Brace for more uncertainties in 2020
An undercurrent of seemingly benign financial market and political developments are poised to move both prepared and unprepared households further away from their financial goals in the coming years.
These issues include monetary policy-related financial market distortions, a drag from excessive global debt and the rise of geopolitical uncertainties.
Households attempting to financially prepare for the future will need to contend with financial market distortions that induce greater risk taking, debt constrained growth that lead to increasingly more expensive investment options and weaker economic activity and political developments that have the potential to batter financial assets.
An undercurrent of seemingly benign financial market and political developments are poised to move both prepared and unprepared households further away from their financial goals in the coming years. Contributing to this outlook includes the fact that the global economic ties that had in recent years contributed to higher standards of living for millions of people globally are at risk of unwinding with the rise of populist politics and social unrest. At the same time, policy responses are forcing some savers into riskier investments and creating unsustainable excesses in debt and equity markets.
How financial market distortions make it easier to lose money
Central banks, in a bid to reverse slower economic growth and weak inflation, have maintained unconventional monetary policies since the height of the Global Financial Crisis. Doing so has nevertheless led to certain distortions in the global financial system, like extremely low interest rates (negative in places like Europe and Japan), excess liquidity in some corners of the financial system and liquidity shortages in others.
And these policies aren’t likely to go away anytime soon as gross domestic product (GDP) and inflation in the U.S., Europe, Japan and China remain weak, prompting policymakers to remain committed to unconventional monetary policies for the long term.
Figure 1: Major government bond yields remain in decline
This has two important implications for both savers and retirees when it comes to asset accumulation and distribution strategies. First, lower central bank interest rates have put downward pressure on traditional fixed income asset yields. What this means is that individuals and institutions setting aside funds to meet long term obligations will either need to put away more money today to boost saving levels or allocate their savings to high yielding (and often riskier) financial assets to generate higher investment growth rates.
There is no such thing as a free lunch and so the cost associated with higher returns is either the increased time need for more investment due diligence on riskier assets or the need for greater investor risk tolerance for inevitable swings in market prices. Either way, these central bank policies have effectively made it easier for unprepared savers to lose money by incentivizing higher allocations riskier investments.
Figure 2: A notch above junk: BBB rated corporate bonds a key market risk
At the same time, the number of firms rated as financially risky has increased as lower borrowing costs provide a support to otherwise structurally uncompetitive firms. Typically, rising interest rates late in the business cycle has the natural effect of weeding out weak firms as revenues typical with selling goods and services dry up and increased borrowing becomes prohibitive. Yet, lower rated firms have been given an artificial lifeline as central banks maintain extremely accommodative policies, keeping borrowing costs lower than usual.
Further, lower rates have pushed up valuations of riskier investments like stocks even as corporate earnings growth has weakened recently. The implications here is that valuations for some stocks and bonds, particularly those of lower quality issues, may become susceptible to outsized price swings when political or economic concerns inevitably lead to bouts of increased market volatility. Lower interest rates have also contributed to a notable rise in the amount of debt outstanding globally.
Figure 3: A rise in global debt will challenge growth for years to come
Debt and when a rising tide does not lift all ships
According to the Institute for International Finance, total public and private debt outstanding globally was $246 trillion at the start of 2019, which is 50% higher compared to a decade ago and nearly three times the annual output of the global economy. At some point this debt must be paid back, which becomes increasingly problematic and a rising source of financial market volatility when economic growth rates for major global economies are expected to remain subdued in the near term.
Closer to home, the cost to service debt is actually below where they were prior to the Great Recession in the U.S. Yet, lower interest rates have created an incentive for households to borrow more money, pushing up the value of non-financial assets like home prices and contributed to the ballooning cost of education, crowding out other discretionary spending and in some cases making important life transitions harder to attain.
And while lower interest rates have reduced government debt service costs, Washington has only increased debt-fueled deficit spending and hindering its ability to invest in important growth-oriented infrastructure projects. Taken together, what this means is that households and governments alike increasingly remain constrained in their ability to spend on growth-oriented ventures as balance sheets remain hampered by ballooning debt piles.
Therefore, potential economic growth rates (and rates of corporate earnings growth) are likely to remain subdued in the coming year, further challenging firms’ ability to service growing stockpiles of debt and potentially leading savers to buy investments at a time when asset prices are becoming more expensive and economic and market risks are increasing.
Figure 4: A rise in global policy uncertainties has challenged growth
Reasons to be worried: geopolitics and Main Street uncertainty
And if low interest rates and a debt overhang didn’t already complicate financial strategies for preparing for the future, a rise in geopolitical tensions has contributed to a rise in economic and financial market concerns. This comes as the U.S.’s Trade War with Canada, Mexico, the European Union and China has led to higher prices paid for goods by some households and a simultaneous decline in business confidence. What’s more, the unclear outcome of the 2020 U.S. presidential election is likely to intensify political uncertainties that markets, businesses and households have already contended with in the past year.
From a trade policy perspective, leaders on both sides of the political aisle remain energized to address economic issues caused by past trade policies, particularly as it relates to the U.S.’s seemingly unbalanced relationship with China. And so, the implication here is that while a partial trade deal between the U.S. and China may be secured at some point, tensions between the U.S. and China are likely to remain elevated for years to come irrespective of the 2020 election outcome.
Meanwhile, some U.S. presidential candidates have proposed tax and spend policies that are likely unfavorable for some families and complicate long-term estate planning considerations. Moreover, financial markets – abhorring uncertainty – are likely to become increasingly choppy heading into the 2020 U.S. elections as the potential for notable shifts in trade or economic policies brought about by shifts in the executive or legislative branches are likely to buffet risk asset prices and dampen near term business and consumer confidence.
Taken together, households attempting to financially prepare for the future will need to contend with financial market distortions that induce greater risk taking, debt constrained growth that lead to increasingly more expensive investment options and weaker economic activity and political developments that have the potential to batter financial assets.
Above all, these developments have the potential to raise the risks of a U.S. recession which we cover in our next post.
This post is an excerpt from our report, Getting Ahead Financially in 2020. You can download this report in its entirety by visiting franklinmadisonadvisors.com.
Broadview Macro Research is a division of Franklin Madison Advisors, Inc (“FMA”). The commentary provided on this website is limited to the dissemination of general information pertaining to Franklin Madison Advisors’ investment advisory services and general economic market conditions and are subject to change without notice. The information contained herein is not intended to be personal legal, investment or tax advice or a solicitation to buy or sell any security or engage in a particular investment strategy. For additional information about FMA, including fees and services, please contact FMA or refer to the Investment Adviser public disclosures.
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