After a turbulent year dominated by the U.S.-China trade conflict, a global economic slowdown, U.S. recession fears, and Brexit uncertainty, 2019 finished with a bang, with nearly every type of investor seeing great returns.
Looking ahead to 2020, continued growth should keep the risk of recession low, but political risks still remain, in particular from the upcoming election and an unresolved trade war. Meanwhile, central banks have even less room to manuever against future recessions as rates move closer to zero or further into negative territory. The low current low or no yield environment is likely to persist, and as it does, it will extend the return asymmetry in traditional asset classes.
The U.S. consumer – about 70% of the economy – is likely to stay strong, on balance. The consumer credit market, which has not seen the same yield compression as other asset classes, remains one of the few places still consistently generating high single digit returns.
Pagaya Research has explored five key macroeconomic themes for 2020 that we believe investors should watch. These are areas where we see a wide range of scenarios that could disrupt macroeconomic growth and provide a challenging investment environment.
- Central Banks
2019: A Wild Ride of a Year
What a year 2019 ended up being! It started off rocky but ended with stellar returns in the bond and equity markets .
(see Figure 1 and 2)
These were greatly boosted by the Fed’s dovish pivot at the start of the year and the subsequent monetary policy easing rounds around the world.
Although the stock market hit several record highs and closed 2019 up over 30%, recession fears were still prevalent. Economic growth slowed, the Fed put their rate hike cycle on pause and bond yields rallied, resulting in an inverted yield curve, first in the spread between the 10-year and three-month Treasuries going negative in March and then in the spread between the 10-year and two-year Treasuries dipping below zero in August
(see Figure 3)
As growth slowed and trade tensions ramped up, the Fed responded and cut rates three times in the second half of 2019, which reversed the yield-curve inversion. This declining interest rate environment supported the bond market last year, but the lower yields will diminish expected real returns in the coming years
(see Figure 4)
Still, the economy and consumer spending remain supported by solid growth in the service sector and in employment. The jobless rate held at a half-century low and year-over-year growth in disposable personal income and personal consumption expenditures (PCE), or household spending remains fairly strong. With income growth staying above spending growth, this should continue to bolster consumer spending.
(see Figure 5 – 6)
The manufacturing sector has been a weak spot and slowed significantly last year. However, with phase one of the trade deal signed and companies starting to reroute their supply chains out of China, demand is likely to pick up.
Nevertheless, negative effects from the trade war continue to be felt beyond the U.S. and China, particularly in manufacturing and trade-oriented economies. Notably, economic growth in export-driven Germany is the lowest in six years, as manufacturing and foreign demand slowed. It remains to be seen if global demand will pick up and support export-driven economies such as Germany.
While 2020 is starting off on a more positive note than 2019, the returns of last year will be hard to repeat and high volatility remains a major concern.
Looking Ahead to 2020: Five Themes
- Central Banks
Elections: What a Trump Win vs. a Democratic Candidate Win Would Mean
With less than a year to go until the U.S. election, the impact of the different outcomes remains a key question for financial markets. With the Democratic candidates’ agendas in direct opposition to many key policies President Trump has promoted, including in financial regulation, the corporate tax cut and the healthcare system, the result of the election could drastically roil the financial markets.
If a left-leaning, high-tax and high-regulation Democratic candidate like Elizabeth Warren or Bernie Sanders starts gaining support during the primaries, this would likely depress expected equity returns and could dampen growth. Business investment and sentiment would likely be constrained and could lead to worsening conditions in financial markets. Support for Democratic candidates is likely to be bolstered if economic growth experiences a significant downshift, equity markets start slipping, or political tensions ramp up.
Meanwhile, the impact of a win by Joe Biden or Pete Buttigieg, who are more centrist candidates, but whose platforms are less clear, would be viewed as more positive for the financial markets, though not as much as a Trump presidency. Diversification into less volatile alternative asset classes, such as consumer credit, could be part of a defensive strategy to reduce risk.
If Trump wins a second term, it will likely mean a continuation of the status quo, in terms of pro-business policies for example. However, there are still potential headwinds, such as the trade war and middle east conflict, for his reelection campaign.
Central Banks: Spotlight on U.S. and Eurozone
Last year was characterized by a global falling interest rate environment. In H2 2019, more than half of global central banks were easing, the largest proportion since the aftermath of the financial crisis. Though this highly accommodative environment boosted investor returns, both in equities and bonds, it was a result of total return, not yield. With interest rates likely to stay at rock bottom levels around the world, the outlook for positive expected real returns continues to be grim.
The Fed cut rates three times (see Figure 4) in H2 2019 and has signaled a pause in 2020 barring a “material” change in the U.S. economic outlook. Though CPI inflation rose in 2019 at the fastest pace in eight years, rising 2.3%, inflation is still low by historical standards. This relatively stable, low interest rate environment will be positive for equities because the relative rate of return to bonds is high. In terms of fiscal stimulus, the Treasury Department reported that the U.S. budget deficit was over $1 trillion dollars last year, the first trillion dollar deficit in eight years.
Meanwhile, at the European Central Bank (ECB) signaled that they will keep rates steady at historical low of -0.5%, until “the inflation outlook robustly converge[s] to a level sufficiently close to, but below 2%..”. Inflation measures generally remain weak, continuing to lag the ECB’s target of below, but close to, 2%. Core inflation stayed at 1%, though overall inflation edged higher to 1.3%.
New ECB president Christine Lagarde has launched a review of central bank’s strategy this year, including a deep dive into the causes of weak inflation. This is likely to set the course for the bank and dominate the investors’ attention.
Markets: The Longest U.S. Equity Bull Market Continues its Run, But How Long Can It Go?
Rising uncertainty surrounding the election and geopolitical risks are an area of market concern and mean that there are drastically different scenarios possible. At the same time, further tensions in the middle east or elsewhere are also a significant downside risk.
U.S.-China trade tensions appear to have paused, and both countries have incentives to keep it that way through the year. Still, the trade war remains unresolved and tensions could flare up again, which would push down market sentiment as well as threaten a recovery in the manufacturing sector.
Additionally, the Fed’s dovish pivot has paused for now, with more rate cuts unlikely this year. This means that while monetary policy and financial conditions remain accommodative, growth is left to be the main driver of assets this year. The lagged effect from monetary policy should support growth, but the numerous uncertainties threatening the economy and the markets are a risk.
The U.S. Consumer: Backbone of the Economy
If the economy continues to expand at a steady clip, it is expected that job growth will continue to advance, and consumer spending will stay solid. Historically, the risk of such an environment would be an overabundance of consumer spending relative to income, though because of the relatively weak economic recovery and a wage growth that has not taken off, this has been far from the case today.
The last three recessions saw the household debt service payment as a percent of disposable personal income peak before or during recessions. Today, this number sits near its record low, going back to 1980 (see Figure 11). Should this rise, that would be a red flag. As it stands, the trend in the consumer debt level stands in stark contrast when compared to the business sector. The corporate credit ratio (total corporate debt to GDP) is at a historical high, going back to 1952, while the household credit ratio (total household debt to GDP) hovers just above a 17-year low (see Figure 12).
However, there are potential headwinds to the consumer spending outlook. Large business confidence is weaker than both small business confidence and consumer confidence levels. If we see significant deterioration in the business sector, it could challenge consumer spending as employers would be increasingly under pressure to cut hours and perhaps even jobs in order to reduce costs.
An abnormal rise in fuel costs, possibly sparked by geopolitical conflict, would also hamper consumer’s ability to spend. Another potential risk to consumer spending is a large rise in inflation, which could result from a rise in commodity prices or a run up in wage growth. Though this is unlikely, it would pressure the Fed to act and inhibit consumer spending.
Overall, despite risks to the downside, the consumer is still in a healthy position.
Yield: A Challenging Thing to Find
The search for yield sometimes feels a bit like a once-fertile garden gone dry. No matter how much water is pouring into it, it does not go back to how it once was, and it has become a lot harder to find anything worth bringing home.
Years of central banks’ asset buying programs – which brought down government bond yields – has resulted in yield compression across most major asset classes. Negative yielding debt totals $11 trillion around the world.  And still economic growth has not revived, nor is there an expectation of a breakout in growth.
Given that the return on less risky assets has been going down, investors are willing to increase their exposure into riskier investments, which is driving down the risk premium. In other words, it pays less and less to take more risk.
Even in emerging markets like Brazil, rates have moved lower. Just a few years ago, in 2016, the interest rate (Selic rate) was above 14%. It has since dropped to below 5% . Now, investors in Brazilian fixed income, who have historically not needed to look for new investment avenues, are having to turn to alternatives to generate sufficient returns. 
Though it may come as a surprise to those used to the high sensitivity of assets in traditional capital markets, the U.S. unsecured consumer credit as an asset class is inherently more resilient to macroeconomic downturns, due to a combination of several factors.
First, unsecured consumer credit has relatively high baseline default rates during normal market conditions that are already reflected in the loans’ interest rates. There is also an absence of positive-feedback default mechanisms such as in the mortgage market or the discounting of long-term growth and profitability expectations such as in the equity or corporate bond markets. Third, the relatively short loan durations are not very sensitive to changes in interest rates.
As we look ahead to 2020, we see increased macroeconomic uncertainty. An investment position for this year should be prepared for a wide range of scenarios, including slower growth and political shocks. Equities are unlikely to repeat last year’s performance and yields remain at or near record-low levels. Still, the consumer remains healthy and manufacturing is likely to see some stabilization.
In this environment, investors may benefit from greater exposure to the U.S. unsecured consumer credit asset class, such as Pagaya’s, which offers attractive returns, relatively low volatility and macroeconomic resilience, including late in the cycle.