Panorama - November 2020 -
Light at the end of the Covid tunnel
Deputy Chief Executive Officer,
Chief Investment Officer
The uncertainties that had piled up after the summer have been wiped out in just a matter of days: the outcome of the US presidential election points to an encouragingly moderate scenario and, above all, it looks like we will soon get the better of Covid-19! The markets have been quick to price all of this in. We have yet to see whether this new state of affairs will adjust the balance established in recent months… Will the central banks continue to prop up the markets with unlimited resources? Will fiscal policies remain expansionary? Having generally rallied together given the urgency of the situation, will European countries remain united once the crisis is over?
So we still have some unanswered questions, but visibility on the whole has improved.
The main stock markets have regained almost 20% in the space of less than two weeks. The world’s major indices (S&P 500, EuroStoxx 50, CAC 40) have thus broken though the trading ranges they had been confined to for months, which is very encouraging for the medium term. The rally was a swift one, for reasons we all know, so much so that equities are now technically in overbought territory for the short term.
We are likely to see occasional bouts of consolidation and we would recommend buying on these dips as investors now suddenly find themselves reassured on two major topics:
US PRESIDENTIAL ELECTIONS
The outcome was not the most likely one but ultimately seems to be almost ideal: Joe Biden has won the presidency but without a Congress majority, as the Senate has a good chance of remaining in Republican hands. The next major election deadline is 5th January, which is when Georgia’s senate runoffs will be held; they will in turn determine which party ends up controlling the Senate. The fact is that this ballot will probably lead to a government that will always have to strive for compromise. There is little chance that a dogmatic agenda would succeed in these circumstances. And what really matters here is that the questions raised post-election show that the economy is the biggest concern among Americans and that Donald Trump was the most credible candidate on this major issue. So the Republicans have come out of these elections in a somewhat stronger position and will take a hard line on public spending matters, especially now that we are moving into a post-Covid era when the economy should have less need for support. This means that the massive economic stimulus plan worth over $2,500 billion backed by the president-elect is unlikely to ever be adopted. Meanwhile, Joe Biden’s more flexible and less abrupt nature (compared with Donald Trump) is bound to soothe international relations with Europe and, on the surface at least, with China as well; and the US is set to rejoin the Paris Climate Agreement too. So, basically, we have an ideal scenario.
COVID-19 AND THE ECONOMIC OUTLOOK
The second wave of the epidemic has intensified in recent weeks in Europe and the US, seriously disrupting the economic outlook; it has also underlined differences in how the crisis has been handled in Western countries on the one hand and Asian countries in general (particularly China) on the other. The fact is that the epidemic has now generally been brought under control in Asia. Our governments have not at all been exemplary or clear in the directives they have issued to manage the public health crisis, and citizens have generally failed to adhere to them. Their unwillingness is another example (along with the many “populist” movements that have achieved prominence in recent years) of the real social divide that exists between the general public and the elites (especially politicians), fuelling self-interested and unruly individualistic behaviours. There is a risk that this will become a real issue at some point in the future when the Covid-19 crisis is over and governments need to reform their countries in order to repay all the debt they have accumulated. The road to healthier management of public finances will be a long and winding one, and countries may each have very different points of view.
Still, the economic outlook is bound to improve considerably in 2021 thanks to this vaccine. The most recent projections published by the big international forecasting institutes are now null and void. The recovery that kicked off when lockdowns were first lifted has since been brought to a halt by the second round of restrictions imposed more or less everywhere in Europe and in the US. This is a shame as the growth figures published for the 3rd quarter were generally very good indeed, indicating that economies have quite considerable capacity to bounce back. The recent prospect of a reliable vaccine will revive hopes of a rapid recovery, even though logistics will be an issue and result in lockdowns being lifted later than first hoped. This is because it will take some time for the new vaccine developed by Pfizer and BioNTech to reach the market: the duo has said that 50 million doses will be manufactured by the end of the year and a further 1.3 billion in 2021, but suitable (ultra-cold chain) infrastructure will be required to transport and store the vaccine.
Nonetheless, the discovery of this vaccine should speed up the economic recovery and we can now hope that growth will come out a little higher than currently forecast, i.e. reaching around 4% to 5% in the US and 6% in the eurozone. China’s economy is already back at its pre-crisis cruising speed. Its growth rate might even exceed the 8% forecast for 2021 if its trading partners recover faster than anticipated.
Although these new circumstances look very promising for the medium term, there are still some questions left unanswered. In some respects, we are shifting away from emergency crisis management mode and now suddenly imagining life after Covid. We know little about the post-Covid world at this stage, of course, as the vaccine was discovered so recently, but we will pay close attention to two key issues in particular:
Once again, the central banks “stepped up” during this crisis. They adopted pragmatic policies by keeping interest rates very low and providing support for the bond markets, and they communicated clearly by emphasising on several occasions that they had potentially unlimited resources. We are convinced that their policies will remain accommodative, even once the crisis is over. This is because public and private debt has soared, so interest rates will have to be kept down. As things stand today, debt servicing costs matter more than the actual stock of debt, which has grown to considerable proportions. Higher interest rates would therefore have a devastating impact. So although controlling the yield curve is not part of their job, central banks will probably ensure that bond yields do not rise at all significantly.
GOVERNMENTS AND ECONOMIC STIMULUS PLANS
Assuming the economy kicks off again rapidly thanks to the vaccine, it might prove trickier to free up massive amounts of public capital to prop up the economy as there could be less of a consensus. In the eurozone, for instance, we might see arguments about how to manage public finances at a time when Germany is preparing for a general election in autumn 2021. This could lead to diverging viewpoints and analyses and challenge Germany’s recent U-turn; the country had ended up reassuring international investors by ultimately agreeing to the first bond issued in the European Commission’s name to fund the economic stimulus plan. The eurozone’s recent show of unity would thus be put to the test since the €750 billion recovery fund that was agreed has not yet been deployed.
Will the central banks remain as pro-active as before?
That is the big question. An untimely rise in long-term bond yields would take a very heavy toll on public financing and also on asset valuations across the board, especially growth stocks. Bond yields have naturally risen in recent days on the prospect of an economic upturn: the yield on US 10Y T-Notes has regained about 50 basis points since bottoming out over the summer and has settled at under 1.00% for the time being. The same goes for the German Bund, albeit to a far lesser degree; its yield has risen from around -0.65% to -0.45%. Central banks will keep a very close eye on the pace and magnitude of these yield increases and would intervene if the markets were to move too abruptly. So we think yields are unlikely to widen all that much. The Fed has already insisted that it will keep key interest rates at 0% until 2023 and it is still buying up bonds at a rate of $120 billion per month. We therefore believe US bond yields might gradually move towards the 1.00%/1.25% range over the coming months, but hardly for very long. Meanwhile, we see the Bund yield expanding slightly to around -0.30% eventually.
Credit spreads have also narrowed significantly in recent trading sessions, so there is little scope for further tightening at this stage. We reiterate our positive stance on short-term Investment Grade bonds for long-term cash management strategies. High Yield bonds are still attractive based on the additional yield they offer and their reasonable level of risk given the prospect of an economic recovery. Emerging market bonds in local currencies are also shrewd investments to add to a portfolio. They offer investors a good way to diversify their assets as they are decorrelated from other markets because of movements in their underlying currencies, which generally seem undervalued after a tough year. The yield on a portfolio of emerging government bonds in local currencies works out at around 5% for a maturity of about 5 years. It is also worth adding Chinese yuan-denominated bonds to one’s portfolio. China’s financial markets are in the process of becoming decorrelated from Western markets: the country’s economy is increasingly focused on its domestic market, its national currency is set to become an international reserve currency and its 10Y govies offer yields in the region of 3%, which is far higher than their US and European equivalents. So, basically, adding Chinese govies to a portfolio makes it more robust.
Still with diversification in mind, the current slide in gold prices offers a good opportunity to build up positions from a medium-term perspective. Gold benefits from negative real interest rates and provides a hedge against various risk scenarios, such as an unexpected uptick in inflation.
The time has come for “reopening” stocks to thrive
The big tech stocks as a whole have benefited in recent months as lockdowns have shifted our offline/online life balance further away from offline and more towards online. Investors have thus turned their back on industries such as transportation, tourism, catering, entertainment and oil. A catch-up effect now seems possible, especially as valuation gaps have become extreme, although stocks on the whole are not excessively overvalued. The Nasdaq index’s 2021 PER (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) currently stands at 29 versus 21 for the S&P 500 index. Tech company revenues now represent 17% of US GDP versus less than 10% just 10 years ago, and the sector accounts for 27% of the S&P 500 index’s market capitalisation. During the 2000 tech bubble, it accounted for 35% of the index but just 7% of GDP.
So the long-term trend seems to lean rather in favour of growth stocks. Short term, however, investors are probably going to take up positions on value/cyclical stocks, particularly in “reopening” sectors on which they were mostly significantly underweight.
More generally, earnings growth forecasts for 2021 (~25% in the US and 45% in the eurozone) look more plausible in a post-Covid-19 scenario. Medium term, there are few liquid asset classes with prospects as bright as equities. Assuming corporate earnings double within the next 7 years (which is a real possibility considering historical corporate performances), aggregate earnings for companies listed on the S&P 500 index would reach about USD300 per share in a few years’ time while those on the Eurostoxx Large index would turn in EUR35 per share. With interest rates set to remain low for a while, an equity index PER of 20 would make sense; it would point to an S&P 500 index at around 6,000 points and an Eurostoxx Large index at 700 versus their current levels of 3,270 and 338 respectively… not to mention their dividend payouts which also need to be factored in, corresponding to ~2% for US equities and ~3% for European equities.
Our central scenario
Having moved in no particular direction in recent months, the markets have now surged in all the main asset classes. The uncertainties that had recently kept the markets down have now eased, and we suddenly find ourselves entering the post-Covid era. The transition raises a number of issues, particularly regarding interest rates; this is a very important topic as interest rates are a point of reference for valuations across all asset classes.
We are emerging from this awful crisis with an even more gigantic debt burden. But the prospect of a recovery is encouraging and companies are expected to begin growing at a more “normal” pace again, albeit bearing in mind that the crisis has provided further impetus for online living and emphasised the need for sustainable development.
With visibility improving, it is now time to gradually adopt less defensive investment strategies by making the most of the more volatile phases that are bound to arise.
Document completed on 12/11/20
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com