Panorama - September 2020 -

The markets already seem to be in the post-Covid-19 world

Jean-Marie MERCADAL, Deputy Chief Executive Officer, Chief Investment Officer - OFI Asset Management
Deputy Chief Executive Officer,
Chief Investment Officer

Summer was rather quiet on the financial front, with the VIX settling in at 20 to 25, after spiking at 80 in March. The pandemic is regaining ground almost everywhere, but it doesn’t seem to be a major concern for the markets, as healthcare systems are far from being overwhelmed, social distancing is now widely practiced, and optimism is growing that a vaccine will soon be developed. Investors are therefore pricing in a gradual recovery, with markets under central bank control in an increasingly connected and technological world. Is this optimistic exit scenario already priced in? What risks should we look out for this autumn?

Our allocation at 03/09/20

Investors were able to enjoy their summer. Central banks anchored interest rates at very low levels, and rates have, in fact, not budged since March. This had a soothing effect on all markets. The CAC 40 has traded around 5000 points since the start of June, and the EuroStoxx around 3250 points. And there was rather little movement in exchange rates.

Only three asset classes stood out from this monotonous landscape:

  • Technology, and especially US large cap tech stocks. For the first time, a company has just surpassed $2bn in market capitalization – Apple, whose market cap amounts to almost 85% of French GDP. Its share price has doubled since March, and other tech stars have performed similarly.
    The rally in equity indices is impressive, but it masks a yawning gap in performances from one sector to the next. The S&P 495, which excludes the S&P 500’s five largest market caps (Apple, Microsoft, Alphabet (Google), Amazon and Facebook), would have risen by just 23%, while the S&P 500 gained more than 55%! In other words, these five stocks have added $4800bn in market cap since the market bottom, vs. just $3,800bn by the other 495 stocks.
    There have always been dominant sectors on the equity market, but this time, there are extreme degrees of concentration, with these five stocks accounting for almost 25% of the flagship index. Keep in mind that the average 2020 P/E (Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of these five stocks is almost 40, and that their 2021 P/E is 32, which suggests that their aggregate profits are expected to rise by more than 20% next year. This is the big difference compared to the 2000 tech bubble – these companies are profitable.
    For the moment, the forces underlying growth stocks, tech stocks in particular, are still active. Their market path reflects their ability to generate robust positive cashflow in a low-growth environment. Discounting of these future positive cashflows at lower and lower rates is one factor driving their share prices up. But after such a performance, the risk of a correction should not be overlooked, and the slightest grain of sand in this segment could trigger an across-theboard consolidation in the equity markets. Meanwhile, industrial sectors (autos, aerospace, etc.), financials, and energy are weighted lower and lower in the indices. A clear illustration of this is the exit of ExxonMobil, one of the oldest stocks in US history, from the Dow Jones index.
    However, there are objective reasons for the “downgrades” of these “traditional” sectors. For example, air transport could be impacted for some time to come by the greater use of videoconferencing, while it is increasingly politically incorrect to travel by plane. Likewise, internal combustion engines are increasingly stigmatised.
    Another illustration is Tesla. Its market cap of almost $400bn, which is more than the rest of the US auto sector combined, but this does not reflect its automaking know-how alone. Tesla is revealing of the current atmosphere, in that it embodies the “future”, with advances in several fields, including autonomous vehicles, space exploration, new means of travel, etc.
    But can the “future” be priced objectively?
  • Gold: this summer set a new all-time record, surpassing $2000 at its peak and bringing its year-to-date gain to almost 30%.
    We had already pointed out that gold and precious metals are very attractive in the current environment. Their holding costs are low in a world of negative real interest rates.
    Meanwhile, currencies’ intrinsic value is now an issue given that they are backed by countries that are now heavily indebted. Confidence in government bonds has been seriously undermined by the issue of government solvency, and “physical” investments are a good alternative. All the more so as gold is a diversifying and decorrelated asset in portfolio construction and can therefore replace some government bonds in allocations. Government bonds are the ultimate safe haven, but, at their current low yields, no longer offer much potential.
    Gold also offers inflation protection. That being said, after its recent performance, it could enter a phase of consolidation, as, here again, this favourable scenario has probably already been priced in. But any consolidation would be an opportunity to add to positions.
  • Inflation-linked bonds. Few investors had been interested and justifiably so, as the current environment looks more like across-the-board Japanisation, with increased fears of deflation. The implied inflation (inflation implied in the price of indexed bonds) priced into these bonds has risen considerably in recent weeks, from 1.00% to 1.75% in the case of the 10-year US bond and from 0.20% to 0.75% in the 10-year Bund. Euro zone linkers (bonds whose prices track inflation trends) have therefore gained more than 4.5% since last spring’s lows. That means that more and more investors are hedging against a possible upturn in inflation, which has fallen to very low levels and could be driven up in the coming years by central banks’ highly aggressive policies.
    Central banks have allowed their balance sheets expand to allow governments to cover their deficits, a form of artificial monetary creation. Other pro-inflation arguments include reshoring, higher wages because of government payouts, and the search for qualified workers.

On the economic front, the latest statistics are encouraging. The recovery is broad-based, especially in consumption, as US and European households have benefited from government assistance measures and as their financial situation has not worsened too much. But this may not last. Sooner or later, the measures will stop, and sectors that have laid off workers, or will lay them off, are not going to start rehiring right away. This is the case of services (tourism), air transport, aerospace and autos. Unless a vaccine is found soon, the consensus is that pre-crisis levels of global activity could be reached sometime in late 2022 or early 2023. In the meanwhile, statistics will be impressive, but one-off growth rates should be considered against the backdrop of bases of comparison driven down by last spring’s shutdown of economies. All in all, the global economy is expected to shrink by about 4.5% this year, before rebounding by 5.4% in 2021.
In the short term, keep an eye on trends in the pandemic. An upturn in case numbers is possible as people return from summer holidays. If healthcare systems are not overwhelmed in the coming weeks, the markets will be “right” to “move onto something else”!

The markets will also be impacted by the geopolitical and political environment. In the coming weeks, it will be worth keeping an eye on two main issues: the US presidential elections and the social context in Europe.

In the US, there are fewer than 100 days left until the elections. A victory by Joe Biden currently looks like the most likely outcome, but the markets do not yet seem to have priced it in, due to their lack of trust in polls and the fact that the campaign is likely to toughen in the coming weeks.
There are two main scenarios. The simplest for the markets right now, but not the most likely, would be a victory by Donald Trump, with the Republicans keeping control of the Senate. This would result in little market movement. The second scenario is a “Democrat wave”, with both the election of Joe Biden and a majority in both houses of Congress. If this happens, his platform would be implemented, resulting in a possible market correction, as Biden wants to raise the corporate tax rate (from 21% to 28%), payroll taxes (on salaries of more than USD 400,000), and the minimum wage. Biden is also considering a series of measures that would raise taxes on high earners and reduce tax deductions on dividend and capital gains. Some strategists estimate that full implementation of Biden’s platform would subtract almost 8% from S&P 500 companies earnings.

In Europe, and France in particular, there could be some social unrest this autumn. Mindsets are still marked by lockdowns and by the anxiety-driven climate, and central bank liquidity injections are generating greater social unrest.
It will be worth keeping an eye on this front. The euro zone’s recovery plan, which for the first time is being funded by bonds issued by the European Commission, mustn’t be squandered on mere salary hikes, instead of being invested in the sectors of the future, something that might restart dissension between European countries.

Interest rates

The slight shift in US monetary policy provides visibility but could also generate more volatility

The US Federal Reserve’s strategic review of its monetary policy is expected to refocus its objectives in favour of the economy and employment, rather than a strict inflation target. Inflation could therefore be allowed to exceed 2% for a certain amount of time without triggering a proportionate shift in key rates. Jerome Powell has hinted that, under this new approach, key rates would not have been raised in 2015 to head off inflationary risks. The markets have therefore got the message that the Fed Funds target will remain within the current 0.00%/0.25% range for a long time to come. Fed Funds Futures are therefore stable out to 2024. Paradoxically, this could trigger more volatility on the longer part of the yield curve. After Powell’s teleconferenced Jackson Hole speech, the yield on 10-year T-Notes rose by about 10 basis points. We therefore believe that there could be a resurgence in volatility in long bond yields and that they could move to around 1%, as the economic recovery continues.
On the other hand, we don’t expect much upward movement in long bond yields with growth currently running under potential and, more importantly, as federal deficits require refinancing at low interest rates. In the event of an upward surge, the Fed would step in with market purchases, which, in a way, would be tantamount to taking total control over the yield curve.

In the euro zone, the ECB’s new president, Christine Lagarde, also pledged early in her term to conduct a comprehensive strategic review. Its findings have not yet been made public. No shift in strategy is expected in the short term, and key rates will remain current levels for a long time to come. The issue of the euro will sooner or later come to the fore if the dollar continues to decline, as a too-strong euro would undermine euro zone industry. That being said, we don’t expect any major shifts in the euro/dollar exchange rate, as interest rates have already converged greatly this year, as have fiscal and monetary policies. Nor do we expect much directional movement in bond yields. The 10-year Bund could possibly rise back to about -0.25%, tracking US rates and the economic recovery.

Investment Grade and High Yield corporate bonds continue to be sought out, and spreads have narrowed further. These bonds are now far less attractive but, as short-term rates are going to remain at their very low current levels, they are still worthwhile for the spreads on offer.

Yields have also fell on emerging market bonds, while there was little change on the whole in currencies vs. the dollar in recent weeks, at levels rather close to the low end of historical trading ranges. A balanced portfolio of local-currency emerging market bonds yields about 5% on five-year maturities, which is not bad at all and helps diversify a bond portfolio.


US corporate earnings have been rather resilient

On the equity markets, the rally that began after the March bottom continued. The rebound in equity indices is impressive (+57% by the S&P 500, +43% by the EuroStoxx, etc.), but it masks a very wide disparity from one sector to another. This summer, companies released their financial results for the period covering last spring’s lockdowns. As expected, their full-year results will be down sharply but perhaps less than had been feared. Some sectors, such as technology, have even fared very well.
In the United States, aggregate S&P 500 earnings will be about USD 125 per index unit this year, down from USD 162 last year, a decline of “only” 23%, in sharp contrast with initial top-down forecasts of about 35% to 40%. At current share prices, this would work out to a 2020 P/E of 28. A 30% rebound in earnings is currently expected for 2021, which would mean a return, on aggregate, to 2019 levels. As things currently stand, this doesn’t look very realistic. If it does happen, however, that would mean a 2021 P/E of 21, which would be historically high. So, the question is whether this repricing trend, which is now being driven mostly by the growth segment is not going “too fast and too far”.
Markets generally price in a rebound in profits and when this happens, P/Es come down. If we assume that higher valuations are justified by the fact that interest rates are going to stay structurally low, a 2021 P/E of 25 would point to an index at 4075, hence 16% additional upside from current levels. This would be the best-case scenario.
Much the same reasoning applies to European equities. Earnings there are projected to drop by 40% this year, on which basis the instantaneous 2020 P/E would be 25. A 45% rebound in profits is forecast for 2021, which, in contrast to US equities, would still be 10% below their 2019 levels.
We accordingly believe that, under a highly favourable scenario, the markets have upside potential of about 15% on current levels. This scenario assumes a perfect alignment of the planets, something that looks unlikely at this point. We believe that a more uncertain and more volatile phase may lie in wait, but one that would provide some attractive entry points.

Our central scenario

Anything looks possible in this very unusual year of 2020.
The markets are pricing in an almost ideal crisis-exit scenario and, mesmerised by perceived central bank omnipotence, appear to be overlooking risks. But most of this favourable scenario already appears to have been priced in.
We therefore reiterate our neutral stance on equities. They offer lots of advantages and long-term potential, particularly for their dividends. But investors should avoid having to switch suddenly to a riskoff stance in the event of a new, untimely correction.
Rather, it is worth holding onto some cash ready for investment at attractive prices. During this post-summer period, which is traditionally more volatile, we therefore recommend diversified and balanced strategies, with a focus, if possible, on convex options strategies.

Document completed on 03/09/20

The figures cited deal with past years. Past performances are not a reliable indicator of future performances.
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited:
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