2019 has been lived with prudence by active managers who, like Simplify Partners, have decided not to follow the market trends fueled by the immense liquidity of central banks and unrelated from company fundamentals. A euphoric period that usually precedes downturns.
During the year the Simplify 02 fund has:
1) Maintained a significant reserve to be able to make purchases in the event of a fall in prices;
2) Avoided investing in market risk because valuations remained above expectations;
3) Reduce volatility;
4) Gradually increased specific investments with a medium-term view;
5) Kept the position in gold.
Following, passively, the performance of the indices would have almost certainly have generated returns above inflation but it would have been a bit like starting to collect coins while a steamroller is coming: you risk your hands for nothing.
The (many) good reasons for prudence
We have had several good reasons to be cautious:
1) The obvious slowdown in world economies;
2) Trade tensions between the United States and China;
3) American unemployment at least for 48 years which, if inflation had started to grow, could have led the Fed to raise rates;
4) Rise in the dollar with the maximum reached in mid-2019;
5) Concern about the fundamentals of the Italian state budget;
6) Forecast of an increase in the price of oil to 80/85 dollars;
7) Corporate profits, adjusted for the stock and the depreciation, well below the value expressed by the valuations, as and more than at the time of the bursting of the 2000 internet bubble.
To these reasons, two added to the scenario: 1) the sustainability of the monetary stimulus necessary to keep market prices high and 2) the concern for some signs of monetary market failure, a phenomenon we saw in September 2007. In September this year, in fact, following the US overnight rate hike (turbulence of the REPO market) reflecting a drying up of liquidity, the Fed started expanding again its balance sheet without giving any clear explanation for weeks. A subsequent study by the Bank of International Settlements then noted the shift by the four major US investment banks, for still unclear reasons, of huge amounts of liquidity towards long-term loans, which may have led the Fed to expand the balance sheet of 350 billion dollars for providing liquidity to the overnight market.
A secondary effect of this injection of liquidity has been a new rally for the S&P 500 which further distanced the valuations from company fundamentals. The relevance of all these events was overshadowed by the emphasis on political news, or the tweets of President Trump that celebrated new market highs.
The economy in contraction and markets supported by a huge monetary expansion have led us to a particularly conservative equity policy with neutral exposure to markets and concentrated in the economies of developed countries. We understand the frustration vis a vis the trend of the main indexes but we are also aware of the fallacy of the enthusiasms towards the end of the cycles.
A policy that an active and independent manager like Simplify Partners can more easily pursue by being released from the benchmarks that condition the managers of mutual funds.
There was, as we said, the possibility of achieving a good return through equity investment (fueled for the whole of 2019 by general euphoria) but it seemed minimal compared to the risks, to the evolution of the scenario (change of guard in the ECB and less certainty than a continuation of expansionary monetary policies) and at the risk of the typical turbulence of the end of the economic cycle.
With regards to the US markets, we find the general narrative about the "Election year" plausible but based on unstable ground. We do not close the door to trying to profit from market dips but we suspect 2020's volatility will be higher.
The 2020 scenario
In 2019, the expectation of a further rise in American rates didn't realize while the turbulence of the American REPO market led to an unexpected cash injection of 350 billion dollars and the creation of a de-facto new QE.
The expected economic slowdown has occurred but may have been exhausted and China may have an expansionary push: the leading indicators of the OECD support this view.
At present, meanwhile, the S&P 500 index is trading at 21.06 times, way more than the historical average (17). Only in 1999 was such a wide divergence of evaluations from corporate profit.
At a macro level, the main theme is probably the exhaustion of the debt supercycle. Some indicators go in this direction. Since 2009 US private debt has declined by 20%, aggregate debt seems to have reached a ceiling and the low level of rates reflects a poor appetite for credit.
The possible implications, especially for the United States, are:
1) the lack of an increase in leverage would reduce inflationary and growth pressures...
2) therefore, the economic cycle could last longer.
If we still wanted to focus on growth originating from the debt supercycle, we should rather focus on countries like China where the trend is solid. In China, however, the monetary authorities have started a contrast excessive leverage and there is, therefore, the risk of a brake on easy liquidity. Signals from PBOC though are a bit contradictory.
The management of the trade-off between debt and growth will, in any case, influence global inflationary pressures. Today, monetary policies are accommodating while Chinese and US political leaders seem oriented towards reducing trade policy tensions. We are entering the final phase of the economic cycle. As we said, the cycle could stretch a bit more but market valuations are pricing-in a lot of all this.
Corporate rates, therefore, will tend to rise even if the central banks, terrified by the risk of a replica of the Japan case, will use all the weapons available to support the economy.
When heading towards the end of the cycle it is not easy to predict when the recession will begin. The stock market usually anticipates the contraction of about six months compared to the fall in profits. It, therefore, remains to be decided whether there will be room for further growth in the stock markets over the next twelve months. The first effect of this uncertainty will however be an increase in volatility.
Every risk-taking, in this scenario, recalls the image of the collection of coins while the steam roller is coming.
The asset allocation of Simplify 02
We maintain a large part of short-term investments as a hedge to a downturn and reserve for further purchases. Equity markets might end 2020 higher than today but it is likely the trend will not be without substantial bumps along the way.
We continue to increase the weight of opportunistic arbitrage of high yield bonds after a positive credit event. This strategy should be rather market-neutral although not without volatility.
All other factors linked to the equity beta are market neutral or with minimal exposure that could increase following a downturn. We gradually increase the position in gold.
The deviation of valuation from corporate profits (adjusted for inventory and amortization as defined by the U.S. Bureau of Economic Analysis) has never been so wide since 1999.
U.S. Bureau of Economic Analysis, Corporate Profits with Inventory Valuation Adjustment (IVA) and Capital Consumption Adjustment (CCAdj) [CPROFIT], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/CPROFIT, December 14, 2019.
The turbulence of the REPO market. A first surge in the overnight rate prompted the FED to restart extraordinary liquidity injections.
The Fed's balance sheet has expanded as a result of the REPO turbolence
A positive note from the OECD leading indicators. Possible recovery of the Chinese economy.