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Following the brutal December 2018 market decline, which pushed major indices almost into bear market territory, investors began 2019 on a nervous note. After a 10-year bull market, central banks' determination to end the era of extraordinary monetary policies and the escalating China-US trade war impacted the global economy, raising the risk of a recession.

In fact, several fundamentals deteriorated in 2019: Expectations for corporate earnings continuously declined throughout the year, and manufacturing sentiment in several major economies moved into contractionary territory. Germany only narrowly avoided a recession. And while there was a lot of talk about the need for preemptive fiscal stimulus programs, there was ongoing reluctance among the few countries that would be able to conduct such measures.

In such an environment, central banks proved again that they remain firmly in the driver's seat of the global economy. Not only are their monetary policy decision key for fixed income investors, but their steering of liquidity flows, financial conditions and ultimately sentiment continues to play a decisive role for risk asset returns, at least in the short- to medium-term.

But even if we end the year with virtually all asset classes up, there might be certain investor groups that struggle more than others. For bond holders in general and liquidity-constrained sovereign institutions with large short-term fixed income instruments (i.e. central banks) in particular, the environment got even more challenging in 2019. In a year with dramatic shifts that made investors suddenly buy blue chip stocks for the coupon while speculators moved to trading bonds for price action, conservative portfolios came out ahead when they had at least some exposure to equities.

For central bank portfolios, having a diversified portfolios made a big difference in 2019. Liquidity-constrained central banks' portfolios made moderate gains in 2019YTD (sample portfolio CB1 in our chart below, which holds a mix of short-term instruments and cash, returned about 2.5% as of November-end). Central banks with larger exposure to low/negative yielding currencies such as the euro had even lower returns and were not able to protect the capital from inflation.

Source: �۶���Ƶ Asset Management. Data as of December 2019. For more information on central bank sample portfolios CB1-4, please see exhibit 2. The portfolios of Norges GPFG, ADIA, CIC, GIC and Sofaz are replicated based on publicly available information, using broad indices and listed instruments to estimate the monthly performance progression.

As illustrated in the left chart in Exhibit 1 above, central banks that hold portfolios more diversified towards equities were able to achieve significantly higher returns YTD. Central banks with an allocation of 15% to equities (sample portfolio CB4) reached more than 8%. First, central banks have reacted to falling short-term interest rates by extending duration and have benefited from falling long-term interest rates, most notably in the US.

Second, it is no surprise that the diversification trend towards equities initiated by central banks a few years back has continued unabated in 2019 despite the rising concerns about trade wars and its impact on the global economy (see the last �۶���Ƶ survey here).

Thanks to a high exposure to risky assets in both the traditional and alternative asset class spectrum, 2019 is set to be the second-best year for SWFs since the Global Financial Crisis. Institutions such as Norges, GIC, Sofaz, CIC and ADIA – for which we replicate the performance of their portfolios based on publicly available information – generated returns of 18% or above in 2019YTD. Most risky asset classes including investment grade credit, EM debt and alternatives generated double-digit returns YTD.

What 2019 has shown (once again) is that monetary policy is the main driver of asset prices. In 2020 all eyes will continue to be on central banks and in particular the Fed, which will have the difficult job of setting interest rates in a somewhat unique set of circumstances. US unemployment remains at a 50-year low of 3.6%, according to published figures, but there is no inflation pressure. The "inter-cycle" cuts in 2019 have been an insurance against the trade war-related weakness in the manufacturing sector; this has propelled stock prices to historic highs despite the slowdown in corporate earnings.

The weakness in the cycle has remained confined to the manufacturing sector. The service sector, accounting for the lion's share of the US economy, remains in expansion territory supported by resilient consumer spending. It is this last factor which we believe makes a US recession a lower probability event in 2020. But trade wars might continue playing the swing factor, especially if the US starts targeting other regions. While the final outcome is hard to predict, we believe that the most likely scenario is still a deal that will stop the tariff spiral between China and the US. This will remove a massive source of uncertainty in the corporate sector and could eventually lift the manufacturing sector out of stagnation.

For asset prices, the key question will be if the dampening effect of trade wars on growth and inflation outlook will keep Fed policy loose enough to (more than) offset disappointing corporate earnings, leading to a continuation of what some observers already call a new "Goldilocks" experience (we want to use this opportunity to remind readers that three bears appear at the end of the original Goldilocks tale). Expectations for corporate earnings have been lowered throughout the year 2019, which in combination with the recent rally now makes price-to-earnings ratios for some areas of the equity market look stretched. Also, warning signs are emerging in corporate bond markets, and the liquidity situation is deteriorating. Overall, we expect equities to do better in 2020 than fixed income, but stock market performance is very likely to be more muted than in 2019, i.e., only reaching single- digit returns.

Might governments jump in to prop up declining growth numbers with preemptive fiscal spending programs? Discussions around it are increasing, also in Germany, but chances are low unless there is an outright recession and stronger increase in unemployment numbers. Still, with expectations around stimulus rather low, there might be room for market-moving surprises, also with smaller programs. Coordinated fiscal expansion in the US and Europe would benefit equities and some alternative asset classes such as infrastructure and green assets the most, but as debt levels and inflation expectations rise, it would have the potential to shake up fixed income markets which still operate at historically low interest rate levels.

We continue to see benefits for sovereign investors to diversify across more asset classes and regions. Adding equity exposure makes sense in particular for central banks which come from still very low levels of equity holdings and are overly exposed to fixed income. However, this should now be done more selectively and opportunistically. In an environment where more and more investors might be forced to tap equity markets in their search for yield, quality and dividends should continue to perform well. We would also advise those central banks which are already exposed to developed market equities to consider emerging markets given the more attractive valuations and the better growth outlook.

Given that policy rates are unlikely to rise and could eventually fall more if there is a further deterioration in the global economy, we would also advise central banks to look at their short duration portfolios denominated in negative yielding currencies such as the euro. In the previous Investor Note (here), we provided some options to raise returns on these assets: In most cases, it would require either a relaxation of investment guidelines (i.e., use of derivatives, broadening of the inves table universe) or the adoption of unconstrained investment strategies.

Finally, we urge investors to choose sustainable over traditional investments as much as feasible among all of their investments. That way, investors can also position their portfolios to benefit from the most significant trends and themes over the next decade and avoid the impact of 'negative' trends like Climate Risk. For example, in the fixed income space, we believe that "climate aware" corporate and green bonds are well positioned for 2020 because they have less exposure to cyclical sectors and a higher average credit quality than the broader investment grade market.

In 2020, we see the main challenge for SWFs will be to replicate 2019's performance given current levels of yields and equity prices. We have observed that SWFs already started signaling to their political sponsors that double digit returns are unlikely to be repeated in the near future given the late cycle environment we are in and the uncertainty surrounding globalization. The excellent performance in 2019 might raise the return expectations of main stakeholders once again.

In our view, SWFs should take advantage of their low liquidity constraints and their long-term investment horizon by diversifying more aggressively into emerging markets and alternative asset classes. Emerging markets including China – the best stock market in 2019 despite the ongoing trade war – still provide the bulk of global growth. Should a trade truce prevail, we believe that emerging market economies are likely to be the main beneficiaries with a potentially positive impact on their exchange rates. And the structural drivers of their growth outperformance – rising middle class, urbanization and domestic reorientation – remain intact.

Real assets provide SWFs with additional flexibility to diversify fixed income when compared to central banks which can only rarely invest in illiquid asset classes. While valuations for some of these assets look expensive given the late cycle environment we are in, one should keep in mind that the low yield environment will most likely persist, thus providing support for the foreseeable future. Alternative asset classes also provide a very important source of diversification for both equity and fixed income. A diversified hedge fund portfolio for example could be an important tool to not only address tail risks arising from trade wars or other geopolitical events, but also the eventual turn in the interest rate cycle. Infrastructure debt and equity also provide steady cash flows and diversification benefits, and the pool of investment opportunities is likely to rise both in Europe and the US due to the increased likelihood of political support for green investment strategies.

SWFs should also continue investing resources and time on ensuring that their portfolio are resilient to the impact of mega-trends such as demography, technology and climate risk. Diversification across these themes will likely become an important performance driver going forward and more attention to countries and sectors' exposure will be needed in this area. We are moving into a different world where there will be winners and losers at country, sector and corporate levels. Such an approach requires a move away more from traditional benchmarks.

Typical central bank holdings (% of portfolio)

Typical SWF portfolios

Performance - Typical central bank holdings (% of portfolio)

Performance - Typical SWF portfolios

Source: �۶���Ƶ Asset Management
¹Fixed income portfolios based on short-term (GGB 1-3) and long-term (GGB) government bond indices of the respective country. Country weights: US 65%, Germany 15%, UK 5%, Japan 5%, France 5%, Netherlands 5%.

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