Monthly Investment Review
LT macro regime. Below average potential growth and volatile dis-inflation. Demographic – ageing – and excess debt are undermining potential growth. Coupled with digitalization, it continues to fuel secular disinflationary pressures
Beyond peak liquidity – The momentum of investable liquidity is declining. This will continue in H2 in the context of taper talks and global recovery
Growth peaked in Q2 and is losing steam. Expansion delayed, but not derailed – Global soft patch in H2 21, due to Delta Variant and Chinese softlanding. Better – synchronized – perspectives in advanced economies in H1 22
Geopolitics. A complex G-Zero landscape – Afghan failure raises doubts about the reliability of US strategic guarantee. Indo-Pacific as the new World epicenter (Taiwan)
Healthy rebalancing of capital flows – Risk-free assets benefitted from new inflows. High leverage among retail investors. Risks for financial stability remain significant
Scarce and expensive quality assets – Financial repression to continue in the foreseeable future. US long rates to come-back in the (1.5% – 2.0%) range
Resilient risk appetite – Reflation trades will regain steam in H2 21
Global expansion. Delayed, but not derailed – We are transitioning towards Mid-cycle. Western countries are gradually removing fiscal and monetary supports. US mega-plans, which will only deliver over a few years, pale compared to last 18 months stimuli. China is soft landing. In Europe, the German and French elections will prevent new ambitious stimuli, at least until summer 2022. Emerging countries will still suffer from sanitary troubles a few more quarters. The spectacular rebound in world trade is running out of steam. It was boosted by the health emergency and by Chinese exports of specific products / instruments; but the barriers to maritime transport will continue to impair it.
On the bright side, we probably passed peak pandemic. In any case, new large-scale shutdowns are – very – unlikely. It would be politically untenable after the enormous efforts made by households and companies and unsustainable for public finances. But the virus still has a non-negligible capacity to cause harm. It encourages precautionary savings in the private sector, fuels disruptions of international production chains and increases inequalities…
Beyond a temporary soft patch, growth will remain above trend
Stagflation fears are overdone
What does transitory mean? – The cyclical acceleration of inflation is underway. It will persist beyond what the Fed expects, i.e. across 2022. This is basic mathematic, due to the contribution of the rent factor, which represents an important part of the price indices. The recent rise in wages, due essentially to the jolts of the reopening, may become sustained in the medium term, thanks to the redistributive policy implemented by the Democratic Administration. This is a significant risk factor, which could ultimately lead to sustained price increases. Watch this space. For now, the structural disinflationary forces, the three D’s, remain prevalent: Demographics, Debt, and the Disqualification of low-skilled workers by digitalization/technology. They are strong enough, for now, to put some lid on runaway inflation.
We expect the macro landscape to shift back from to the yellow Quadrant
Asset allocation conclusion – We are beyond peak liquidity and peak growth, but Pandemic stress may also have reached its climax. And some assets are priced for perfection. This transition period which started in Q2 will continue by year-end, featuring a little more challenging global landscape.
This low visibility landscape requires a lot of tact and a bit of luck for our decision makers, especially G3 central banks. Stakes are getting higher and, consequently, risks of a policy mistake are on the rise. The deliberate decoupling of China adds to the dilemma. After some stabilization following Trump’s defeat, renewed geopolitical tensions add complexity to the global picture.
Safe event currencies still a haven of peace – Much of the FX focus over the last month has been on USD strengthening. The CHF is the 2nd best performing developed currency in Q3. When risk appetite recently weakened, the EUR/CHF temporarily slipped below 1.07 for the 1st time since November 2020. A strong CHF will not be welcomed by the SNB, which continues to view the currency as highly valued. Swiss total sight deposit data (an indicator for potential FX intervention) picked up at the start of August, but policymakers do not seem to have many options to weaken the CHF. Whilst the economy seems to be handling the CHF strength, it continues to pose a downside risk to inflation. So, monetary policy will be looser for longer. The CHF should remain firm as long as the market remains focused on the Covid-19 outlook, even if the focus has been more in Asian than in Europe.
The JPY has remained firm too. The rise in domestic Covid infections, pace of vaccine rollout and additional lockdown and state of emergency restrictions have undermined sentiment. The JPY is expected to continue to find support in the short term. Once pandemic risks fade, the prospect of a BoJ keeping Japanese monetary policy looser for longer should be a strong negative JPY factor.
Stable CNY amid ongoing policy support – The CNY has performed well over the last month against the developed and Asian currencies. Since the start of Q3 2021, the CNY has tended to move sideways against the USD, whilst slightly underperforming the CHF and JPY. Recent Chinese data has been softer than expected, which has renewed concern about the pace of the recovery. Retail sales, industrial production and investment growth were all strongly positive in year-on-year terms but slipped from June and were weaker than expected. The PMIs showed global sentiment is under pressure.
Increased government regulations are weighing on some sectors and should favor a softer yuan. The PBoC has pledged to maintain support for the economy as the Fed is in advance, which should imply a higher USD/CNY. The CNY has been unable to break above 6.50 and the Chinese authorities should make their maximum to avoid a major trend shift.
A delicate time for long-end yields – Now that the Fed has prepared the market for a tapering, the question is more about its length and its market impact than the exact timing. We do not expect a tapering announcement before the October FOMC meeting. The risk is that the rapid spread of the delta variant could postpone any decision. We expect that tapering will be conducted until mid-2022 followed by a rate hike not before early 2023.
Are the previous QE a good guide? The first 2 QE programs were well defined and had no market impact. The QE3 was launched in September 2012 with the idea of keeping rates unchanged through mid-2015, and then raised to $80bn in December 2012. Bernanke mentioned a tapering for the first time in May 2013. It came as a big surprise and the US 10-year yield jumped by 1.0% in a few months. Nowadays the Fed is eager to avoid a new tantrum and has telegraphed it well ahead. Over the whole QE period, counterintuitively, yields rise pushed up by higher inflation expectations and a steeper yield curve while the Fed purchases were sizeable. Then we had the 2014 conundrum when yields dropped and the curve flattened despite an improving economy, Fed taper and forthcoming rate hikes. The main driver was foreign purchases of higher yielding US Treasury from Asian investors. This time a tapering announcement will not be a surprise. The big buyer could come from Europe. The new ECB strategy indicates that the key rate will stay at the current level for many years with a relatively flat curve. This will tend to push investors towards US Treasuries especially as the currency hedge is relatively cheap. However, this time markets will have to navigate with higher inflation.
Debt ceiling and downgrade risks – The debt ceiling is just one more thing that sets the US apart from other countries. Ordinarily when a country outlines its spending plans, it can simply borrow more. In the US, the Congress needs to approve it by raising the debt ceiling level to a new higher figure. Since 1917, the ceiling has been raised more than 100 times. Recent years have seen more political fractious on Capitol Hill. A previous political impasse has resulted in a rating downgrade, government shutdowns and market volatility. This can happen again this year.
Fitch has recently revised its rating outlook to negative on the buildup of debt during the pandemic. If in September the Congress fails to act, Fitch could downgrade the US. Does this matter? Yes and no. When S&P downgraded the US in 2011, while Treasury was optically tarnished, the downgrade generated an excess of demand. With so deep negative real yields and nominal yields not offering much of positive yield, the risk is that yields ratchet to the upside on a severe credit deterioration premium. This could also be the opposite. As an important counterforce, the Fed could, in extremis and temporarily, increase its purchases.
Credit supply remains supportive – Credit spreads have been extremely stable and resilient all the year, supported by robust credit metrics, a strong technical bid (the result of lower issuance volumes than last year, high scheduled redemptions and an ongoing ECB purchases) and an improving economic picture. Additionally, funding costs continue to fall and should remain at record lows in the coming months. Default rates are falling again, and we have more rating upgrades than downgrades. If corporates do not start to re-leverage quickly again, default rates should remain very low, and we should continue to see more rating upgrades.
On the IG side, 2021 net issuance stands at €85bn. However, when we consider the ECB purchases, the net figure drops to €35bn. On the HY segment, the tally stands at €92bn, almost the same amount as the record seen all last year. In that environment, credit should continue to outperform sovereign bonds.
Strong re-leveraging across the board would push the risk of default and rating downgrades higher, and this should be reflected in wider spreads. But we do not see this happening before a while. And this means that credit spreads should remain well bid in the medium term. An early tapering or aggressive tapering announcement would very likely push credit spreads a little wider. The impact should not last given the structural search for yield mindset.
The risk of a significant correction is low – The Fed will moderately reduce its support for the economy to avoid a stock market crash, to support the household wealth effect and to allow the stock market to partially finance investments linked to the climate emergency. But it will not move the Fed Funds until 2023.
Despite an increase between 16% and 20% according to the indices of developed countries in 2021, stock market valuations, 22x 2021 for the S&P 500 and 17x 2021 for Europe, remain stable thanks to the strong increase in profits, and they are even lower than a year ago. Profit growth of the Stoxx Europe 600 companies was 248% in the 2nd quarter compared to +155% estimated in March and that of revenues was +29%; for 2021, profits will increase by 63%. S&P 500 profits was up more than 95% in 2Q21 and are expected at +30% in 3Q21 and +42% in 2021.
Sentiment indicators show that investors are cautious and indices are not overbought; therefore no detrimental exaggeration in the increase. Investors do not want to get out of stocks and are doing sector rotations according to the evolution of the US 10-year. The strategy does not change: Buy on dip.
For the last 4 months of the year, investors will focus on:
- Expectations of a delayed economic rebound due to the rise in infections this summer.
- Stellar corporate results.
- The gigantic spending plans in the United States, of $ 1.2 trillion for traditional infrastructure and $ 3.5 trillion for social, labor market, social inequalities and green investments.
- COP 26 in November which should result in significant global green investments linked to the climate emergency
The equity democratization thanks to e-trading platforms and the craze / speculation on meme stocks – shares bought by individual investors on e-trading platforms whose information circulates on social media – does not represent a risk for stock markets, because they are specific operations and not through collective instruments.
Investors who anticipate a correction, fear the announced reduction in liquidity (tapering) by the Fed and the absence of significant corrections (>5%) of the S&P 500 in 2021 which recorded 7 consecutive months of increase between February and August and 9 positive months over the last 10 months, rather rare performances. The unfavorable seasonality in August and September, a generally more volatile period, gives bears an additional argument. August mocked statistics with a 2.4% increase for the MSCI World.
Will 2021 offer few opportunities (weak corrections) to enter the market, as in 2013 and 2017, 2 post-electoral year? We are taking the same path. The comparison between the bull market from October 1987 to March 2000 and that from March 2009 to August 2021 is interesting: the 1st had recorded an annualized performance of 15.3% for 4,535 days, including 3,239 working days, and the current by 18.8% for 4,558 days, including 3,256 working days.
Our sectoral tactical allocation is neutral. A large part of the catching-up of the Value / Cyclical segment was made between September 2020 and May 2021. With a view to a rebound in the economy in 2022 – in W – the segment of US small and medium-sized companies conceded a performance lag compared to large values. US domestic spending programs should let the Russell 2000 to catch-up its gap compared to the S&P 500.
Investors are also betting on the cash-rich companies that should spend on new factories, on research, on debt reduction, on acquisitions, while prioritizing dividends and share buybacks. S&P 500 companies (ex-financials) have $ 2 trillion in cash. At the end of July, share buyback programs totaled $ 680 billion, slightly below the 2018 record. Since 2011, S&P 500 companies have repurchased $ 5.7 trillion in shares, including $ 444 billion for Apple. Over the next few years, the corporate investment cycle could be one of the most powerful ever, thanks also to the decarbonization of the economy and the climate emergency.
We are more cautious on emerging countries. The pandemic has resurfaced the problems related to industrial relocations and services in emerging countries, in Asia in particular. The climate emergency and the measures that will be taken to decarbonize the economy will be a cost for their finance and their growth. The new geopolitics, with the United States-Russia-China-Greater Middle East confrontation, with a Europe that cannot position itself, makes emerging countries more at risk where (re)emerge authoritarian/dictatorial regimes in certain countries. A risk of a China-Taiwan-US and/or China-India-Pakistan confrontation could chill investment projects in Asia. China’s new confrontational attitude (rightly or wrongly) makes the Asian zone less stable. Latin America remains unstable and unpredictable; the presidential elections in Brazil in 2022 could bring stock market volatility on this continent.
The Commodity Supercycle is solid despite weak global growth due to the Covid – Low-carbon investments, intense in industrial metals, will accelerate. Oil prices will rise as 45% of world production is controlled by OPEC+. Droughts and floods (climate change) will put pressure on the prices of agricultural commodities. After the pandemic period with its share of disruptions, the impact of stimulus plans, economic recovery and ecological transition will be more visible on commodity prices. Inflationary expectations will push financial investors to buy real assets to hedge against inflation.
After a jump of nearly 90% between March 2020 and April 2021, the prices of industrial metals (Bloomberg Industrial Metals Index) have consolidated since May, without really falling. This lateral trend reflects the pandemic which continues to weigh on global economic growth. China is cutting back its steel production. Despite everything, the prices of industrial metals are behaving well. Copper and iron ore prices have fallen with the downturn in China, but nickel, aluminum, cobalt and zinc are rising. Lithium, linked to batteries for the electrical transition in the automotive industry, has seen its price soar by 120% over one year.
With improving health situation, investors will quickly switch back to base metals. A more inflationary environment will encourage traders in industrial metals to replenish their inventories. US spending of $ 4.7 trillion, spread over several years, with traditional and green infrastructure for nearly $ 2 trillion, and, we hope, investment announcements of billions of dollars for the ecological transition following COP 26 in November in Glasgow will obviously be very good news for industrial metals. In conclusion, we remain positive on base metals pending the triggers mentioned above.
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