Panorama - June 2021 -
The “post-pandemic” boom is here. And in other news…
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
Governments and central banks have managed to save what’s most important during this crisis, and the results are there to see. The reopening of the economy is impressive, companies are putting out solid numbers and are optimistic, and most market indices are rubbing up against their all-time highs. Now that the good news is here, several other issues could dominate the second half of the year, including inflation, monetary policies, and how to restore public finances. These heavy issues will be pondered for some time to come. Will that mean a market stall?
Context and analysis
This first half of the year has been very robust, thanks to the fast pace at which economies have reopened. We are experiencing a true “post-pandemic boom”, which, of course, is being driven by demand pent up during the lockdowns. Overall morale is improving quickly and is driving a strong recovery in consumption and investments, which, in turn, is generating unprecedented economic growth rates. The US economy could keep up a pace of 10% in the second and third quarters, or almost 7% for the full year. Activity has fully restarted in the euro zone, a bit later, true, but it is now also very robust and should approach 7% in the second quarter, and maybe a little more than that in the third quarter, which would mean a full year between 5% and 6%. Among emerging markets, China is recovering the fastest, as it opened its economy earlier after managing the pandemic very strictly. Its growth is likely to approach 8.5%. The rest of the emerging world is faring far less well, as it has had a harder time margining the crisis without adequate infrastructures or efficient governance. This crisis has thus shed light on the structural advantages of developed countries in dealing with this type of configuration and has exacerbated certain gaps. Ultimately, global growth is expected to come to almost 6% in 2021 before slackening slightly to about 4% in 2022, with little disparity between the US and the euro zone, which will also be close to 4%. Meanwhile, companies are putting out a highly optimistic line through the spectacular recovery in their finances but also in their highly optimistic guidance for the coming months.
Corporate earnings are expected to rise by almost 35% in 2021 in the US and by more than 40% in the euro zone. For 2022, forecasts are currently hovering around 15% on both sides of the Atlantic.
In short, everyone is doing better, and this is showing up in financial performances. At almost the halfway point in the year, the main market indices are up by about 15% and in many cases have set all-time records, while credit spreads have narrowed. Keep in mind, however, that over the past weeks market volatility and volumes have fallen drastically.
This could be due to investors’ far greater tentativeness after such a strong first half and much good news already priced in, particularly as other issues are beginning to emerge.
This across-the-board economic recovery is pushing up prices as demand has spiked while supply was not ready in many areas, including labour, freight, energy and electronic components. The resulting shortages have led to a resurgence in inflation to levels unseen in several years. Central banks will therefore be challenged on whether it makes sense to stick to such accommodative monetary policies.
Inflation has risen significantly and is once again a concern. Long-term inflation expectations are one of the essential parameters in anchoring interest rates. Recent years have been marked by a steady decline in inflation expectations as priced into inflation-linked bonds. This was normal, as large Western economies were on the brink of a deflation scenario, driven by underlying trends such as the ageing of the populations, rather restrictive fiscal policies (especially in certain euro zone countries), globalization (which lowered product prices through competition from low-wage emerging market economies), and technologydriven productivity gains. The situation could very well change on several of these fronts, even though it is still too early to say for certain for the medium-/long-term. In any case, the Covid-19 crisis has exposed the “zero stock” model and its overdependence on faraway suppliers.
Reshoring is also being pushed by societal pressure to maintain the fabric of nearby economic activity and by the growing focus on environmental concerns. This will take some time, as the entire supply chain will have to be rethought, but if it does happen, production costs could become structurally higher. Similarly, the transition towards a decarbonated economy will require some capex-heavy industrial adjustments that will, in one way or another, have to be passed on in higher prices. The latest figures show that inflation has risen fast. In the US, the consumer price index rose by 4.2% year-on-year and by 3% when excluding the highly volatile components of energy and food. This is its fastest pace since 1995. For the moment, the markets have not reacted to these figures. They seem to believe, like Jerome Powell, the Federal Reserve chairman, that this is merely a temporary catching-up phase.
A more sustained rebound in inflation could suit governments in financing their debt.
The thinking on shoring up public finances has changed, driven by the US. In light of government debt levels as we emerge from this global pandemic, a new path is necessary, as debt/GDP ratios are now far too high for a round of austerity. It would take far too long to return to acceptable ratios, especially in the current social climate in many countries. This new path would consist (“well, as long as we’ve come this far…”) in continuing to spend and invest massively, with the goal of boosting countries’ growth potential. Future key development sectors are infrastructures, green ones in particular, the energy transition and technology. With this in mind, businesses and households will probably be taxed more heavily in exchange for those improved services. The US has clearly chosen this path, as seems obvious in the more than $6,000bn in support measures and investments planned (equivalent to almost 30% of GDP). As for what comes next, to restore public finances, the US government is starting to talk about heavier taxation, as seen in the boost it has given to global taxation of multinationals.
The euro zone is still hesitating in joining it. As is often the case, there is a wide divergence between the German and “Latin” points of view, France in particular. It is also true that there is a wide gap in financial standings – France’s debt/GDP ratio is about 120%, vs. just 75% in Germany, and this fundamentally alters the range of choices. Let’s point out once again that the issue of the euro zone’s functioning will ultimately have to be resolved.
This will probably be a major issue in the campaign leading up to German elections in September and could be a source of volatility for euro zone bond markets.
In this “US-style” way of restoring finances, central banks will play a decisive role. They could tolerate a resurgence in inflation by leaving real rates in negative territory, which would benefit governments but completely undermine bondholders’ returns. Sticking to highly accommodative policies longer than necessary in interest rates and securities purchases would be tantamount to a form of yield curve control that dares not speak its name. this is something we have already seen in the past during phases of heavy debt. The issue of central banks’ independence and mandates has often been raised, and this will probably be one of the markets’ major concerns in the coming months. The markets are beginning to ponder these themes, and the rush into real assets, including cryptocurrencies, is therefore no surprise.
What’s behind the relative stability of long bond yields amidst a strong recovery?
This is a question being asked in the US in particular, with the robust recovery in its economy and, even more so, in inflation, given that the 10-year T-Note yield has levelled off at about 1.60%. Keep in mind, however that the yield had risen fast at first, from 0.50% last summer to almost 2.00% early this year. There are actually two reasons for its recent stability. The first is that investors are afraid of “fighting the Fed”, which has unlimited resources and has not yet shown any sign of shifting the direction of its policy. Given the amount of federal debt issued, a form of “cooperation” between the central bank and the government in the coming years makes sense. The second reason is that the markets do not seem to believe in a structural rise in inflation, judging by current prices of inflation-linked bonds. They therefore seem to be accepting the Fed’s take on inflation. But how would the markets react if pricing pressures continued to intensify in the coming months, especially in the very tight segments of commodities and skilled labour? In the euro zone, inflationary pressure exists for the same reasons as in the US, but, on the whole, to a lesser extent.
In light of the above, interest-rate risk is more on the upside than on the downside. It’s merely a matter of how fast and how much. With this in mind, the traditional annual central bankers’ meeting in Jackson Hole in late August will be even more closely watched than usual, particularly regarding a possible tapering in the US, i.e., a reduction (announced or not) in Fed asset purchases. Between now and then, we expect the US 10-year yield to oscillate between current levels and the 2.00% neighbourhood. Depending on the announcements made and the markets’ take on those announcements, we will then adjust our forecasts. In the euro zone, we expect the 10-year Bund yield to range between -0.20% and 0.00%.
Recent weeks have not been very eventful in corporate bonds. Spreads (difference between rates) are still rather narrow in both investment grade and high yield, and we don’t see much happening there in the coming months. Emerging market currencies have recovered on the whole against the dollar in recent weeks but are still rather weak, as the pandemic has hit the emerging world harder as a group. The relative returns on local-currency debt (about 5%) do not look attractive enough.
Earnings are on the right track; everything will now depend on interest rates
The main equity indices have risen in anticipation of the earnings recovery that is now occurring, so much so that valuations on the whole are now relatively high both in absolute terms and by historical standards, although not excessively so. The S&P 500’s P/E (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) is almost 22 for 2021 and 20 for 2022. In the euro zone, it is 18 and 16, respectively. Barring a halt to the recovery in 2023 or 2024, recoverydriven earnings growth is likely to continue, albeit at a slower pace. There is also the unknown regarding taxation of corporate earnings. The pricing in of a tax hike on US companies from 21% to 28% could make a temporary dent. However, that would mean that equity valuations are not so high from this point of view, especially when looked at through the prism of dividend yields – a little less than 2% in the US and a little more than 3% in the euro zone, which is not bad at all compared to bond yields. In short, the direction the equity markets will take in the coming years will depend closely on the general level of interest rates. If rates level off in the coming weeks, as we expect them to do, the equity markets should remain mostly directionless. They could nonetheless be a little more volatile, as recent gains could lead to some profit-taking by investors who will probably want to lock in those gains while hoping for more visibility on inflation and monetary policies.
In terms of styles and sectors, cyclical/value stocks have already caught up somewhat, as they are sensitive to an increase in interest rates. We expect them to do so less in the coming months.
Our central scenario
After a solid first half, a phase of greater uncertainty could begin. Investors will probably seek to forge a clearer conviction on the reality of inflation and on how central banks will react to this burning issue. They may suspect the central banks of a little too much complacency with regards to overly indebted governments, to the detriment of bondholders.
That’s why we are sticking to our neutral positions on equities in our strategic allocations. Once greater volatility returns to the markets there will be opportunities to add calmly to our holdings.
In the longer term, given the “new path” chosen by the US to restore its public finances on a sustainable basis, growth should be robust and equities should once again be the most attractive asset class by far… if central banks manage to be convincing and remain credible in their “yield curve management”.
Document completed on 10/06/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com