Financial Markets Flash - 21 April 2020 -
Capitalism culminates in communism… and vice versa!
Deputy Chief Executive Officer,
Chief Investment Officer
Just a little humour there to refer to the 1970s, an era of highly engaged ideological and political debate. But then the Berlin Wall came down, the Soviet Union collapsed, globalisation arrived... and society’s priorities changed. But with the economic crisis now deepening and public authorities intervening in an unprecedented manner, the topic of nationalisation has begun to resurface…
Governments and central banks have been quite quick to take matters in hand as they strive to save businesses during this brutal economic recession triggered by the global coronavirus epidemic. This has been a rather more complicated process in the eurozone, as is often the case. An economic stimulus plan was finally agreed on, but without resorting to eurobonds, a form of debt mutualisation fiercely opposed by some of the region’s northern countries. The debate is set to continue this week at the EU summit meeting to be held on 23rd April, which will probably create tension and potentially take a toll on the euro in the short term. France has taken some rather specific measures to avoid bankruptcies as far as possible. The most spectacular and probably the most important of these is the government’s decision to cover the costs of short-time work, which is ultimately a form of wage nationalisation.
But it is in the USA, the world’s most ideologically capitalist country, that the most substantial measures have been taken. An action plan totalling $2,300bn has been adopted at a time when the budget deficit was already heading towards the $1,000bn mark; this amount is unprecedented at such an advanced stage of the cycle following more than 10 years of continual growth. Meanwhile, the Federal Reserve has so far added $2,000bn to its balance sheet since the crisis began, corresponding to a 50% increase. One new development is that the Fed can now purchase High Yield bonds via ETFs (Exchange Traded Funds). This puts certain issuers at an advantage over others: based on the method used to calculate these trackers’ underlying indices, the most heavily indebted companies are the most heavily weighted and therefore best placed to benefit from the purchase programmes, which have so far amounted to over $7bn.
So we have moved into uncharted territory, and questions are being raised. Such intervention distorts a naturally illiquid market and skews the natural price setting mechanism, so much so that fundamental fund managers and investors could find themselves undermined.
The next step that central banks might take is to buy up equities. The Bank of Japan has a head start when it comes to providing economic stimulus and tackling deflation as it has been buying up Japanese stocks for several years now, also via ETFs. But it stands accused of distorting natural market mechanisms and sustaining zombie companies which should otherwise have died off.
So the border between natural market mechanisms and state intervention has become a porous one. The best option is to remain more pragmatic than ideological. When the economy eventually recovers, it will be up to governments to withdraw and once again leave the price-setting game to the free market. The precedent of 2008 shows that central banks and governments “made money” from the crisis: the assets purchased under the US Troubled Asset Relief Program were subsequently sold off and generated an overall capital gain. Ditto for the partial nationalisation of General Motors.
This leaves the question of public debts, their value and their significance. These debts might never be repaid considering the amounts in question, now exceeding 100% of GDP in many cases. They will be rolled over with the support of central banks, which hold the lion’s share of these debts. Should they be cancelled, at least the share held by the ECB? A debate is beginning to emerge around this question. But, in any case, it amounts to more or less the same thing if these debts are held to maturity. Such arguments surrounding ideology and principle will continue. If we want to put our public finances back on a healthy footing, spending will have to be cut back and/or taxes will have to be increased, which is currently inconceivable. And soon the debate will turn to the question of introducing a universal income. Why not?
As far as debt levels are concerned, interest rates are likely to remain low over the coming years judging by the IMF’s latest reports The IMF has naturally cut its 2020 growth projections: it now expects the global economy to contract by around 3.0% (it forecast about 3.4% growth at the start of the year) and then bounce back by +5.8% in 2021, which seems an arbitrary estimate at this stage. More importantly, the IMF expects the output gap to remain in negative territory until 2022 or even 2023: in layman’s terms, this means the global economy will operate at less than full capacity for another 2 years. This also means that inflation will stay low and probably that interest rates will remain close to their current levels of around 0%.
As such, we think the best option is to invest in companies and/or “real” assets rather than government debt.
With respect to companies, we currently find corporate bonds more appealing than stocks, even though High Yield bonds have rebounded significantly over the past two weeks. Yields on Investment Grade bonds (especially at the short end of the curve) and on High Yield bonds nevertheless remain attractive in relative terms from a buy-and-hold (buy to then hold) perspective. Meanwhile, the main equity indices have regained more than 20% recently, so our view is that stocks offer little upside in the short term and that a period of higher volatility will probably create more appealing entry points. The reporting season has barely begun and could prove disappointing.
It might disappoint partly due to a dearth of information, with CEOs struggling to issue reliable guidance given the sheer lack of visibility on how and when we are going to emerge from this crisis. Moreover, earnings are expected to plummet. For instance, aggregate earnings for S&P 500 companies were in the region of $170 per index unit in 2019. This corresponds to a 2019 PER (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of 16.2 for the index at current levels. However, given the scale of the economic recession, earnings could possibly slump by 35% this year; this would point to a 2020 PER of over 26, with no visibility on how or when the situation is going to return to “normal”…
Real assets provide a form of insurance against market wariness towards public sector assets and currencies, at a time when the markets feel they have lost their bearings.
Gold should continue to benefit from these circumstances and push past its historical highs of around $1,900 per ounce in the coming months.
Document completed on 21/04/2020.