exceptionally difficult one.
“It ain’t what you don’t know that gets you in trouble, it’s what you know for sure that just ain’t so.”
It is a very human tendency to think that the world is more predictable than it actually is. This often leads to inappropriate certainty among investors, with market pricing to match. Following on the example above, a year ago markets were convinced that 10-year US Treasury yields would edge back up towards cycle highs around 3.25%. In fact, yields ended up 2019 at barely half that level as the global economy weakened and the Fed eased.
A cornerstone of our investing approach, therefore, is not to take on the almost-impossible challenge of out-forecasting markets, but rather to look for opportunities where markets themselves appear certain about things they have no business being so certain about, and then take the other side.
With this approach in mind, and as we embark on a new decade, we discuss below three areas where we are positioning the Canadian multi asset class funds to take advantage of consensus expectations that look vulnerable to surprise:
Outperformance of the US equity market?
Investors have been convinced that the US equity market is the place to be. This has certainly been the case over the last decade, as the US equity market delivered a total return of around 250% versus 65% from the rest of the world (see Chart 1). The outperformance has been due not only to the relative strength of the US economy over this period but also the kind of companies listed in the US, notably the prevalence of growth-oriented technology stocks.
Chart 1 – An unsustainable-looking divergence
The divergence between the US and other markets (which not coincidentally resembles the style divergence between growth and value stocks) may indeed have been warranted based on differing fundamentals over the past ten years. However, such divergences historically have almost always reversed as investors get overconfident that the trend will continue forever, creating opportunities for contrarians. As a result, we have been moving equity capital out of the US to other areas of the world that have been left behind. In many parts of European, Japanese and EM equity markets, there looks to be more room to outperform expectations than in the more expensive US market, where many companies seem priced for perfection.
Inflation will never return?
Chart 2 shows a market-based proxy for Canadian inflation expectations, which is running well below the 2% rate the Bank of Canada is mandated to deliver. The same story is largely true in many other parts of the world; markets generally seem convinced that inflation is gone for good. This expectation is certainly consistent with the past decade where inflation has remained stubbornly low despite the extraordinary efforts of central banks to inject unprecedented amounts of stimulus into the global economy. But in our view, it may be this very lack of inflation that makes higher inflation a greater risk down the road, primarily for the following reason.
Chart 2 – ‘Free insurance’ against inflation
In the view of many, central bankers have been less effective in generating good economic outcomes and more effective in inflating asset markets, in turn worsening the inequality that is feeding populist and anti-globalization sentiment around the world. The risk is that these forces lead to the loss of central banks’ independence and greater direct government control over the money printing presses, which historically has almost inevitably led to higher inflation. And while this remains a low probability outcome, at least in the short term, it would be dangerous to dismiss it outright. As a result, we are taking the other side of the ‘deflation trade’ with overweights to inflation-sensitive assets like TIPS, RRBs, gold and other commodities.
Canada is in the clear?
The market continues to be discounting a relatively optimistic outlook for the Canadian economy. Chart 3 shows 2-year bond yields in various advanced market economies, which reflect both current and future expectations of short-term interest rates. Canada is the highest yielder, which effectively suggests that the economy is seen as less in need of stimulus than just about any other country – an expectation reinforced by the recent rebound in housing markets.
Chart 3 – Canada seen needing less stimulus
But Canadian economic growth has already long been relying almost exclusively on housing and the consumer more generally, funded by record levels of household debt, to the point where these sectors represent their highest share of GDP in more than 50 years. At the same time, the more productive sectors of the economy—exports and business investment—have contributed almost nothing to growth in recent years. This type and degree of economic of imbalance has not proved to be sustainable anywhere else in the world, and it is not likely to be in Canada either. The exact timing of when this imbalance will be unwound remains uncertain, but the market seems too complacent in barely pricing in this risk. As a result, we have generally underweighted assets levered to the Canadian economy, including the currency.
Let us conclude with a third quotation: “Hit ‘em where they ain’t”. This one is attributed to Wee Willie Keeler, a baseball player in the 19th century explaining his batting prowess. There is wisdom here too for investors. Allocating to assets into which investors are already crowded based on consensus expectations is unlikely to lead to outperformance. It’s where those expectations are inappropriately certain that there is value to be added by investing where markets ‘ain’t’. We can’t be sure what’s going to happen in 2020, but nobody else can either, and we will continue to seek to take advantage of market overconfidence in positioning for strong risk-adjusted returns in our Canadian multi asset class funds.