Panorama - July 2021 -
The world of tomorrow is here, today!
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
Market indices have by far wiped out the impact of the crisis and hit new summits. The reopening-driven economic rebound is very powerful, so powerful that the world will return to 2019 levels of economic activity as of this year. So, the crisis appears to be behind us from both points of view. Yet several questions remain unresolved: how to finance this mountain of debt? Do countries now have greater growth potential? Is the upturn in inflation only temporary? Will central bank policies return to normal and retain the markets’ confidence? Will the euro zone reform and, if so, how? What is the most likely scenario in this context and what investment strategy is the best?
Context and analysis
Almost three weeks after the Fed unveiled its “new tone”, more or less flagging the end of the highly expansionist monetary era and an ultimate return to something of a normalisation in its monetary policy, equity markets hit new highs, while bond yields were surprisingly stable. This is in stark contrast with the previous occasions, in 2015 and 2018, when the Federal Reserve flagged a tapering (reduction in purchasing programmes), which led to higher bond yields and a “taper tantrum” on Wall Street. Nothing like that happened this time.
The current period does indeed seem to be driven by dual confidence – in the very powerful recovery in economic activity, driven by the reopening frenzy and the central banks, the supporter of last resort. The markets do not yet look worried about a possible resurgence in the pandemic in the form of new variants, which are beginning to trigger some restrictions in Australia, Portugal and other countries. True, growth has rebounded more than expected, with the US pegged at almost 4% this year and 4% next year, and the euro zone probably at 5% and 4%. Momentum seems to be slowing somewhat in China, but, on the other hand, it was spared a recession in 2020 and it has also rebounded very strongly. So, the 2019 level of activity is on the verge of being exceeded, and the rebound is likely to continue.
However, public finances, which were already in distress, have worsened considerably during the crisis. Debt/GDP ratios are now above 100% in many large countries, including the US and France, at about 115%/120%. It would therefore seem impossible to return to “acceptable” levels solely through “austerity” policies, particularly in the currently potentially unstable social and societal environment in most large countries. This is one of the main consequences of this “world of tomorrow”: debt has, in a way, been sterilised by central banks and, rather than reducing it, governments will have to invest in infrastructures, telecom networks, etc., with a goal of boosting their growth potential. Another goal is to accelerate the transition towards a low-carbon economy and, to certain extent, to reshore industries in order to limit supply-chain risks and reduce their environmental footprint. In exchange for these services, governments will call on businesses and wealthier individuals more in the form of taxes. A 15% minimum tax on multinational companies went through after the US lined up behind it. We seem to be entering a world of heavier tax burdens, as well as heavier regulation.
The problem is that not everyone in the euro zone is on the same page in managing public finances. True, the situations vary from one country to another, particularly between Germany and the southern euro zone countries, including France. Germany’s debt/GDP ratio, for example, is only about 70%. This lack of homogeneity could quickly become a concern for the markets on two occasions:
1/ the ECB will soon release the findings of its review of its mandate, which so far has been devoted solely to price stability, a stance it inherited from the Bundesbank; and 2/ German general elections, scheduled for late September. Here is it worth pointing out that the Christian Democratic Union has just risen by 10 points in opinion polls, while the Greens have fallen, and that orthodox management of public finances within the euro zone is a key issue for the CDU. This is a structural issue that could therefore return to the fore, especially as discussion is also expected to open regarding a new stability pact, now that the Maastricht criteria, which had been set during the process of creating the euro, have been exceeded by far and are now out of reach. So, by this autumn we see a return of the concept of “country risk” within the euro zone.
One issue in the coming months will also be how the markets perceive the return of inflation – either as a structural phenomenon or merely a temporary one, due to reopening-driven bottlenecks, caused, in turn, by pandemic-related disruption of production lines. We don’t yet know the answer to this, and that’s why it will be necessary to track indicators over the coming months. Is a post-Covid-19 world of reshoring and a greener economy more inflationary? In part, yes. The cost of a tonne of coal has more than doubled in recent months and is likely to continue rising in the coming months. Massive investments in electrification of transport and production will require very heavy capital expenditure. Meanwhile, reduced investments in oil exploration could send oil prices above $100/bbl. In short, all this will stoke pricing tensions. Will companies pass them on in their prices? For the moment, the markets don’t seem to think so. While we do not yet have any in-depth conviction on whether or not inflation is structural, we do expect this resurgence to last several months and to end up weighing on bond markets, at least partially.
Against this backdrop, recent movements in the US yield curve may seem surprising. Historically and logically, during economic recoveries the yield curve has tended to steepen through a rise in the long section that precedes a hike in key rates, which comes with the economic recovery and helps head off overheating. This time, however, two-year intermediate rates have naturally risen in anticipation of this likely monetary tightening, but long-term rates have fallen, which would point to a flattening of the yield curve flagging a peak in the economic cycle.
There are several possible explanations for this, but none of them can yet be pinpointed as the cause. The first of these is that we may very well be at the end of the cycle. Before Covid-19, the US cycle had already been the longest of the post-war period. Perhaps the cycle has merely been prolonged by the necessary issuance of debt, which, in any case, has been absorbed by central bank monetary creation. In which case, perhaps current pricing pressures are being driven by end-of-cycle overheating, a harbinger of a slowdown that will occur once pent-up demand has been satisfied. We already discussed the second possible explanation in last month’s Panorama, i.e., friendly cooperation between central banks and even more heavily leveraged governments. This would mean negative real rates for a long time to come and, hence, an erosion in bondholders’ purchasing power. If so, that would narrow allocation choices down considerably as bonds ordinarily constitute an essential component in portfolio construction. With this in mind, high equity valuations make sense, as they are far more attractive in relative terms for the long term, even though we forecast more erratic and more volatile shifts in the short term.
The markets don’t believe the Fed’s long-term rate projections
Through its chairman, Jerome Powell, the Fed announced that members of its Federal Open Market Committee would “soon” provide details on a possible shift in pace of its asset purchase programme. The announcement hinted at tapering (reduction in purchasing programmes) and came with the projection of an initial key rate hike as early as 2023. The market naturally reacted with by flattening the yield curve, which is to be expected in a monetary policy phase like this one. Yet, the absolute level of long bond yields from which this movement extends (1.50%) was a greater surprise, as it was rather far below the projected terminal rate of 2.50%. It would therefore appear that, for the moment, the market does not believe that this rate will be reached by the end of the cycle.
Against this backdrop, risk, in our view, is more on the upside than on the downside in the 10-year US yield, with a target of almost 2% between now and yearend, due to the reopening of economies and uncertainty on whether inflation will last beyond the “temporary” horizon indicated by central banks.
Regarding rising prices, in projecting a key rate hike as early as 2023, even as its inflation projections are only slightly above target on that time horizon, the Fed talked down investor expectations, who then accordingly adjusted their positions downward. This adjustment doesn’t mean that the issue is behind us once and for all and that it will not continue stoking volatility in long-term rates over the next few months.
In the euro zone, the ECB is staying on a highly defensive footing and surely wants to avoid worsening financial conditions during this economic recovery phase. We don’t expect the German 10-year yield to rise towards 0% by yearend, given the coming increase on the supply side of the government bond market (including the European Union and the financing of its “Next Generation” programme), as well as the trends we expect on US rates.
Spreads (difference between rates) remain quite stable and at narrow levels in both investment grade and high yield. We do not expect any big shifts in the next few months, based on our scenario of a moderate increase in rates in terms of both pace and extent. This creates a favourable environment for the carry trade and justifies increasing high yield exposure in the event of a temporary widening in premiums.
A record half-year
With gains of almost 15% on both sides of the Atlantic, and even 20% for our national index when including paid out dividends, equity markets turned in one of the biggest half-years in their history. With forward 2022 price/earnings ratios of 16 in Europe and 20 in the US, the equity markets can hardly be described as “cheap” by historical standards. That being said, equities are priced not just on their future earnings but also in comparison with long-term interest rates and, on this point, the still moderate level of interest rates, especially in Europe, is a powerful argument. We stress this point, as we see clearly that interest-rate trends will be the decisive factor in further gains on the equity markets.
First-half reporting season will mark the next few weeks. We are unlikely to have any bad surprises, judging by the guidance put out by companies that seem to have excellent visibility on their business prospects in both the current and next few years. The question will be whether the ongoing rise in commodity prices, especially the spike in oil prices and some wage pressures in certain sectors, will affect earnings.
By sector, the outperformance of cyclicals and value vs. defensives so far this year has been wiped out completely by the receding in long-term US yields. But all this could change with a new increase, even a modest one, in these yields.
Our central scenario
The first half of the year ended with a very strong showing by equities against a backdrop of tight central bank control of interest rates. With the economy reopening, the Fed has begun to raise the possibility of reining in its highly accommodative policy in the coming quarters. The markets have reacted very well to this news for the moment. The coming period is likely to be more uncertain, as, in our view, it could be steered by inflation, fiscal policy and pandemic trends.
Accordingly, we are sticking to our neutral stance on equities in our strategic allocations, based on the belief that a more volatile phase on the markets will open up new opportunities at more attractive prices.
Our thinking is based on the idea that the stimulus measures announced in various countries offer a positive outlook for the coming quarters, as long as investors are confident that central bank will continue to steer bond yields.
Document completed on 07/07/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com