Monthly investment review
Strategy and Macro
- Financial repression continues
- With Fed shift from re-liquefaction to reflation
- (Too) Prudent institutions at odds with gambling retail investors
- U-shape economic recovery
- Pandemics not over, but no global lockdown
- Weak USD if favorable for financial markets
- Prefer credit and inflation linked bonds
Economic fear remains dominant, considering the current deterioration of unemployment and the emergence of numerous bankruptcies. Many sectors, where social distancing is impossible, remain under huge pressure. In the US, the second part of the stimulus package is delayed because of an inevitable gridlock, as we approach elections. Policymakers remain on alert, as Covid infections are rebounding across the world. Consensus economic forecasts remain very cautious. In this context, the arrival of an effective vaccine late 2020 would re-ignite pent-up demand from consumers, major tensions on bond yields and fears of outright inflation. Volatility would ensue, with possible multiple (PER) contraction.
Financial repression is in force as long as US long yields remain in a 0,5%-1% range
Our global allocation remains constructive, with a portion of into anti-fragile assets
Here comes the flood
With their bazookas, hyperactive policymakers have restored companies’ refinancing and temporarily re-float individuals. Flooding liquidity favors risky assets, which continue to climb a wall of worry. Lot of capital, namely from global institutions remains on the sidelines. Not yet completely re-assured by the containment of volatility, they have barely started to reduce their cash / short dated bonds positions.
A ¨buy the dip¨ mentality has re-emerged among retail investors. Indeed, the pace of their investments dramatically accelerated with the concurrence of zero-commission brokerage fees and the collapse of online sport / gaming activities… Time will tell if this is a new paradigm or, rather, a new kind of dangerous Mania (like the now RIP ¨short-volatility strategies¨)… This is an emerging concern.
Early signs of economic recovery, the relative containment of Covid-related deaths and the birth of the European Recovery Plan diminish the risks of a dramatic double-dip recession / depression. That is good news, definitely. US elections represent an undeniable factor of uncertainty. Still, considering the current advance of Democrats, we doubt that it could turn into a messy event. Indeed, Republican policymakers would not support unconstitutional developments from the incumbent President. This nevertheless bears watching.
An entrenched Financial Repression
As a matter of principle, free market economies generate regimes of positive nominal and real interest rates. This is their normal state of equilibrium. Indeed, regimes of negative real yields only happened in the – recent – history of the US economy on three occasions. It first happened in the 1920s and 1940s to help government pay off debt incurred to finance World Wars (I and II). During these periods, it was caused by the collapse of policy rates by incumbent administrations and central banks. Negative real yields also briefly happened in the late 70’s, but this time as a result of an unbridled spike of inflation.
The current episode definitely belongs to the first category, as it is caused by an intentional collapse of policy rates. The afterthought of policymakers is crystal clear: alleviating as long as necessary the burden of indebted governments (be it the service or the ultimate reimbursement of sovereign debt). To put things in context, Covid essentially accelerated the relentless decline of yields already engaged for 4 decades. Part of it – from 1980’s to early 2000s – was due to structural factors, like the excess supply of capital (savings) compared to demand (investment). This structural ¨over-abundance¨ of savings results from both Asian and oil producing countries and from ageing Western countries.
Financial repression is now widespread among Western Democracies because of the pandemic. Considering the corollary increase in public debt they generate; a debt time bomb is gradually in the making. Interestingly, China is a key exception, for several reasons. Firstly, it has engaged for years in the deleveraging of its economy, which lived on credit for too long: banks are not in a good shape. Secondly, it wants to attract capital (with positive nominal yields) and engineer the emergence of its currency as a solid regional anchor, if not gradually an alternative to the USD. The de-coupling of China from Western countries will intensify, even if Beijing should sacrifice some growth in the short-term for doing it.
Expect financial repression to last longer than pandemics
This is fundamentally supportive for risky assets, at least in the short-term
Only a Pause
The USD has remained weak over the last month. Its pace of decline has slowed from July, which may signal that the momentum behind the multi-month dollar sell-off may be slowing. US economic data has tended to improve. Low US interest rates have removed a key support to the USD and concern about further fiscal stimulus has not helped sentiment ahead of November’s elections.
The USD slipped further in August to reach its lowest level since April 2018. The USD did weaken after Fed Chair Powell signaled the Fed will target inflation that averages 2% over time, rather than specifically 2%. This would allow the short-term US rates to remain lower for longer and be a barrier to an USD strengthening in the years ahead. In the near term, investors already did not expect US rates to be hiked before 2022 and low US yields were already priced in the weak USD.
So, the focus will stay on fiscal measures. Congress returns in early September amid concern that the looming election may hamper agreement on extending job support measures. In this regard the US compares unfavorably with Germany and other European countries which have extended their job retention scheme.
This time, further stimulus is likely, whoever wins. A Trump win would represent the status quo and should be less likely to prompt a big shift in FX, but it might mean more protectionist policies. This should be USD negative, even if in the past, it was a risk off factor and supported the USD. Meanwhile, a Biden victory might be more uncertain for the USD as the market adapts to new policies. Additional stimulus should boost the USD in the very short-term, but if Biden is more conciliatory in geo-politic talks and less protectionist the reversal of recent USD losses might be small.
We are still positive about the EUR into 2021 but favor a period of consolidation in the nearer term. Some factors suggest that the upswing since mid-May may lose some of its momentum. However, if the global economic recovery is not derailed by rising Covid infections, the sizeable European support measures and low US interest rates should point to a sustainably firmer EUR in 2021.
The EUR has been on an upswing since mid-May. It rose from a low at 1.0775 on May 14th to a recent high at 1.2020 on September 1st. The currency appreciation over the last 3 months has been incredibly significant in historical terms. It has increased by just under 10%. Looking back to before the global financial crisis, there are only a few occasions when the EUR/USD has managed such an advance over that period. Such technical factors do not guarantee the currency will reverse much of its gains but suggest that further appreciation could be harder to generate and a period of consolidation may be likely.
A similar story can be seen in the speculative positioning. Speculators remain extremely overweight the EUR, but the absolute position already dipped from the recent highs, which could perhaps signal that any upside EUR pressure from this part of the FX market may now have run out of steam.
Despite concern over rising Covid-19 infections, risk appetite indicators, such as equities, have remained firm. The improvement in sentiment over the past 3 months should have implied a CHF weakness. The CHF continues to appear to respond asymmetrically to risk, gaining when risk appetite tumbles but not completely reversing those gains when risk fades. Amongst the reasons for us remain the non-resolution of the Brexit, which generates protection flows in favor of the CHF.
Given its high level, the SNB cannot intervene indefinitely without being explicitly qualified of currency manipulator by the US Treasury department. The SNB could cut interest rates further. But they are already the lowest in the developed market world. Another rate cut may have only a short-term effect on the CHF and potential be a bigger worry for the financial sector.
The SNB may prefer to play for time hoping that market sentiment continues to improve in H2 2020 and that a stronger euro persists and eventually pulls EUR/CHF higher.
A US monetary policy response to low inflation
The Jackson Hole conference is notoriously one of the potential policy-defining events of the year and this year was not different, even if it was virtual. The market was already exhausted by the plethora of monetary measures announced during the Covid-19 crisis. Powell used it to communicate a new US monetary policy paradigm. The new framework lays out a flexible average inflation targeting that avoids setting a formula and a time horizon over which the Fed seeks to average 2% inflation. He emphasizes that the Fed will target an inflation overshoot in recoveries following inflation shortfalls during downturns. Applied today, the Fed has now solidified a more dovish path compared with previous recoveries. The Fed entails seeing inflation raising first, before rates, rather than simply forecasting it to rise. The Fed Funds rate will stay low for long.
The coronavirus pandemic and the Fed actions have depressed the US 10-year yield, leaving it stuck. It has not reacted like it did in the past to the improvement of the leading indicators (Global PMIs), the cooper-to-gold or cyclical-to-defensive stocks ratio. The Fed has achieved its first phase target: keeping long-end yields low. Now, long-end yields will evolve more naturally.
Fast and furious Treasury supply is coming
World central banks have already purchased historical amounts of debts. There is still $1trn of sovereign bonds coming to market before year-end. The flood of fresh government debts, to fund pandemic-rescue packages, will largely surpass central-bank purchases.
Government bond sales in the euro area look set to fall short of the ECB purchase plans and investor redemptions by €200bn. The exception in the area is Germany which will issue €150bn in H2, more than any of its regional peers. Most of European bond markets are set to benefit from the ECB purchases.
Policy-maker purchases will lag issuance in the US and Japan, where a continuing tilt toward buying short-maturity debt would risk allowing yields on longer-dated bonds to rise. The huge supply is expected in maturities beyond 7 years, which could push up yields on longer-maturity debts.
Stellar credit performance
After a 20% loss in Q1 this year, the Bloomberg Barclays Global High Yield index is up 0.6% on a year-to-date basis. Spreads have tightened back to historical average levels. We attribute much of this rapid recovery to the introduction of the Fed Secondary Market Corporate Credit Facility. This program supports market liquidity by purchasing in the secondary market corporate bonds issued by investment grade US companies or certain US companies that were investment grade as of March 22nd, 2020. It was initially scheduled to cease on September 30th but has been extended to year-end. The Fed program has proven highly effective, despite having executed less than $15bn in total purchases out of a maximum program size of $250bn, making it a low-cost option for policymakers to support market functioning.
However, rating migration has been negative and default rates have risen. The Fed programs cannot repair solvency issues. The number of US companies filing for bankruptcy has been quicker than during the past 2 crises. The CCC-rated segment has a default rate of 41.3%, while it was below 10% by mid last year. Selectivity remains essential.
Companies have seen their financial leverage ratios deteriorating. First, corporate indebtedness has ballooned as bond sales have spiked due to low interest rate environment and investors search for yield. At end of August, the new issue volume has already surpassed 2017 record level. Second, earnings have been hammered in Q1 and Q2. Together they have pushed credit leverage ratios to their highest levels in over 2 decades. There is still scope for credit spreads tightening given the Fed whatever it takes mantra. BBB-rated spreads remain still 45bps wider than in January, BB-rated 167bps wider, and B-rated 176bps wider.
A favorable scenario for equities: liquidity, vaccines and anticipation of a V-shaped recovery in profits in 2021
We therefore remain positive on equities for the medium to long term. The Fed will not allow a major correction in the stock market; it will intervene. Equity correction will constitute buying opportunities. The record of cash in money market funds and the lack of alternatives are important advantages in favor of equities. At 6 months, we value the S&P 500 at 3,650.
The rise in stock market valuations is due to the drop in earnings per share, as indices have risen sharply since March 24th. In the 4th quarter, we should observe a normalization of PERs with the rebound in profits.
The decline in dividends and share buyback programs, either voluntary in order to keep cash or imposed to receive state aid, has not had an adverse impact on stock market performance. In 2008, dividends and share buybacks had declined, and then everything normalized. We expect the same development in 2021. According to Janus Henderson, global dividends will fall by 19% in 2020 to $ 1,180bn ($ 1,428bn in 2019), and by 25% in a worst-case scenario.
The main risk is an inflationary slippage, which could push long rates upwards, negatively affecting the high PERs of growth stocks through a price correction, as well as a sharp fall in the dollar which, in general, has negative consequences on financial markets.
In a 1-2 months horizon, we would be more careful for technical reasons. A consolidation in a bull market :
- Statistically, over 30, 20 or 10 years, the average monthly performance for August and September is negative.
- Short positions on the US stock market are at their lowest for 15 years, signaling that the US indices have outperformed (also) thanks to the unwinding of short positions during the rally and that there is no additional ammunition in case of positive news.
- The S&P 500 and in particular the FAANG segment, especially Apple, are in an overbought zone. Apple could be boycotted in China if Donald Trump banned Chinese Tik Tok and WeChat apps in the US at the end of September.
- The political environment in the US is corrosive and dangerous with the presidential election.
Despite the unfavorable statistics, August 2020 has been the best August since 1986.
In general, like in the 4th quarter of 2018 or in 2000-2001, the Value segment (low valuation) outperforms the Growth segment (high valuation) in a period of consolidation / correction. If there were to be a correction, the price decline would likely be larger among FAANGs, whereas banks would be more resilient.
With the stratospheric performance of FAANG+ stocks in 2020, the tech sector, together with Amazon, Alphabet and Facebook, accounts for nearly 40% of the S&P 500, with Apple accounting for 7%. This reinforces our conviction of a revaluation of the Value segment, if an economic recovery occurs in 2021.
As of August 2020, the top 10 companies in the S&P 500 represented 31% of the total market capitalization, compared to an average of 25% over the past 20 years.
We are therefore maintaining our tactical overweighting in Value (low PER), Cyclical (steepening of the yield curve) and Switzerland. We overweight the health sector with the need to find vaccine(s) to get out of this health crisis affecting the economy.
The notion of Value / Growth is more difficult to apprehend than that of Cyclical / Non-cyclical
Prior to 2008, there was consistency between macroeconomics and microeconomics, central banks dealt with inflation, and the stock market was segmented into cyclical and non-cyclical (defensive) stocks. Reading the stock exchanges was easier.
After 2008, central banks have been forced to take control of the financial markets and can no longer get out of their interventionism and their accommodating monetary policy. Very low interest rates make valuation models obsolete. With the very low cost of (re) financing, the arrival of disruptive companies and imperfect globalization, the micro and the macro are disconnected. Then, forget the concept of cyclical and non-cyclical; the Value versus Growth approach was born.
The concept of Value and Growth is more complicated, because the notion of economic cycle disappears and that of valuation is born: we only take into account the level of interest rates and we compare fundamental and stock market ratios – PE and P/Book ratios – relative to industry and market. You could very well have a pharmaceutical company in the Value segment and another in the Growth segment. The notion of cyclical / non-cyclical (defensive) disappears.
Today, the Growth segment is dominated by FAANG and Technology, and the Value segment by Banks.
In times of disruption and technological innovation, investors turn more to the Growth style.
In the past, the emerging zone would have benefited from the prospects of an economic improvement and the rise in the prices of industrial metals and oil. But the disruptions of supply chains due to Covid, US protectionism, the scheduled repatriation of certain production chains into developed countries and the end of globalization mark a more difficult period for emerging countries, or at least the end of the homogeneity of the emerging zone.
The risk of a correction is limited by large positions in money market funds. The equity positioning is low in historical comparison and the outflows of funds / ETFs invested in equities have never stopped since February.
According to analyst firm Crossborder, global equity holdings relative to global liquidity in dollars is low over the past 20 years. So, the gigantic injections of liquidity did not translate into a massive overweighting in equities. The 2009-2020 bull market is still unloved and the rally that began on March 24th, after the strong 1-month Covid correction, was missed by many investors.
Stock markets have become addicted to monetary stimuli, but valuations are not excessive.
Another argument in favor of the Value segment is its outperformance compared to the Growth segment, when interest rates rise with the scenario of economic recovery in 2021.
The price of gold is consolidating between $ 1,900 and $ 2,070 an ounce, after jumping 60% since early 2019 thanks to falling real interest rates and purchases by emerging central banks.
In 2020, central banks in emerging countries slowed down their net gold purchases. Russia has stopped its purchases. In H1 2020, central bank purchases were 39% lower than H1 2019.
The confirmation of a durable accommodative monetary policy by the Fed, relaxing its inflation targets, and the weakening of the dollar have allowed gold prices to rise again. The consolidation of gold in August reflected investor questions about the direction of real interest rates, but also a very overbought technical situation (MACD, RSI) in early August, requiring a pause. The situation is healthier today and the price should come out of the consolidation triangle to go North again. Basically, the massive rise in public debt (currency debasement), potential geopolitical shocks and the emergence of the yuan as an international currency make gold attractive in the long run.
But gold is supported by massive purchases of investors in funds / ETFs invested in physical gold. If one were to see an arbitrage towards the more cyclical segment of equities and/or a rise in real interest rates, gold prices could be under pressure in the near term. In India and China, these 2 countries account for 40% of the world gold demand, demand remains weak due to the health and economic situation; gold prices in these 2 countries are treated at discounts, compared to international prices, which are rarely observed.
Oil and industrial metals
Equities in the oil and industrial metals sectors are under pressure from ESG and green management. Investors avoid fossil fuels and industrial metals that are unsustainable and non-responsible. The messages given by the European oil majors with the reduction in dividends and the value adjustments on long-term assets (reserves) show that the ecological transition has begun. The big commercial banks, under pressure from investors and customers, are announcing one after the other the end of the financing of the exploitation of mineral and fossil resources from 2030.
However, since the massive intervention of central banks, coordinated with governments, industrial metal prices have been rising. Oil prices rebounded later because of an issue over a maturity rebalancing of a WTI future. At the Jackson Hole central bankers meeting last week, the Fed confirmed accommodative monetary policy for a long time, which boosted industrial metals. Copper benefited from lower inventories in London. The pandemic has not only affected demand, but also supply, as many mines have had to close, either for health reasons or by failing logistics and international transport.
Global demand for oil is picking up, but output will stay below, until stocks normalize.
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis contained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or pub-lished without prior authority of PLEION SA.