Panorama - April 2021 -
From a sense of vertigo to a state of euphoria, all in the space of a year…
Deputy Chief Executive Officer,
Chief Investment Officer
It has been a rollercoaster of a year, with a steep drop in the markets followed by a spectacular rebound that has pushed equity indices back up towards their historical highs or pre-crisis levels.
These sudden fluctuations are worth examining more closely and there are lessons to be learned from this unprecedented crisis. We would recommend taking a step back, from an investment perspective of course but also to consider what we can learn from recent events at a time when the best opportunities on offer also incur a number of risks.
The figures cited deal with past years. Past performances are not a reliable indicator of future performances.
We are gradually emerging from this crisis with mixed feelings
On the one hand, the pile of debt has increased further to worrying proportions. This debt will have to be repaid one day and/or carried for a long time, and we all know that a big debt burden erodes a country’s capacity to invest on behalf of its future generations. Moreover, our economies seem increasingly dependent on life support from their monetary and government authorities. On the other hand, there is also reason to get excited! The past year has shown just how creative and entrepreneurial humankind can be. We saw this in the speed at which vaccines were found, of course, but it is also reflected more generally in an expanding digital economy. Meanwhile, the crisis has further boosted our ecological awareness and we will see tremendous progress made towards building a “green” economy in the years ahead.
However, it is worth bearing in mind that the crisis is not actually over yet. There are still too many Covid-19 patients, and many economic sectors are still running below capacity. But investors are in an entirely different position. They have seen economies bounce back rapidly thanks to vaccination campaigns, vast amounts of liquidity injected by central banks, and a massive investment plan in the USA which could provide fuel for other countries… So growth is going to pick up, and most economists feel equally optimistic about this. Economic activity will begin to rebound sharply as of the second quarter, especially in the USA. Global GDP growth might therefore beat the consensus, which currently stands at +5.5% for 2021. The eurozone will lag behind somewhat due to complications on the vaccine front but is expected to deliver more than 4.0%. China, on the other hand, is ahead of the cycle. The country reopened its economy earlier and has also benefited from its exports of electronics and healthcare goods. It is now beginning to remove the macroeconomic stimulus measures it had introduced, for instance by curbing bank lending.
WHAT FACTORS SHOULD WE CONSIDER IN THESE UNUSUAL CIRCUMSTANCES?
The central banks are now part of the public debate and have become a key parameter to consider in any market or economic analysis. The Chairman of the US Federal Reserve, Jerome Powell, provides a good example of the social role taken on by central banks. He regularly points out that he has two major objectives: to push employment rates back up to fully satisfactory levels, and to keep the average trend for inflation stable at around 2%. So until these two goals are achieved, we can expect US monetary policy to remain unchanged; this means that key interest rates will stay at 0% and the bond-buying programme will continue apace ($120bn per month). It is all really quite simple. The ECB’s policy, meanwhile, is actually rather similar even though it has not set such specific economic objectives. The ECB’s strategy review (launched in early 2020) is still ongoing, the aim being to review its purpose and objectives. The conclusions of this strategy review are to be published soon and will provide some hugely valuable guidance. So the “central bank” parameter is crucial to understanding market behaviour, and economic observers must bear in mind that central banks have their convictions and unlimited resources. However, this “nationalisation” of yield curves and of the bond markets in general raises questions about the structural allocation strategies investors should adopt, given that many of the assets in their portfolios are delivering almostzero returns and offer poor rerating prospects.
It is amid this abundant money creation and almost-zero interest rates that a new asset class has begun to emerge in recent months: cryptocurrencies. Bitcoin in particular, the most emblematic of them all, has become something of a symbol of our time. The bond segment as a whole, long considered an essential building block of any robust long-term portfolio, has now lost much of its credibility. This has prompted some of the big international banks to advise their clients to add bitcoin to their asset allocations, which is by no means inconsequential. It is worth taking some time to consider this topic, without being dogmatic, in order to answer a few basic questions.
What is bitcoin? It is a tradable asset, the value of which fluctuates depending on supply and demand; bitcoin transactions seem quite secure and traceable, and it is blockchain technology that provides this security. Supply of the asset is limited: the cryptocurrency has been designed in such a way that no more than 21 million bitcoins will ever be issued. There are currently 18 million bitcoins in circulation, which means that they are now being issued at a slower pace, unlike conventional currencies.
So is it actually a currency? The answer is no, because bitcoin is not referenced by the international central banks that oversee the banking industry. Banking institutions are therefore not obliged to accept bitcoin as a means for settling transactions, contrary to currencies. That does not change the fact that transactions can be settled in bitcoin if both parties agree to exchange goods for bitcoins, just as goods can be exchanged for gold… in a sense one asset is being swapped for another. Plans by the major international central banks to issue cryptocurrencies will never really create any competition for bitcoin, for one simple reason: they will probably be interchangeable with existing currencies. A “cryptodollar” will thus be closely correlated with the existing dollar, with perhaps just one difference being the transaction fees involved when using blockchain technology. Otherwise, if these newlyissued central bank cryptocurrencies were not interchangeable, it would amount to an implicit admission that central banks have reservations about the value of their own currencies; this would undoubtedly have devastating repercussions for global confidence. In short, we simply need to acknowledge that bitcoin exists, it seems quite secure as a transactional currency, and its price varies according to supply and demand and is extremely volatile. Its underlying “fundamental qualities” could be listed as follows: limited supply, loss of confidence in conventional currencies, and evidence of the market’s general appetite for risk.
We would also point out that bitcoin is highly controversial from an environmental point of view. In any case, this is a new asset that is worth keeping an eye on, but a highly risky one.
Does Joe Biden’s election in the USA signal the end to the “liberal revolution” that began over 40 years ago? Donald Trump ultimately comes across as being one of the most emblematic victims of this Covid-19 crisis. If Covid-19 had never happened, he would probably have been re-elected for a second term as he delivered an otherwise rather satisfactory record, including joblessness at a low and Wall Street at a high. But his defeat clearly shows that times have changed. Liberalism (at least state liberalism, i.e. fewer taxes and fewer regulations, which kicked off when Ronald Reagan was elected in 1980) has run its course, at least in the public mind, despite having sustained a long period of general prosperity worldwide. Attitudes are changing as people now aspire to sustainable modes of consumption, they are questioning the search for perpetual economic growth, and movements like Occupy Wall Street and France’s “yellow jackets” have emerged along with personalities like Greta Grunberg. Joe Biden may have won largely on the back of Donald Trump’s disastrous management of the public health crisis, but he was also elected because his ideas overlap with many of the themes embraced by the younger generation. So current thinking points in the direction of establishing new consumption models and imposing higher taxes (all this debt will have to be repaid, the state will need to take on a bigger role, etc.). The 8-year investment plan adopted by the US administration amounting to approximately €2,200 billion is all part of this new mindset, and it focuses on two segments in particular: infrastructure and the “green” economy… Furthermore, it will be funded not by taking on more debt but from tax revenues! It is important that the prospect of higher taxes (more or less everywhere) to pay off all this debt does not erode consumer confidence or make consumers think twice about spending the savings they have built up.
The eurozone’s structure: the never-ending story... This is a recurring issue and often at the back of international investors’ minds as the euro’s construction does not always seem coherent: the criteria set out in the Stability and Growth Pact fell apart at the seams during the Covid-19 crisis, and it now seems clear that many countries (including France) will be unable to bring their debt/GDP ratios back below 60% and their budget deficits to less than 3% of GDP any time soon (these are the two main rules to observe, in theory). A growing number of economists did indeed denounce these principles when the crisis hit. With Brexit signed and sealed, the eurozone initially managed to reassure the markets by agreeing on the economic recovery fund to be financed by debt issued in the European Commission’s name.
But the sunny spell did not last long. The eurozone handled the public health crisis in a bureaucratic and rather inefficient manner, with no real solidarity between the different countries. The euro is bound to become an issue for the markets again sooner or later.
Germany’s federal election in September will probably fuel the debate on the euro, and the markets will follow it closely.
The central banks may have a harder time communicating to the public due to the issue of higher inflation in the short term
Consumer price indices are going to pick up over the coming months due to factors that will very probably be short-lived. Commodity prices have surged in recent months, as have freight costs, and some sectors are also experiencing shortages due to temporary imbalances between supply and demand. But there is not yet any risk of prices spiralling out of control in the medium term. Wages are still being held back by the fact that economic activity is not yet vibrant enough to secure full employment. The bond markets could therefore become more volatile, vacillating between the immediate impetus provided by a sharp rebound in economic activity on the one hand, and by the “overall trend” perspective adopted by central banks on the other. So we do not expect any changes to be made to monetary policies in the coming months. Short-term interest rates will thus remain at 0.00% in the USA and between -0.50% and 0.00% in the eurozone. Long-term bond yields, meanwhile, are likely to end up settling at around 2.00% in the case of US 10Y T-Notes and in the region of -0.20%/0.00% in the case of the German 10Y Bund.
The credit bond markets are also expected to stabilise. A look at the Investment Grade segment shows that the widening of spreads (difference between rates) observed in March has been almost completely absorbed, and there is now very little potential left. High Yield bonds have followed a similar path.
Emerging market bonds as a whole have been somewhat penalised by the rising dollar and by certain specific cases, namely Brazil and Turkey. The dollar is riding the wave of the USA’s economic growth momentum and higher bond yields, and an appreciating greenback tends to take a toll on emerging currencies. The Brazilian real and Turkish lira are having a particularly hard time because Brazil is managing its public health crisis very poorly and Turkey’s governance is hard to decipher.
Our view is that emerging currencies are rather attractive on the whole, and the yield on local debt looks appealing at around 5% overall for maturities of around 5 years.
Company earnings are set to rise, but share prices may not do so in the short term
We have already pointed out on previous occasions that a rise in interest rates is not necessarily incompatible with an equity market rally, as long as they are being hiked for the right reasons (i.e. an upturn in economic activity) and not too rapidly, and the hikes are carefully administered by the central banks and fully understood by investors. This ought to be the case here. Interest rates are among the most crucial factors to consider when evaluating equities: interest rates have fallen steadily for a number of years and valuation multiples (expressed mainly in terms of PER, i.e. price to earnings ratio) have risen significantly, as indeed have all asset prices. So interest rates are naturally a point of reference for valuation estimates. The PERs of S&P 500 stocks (the USA’s 500 biggest stocks) are currently around their historical highs of 22 for 2021 forward earnings and 20 for 2022 forward earnings. To put it simply, we expect earnings per index unit to reach USD200 in 2022, which would put the index at 4,000 points for a PER of 20. This means that the expected positive earnings momentum (earnings per index unit came to around USD138 in 2020) is already priced in. The same applies to European equities, although absolute valuation multiples in the eurozone are lower (with a 2022 PER of 15).
We therefore believe that most of the stockmarket’s upside potential has already materialised, which is why we are a little more conservative on equities and will remain poised to reinvest if the markets dip. Note also that earnings forecasts will be at risk if corporate taxes are raised. The analysts at Goldman Sachs have calculated that an increase in the corporate tax rate from 21% to 28% (it was 35% when Donald Trump reached office) would shave 9% off company earnings. If that were to happen quickly, earnings per S&P 500 index unit would fall from USD200 to USD182 in 2022. However, we still consider equities to be the most attractive asset class from a medium-term perspective: bonds offer little upside potential but dividends still look relatively appealing. We also expect the catch-up to continue for the market’s more cyclical stocks and those exposed to higher interest rates.
Our central scenario
We still feel generally very upbeat about the economy; however, we reiterate our rather moderate position on the financial markets, which have already priced in this recovery, and are somewhat wary of the current bout of excessive euphoria.
Our central scenario therefore sees the markets settling at current levels, although perhaps with more volatility. The current uptrend in the equity markets looks impossible to sustain in the short term.
Nonetheless, we still feel very optimistic about the medium/long term and are convinced that the positive impetus driven by corporate creativity and risk-taking will prevail. So it will be worth bearing this in mind in the event of a rather steep correction.
Document completed on 08/04/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com