Panorama - December 2020 -
What lessons can be drawn from this unusual year in 2020? What about the outlook for 2021?
Deputy Chief Executive Officer,
Chief Investment Officer
This very long and painful year of 2020 is ending like it began – with bullish markets!
In the meantime, we experienced the worst recession since World War II, and one of the most sudden and steepest market drops in history, followed by a powerful rally. The year will indeed remain nestled in investors’ memories.
Moreover, ordinary lives and lifestyles have been seriously disrupted, something that will have medium- and long-term consequences.
The markets got off to a good start in 2020, with the main equity indices soaring by almost 10% in January. And they are ending the year well, having just regained more than 20% from its lows of late October. As a result, the effects of the February/March crash have been completely erased, and 2020 is ultimately looking rather good. International equity indices gained almost 3% (in EUR), and US equities almost 15% (in USD), while European equities declined only slightly, including -3% by the Stoxx 600, -7% by the CAC 40. Bond indices also rose: +4.10% by the aggregate index of international bonds, and +4.65% by the euro zone bond index.
This recent return of bullishness is being driven mainly by the development of vaccines. There is a general feeling that the epidemic, which has dragged down economies, has been brought under control, and that the recovery will begin. It will then be time for reflection and taking stock of the pandemic, which has laid bare some failings in how our societies are organised and will leave traces – financial traces, of course, but also societal ones. For the pandemic has come in the midst of a sea change in mindsets, including a greater focus on climate change and, in societal terms, the development of ideas on virtuous consumption and other areas. Meanwhile, the surge in the financial markets has accentuated the feeling of an increasingly wide chasm between the financial sphere and the real economy. This is driving discussions of central bank policies, which are suspected of feeding bubbles. Accordingly, sooner or later the issue will arise of inequality between the haves and have-nots, and this will influence policies voted on in future elections.
In short, mindsets have been seriously modified by the events of recent months. It’s time for a look at the main consequences in the short, medium, and long term.
In the short term, the development of vaccines will accelerate the economic recovery. Vaccination campaigns have already begun in some major countries, and economies will reopen one after the other in the coming months. Given the delays in business investment and consumption, growth could be stronger than in 2021 and stronger than is currently forecast by major economic forecast institutions.
The global PMI (The PMI manufacturing index of economic activity is based on a survey of purchasing managers in the industrial sector) index hit a high since 2018, at 53.7, far above the threshold of 50 between expansion and contraction. However, this acceleration is mainly due to the rebound seen in the US and China, while the indicator continues to decline in the euro zone. The situation is more critical in services, but the prospect of reopenings in the next few weeks is likely to generate a clear improvement, especially as the savings rate has risen on the whole, driven by job-support measures. For example, in the United States, it hit 13.6% in October vs. a 7.6% average in 2019. This should ultimately offer powerful support for household consumption. On the corporate front, postponed business investment is another reserve of growth, although the number of bankruptcies could increase, once support measures are phased out. Mobility will also recover and, here again, there will be some catching-up, which could drive a temporary acceleration before a new form of normalisation, due to the development of videoconferencing and remote-working. Ultimately, the prospects for a rebound in business activity in 2021 look solid and forecasts for global growth of about 6.0% look credible. The latest Bloomberg consensus of 5.2% probably does not yet reflect the development of vaccines.
Growth could therefore be around 4.5% in the US and about 6.0% in the euro zone. In China, the acceleration continues, as it did not experience a second wave in the pandemic and its economy could rebound by 9.0% in 2021, after 2.0% in 2020. This upturn will show up in company accounts, and earnings forecasts are likely to be raised considerably.
In the medium term, all countries are emerging from this crisis with an even heavier debt burden. Fiscal responses have been massive, and public debt levels compared to GDP have become impressive and worrisome. Indeed, past measures and future ones (stimulus plans set up in 2021) amount to about 15% of GDP for the euro zone and 20% to 25% for the US. This has pushed debt/GDP ratios to more than 100% in the US, 120% in France, 150% in Italy (Germany’s would rise from 60% to 75%). Corporate debt has also risen. Against this backdrop, central banks have no other choice than to keep monetary conditions highly accommodative, holding interest rates very low and supporting the bond market through securities purchase programmes. This will allow companies, and governments in particular, to access inexpensive funding, at tolerable interest charges. This is even more necessary as it will be hard to quickly adopt rigorous management of national budgets, given the rather tense social situation in the main Western countries and at a time when massive investments will be made to adjust our economies to the energy transition. From this point of view, it will be especially important to monitor stimulus plans, with the hope that they will be able to structurally stimulate growth, which is on a weakening trend. In the meantime, bondholders’ “purchasing power” will inevitably decline, as real interest rates are likely to remain in negative territory for a few years to come.
Meanwhile, this crisis has laid bare an initial real disconnect between Chinese and Western markets: Chinese equities have gained more than 20%, and the yuan has gained 6% vs. the dollar.
This trend could gather strength in the coming years. China has begun to transform its economy. The 14th fiveyear plan was unveiled on 26 November. It is part of the “China Standards 2035” plan. It aims to double GDP by 2035, which suggests, de facto, average growth rate of about 4.5% between 2021 and 2035 (vs. 7.0% between 2011 and 2015 and 6.5% between 2016 and 2020). The more China’s economy develops and becomes mature, the more the pace of growth will natural slow. And a slower pace of growth will have to be accepted, as that avoids too much credit-driven stimulation to keep excessive objectives in place, as has occurred in the past. The focus is now being placed on domestic development, which does not mean that China step completely away from international markets, as its industry is established and competitive.
By sector, the Chinese plan targets autonomy and cutting edge know-how in semiconductors, artificial intelligence and biotechnology, particularly by stimulating investment in research and development and in education. China is also opening up its capital market. Chinese equities and bonds are gradually joining international indices. These are deep, liquid and highly diversifying markets that can make portfolios more robust. This should boost the pace of internationalisation of the Chinese currency.
In the long term, there are several issues afoot. How will we get out of this massive debt accumulation? The possibility of cancelling public debt is beginning to arise on several fronts, particularly regarding the portion held by central banks. In the euro zone, the foundations of the Growth and Stability Pact will have to be revisited. The main Maastricht criteria (with caps equivalent to 60% of GDP on debt and 3% on deficits) have been blown up, and a reset of common rules will be necessary for safeguarding the euro. Several ideas are beginning to emerge on this issue regarding possible new criteria, including the debt sustainability indicator, “Covid-19” debt forgiveness, and investment and growth objectives. So, there’s lots on the agenda. The issue of harmonising euro zone fiscal policies could dominate newsflow and generate some volatility on the markets next autumn, when Germany holds elections, which will result in a new coalition and a new chancellor.
The question of inflation will also arise in the long term. The massive monetary creation resulting from central bank purchases could trigger a decline in the value of currencies vs. real assets or, in any case, confidence in them. This is why the rush into cryptocurrencies is not happening by chance. The recent spike of the best known cryptocurrency, the bitcoin, shows that investors are beginning to price in these issues. Some strategists are even advising holding a (small) portion of portfolios in cryptocurrencies, now that some financial products make it possible to invest in their indexed performance.
We have no particular view on cryptocurrencies, but we are watching this movement with interest. We believe that gold and precious metals are safer and can be used to hedge this type of risk in the long term.
Little upside potential for interest rates, even with the recovery
Covid-19 has been a deflationary shock, and it is too early to draw up scenarios that include a significant rise in inflation, although there are a few arguments in favour of such a scenario in the medium term. In reality, in the short term, central banks will keep their policies accommodative, to avoid holding back the cyclical rebound but, above all, to allow governments to refinance without an excessive burden on national budgets. Money-market rates will remain unchanged in the coming months or years, at -0.5% in the euro zone and at 0.0% in the US. Buying programmes will also be kept in place, albeit on a smaller scale, given the economic upturn. The Fed could conduct some twists, i.e., prolong the maturities in asset purchases, something that will keep yields in check on the long section of the curve.
Against this backdrop, we expect long-term interest rates to rise very little, to about 1.25% for US 10-year T-Notes and -0.30% for 10-year Bunds. So, bond investments are still unattractive on the whole, as almost 70% of the euro zone bond pool serves negative yields. High yield bonds are still attractive, but only for their relative yields. But with less than 3% now of the bond pool, we have to be aware of the risk taken in terms of both credit quality and liquidity. We believe that emerging bonds on the whole offer a better risk/reward pairing. Foreign currencies are not intrinsically expensive and benefit traditionally from downward trends in the dollar. From this point of view, the consensus is rather unanimous that the dollar will weaken vs. the other major currencies, including the euro.
We agree with this, but the momentum involved does not seem too powerful. The region around $1.25 per euro is quite possible. Any further weakening would require new factors.
So, is this a bubble?
Recent events bring to mind the “tech bubble”, which played out from late 1999 to March 2000. These include Tesla’s entry into the S&P 500 on 21 December 2020 after surging by more than 500% from its lows of this year and 50% since its entry in the US flagship index was announced, which gives the stock a 2020 P/E (PER : Price to Earnings Ratio. A stock market analysis indicator: market capitalisation divided by net income) of almost 160.
Incidentally, it will account for 1.5% of the index, hence the eighth largest market cap, which will cause readjustments from passive strategies, including trackers. We see this as an opportunity for active strategies, but that’s a topic for another day. Indeed, this reminds us of what happened more than 20 years ago, in December 1999, when Yahoo gained almost 60% after the announcement of its inclusion in the S&P 500. More recently, there have been hyped IPOs, such as Airbnb, whose share price doubled on its first day of trading. We don’t agree with the bubble theory. Keep in mind also that from autumn 1999 to June 2000, the Fed Funds rate had been raised from 4.75% to 6.50%. Interest rates are now very low, and the main equities do not look too expensive when seen in this light. Earnings per S&P 500 unit could amount to about 170 dollars next year, up by about 25% vs. this year, thus giving a 2021 P/E of S&P 500 of almost 22. The P/E of the GAFAMs (Google, Amazon, Facebook, Apple, Microsoft) is about 40. That’s high, but they have real profits and solid growth. This is indeed high by historical standards, but there are currently few investment alternatives.
In Europe, the reasoning is similar, although the makeup of indices is different. With momentum in economic growth, earnings growth could rise by more than 50% in aggregate next year and surpass the current consensus forecasts.
Equities have therefore become a must, and dividend yields are still attractive at about 2% in US equities and 3% in Europe. The most cyclical sectors and, more generally, the value style, are likely to continue to outperform in the coming months.
In short, we believe that equities remain highly attractive intrinsically and especially relative to other possible investment choices. In the short term, overall sentiment is too bullish. The latest survey by the American Association Survey found that bullishness has spread far and wide and a historically high level. This points to a correction in the short term, which would be an opportunity to add to positions.
Our central scenario
This unusual year is coming to an end with, for once, some clarity: the economy is taking off again, and debt is begin absorbed by central banks, which have been highly responsive and will remain on high-alert regarding refinancing terms. This, along with the development of vaccines has restored some optimism to the markets. That optimism has not necessarily carried over to everyday life for most people. But let’s not overlook the fact that the markets, by definition, anticipate.
What they are anticipating is a world moving ahead, a feeling that we share, even though everything has gone a little “too fast” in recent weeks.
Document completed on 17/12/20
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com