Panorama - November 2021 -
Has the traditional yearend rally begun?
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
Spike in commodities prices, shortages, inflation, announced tightening of US monetary policy, disruptions in China, rebound in Covid-19, and so on. The equity markets have mostly shrugged off these burgeoning concerns and have shown remarkable resilience.
They are once again rubbing up against their all-time highs, on the back of companies’ quarterly results.
A yearend rally in view?
Context and analysis
The spike in bitcoin is a perfect illustration of the Zeitgeist. The best-known cryptocurrency is up by almost 50% since the end of September and has hit a new all-time high. And yet, few cryptocurrencies have been singled out in recent weeks for so many attacks and controversies as bitcoin. It has been criticised in China for miners’ carbon footprint, targeted in US for a rumoured regulatory crackdown, and suspected by central banks of being dangerous. But buyers don’t seem to care. The creation of an ETF indexed to bitcoin futures has been a big success, with more than $1bn in inflows in just two days.
Nor has the general nervousness had any impact on the markets. Solid company earnings have actually caught overly cautious investors wrong-footed. 80% of US professional investors surveyed in early October by Barron’s, a financial weekly, expect a correction on Wall Street in the next six months, i.e., a plunge of between 10% and 20%. And, of course, when the entire market expects something to happen, it never does.
So, the main Western indices have hit their all-time highs and seem to be solidly anchored in the bullish trend that has endured for several months. But are they really? Maybe. Or maybe this is a mere phase of “short covering”. A return to a risk-on stance may be problematic in such a challenging economic and political landscape, which is being dominated by two major issues:
- The risk of a slowdown in the economy.
For a few months now, consumer confidence indicators have declined, particularly in the United States. Statistically, this is a rather reliable indicator that tends to flag economic downturns several months in advance. And this is entirely possible. After a post-pandemic spike driven by pent-up consumer demand and with household savings up, higher prices could take a toll, energy prices in particular. Wage hikes are expected to follow suit. This shouldn’t hit companies too much, as productivity is still strong for the moment. But the risk of slowdown could also be exacerbated as fiscal policies become more restrictive.
We are about to hit the end of “whatever it takes” almost everywhere in the world. In the United States, the two stimulus plans have not been approved as is and will be smaller than expected. Of the $6tn originally expected for the two plans (infrastructure and social), only $2.5tn should be left. This will mean a smaller fiscal stimulus next year than this year. In the euro zone, a consensus is emerging in southern countries to continue supporting the economy, despite tax receipt “surpluses” that are better than expected (actually, fiscal deficits that are lower than expected). Northern European countries, Germany in particular, have not yet stated clearly their fiscal strategy for the coming years. But a divergence in opinion looks likely within the euro zone. Moreover, tax hikes could ultimately be in the offing, and that could make households even more cautious. For the moment, global growth is forecast at 4.5%, but with a downward revision risk.
In light of the above, the rise in inflation expectations seen in recent months is likely to stall, which would be good news. For several months now, we have seen a spectacular rebound in inflation, which makes sense given the aggressive recovery in the economy that followed the Covid-19 crisis.
Implied inflation as priced into 10-year US inflation-linked bonds has also risen sharply in the past year and a half from almost 1.00% to 2.65%, which is closer to the 20-year high. We see this as a very important indicator, as central banks tend to keep a close eye on this perception of long-term inflation.
This illustrates their credibility and limits pressures on the bond markets. For the moment, investors are accepting negative real rates, as, like the central banks, they seem to believe that rising inflation is a mere transitory phenomenon.
The central banks have managed to create conditions that are favourable to financing of governments, and their debt burdens are becoming no worse. Accordingly, given the risk of an economic slowdown, and if inflation expectations recede, the bond markets should stabilise on the whole, with yields around 2% on 10-year US paper and 0% on the Bund. This is the most important point. Remember that long-term interest rates are the anchoring point for valuing all assets. In our view, the main risk for the markets is no longer upward pressure on bond yields, but an economic slowdown likely to trigger downward earnings forecasts.
- The issue of China.
China has become a very important player in the global economy. Not only is it the world’s second-largest economy, it is a very important market for many Western companies and has become an essential link in international manufacturing chains. And in recent months, pushed it this direction by President Xi Jinping, it has been in a phase of adjustments and changes of direction that are creating lots of short-term disruptions. The real-estate sector has been especially hard hit, and it accounts for almost 30% of GDP. China’s growth was almost nil in the third quarter. While a rebound is likely in the fourth quarter, there is little visibility in the current context. The decision to impose a real-estate tax (whose terms are still unclear) could slow investment drastically in this sector. In the longer term, the goals are certainly praiseworthy and aim to rebalance the Chinese economic model towards “common prosperity”, meaning greater solidarity between social classes, a greener economy, a boost to the birth rate, and so on. But this could also mean a more inward-looking China that relies mainly on its huge domestic market of 1.4 billion persons, with a boost to the birth rate and the critical mass necessary for the development of large companies. With, in addition a population that is more isolated from Western ideas.
This scenario that seems to be looming would be a pity, coming just 20 years after China joined the World Trade Organisation (WTO). This entry into a globalised world gave it access to international markets and thus allowed it to speed up its industrialisation and development through highly competitive exports and exchanges of know-how with the West. Within 20 years China’s GDP has risen 15-fold. While it has become a bigger player on the international stage, Covid-19 may have acted as a sort of catalyst in accelerating this inward-looking mindset. However, we don’t believe these measures signal a complete change in direction and a retrenchment into a fully nationalised economic model. Capitalism and entrepreneurship have not been set aside, particularly in China’s fast-growing tech sector, in which it has achieved something of a lead. This is what President Xi Jinping just reaffirmed, stressing that China had the means to be fully autonomous in technology in the coming years. The digital economy’s share of China’s GDP is targeted to rise from 7.8% to 10% during the current five-year plan, which is due for completion in 2025. In short, if the regime has no electoral legitimacy, it must have some by producing concrete results from its “common prosperity” policy. That’s why we believe that China remains “investible” for the long term, as it offers an environment that is favourable to expansion by growth companies. And yet, recent events have sent international investors to the side-lines. A recent survey of US professional investors by Barron’s, the financial weekly, is instructive: 80% of them have no plans to buy Chinese equities in the coming 12 months, owing to the unclear environment that we have described, as well as the tense geopolitical context between the US and China. In a way, this is a good sign. That means that investors will “chase” the market in the event of a rebound, especially now that Chinese assets have joined the international indices. For, at current prices, a rebound cannot be ruled out, as absolute valuations have become attractive and relative valuations, even more so.
Accordingly, while the risk of runaway interest rates appears to have receded, the economic, geopolitical and public-health context does not favour near-term risk-taking in portfolios. We therefore have the feeling that there’s no point in trying to blindly join the possible yearend rally. We prefer sticking to equity weightings that are in line with our strategic allocations, and will add to those weightings on any dips.
Yields rise under the control of the central banks
Nominal rates have risen in recent weeks on both sides of the Atlantic. Meanwhile, real rates have fallen substantially, hitting all-time lows in Europe. The real 10-year German yield is now close to -2.20%, and its US peer has fallen below -1.00%.
This divergence has resulted in a sharp rise in inflation breakeven points, to 2.00% in 10-year yields in Europe and 2.65% in the United States. So here we are, at 2011 levels in the former case, the last year in which the ECB raised its key rates. But we’re not there yet.
This trend is being driven mainly by the spike in energy prices, which are pushing up inflation numbers, the highest of which are still ahead of us. Total inflation in Europe is projected at more than 4% at yearend, before beginning to recede in 2022. In the US, it could brush up against 6%.
This trend is also due to the fact that the Fed and the ECB insist that they see inflation as mostly due to transitory factors and that they will not rush into monetary normalisation. The market is beginning to have its doubts, given the number of rate hikes now priced into futures for 2022: two in the US and almost one Europe. This may be jumping the gun, especially as consensus growth trajectories for 2022 are being rounded off by production constraints caused by shortages of labour, components and freight bottlenecks. In 2014, the Fed took two years to complete its tapering and begin its tightening cycle. It may be less patient this time.
We should have a better view in the coming weeks of central banks’ plans. The Fed is expected to clarify its tapering intentions at the next meeting of its Federal Open Market Committee (FOMC, the monetary policy committee) in early November, while the ECB has already flagged a recalibrating of its various programmes for its December meeting, particularly bond purchases. These uncertainties are likely to stoke volatility in bond yields, throughout the curve. But we do not expect any sudden repricing, as we saw in May 2013. Yields should continue to rise towards neutrality in Germany and towards 2% in the United States, in orderly and disciplined fashion.
Investment grade credit yields in euros have been driven up solely by their interest-rate component, as credit spreads (difference between rates) have been almost unchanged at 50 basis points. They are now at 0.45%, twice as high as at the start of the year. Performances will now be driven mainly by interest-rate trends.
It’s a different picture in euro high yield, with a widening of about 40 basis points in recent weeks. High yield’s spread curve is wider in Europe than in the US, regardless of ratings, thus illustrating Europe’s underperformance. We believe that an additional widening of 20 to 25 basis points would be a good opportunity to increase exposure to this asset class.
Macroeconomic uncertainty vs. microeconomic excellence
Environmental parameters have clearly worsened for the equity markets. China has slowed; commodity prices are becoming more and more stretched, with the spike in natural gas prices; disruptions in supply chains are far worse than initially estimated; and companies are having a hard time hiring (mainly in the US). As a result, reporting season looks more challenging, especially on the heels of an exceptionally strong first half. Even so, initial numbers are rather encouraging. Some sectors, such as autos and, to a lesser extent, industrials, have been hit especially hard by supply chain problems (delivery costs and times, semiconductor shortages). Even so, in the vast majority of cases, listed companies have reported very good operating performances.
They are enjoying strong operating leverage and, paradoxically, good pricing power (increased costs are so visible that customers cannot deny they exist). Prospects are also surprisingly good, with a significant expansion in order books.
All in all, equity markets are still reasonably valued based on aggressive earnings upgrades (on the year to date, +22% for the S&P 500 and +27% for the EuroStoxx). Estimated earnings growth for 2022 looks quite reasonable (+7% for the EuroStoxx and +9% for the S&P 500), especially as the likelihood of a significant increase in corporate tax rates is receding for US companies. Margins are under greater pressure from renewal of hedges on prices of intrants (a lagging effect of rising commodity prices). On the demand side, we remain alert to the consequences of these higher prices on consumer purchasing power, particularly for energy. On the other hand, corporate spending is likely to continue to be driven by ongoing investments in digitalisation of processes and the acceleration of spending on the energy and climate transition.
Our central scenario
Central banks continue to efficiently steer the normalisation of bond yields as economic activity gradually returns to normal. We are making no change to the yearend targets we have held over the past few months, i.e., 0% on 10-year German bonds and between 1.75% and 2.00% on 10-year US paper.
The markets have thus far been highly resilient to various risks, including inflation in energy prices and their spillover into production chains, sustained disruptions to supply chains, and a macroeconomic slowdown. But these risks are dragging on, and we therefore believe it is too early on a yearend horizon to return to a riskon stance. We are sticking to our strategic allocations and will take advantage of any dip to take back on some risk and position ourselves for 2022, which is likely to be driven forward by stimulus plans in several parts of the globe.
Document completed on 27/10/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com