In 2019 the key drivers of global markets have been trade tensions and central bank easing, in our view. We were early to see that a protectionist push would hurt the industrial cycle and business investment — a key reason for our global growth downgrade. And we were correct to say that government bonds would play a crucial role as ballast during equity sell-offs even at low yields. But we did not see such a strong and persistent flight to safety and the unusual synchronized easing pivot from central banks at this advanced stage in the expansion.
We said that geopolitics and trade disputes would be a major driver of asset prices and volatility in 2019. This has played out, as seen in the chart above. Our BlackRock Geopolitical Risk Indicator for trade tensions shows that market attention to the protectionist push picked up through the year. It remains elevated, even after the U.S. and China talk up phase-1 trade-deal progress. We see a temporary truce in 2020 as likelier than not. Even if a deal isn’t signed this year or early next, market participants may be happy if the current détente is preserved and tariffs scheduled for Dec. 15 are postponed. Risks remain: the shifting sands of domestic politics in both countries, including around the situation in Hong Kong, could change the calculus currently favoring a truce.
Stretching the cycle
Central banks have eased policy with the aim of offsetting the trade shock and sustaining the economic expansion. Yet we did not see this coming in our 2019 outlook given the late stage of the business cycle, with interest rates low, inflation subdued and consumers in strong shape. The surprising force of this dovish tilt has made it a big driver of markets, becoming one of our investment themes early in the year. As global bonds have rallied, yields have fallen in some places and tested the lower limits of central bank policy rates. Central bank easing, declining bond yields and strong risk asset markets have led to the recovery of our Financial Conditions Indicator. This now suggests that global growth should pick up over the next 6-12 months. Especially in Europe and Japan, monetary policy may have reached its limit in stoking growth and an unprecedented mix of fiscal and monetary policy will be needed if and when the next downturn arrives.
Elevated macro uncertainty in the late stage of the cycle reinforced our call for building portfolio resilience. Even at low yields, we said that bonds would play a key role in protecting portfolios against equity sell-offs. This happened in May and August. Yet we did not see how low rates would fall from already depressed levels. U.S. Treasuries rallied more than we anticipated, even though market expectations for aggressive Federal Reserve easing and for a recession were excessive, as we identified. The plunge of bond yields to new lows earlier this year amounts to a paradigm shift that is challenging the role of some government bonds as ballast in portfolios given how close yields are to their effective lower bound.
We were correct to take a modestly risk-on stance during the second half of 2019. Yet we were neutral on global duration and should have been overweight given the bond rally. We were right to stay overweight U.S. equities as a way to play our up-in-quality view, and the quality factor also outperformed. We missed the boost that Japanese equities would get starting in September from the lull in the protectionist push, but were right to underweight emerging market (EM) equities given their vulnerability to U.S.-China trade tensions. We were overweight EM debt because of the high yields on offer, and were positive on euro area bonds – especially in the periphery – on the prospect of ECB stimulus. Both outperformed. We will revise some of our asset views in our 2020 outlook as we re-evaluate macro and market drivers on a tactical horizon.