Panorama - March 2021 -
Central banks: is their discourse now discredited?
Deputy Chief Executive Officer,
Chief Investment Officer
This Covid-19 crisis has put central banks under the spotlight, and they have received praise for their rapid and pragmatic response. But after a year of money creation on a massive scale, there are now various questions that need answering. Are they still independent, working on behalf of economic growth and price stability, or have they been led astray by governments looking to lighten their debt servicing costs? US 10-year yields have tripled since last summer and they are now picking up more quickly. Is this merely because bond investors are in a temporarily despondent and rebellious mood, or are we seeing the signs of a more serious loss of confidence?
The figures cited deal with past years. Past performances are not a reliable indicator of future performances.
Economic and financial newsflow has been dominated by the Covid-19 virus for practically a year now, putting our nerves to the test! But now, at last, we are beginning to see the light at the end of the tunnel: the number of Covid cases worldwide is falling sharply and we are now increasingly hopeful that the world will open up again quite rapidly. The US and UK vaccination campaigns are going really well. The eurozone is lagging behind for the time being, for some reason, but things will sort themselves out eventually. Asia, meanwhile, and China in particular have generally resolved the problem already…
So the outlook is improving, following the worst recession since WWII, and questions are going to be asked about monetary policies returning to normal. The central banks have well and truly stepped up to the plate during this crisis, financing public deficits and debt on a large scale. They have thus gained a great deal of credibility throughout the world and become central to the public debate. The measures they have taken have proved effective: they helped to support companies and prevent bankruptcies, and they also created adequate conditions to maintain a certain degree of social cohesion among the population. The strategies and resources they deployed may have seemed rather bold, but the action they took was ultimately consistent with one of their top jobs, which is to maintain adequate growth conditions to aspire to full employment. Their other key goal is to guarantee price and monetary stability. In theory there is no upper limit on the balance sheets of central banks, but it is this second goal that is beginning to raise some serious doubts in the markets. With the economy picking up and signs of inflation reappearing, now is perhaps a good time to worry about the potential negative longer-term effects of all this artificial money creation, which will end up eroding the purchasing power of households and savers…
At the same time, higher inflation would lower government debt-to-GDP ratios more rapidly as a higher inflation rate leads to higher nominal GDP growth… Governments will be unable to adopt a more austere approach to managing public spending any time soon because this could upset the social cohesion in their countries. All these topics are beginning to take a toll on the bond markets. In the current circumstances, an uncontrolled surge in interest rates would trigger a negative snowball effect on the markets and on asset prices in general. The central banks are going to have to restore confidence on all these issues.
On the economic front, countries accounting for around 90% of global GDP will be operational again within a few months. We can expect to see a catch-up effect in terms of consumer spending and investment, which will spur faster economic growth and probably push prices up temporarily.
Over in the USA, the model used by the Federal Reserve Bank of Atlanta to measure instantaneous GDP now points to around 9.5% growth versus 5.0% at the start of the year. All the high-frequency data out there agree, and consumer spending could pick up further when households receive their stimulus cheques from the US Treasury as part of Joe Biden’s rescue plan, which has just been adopted and will fuel the economy for the next few years.
Here in the eurozone, there is a risk that the recovery will be held back by a sluggish vaccination campaign that is forcing the authorities to keep their lockdown measures in place. This is penalising the services sector above all, while the industry sector appears to be doing better. Leading economic indicators (PMI) generally look perky nevertheless.
China is ahead of the cycle compared with other countries as it resolved its public health crisis sooner. Having initially bounced back quite strongly, its economy is soon going to run out of steam, especially as the government seems keen to prevent certain sectors from overheating, for instance to keep property prices in check. So China’s leading indicators are beginning to edge downwards; that said, overall business sentiment and consumer confidence for the medium term remain quite healthy, which is reassuring.
Global economic growth in 2021 could therefore exceed the current forecasts issued by the big market research institutes. Having contracted by 3.8% in 2020, the global economy could expand by 5.4% according to the economists’ consensus compiled by Bloomberg. The US economy is seen rebounding by 5.0% this year following a -3.5% recession in 2020. But a growing number of strategists believe it could recover even more strongly now that the American Rescue Plan has been adopted. The most optimistic among them are looking for 7.0% growth in 2021. The situation is a little different in the eurozone where growth is seen reaching 4.2% in 2021 following a -6.8% recession in 2020! China, meanwhile, is expected to deliver a solid economic growth rate of 8.4% this year compared with just +2.3% last year.
All this economic stimulus and money creation is drawing attention back to the topic of inflation. The latest statistics suggest rates of inflation will recover significantly from their very low Covid-19 crisis levels. This could be seen as an indication that the central banks are going to get their way and that the rate of inflation will approach their 2% target (Fed and ECB). But for the time being, it is worth bearing in mind that inflation is often considered on a 12-month trailing basis and that this is primarily the sign of a catch-up effect following last year’s highly unusual circumstances. Oil prices have jumped over the past year and the disinflationary effect of the public health crisis on certain service prices is going to ease off at a time when corporate costs are feeling the strain (shipping rates are up sharply, there is a shortage of electronic chips, commodity prices are generally trending upwards on the back of the economic upturn, construction activity is resuming while lumber prices are soaring...).
So there is clearly a risk that price indices might surge in the short term, especially in the USA where inflation could end up in the region of 3% for a few months; the Fed has already considered such a scenario and said it will not intervene if it materialises. The eurozone rate of inflation is nowhere near the 2% target...
Central banks are once again going to have to defend their scenario...
As we mentioned in our last note, central banks are now going to have a harder time communicating to the public. It is becoming increasingly difficult to understand how such procyclical policies can be maintained when we are looking forward to such a strong recovery. Yet the central banks have not changed their perspective and it does actually make sense because jobless rates are still too high on both sides of the Atlantic. Unemployment compensation schemes have not been as generous in the USA as in the eurozone, and 9 million Americans have still not been able to return to their jobs. Moreover, the labour market participation rate is unsatisfactory, which was not the case before the crisis. So central banks remain vigilant and will be reluctant to change course on their monetary policies too abruptly, which is understandable. It is also worth bearing in mind that Federal Reserve Chairman Jerome Powell had already factored in such a temporary surge in inflation: he says he will consider rather the average trend for inflation, which suggests that he would let the rate exceed the 2% target for some time if necessary. The ECB is set to give another speech in the coming days but is likely to adopt a similar line.
The action being taken by central banks is therefore consistent with their fundamental analysis of the situation and their rationale: so we are unlikely to see any changes made to their policies in the coming months. They will pursue their asset-buying programmes and interest rates will remain at their current levels until 2023. They do not see inflation spiralling upwards for any long period of time. There are certainly still plenty of underlying deflationary forces in play in our economies right now: if the trend towards reshoring does indeed materialise, it will be such a slow one that globalisation will continue to exert downward pressure on prices; technological progress is spurring productivity; our populations are ageing and, in some cases, shrinking...
So interest rates will begin to rise at a slower pace and continue to be steered by the central banks, ending up within a few months in the region of 1.75%/2.00% in the USA (for the yield on 10-year T-Notes) and -0.20/0.00% for the German Bund. We expect no additional tightening of spreads (difference between rates) in the Investment Grade segment as the economic rebound has already been priced in. We might see some tightening as interest rates rise (but by around 10bp, which is still only moderate). The same applies to the High Yield segment, although HY bonds still look attractive based on their yield differential.
Emerging bonds have been penalised by rising US yields and those in local currencies have been undermined by a relatively firm dollar. We still think they look attractive on a medium-term horizon, with a basket of 5-year govies now offering an average yield of close to 5%.
As regards exchange rates more generally, the dollar is enjoying some positive relative momentum driven by the US economy and rising bond yields. This impetus could continue for another few weeks, especially against the Chinese RMB which rallied strongly last year. From a fundamental perspective, however, we do not think the greenback has much upside potential left. Instead we believe the main international exchange rates are close to their objective breakeven levels, without any of these core currencies being seriously undervalued or undervalued.
Gold has recently been undermined by rising real interest rates. Our view is that gold makes an interesting diversification asset to hold in an investment portfolio and that the timing is right to buy gold again given current prices.
Higher interest rates = lower share prices?
We are seeing quite a lot of sector rotation but, for now, the equity markets are generally holding up rather firmly and have not been hit too hard by rising bond yields. Essentially, bond yields are rising for the right reasons, i.e. a brighter economic outlook. History has shown that higher bond yields do not necessary imply lower share prices: the equity markets have risen in 13 of the last 16 instances of significant increases in bond yields since WWII. The only exceptions (all of which left unpleasant memories!) were in 1987, 1994 and 2018: the markets were wrong-footed by the Federal Reserve’s decisions on all three occasions… We would also add that interest rates are particularly low in absolute terms this time around, and that some degree of normalisation is only to be expected. The markets have already priced in the end of Covid-19 and an economic reopening: some of the best-performing sectors year-to-date are those that lost the most during the lockdowns. Note that these sectors began to bounce back in November, with rallies on oil stocks, industrials, airlines, banks (thanks to a re-steepening yield curve), etc.
On the other hand, growth stocks trading on the highest multiples have naturally fallen more steeply in recent weeks: this is because they are by nature more sensitive to interest rate variations, both upwards and downwards.
The world’s largest caps (Apple, Amazon, Microsoft and Tesla of course) lost up to 10%/15% during this period (-33% in Tesla’s case!), before recovering a little in the past few days. We reiterate our view of recent months that the catch-up by cyclical / value sectors is not yet over. More generally, we expect corporate earnings to deliver a spectacular turnaround this year: +25% earnings growth expected for S&P 500 companies and +32% for eurozone companies, and these forecasts could be revised upwards. The first forecasts issued for 2022 point to around 17% earnings growth in both the USA and the eurozone. In valuation terms, this points to S&P 500 PERs (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of 22.5 for 2021 and of 19.5 for 2022, and Eurostoxx PERs of respectively 18.7 and 15.5. This is neither overdone nor undervalued. Other valuation methods (price/asset value ratios, cyclically adjusted PERs, etc.) suggest rather that equities are generally a little overpriced. However, they are still attractive in comparison with bonds, largely thanks to their dividend yields. We believe the markets have already priced in this earnings recovery to a large extent in recent months. So share prices could take a break as the bond markets turn more volatile. We therefore advise investors to maintain a “neutral” position on equities so that they can reinvest more comfortably during the bouts of higher volatility that could materialise over the coming weeks.
Our central scenario
“Good News = Bad News, and vice versa”! The prospect of a rapid economic recovery naturally raises the risk of interest rate hikes and higher inflation… thus putting downward pressure on asset valuations which have been fuelled by all the money creation! However, this shows that the economic climate is improving, and corporate earnings are going to be much better this year and next. In these circumstances, all the underlying forces in play appear to be balancing each other out. And, ultimately, the message emanating from the central banks is this: let’s remain modest and cautious after such a terrible crisis, let’s not rush into anything!
We therefore reckon that monetary policies will remain accommodative and that the markets will factor this in sooner or later. In the meantime, we advise investors to adopt slightly more conservative investment strategies in order to maintain some leeway so that they can take advantage of the more volatile conditions that could possibly arise.
Document completed on 11/03/21
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com