Panorama - February 2021 -
Are markets overconfident in a best-case crisis-exit scenario?
Deputy Chief Executive Officer,
Chief Investment Officer
The markets are “stuck” on a pandemic-exit scenario that is contingent on massive vaccinations, a scenario that sees a mid-year rebound in economic activity. The projected rebound would be even more powerful if it was to be delayed a few months while monetary and fiscal stimulus continued.
In short, a best-case scenario.
Are we read to jump on board? Generally, yes, but while remaining cautious in the short term.
The disconnect between economic and social reality on the one hand and the equity markets on the other has seldom been so flagrant. The markets have been surprisingly resilient amidst a deep recession, possible new lockdowns with new virus variants, and the logistics issues raised by vaccinations. The main equity indices are close to their all-time highs after a generally positive start to the year.
Since the end of October – less than three months – the main equity indices have soared spectacularly: by about 20% in European, US and Chinese shares, and 40% in the Russel 2000 index of small and mid caps. In our view, the crisis-exit scenario is already at least partly priced in. Remember that we had moved back to a bullish after our 9 November committee meeting and had held to this stance. We are now moving to a neutral stance.
This period is indeed very special. Unprecedented financial and fiscal conditions have rendered historical comparison useless with previous exits from recessions. Massive interventions by public authorities have clouded the picture and disrupted conventional methods of assessment. In a sign of the times, a new asset class, cryptocurrencies, has emerged and is drawing more and more interest. Bitcoin is the most obvious example, and its surge in recent months is no accident. Even BlackRock, the world’s largest asset manager, with more than $8,700bn in assets under management, is considering integrating Bitcoin futures into some of its strategies. We have already given our view of Bitcoin, that it reflects a form of wariness with regard to “conventional” currencies steered by central banks with their massive monetary creation policies that should naturally erode their intrinsic value. For example, 1 dollar out of 5 has been “created” in the past two years.
Makes you think! But trends in cryptocurrencies and the Bitcoin in particular also illustrate investor risk appetite. With this in mine, its recent, rather steep correction is revealing of an overall change in perception.
Investor optimism nonetheless remains very high. The Bank of America’s “Bull and Bear” indicator is nearing its extreme levels, something that traditionally signals a market “pause” or correction.
The recovery could beat forecasts. But when?
Delays in supplying vaccines and the emergence of more and more new Covid-19 variants are clouding the picture. New lockdowns are likely, and that will pull down growth further in the first quarter. In reaction, stimulus plans will be activated. In the US, a first plan, worth more than $900bn plan (amounting to almost 4% of GDP) was passed in December. It will include checks sent directly to households.
An additional plan of almost $1,900bn is being prepared and could be adopted rather quickly. It would prolong the direct payments to households and extend unemployment benefits and the Payroll Protection Program. The new plan is also meant to invest massively in infrastructure and adapt the economy to the energy transition. In the euro zone, the €750bn stimulus plan, financed by a bond issue on the European Commission’s behalf, will begin to be implemented this year.
In light of the above, and assuming the vaccines are effective, the economic rebound could be powerful and greater than the current consensus now expects. Household consumption could rebound strongly, as savings expanded considerably in 2020 in most countries. In the US, households are estimated to have socked away almost $1,500bn in additional savings, or the equivalent of 10% of annual consumption. In Europe, as well, households have deposited on their bank accounts what they haven’t spent, something the public authorities have not failed to point out.
After all the lockdowns are over, there could be a consumer frenzy. Likewise, companies have put off investments, and there is clear potential for catching up. We therefore believe that growth could be higher than the consensus’s current forecasts of 4.0% for the US, 4.7% for the euro zone, 8.2% for China and 5.2% for the entire world.
The main risk, ultimately, may not be whether vaccines are effective or not. Rather, it may come from a backlash from the two main current sources of support: an excessively fast rebound in bond yields, which would weaken companies and/or a lack of enthusiasm from consumers in anticipation of an end to fiscal support and, hence, a tax hike. In that case, accumulated savings would not be spent.
Central banks’ forward guidance could be more challenging but they are aware of their societal importance and won’t change course in the coming months
Central banks will have to have a light touch in their forward guidance. We saw that early this year, when the markets began to price in a recovery scenario with the vaccine roll-out, with 10-year bond yields rising in one week from 0.90% to almost 1.20%. Central banks’ first concern is to avoid nipping the recovery in the bud or destabilizing the markets with an untimely and sudden increase in bond yields. And yet, such an increase would make sense, as yield curves steepen naturally during phases of economic recovery and, sooner or later, the markets will reasonably anticipate the end of Quantitative Easing (massive purchases of debt securities by a central bank).
We nonetheless believe that a significant run-up in longterm bond yields would be premature, and central banks are determined to keep this from happening. In the US, the latest explanations from the Minneapolis Fed president illustrate the current view. He is well aware that US society is currently “fractured”, and that the employment situation is far from satisfactory. He also stressed that workforce participation was too low even before the pandemic, even though the unemployment rate was at all-time lows. The employment rate is now far too high, and the best guarantee for social peace is full employment. The Federal Reserve therefore has a crucial societal role and the duty to support growth. The risk of creating bubbles has therefore been put on the back-burner. Another very interesting point he made was that there was no theoretical limit to the size of the Fed’s balance sheet, which is currently the equivalent of almost 30% of US GDP. We’ll keep that in mind.
In Europe, the ECB has been less explicit on its “societal” role. Its prime objective is still price stability, but we feel that, under Christine Lagarde’s presidency, the perception of the ECB’s role could evolve in more concrete fashion. In the meantime, the ECB will be closely monitoring the euro/dollar exchange rate, to rein in the single currency as much as possible.
Ultimately, the issue of inflation will emerge, but that doesn’t seem to be a concern right now, even though inflation expectations priced into inflation-linked bonds has risen from 1.75% to 2.15% in the US and from 0.70% to 1.00% in Germany in recent weeks. More and more strategists and economists are beginning to see a return of inflation in the coming years. There are several arguments in favour of such a scenario. First of all, it would result from the massive monetary creation of recent years and which, in reaction to the pandemic, has been expanded even more. For the moment, there have been no wide swings from one currency to another, as the major central banks have adopted similar policies. But currencies’ intrinsic value looks lower, and that should boost valuations of real assets, including gold and precious metals. Meanwhile, assuming that the pandemic fades in the coming months, the expected rapid rebound in consumption could trigger a temporary outstripping of demand vs. supply, something that would push up prices. In any case, inflation will rise in the coming months, due to base effects. As the months of March and April are erased from the last-12-months statistics, inflation could soon move above 2% in the US.
We therefore don’t expect interest rates to vary much in the coming months. Key rates will remain unchanged, and euro zone money-market investments will remain in negative territory this year. Nor are long bond yields likely to move much. We expect the 10-year Bund to level off at about -0.50%. In the US, the natural rise in 10-year T-Notes should be held in check and trend very gradually towards 1.25/1.50 at yearend.
Corporate bond markets are also likely to stabilise. In Investment Grade, the widening in spreads seen during the run-up in yields in March has been almost fully erased, and there is very little potential remaining. High yield bonds have taken a similar path. With an overall yield of almost 2.8%, they are still relatively attractive in a buyand- hold strategy, as there is no longer much potential narrowing in spreads (difference between rates). Likewise, emerging bonds, particularly those issued in local currencies, offer a relatively attractive yield of about 4.5% on average maturities of about 5 years and constitute a good diversification with currencies more expensive on the whole.
Earnings seen higher but multiples seen lower
After a sharp drop in 2020, corporate earnings are ultimately likely to rise significantly, in tandem with the expected economic recovery. The rebounds could be quite considerable. For the moment, an increase of almost 25% is forecast for S&P 500 aggregate earnings in 2021, and 37% for the EuroStoxx. This momentum in earnings recovery could continue in 2022 with the gradual fading of the pandemic and the gradual return to more normal economic activity.
That would work out to a 2021 P/E (PER: Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of 22.6 for the S&P 500 and 18 for the EuroStoxx – rather high by historical standards but justified by low bond yields. We therefore expect only a portion of this recovery to spill over into the markets, and for a very good reason: once the pandemic is quite under control, it will be time to turn to some sticking points, including the normalisation of monetary, and fiscal policies and tax hikes. Keep in mind that Joe Biden’s campaign platform called for a hike in corporate income taxes from 21% to 28%. Meanwhile, the increasing use of share buybacks (which, in the US system, is a way to return cash to shareholders with a lower tax rate than a conventional dividend) was highly criticised by candidate Biden. This would seem to point to lower valuations down the road. In light of the above, equity markets are likely to rise but less than earnings to less excessive valuations.
To illustrate this reasoning, based on an average assumption that, beginning 2022, earnings of S&P 500 companies will rise by 7% annually for five years, that would mean about USD 250 in earnings per index point in 2027. A P/E of 20 would mean an index at 5000 points in 2027, or almost 30% upside potential from current levels, plus a dividend yield of about 2% per year. But to justify a P/E of 20, interest rates would have to rise very little over the next five years.
Value/cyclical style stocks have suffered somewhat in recent weeks with fears of a delayed economic rebound. But ultimately, under this recovery scenario, they should make up some of the ground lost in recent years.
Our central scenario
The pandemic’s new dynamics, including its variants, could weaken and delay the economic recovery. We are rather confident, however, in prospects thereafter and expect the rebound to be even more robust if it is postponed, as pent-up consumption and investment should stimulate growth, once the pandemic is over.
That being said, the markets have already priced in most of the recovery, and a new, more volatile phase could therefore open up. After the nice recent gains, we recommend reducing equity exposure in order to be more “comfortable” to invest in the event of a correction. We expect central banks to remain on a highly cautious footing in the “return to normal” process and be to be sure to support public financing on accommodative terms.
Document completed on 25/01/21
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com