As 2020 begins, Mercer’s David Scobie takes stock of the eventful 12 months that was and considers what issues are likely to linger on investors’ minds.
The last decade has been a highly favourable one for most investors, almost leaving behind the Global Financial Crisis as a faint memory. Markets are in an extended cycle by almost any measure. Amid this setting, cross-currents became evident as 2019 progressed.
On the one hand, global equity markets have been assisted by a broadly favourable economic environment and generally pro-business government policies, especially out of the US. At the same time, the significance of central bank stimulus in underpinning positive market returns cannot be under-estimated. Central banks pivoted in 2019 to reassure investors that liquidity was available and forthcoming, yet they remain quietly keen to rein in easy monetary policy given the ability to do so. This is particularly the case if signs of inflation rear their head. Inflation feels in some respects like an anachronism, but nonetheless is a threat that investors cannot afford to ignore beyond the short-medium term.
In the credit sector, there have been indications around the world of outstanding debt increasing, covenants deteriorating and more speculative use of credit. While this doesn’t look to be at worrying levels at this stage, it highlights the relevance of stress-testing diversified portfolios under less benign environments. It has also brought into focus the merit of Fixed Interest mandates that are flexible in nature and are less anchored to traditional long-duration bond benchmarks. This is particularly the case given the backdrop of very low yields on offer. While hard to believe, during the course of the year around a quarter of the world’s total Fixed Interest assets traded with a negative yield.
Delving further into investment strategies, a number of sub-themes are apparent.
The debate about the merits of active versus passive management has been around for many years but, more fundamentally, recently it has become harder to distinguish between the two disciplines. 2019 saw institutional investors continue to use quantitative techniques to analyse what the key underlying drivers of equity returns are over the long-term – for instance, tilts to momentum, or high quality or low volatility stocks. They are then harnessing these factors using an approach called “factor investing” which doesn’t require sizeable teams of company analysts and is materially cheaper than traditional active management. This approach, along with the growing popularity of pure index-tracking styles, has fueled a trend of fee compression within the industry.
Also challenging traditional active management is that outcomes in recent years have, as a general statement, struggled to meet expectations. There are plenty of exceptions and we remain believers in careful selection of strong active fund managers. However, when looking at local or international equity managers or hedge funds, median levels of performance versus benchmark have tapered off. When considering why that may be the case, the most obvious candidate is the sheer buoyancy of markets. The best stocks to have been long are those that have been “on a roll” and/or paying out high dividends; however, such companies can trade at valuations which active managers struggle to rationalise. Notwithstanding, ultimately active managers must justify their fees and the risks that they take, and continue to demonstrate the basis for their existence.
2019 also saw continued exploration by investors of “alternative assets”. These are typically private market investments such as unlisted infrastructure and real estate, private debt and natural resources. A question that may spring to mind is “why bother?”, given that equities and bonds have performed so well for so long. If we consider how a vanilla equity and bond portfolio has performed over (say) the last 10-year period compared to previous decades, the returns have indeed been exceptional. This may happen again, but of course it may not. History suggests that diversifying the nature and breadth of return drivers in a portfolio is worth considering – subject to an investor’s liquidity tolerance and fee budget.
A related issue is that share markets have been facing significant headwinds in terms of a lack of new listings and an upswing in takeover activity. This is partly driven by businesses being able to raise capital privately more easily than they have in the past, and so can stay unlisted for longer. In the absence of new companies joining exchanges, private markets are increasingly the avenue to access early-stage growth companies. That said, as the saying goes, there is no asset class that too much money can’t spoil. Jumping to a substantial portfolio weight to Private Market assets is unlikely to be optimal at this stage of the cycle. A preferred approach is gradually seeking out opportunities to deploy capital and balance out risks across different fund vintages.
Political populism and inter-country antagonism are themes that have been building for some time but came to the forefront in 2019. This was witnessed in the antics of the UK’s Brexit debates and the almost daily see-sawing of good and bad news on US/China trade talks. In part this was born out of a more cautious stance on globalisation both by governments and populations. In the last few years, growth in the international trade of goods has plateaued. A reversal of the gains from globalisation witnessed over the past 50 years is unlikely, but the impetus behind it is fading. A potential impact for investors is a lift in the divergence of returns across different regions and countries.
A discussion on 2019 would not be complete without additional reference to China – now the 2nd largest economy in the world. An issue investors have been grappling with is how to balance the risks associated with investing in China with the long-term growth opportunity the country so clearly presents. Partly it is happening on investors’ behalf. Major benchmark providers have been taking steps to increase the weight of mainland China in both equity and bond indices. It is happening very gradually and in a well-signaled fashion, but a general shift to the East is an embedded theme. It’s particularly relevant for passive investors who are “takers” of market exposure via following mainstream indices. China-specific risks are accumulating unless some form of active decision is made to the contrary.
Finally, 2019 saw the concept of Sustainable Investing rise to new heights of prominence. Governments, regulators and end-investors are increasingly expecting a broader perspective of risk and return. As a consequence, responsible investing is becoming standard rather than a niche activity. It entails a longer than typical decision-making timeframe, which can help uncover non-traditional risks and opportunities not currently priced into markets. One caveat is that investors should be wary of product offerings which are somewhat token in their treatment of environmental and social goals, and/or focus only on negative screening, as opposed to truly integrating sustainability into the investment process.
In sum, 2019 threw up a range of challenges to keep investors on their toes, many of which will return in the new year under the same or a similar guise. “Let’s twist again” will perhaps be the catchphrase as we step into 2020.
This article was written by David Scobie, Head of Consulting (NZ) at Mercer Investments.
This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.
Principal, Institutional Wealth
David Scobie is a Principal in Mercer's Institutional Wealth business, based in Auckland. He is actively involved in assisting clients with their investment strategy, portfolio construction and implementation. David is also involved in evaluating fund managers, linking in with Mercer's research capability in Australia and globally.
Prior to joining Mercer in 2003, David gained six years of experience at the Reserve Bank of New Zealand where he was a portfolio manager with responsibility for trading US and European bond portfolios. David also worked in the asset and liability management branch of The Treasury as a senior analyst where he monitored the performance of crown financial institutions and companies, and provided strategic advice on a variety of commercial investments. span>
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