Monthly Investment Review – 06 December 21
LT macro regime. More variable business cycles ahead
The long decline of potential growth is exacerbated by pandemic and rising debt. Secular disinflation is under attack. More volatile duration and amplitude of expansion phases.
Lower liquidity profusion
Production of excess liquidity is fading, with recovery and resurgence of cyclical inflation.
This is triggering ¨some¨ spill-over of tensions across more numerous asset classes
Pandemic is not over. Global recovery is further delayed into 2022
The pandemic continues to be disruptive. It will somewhat delay the economic rebound but boost inflation in Q1. Pandemic’s global impact on growth is diminishing
Geopolitics. A complex G-Zero landscape
Threatening alliance of China and Russia. Indo-Pacific as the new World epicenter (Taiwan)
Buoyant capital flows
Massive equity inflows, namely through passive ETF. More volatile retail flows
Scarce and expensive quality assets
Financial repression will continue in the foreseeable future. US long rates to stay in the (1.5% – 2.0%) range H1 22
Volatile risk appetite
Resurgent inflation and pandemic. Bond volatility starting to spread to other asset classes.
Further macro uncertainty, despite current optimism – The major supranational institutes continue to forecast vigorous expansion in 2022, almost 5% after 6% for 2021 (IMF October 2021). Growth would be driven mainly by the major developed countries. These figures are clearly too optimistic in view of two factors: the return of the pandemic and the change of course in China. The markets, moreover, do not believe it, just as they still doubted last summer the insouciance of the central bankers. On top of this, there are two significant risk factors: the sharp rise in global inflation and the downgrading of major US stimulus plans.
Stagflation fears are overdone, but consensus for economic growth is too buoyant. Global growth will approach potential in H1 2022, not more, thanks to G7 countries
Pandemic, a never ending story? – On three last occasions, summer 2020 and 21 and winter 2021, the US suffered more acute rise of infections than Europe. Without much explanation, the latest 5th wave of Covid has been more subdued in the US. For the moment… Collectively, Western countries have raised their guard with mass vaccination. However, it is clear that the virus still has a considerable capacity to cause harm. As long as the world’s population, particularly that of emerging countries, is not protected on a much larger scale, it is likely to remain so. This fatalistic observation illustrates the growing political tensions inflicted on our democracies. The pressure of an ultra-divided public opinion continues to grow. The virus exacerbates inequalities. It is, in itself, a factor of deep fracture. In Asia, the pandemic has led to the closure of borders. The pandemic is complicating international trade, disrupting production chains, and contributing, in the long term, to a certain increase in production costs. This will contribute to a resilience of inflation, well beyond the ¨statistic base effect¨ behind which central banks hide.
Asset allocation conclusion – The current transition towards an inflationary boom landscape remains the most likely scenario towards 2022. As a result, fixed income volatility has started to migrate to equities and tensions persist in emerging countries, if not in the periphery of the High Yield sphere But despite recent markets jitters, financial conditions remain very supportive. It would take further USD strength coupled with higher interest rates to render us more cautious. For now, we maintain a fully invested allocation, but with a somewhat more cautious positioning within asset classes
Still room for a stronger USD – The USD has recently been helped by a strong economy, high inflation, and a more hawkish Fed. Even intermittent periods of low-risk appetite have underpinned the currency as a safe haven. The USD has been the strongest performing developed market currency in November driven by 1) the prospect of higher interest rates; and 2) market uncertainty linked to Covid, stagflation fears, or China property crisis. These drivers will remain into 2022, but their ability to easily pull the USD higher may diminish.
The next FOMC announcement on mid-December should remain USD-supportive. Economic data have rebounded, unemployment has slipped, and forecasted inflation should remain elevated across Q1 and early Q2 before slowing. The Fed is already tapering and expected to finish in mid-2022. A first rate hike will follow in S2 2022. This will help the USD to remain firm. At that time, US rates may offer less support for the USD as we do not expect the Fed to move more quickly.
Furthermore, the G10 central banks stance should become less clearly USD-positive in 2022. By the way, even if all those drivers are well known, the positioning is not as extreme as we should expect in such a context.
EUR vulnerability will persist short-term – The EUR has remained under pressure, and this is likely to continue into Q1 2022. The economic outlook remains robust, but the recent focus on rising Covid infections and restrictions will not help sentiment. A still largely dovish ECB, maintaining all options open and warning that rate hikes are unlikely in 2022, should keep the EUR on a defensive tone in Q1 2022.
Whilst the EUR took German federal election in its stride, the April/May French presidential election may have more impact. Last time, in 2017, the EUR weakened in Q1 amid the uncertainty but rebounded in Q2 once the result became clear. A similar pattern next year should repeat.
The Fed stays on the same path – A continuation theme should be the dominant outcome from President Biden decision to reappoint Powell as Fed Chair. But there will be a more influential Brainard to be considered. However, we cannot ignore this. The Fed will continue to taper, and likely hike rates in S2 2022.
Central bank watchers are having an exciting period. The latest FOMC minutes highlighted the Fed openness to accelerating its tapering. Even several ECB and BoE officials will keep investors relatively busy, the coming comments should be less market-movers. Markets are already discounting a 150bps Fed Fund rate increase over the next 2 years. It is likely that officials have already shared all the elements they intended to ahead of the mid-December Fed/BoE/ECB meetings.
We are back in the 1.6% area of the US 10yr. This is the third time this year. There have been two themes in play. First, inflation is running well above nominal rates. Second, several auctions failed to attract demand in the past couple of weeks. The paroxysm was the last 30yr auction.
The 2.0% on the US 10yr yield remains our target which corresponds to a terminal Fed Funds rate in the 1.50% area plus a spread. We also have a significant Covid spike in Europe with the risk that some of it gets echoed in the US. For now, the lure of elevated inflation is dominating, with even the Bundesbank talking of 6.0% inflation. A 2.0% US 10yr yield looks low in front of that. As the gap between upside and downside scenarios is widening, fixed income volatility will stay elevated. As the past 20 months bias has been towards easing, it is natural that a hawkish message proves a market mover.
Even with the 5th Covid wave, central banks will hike rates. The main uncertainty is how soon and by how much. Some BoE communication back and forth on the urgency of policy tightening has not helped investors. We think it will raise rates by 15bps in December. However, we think a lot of tightening is already priced in. So, the potential for further USD and GBP rate rises is more limited.
The Euro area is not on the same path. The ECB looks less in a hurry but the synchronized highlighting of inflation upside risk has not been lost. Year-end distortions in EUR money markets have played a role in keeping a lid on EUR rates. The threat of near-term Covid-related economic restrictions is also on everyone’s mind. If and when both drivers fade, EUR rates upside seems significant.
The EM tricky period to continue – The main culprit for softer portfolio and Foreign Direct Inflows is the ongoing narrowing of the Emerging to Developed markets growth differential. According to market forecasters it is expected to be about 1.2% in 2022, down from the 1.2% in 2021, 4% in 2020 and 2.8% on average over the last 5 years. The growth differential will likely remain under pressure.
Moreover, public debt ratios are likely to deteriorate and climb higher in EM according to IMF, whereas they may stabilize in frontier markets and materially improve in Developed markets. This past year, across numerous LATAM and frontier-market economies, we saw increased fiscal pressures translating into materially higher bond yields, weaker currencies, foreign investor portfolio outflows, and disappointing bond auction results.
Still too early to come back on EM local currency bonds while the extra yield offered is compelling.
Consolidation with a huge 5th Covid wave – Since mid-March 2020, the bull market has been marked by numerous sector rotations according to the curves of Covid infections and the evolution of long-term interest rates. The first phase (6 months) was marked by Covid-proof stocks, then there was an alternation between Value (Banks)/Cyclical segment when long-term rates rose and the Growth segment (Technology, high flyers growth stocks) when rates were falling. These strong sector rotations allowed investors to stay in the market, resulting in minor intermediate corrections of less than 5%.
Analysts expect US companies’ profits to rise 21% in 4Q21 and +51% for European companies, and in 2021, by +45% and +90% respectively. For 2022, profits are expected to rise 10% in the US and 12% in Europe. We value the S&P 500 at 4’850 for 2021 and 5’280 for 2022.
We are taking a more neutral approach on equities for the next 2 months. Stock indices could consolidate and generate more volatility due to 1) a return of RSI indicators to a neutral zone (heavily overbought in early November), 2) investor sentiment indicators returning to a more neutral position, 3) a creation of a bubble in a few specific segments (EV and metaverse), 4) upcoming tense discussions on the US debt ceiling in Congress, which expires on December 15th, 5) a surge of Covid in Europe, with its share of health restrictions, and 6) less favorable seasonality for equities in January and February.
In terms of seasonality, November is a good month, December starts to deteriorate slightly before entering the first 2 months of the year which are statistically more difficult. But the bull market remains valid for the next few months. Households and businesses have plenty of cash to consume, to raise dividends, or to buy back stocks. Companies are seeing lower tensions in production and supply chains and shipping prices; July-October will probably have been the peak of the stress. Companies have also learned to work differently. 2022 will be characterized by a restocking.
2021 will be a great year for IPOs and share buyback announcements. According to EPFR, we should exceed $ 1 trillion in share buyback announcements in 2021, close to the 2018 record of $ 1.1 trillion during Donald Trump’s fiscal plan. 30% of share buybacks are concentrated in 5 technology companies, Apple, Alphabet, Meta, Oracle and Microsoft. Concerns are for 2022 with a planned 2% tax on share buybacks to fund Joe Biden’s big spending plans. With one month to go to the end of the year, driven by central bank liquidity, IPOs rise to $ 600 billion, shattering the 2007 record. The winner is Rivian with $ 12 billion. SPACs strongly contributed to this record with 27% of the total (in billions). But IPOs were no guarantee of success: in 2021, the US IPO index underperformed the S&P 500 by 15%.
Conclusion. Stock market consolidation and proximity to a less favorable period for equities. Buying opportunities following a decline in prices and reflation during 2022. In the short term, technology and Covid biotechs / pharmas should perform well with the winter Covid wave. In the medium to long term, we overweight banks and cyclical stocks.
The global emerging index had zero performance in 2021, but performances were also very heterogeneous. The problems of China (economic slowdown and real estate crisis), Brazil (politics), Turkey (dictatorship and central bank), the Covid and the strength of the dollar have weighed on the entire emerging zone. Some countries recorded very good performances such as Mexico (+15% in local currency), Taiwan (+20%), India (+22%), but currencies were rather weak. To fully invest in emerging equities, you need better visibility on currencies. Tensions in the China Sea and between Western Europe and Russia make investors cautious.
China is not immediately investable. The Chinese Communist Party has made a 180-degree turn: control of billionaires who no longer consider the national interest, control in education, control over technology, return to the communist dogma of common prosperity and strategy in self-sufficiency. The engine of Chinese growth, real estate is suffering from its past excesses. The new personal data protection law, the extraterritoriality of the national security law and the relentless tensions over Taiwan do not argue for a return to Chinese stocks, and more to the CCP-controlled BigTechs.
Oil, consumer countries react – In a coordinated decision, the United States, China, Japan, India, Britain and South Korea decided to release their strategic oil reserves to stop the rise in crude and gas prices. In the US, inflation is becoming a domestic issue, but it’s a surprising move for a US administration that is pushing energy transition and climate change. The US will release 50 million barrels between mid-December and April 2022 and oil companies will have to return 32 million barrels to strategic reserves by 2024. Total US strategic oil reserves are estimated at 715 million barrels.
This summer, the US had asked OPEC+ to increase production, but the cartel maintained its strategy of gradually ramping up production to 400,000 barrels per month, seeking to keep Brent prices above $75.
On the announcement, oil prices fell to recover quickly, as the stocks released are not sufficient to have a lasting impact on prices. Consumer countries wanted to make a psychological announcement aimed at the market and at OPEC+. It could do the opposite: OPEC+, which meets in early December, may reconsider its plan to lower output. Oil prices will remain permanently high: 1) the Gulf countries are in a costly economic and “societal” transition, 2) Russia needs money because of international sanctions and wants to punish the US and Europe, 3) new production capacities are scarce because of the uncertainty of the profitability of new projects (legal, climate, environment, financing) and 4) geopolitics is unstable. We do not exclude a return into the $100- $120 range in 2022.
Gold inseparable from real interest rates – The essential factor determining the price of an ounce of gold is the real US 10-year interest rate. The reduction in monetary stimulus and rising interest rates increase the opportunity cost of holding gold. In 2021, the price of gold fell by 5% and the holdings of gold by financial investors in SPDRs, ETFs or other financial products fell by 8%.
But the situation is far from clear with a huge winter Covid wave, already in Europe, which could weigh on economic growth and send interest rates back down.
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