Panorama - October 2020 -
Uncertainty is back… but don’t panic!
Deputy Chief Executive Officer,
Chief Investment Officer
Investors’ overall confidence has dipped this autumn, as the ongoing economic recovery is challenged by a resurgence in Covid-19, and the tense US election campaign dampens hopes for a stimulus plan any time soon.
As a result, after a rather quiet and optimistic summer, the markets have shifted back into a more volatile phase.
But don’t panic! Hopes for a vaccine are reviving and, most importantly, central banks are here!
The month of September contrasted with the calm of last summer. Volatility rose and equity markets pulled back considerably. The S&P 500 is now almost 10% off its recent highs and the Nasdaq, 15%. European equities, which had gained less since March, as they are weighted less in tech stocks, fell by about 7% and are close to the lower end of the ranges they have traded in since May. The CAC 40 is thus at almost 4800 points, down from the high of 5200 points that it hit in early June. Note that the credit market has reacted only slightly thus far.
This more volatile phase could go on. It will be driven by two main topics: the US presidential elections and the Covid-19 pandemic, in a rather troubled geopolitical environment. On top of this, there is a new episode in the Brexit soap opera, as nothing has been resolved despite the approaching deadline. On the contrary, Boris Johnson’s about-face on past agreements has once again clouded the message and pointed to a hard Brexit, with potentially very negative economic fallout on both sides. But this is not our scenario. We expect negotiations to resume and that a new deadline will be set, given the issue’s complexity. Stay tuned.
But let’s take a look at the two main themes of this autumn.
THE US PRESIDENTIAL ELECTIONS ARE HOLDING THINGS UP AS THE MARKETS AWAIT A NEW STIMULUS PLAN.
Jerome Powell, the Federal Reserve Chair stressed this point last week in his testimony before Congress: the recovery will take a long time and require even more public support. A recovery plan is less and less likely to be passed before the 3 November presidential elections, given the hostile relations between Democrats and Republicans. The election is looking like one of the most polarising in contemporary history. The US Constitution is designed to prevent excesses and promote a spirit of compromise, via checks and balances between executive, legislative (Congress) and judicial (the Supreme Court) branches.
Presidential elections do not generally create major disruptions on the markets, but, rather, some sector shifts based on candidates’ programmes. For history shows that there is little fundamental difference between the two main parties, as societal organisation and ideological fundamentals have been widely shared and consensual until now. As a result, the underlying strengths of the US economy are broadly provided by the private sector.
This time, though, the two candidates’ programmes are divergent by nature. As Donald Trump has shown over the past four years, he is rather free-market oriented. Joe Biden’s platform is different. He plans to expand regulation, to raise the corporate income tax rate from 21% to 28%, to raise taxes on the wealthiest, to raise the minimum wage, and to impose greater requirements on employer-provided health coverage. This platform is new for the US, and would probably be poorly received by Wall Street. According to estimates from several strategist, Biden’s platform would lower forecast earnings of S&P 500 companies by almost 8%. The best scenario would be a narrow Biden victory without a majority in the Senate. In this case, his platform would be amended and would be hard to implement.
But what also worries the markets (perhaps even more so) is that US elections this time around are coming at an unusual time, when the economy is being hit hard by the epidemic, requiring a prompt public response. But there is very little chance that a plan will be passed anytime soon. The elections are looking tight. Trump is gaining in the opinion polls with the upturn on Wall Street and in the economy. Biden, who is almost 78 years old – and looks every minute of it – is inspiring little excitement and is therefore seeing a decline in his lead in the polls.
The worst-case scenario – a contested outcome, several weeks of uncertainty while determining the winner – is also gaining in credibility. This potential scenario is beginning to drag down the markets. Trump has already announced that if he loses he will context the results.
THE COVID-19 RESURGENCE IS ONCE AGAIN DRAGGING DOWN GROWTH PROSPECTS.
Until now, post-lockdown economic activity has been rather strong. Manufacturing activity and consumption have taken off again, although individual precautionary savings rates remain high in both the US and Europe. At the current trajectory, 2020 global GDP is likely to be close to 2.0% below its 2019 level. For 2021 the rebound forecasts are 3.5% for the US, 5.5% for the euro zone, and 8.0% for China.
But confidence is slackening and these assumptions are worth doubting, given the resurgence in the virus.
Businesses and consumers need visibility to invest, and they don’t currently have it, given the potential lockdowns that could be decided. It’s hard to make forecasts in this area, but we have the feeling that healthcare systems have made progress in recent months, that social distancing is being widely practiced and, above all, that governments will not impose blanket lockdowns, which this time would be economically disastrous. Meanwhile, the pandemic has jump-started medical research programmes, and treatments and vaccines will be found sooner or later.
The ECB did not react to the slight shift in US monetary policy
The US Federal Reserve decided in August to slightly modify its inflation target and refocus its actions on promoting growth and employment, laying out an inflation trajectory rather than a target objective that would require intervention in the event of a breach. US key rates will therefore remain at their current levels (0.00%/0.25%) for another several years. Real rates will be negative for a long time to come, and that’s how debt will be able to be absorbed in the long term.
The weakening in the dollar therefore makes sense, and, while no one has come out and said so officially, a weak dollar policy could be part of the plan for restarting the US economy.
The euro/dollar exchange rate will be a crucial parameter in ECB policy, as an excessively strong euro would undermine growth in the euro zone. So far, the ECB has not budged, even though the euro has risen in a few months from 1.05 to a high this summer of almost 1.20. For the moment, the ECB is right, and there’s no need to rush.
1.20 has been rather “neutral” range since the euro’s inception. It fell to a low of almost 0.80 in the early 2000s and spiked to 1.60 during the 2008/2009 financial crisis.
The ECB’s strategic review is still in progress and will be reported on within a few months. A structurally more accommodative ECB that is geared more to economic objectives would be well received by the markets.
With this in mind, interest rates are unlikely to shift. Key rates will remain unchanged on both sides of the Atlantic.
Ten-year Bund and 10-year Treasury yields are likely to hover around their current levels, i.e., - 0.25%/- 0.50% in Germany and 0.65%/1.00% in the US.
Corporate bonds have held up rather well during the phase of equity market consolidation. They have become rather expensive, but the quest for yield in an environment of very low interest rates is pushing investors into this asset class. High yield bonds are still the most attractive in this segment in a medium-term vision.
Emerging market bonds are also attractive for the additional returns they offer, although, here again, yields have fallen. They diversify strategic portfolios. With this in mind, we believe that long-dated (10-year) Chinese government bonds have their place in strategic portfolios.
To a certain extent, they could replace US bonds, which historically have served as “macro-hedges”, i.e., rising during recessions or distressed periods.
But they now offer very little upside, with yields of about 0.65% and very little scope for falling any further, as the Fed seems to have ruled out a negative-rate scenario. Meanwhile, Chinese bonds are yielding almost 3% and are more liquid and internationalised, given their inclusion in the major indices. In the event of a global slowdown, yields will fall considerably, as China’s economy is one of the most heavily exposed to the global economy. Capital gains could therefore be considerable.
Along the same lines, gold looks like a promising asset class for the coming years. It will benefit from negative real rates and possible wariness of currencies, as well as from its diversifying properties in a traditional portfolio. We had already stressed in our last report, in September that it would consolidate, and this has indeed been the case. The current weakness is a good opportunity to gradually build up positions.
Volatility could last
The equity markets have rallied spectacularly since their March lows, major tech stocks in particular.
The pace of the rally is justified by low interest rates, but it is unsustainable, and a phase of consolidation seems to make sense. Valuations on the whole have become rather high, and investors need greater visibility on company accounts to remain fully confident. This is not currently the case, due to the factors of uncertainty that we have mentioned.
For the moment, 2021 earnings are forecast by analysts to be far better than in 2020. But they still seem only somewhat credible, especially in European equities.
A 25% gain is forecast for S&P 500 companies, which would be slightly higher than in 2019. This works out to a 2021 P/E (PER: Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of almost 20 for the S&P 500 – historically high, but unsurprising, given how low interest rates are.
In the euro zone, 2021 earnings are forecast at 48%, and would still be about 10% below 2019 levels.
The EuroStoxx 2021 P/E is forecast at 17, which is also historically high. All in all, the markets are rather expensive and could be vulnerable to the more uncertain context that we have described.
We believe that further dips of about 5% to 10% are possible, which would provide attractive levels for adding to positions.
In style terms, we structurally prefer growth stocks, which are benefiting from persistently low interest rates.
It looks premature to return to cyclical stocks in a big way, given the current macroeconomic uncertainty.
Our central scenario
Confidence has declined a bit, but the backdrop has not truly changed.
We therefore reiterate our short-term neutral stance on equities for the aforementioned reasons and reiterate our recommendation of moderation in strategies, in order to hold onto some dry powder for use during the more volatile phase that we expect. But, overall, there has been no change to the market backdrop. It continues to feature solid intervention by central banks, who have anchored interest rates at very low levels for a long time to come, something that, in a way, “freezes” up the bond markets. Moreover, central banks will not hesitate to step in again in the event of an economic or financial relapse.
In a world that, in some ways, looks binary, diversification assets have become rather scarce. But we see at least two for the long term: gold and Chinese government bonds.
Document completed on 01/10/20
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com