Monthly investment review

May 05, 2020 - 15 min read



Asset Allocation

  • A global framework still very unstable…
  • … where, worst case is avoided, for now
  • But prepare for delicate U-shape pattern ahead
  • Maintain an ¨off-road¨ vehicle investment approach
  • Expect further volatility and rapid rotations


Macro perspectives


The World’s perspectives are particularly opaque. The sanitary crisis remains a unique and quasi-unpredictable factor that will continue to impact over-proportionally on economy, politics, and markets. This will result in durable phases of volatility across the board. This spell a tale of highly disparate tentative scenarios:
A. Base scenario: recession, progressive deconfinements (U-shape pattern)
B. Dark Scenario: debt deflation / credit crisis (L-Shape pattern)
C. Rosy scenario: Covid-19 treatment, i.e. over-stimulus and inflation

Q1 was traumatic for investors. It started quietly, with the perspective of an extension of the business cycle (a soft water landing), thanks to a trade truce and a less belligerent Fed. But it rapidly evaporated, due to an external sanitary shock, supposedly regional, which rapidly morphed into pandemic. In the heat of the (first) phase of pandemic, markets shifted in a couple of weeks from residual compla-cency (namely in equities and low-quality fixed income) to a nightmare – black – scenario.

From late Q1, policy-makers hyper-active reactions have reduced the odds of a major corrosive debt deflation, helping a scenario of a U-shape crisis/recovery to unfold. Infection curves are flattening, and scientific research is moving at light speed. The risks of a possible second infection wave by year-end in G7, as well as of upcoming dramatic developments in poorer countries still loom. But one should not underestimate some odds coming from the … positive spectrum of the equation. The arrival in 2020 of an efficient treatment would render current hyper-stimulations excessive. A virtuous cycle of strong animal spirit, quicker money velocity and extremely accommodative financial conditions would trigger resurgent activity and outright… inflationary tensions, namely considering disrupted supply chains.

We consider that the ¨Rosy scenario¨ has lately taken over from black one
Keep a dose of anti-fragile, but avoid distressed assets


The Great Shutdown

Never before did the global economy shut that abruptly, on purpose. Covid-19 will cause an unprecedented loss of economic output exceeding the 2008/9 contraction and spelling the worst contraction since the Great Depression of the 1930’s.

By chance, policymakers learned the lessons of former major crisis. Their massive interventions should compensate 2 to 3 quarters of shutdown. And avoid a major debt deflation to unfold. Still, the price to pay is significant: loss of independence of central banks, bailouts and moral hazard, and a critical progression of debt.

Let us face it. We just do not know what is going to happen in the next quarters. Indeed, the developments of the sanitary crisis will be centerstage when it comes to resuming economic activity. But at this stage, the odds of an effective drug / vaccine allowing for a ¨safe¨ resumption of activity are remote. It is most probably a tentative story for 2021. A second wave of infection may well unfold by year-end, following the progressive re-opening of the economy in Q2/3. Conversely, a fortunate quick extinction of the virus would render current liquidity injections and fiscal stimulus highly inflationary.

But, beyond sanitary developments, other basic macro factors will also play a crucial role. The savings’ rate of – panicked – consumers could significantly rise. A more intense de-globalization process, featuring namely the re-onshoring of ¨strategic¨ supply chains could also happen. The intense intervention of the States will result in durable redistribution processes, major changes in the tax systems etc.

• A severe global recession is underway, addressed by hyperactive intervention of policy makers
• It is fundamentally disinflationary, if not deflationary
• It will probably trigger some re-balancing between labor and capital factors



Still strong USD but off recent highs

Swings in risk appetite remain the key driver of the FX market. The panic that engulfed markets in March has receded. Measures taken by the central banks and governments assuaged concerns about the availability of USD. Over the last month, the USD has been weaker against most of its peers. For the time being, this is probably more a correction the panic driven excessive selling, rather than a period of sustained USD weakness. Source: NBER, BLS, Federal Reserve Board, Haver Analytics

We still expect the USD to soften in H2. The economic out-look will remain weak, with the worst expected in Q2. If correct, the USD safe-haven trades could gradually unwind in H2. The Fed tremendous easing policy is reducing expected returns on US assets. The amount of money into the US economy is increasing at the fastest pace since the WW2.

We see several factors that could provide support for the EUR going forward. The EUR, as the second largest volume currency, should be more resilient once mindset switches. Moves in Italian-German spread will drive the sentiment and the EUR. Further, it has not have been helped by the Eurogroup’s slowness in agreeing a fiscal support package. This, in addition to ECB stimulus amid comments that it will be flexible and do more if required, should help confidence. Of course, the Eurozone economy is still expected to contract this year. Some indication that the spread of the virus is slowing in Europe allows economies to open. This is positive for economic and euro sentiment. The latest German ZEW for April did show the view on the current economic situation at a record low, but expectations rose to +28.2, from -49.5, the highest the survey has been since July 2015.


On the same trend

The CHF has stayed strong over the last month. It is difficult to see this strengthening disappearing soon. Limited risk appetite and external monetary easing measures have supported the CHF. The SNB has tried to weaken it. The best the SNB has achieved is to keep the EUR/CHF above 1.05. We still do not think the SNB will cut rates. The Swiss deposit rate is still the lowest in world developed market. If such a low rate has not weakened CHF demand, it is doubtful that an even lower rate would. And, negative interest rates increase pressure on the financial sector.


The CNY remains a model of stability

The renminbi has performed relatively calmly over the past couple of months. Hence, the yuan has not suffered either a big drop in March amid concerns. Similarly, it has not rallied over the past month as those worries have abated. That said, the USD/CNY has remained above 7 since March-end but is off its recent highs.

Despite slightly better than expected domestic data, the economy is still set to face global headwinds. Additional measures have been put in place over the past few weeks. The Finance Ministry announced that an extra CNY1trn in special purpose local bonds will be sold by the end of May to boost infrastructure investment. These measures appear mild when compared with the actions taken by other economies, but persistent easing measures appear to be helping and boosting credit.



The “whatever it takes” policy response

Everything is happening at a faster speed – including policy, monetary and fiscal responses. The responses of central banks have varied in adequacy thus far and will result in a synchronized spike in central bank balance sheets. The Fed’s emergency actions should inflate the balance sheet to $9.3trn, more than double the prior record. the Fed demand for US Treasuries will far outstrip the new supply.

Interestingly, in the past, massive money printing has caused or has coincided with higher long-end yields. The Fed purchased a lot of bonds, the USD scarcity and financial conditions eased, emerging markets rebounded, and growth prospects repriced positively, so longer US yields rose.

Will the Fed accept such a modus operandi this time? Not that sure. Loretta Mester, the Cleveland Fed president, not known to be dovish, has already admitted that more easing could happen. The Yield Curve Control could prove to be THE tool to prevent long bond yields from eventually rising.

Both headline and core CPI undershot expectations as the economy began its slide. The collapse in energy prices and surging unemployment means inflation pressures will not materialize soon, even if M2 is surging. Further downside risks exist. Huge falls in energy prices will continue to feed through. It accounts for 8% of the CPI. Reduced activity will depress housing prices and rent inflation which both account for 33% of the CPI (Shelter). With initial claims showing 17 million lost jobs in 3 weeks and millions more at risk, there is unlikely to be much inflation pressure generated by the services wage inflation (26%). The main threat is likely to come from food prices, but it counts for 14% of the inflation basket.


Credit markets are more orderly and operational than 2008

Credit markets have suffered in March-April, like all other asset classes. Spreads have dramatically widened. High Yield spreads temporarily spiked above 1000bps, to similar levels of past recessions. But they were much higher in 2007/2008 due to banking crisis, liquidity crisis, and a lengthy recession. Although liquidity is hurting, it is still fully operational like during the European debt crisis in 2011 and much better than in 2008.


The worst is already priced in the credit market

While we expect the recession to be short-lived, its severity will push up default rates. According to S&P data, potential credit downgrades rose sharply to a 10-year high of 860 from 649 a month earlier. But current spread levels are discounting an even worse scenario for defaults. Governments and central banks stimulus will reduce recession severity, boost liquidity, and improve sentiment.

Credit markets are rebounding. The forward potential return is huge, and markets are already pricing in a lot of pain. During times of crisis, credit spreads spike but they do not stay elevated for long. Historically in the US, when HY spreads have risen above 900bps, the following 12-month returns have consistently been strong. An opportunity to add may not last long.

We have seen and will see more defaults, bankruptcies and fallen angels from IG to HY. This is normal during recessions. While the number of fallen angels will rise, they offer great opportunities for investors who pounce on the heavily discounted bonds from forced sellers.


New EM countries mindset

Many emerging economies have seen their currencies falling sharply. This follows a pattern seen in past crises, when countries with the largest current account deficits had taken the biggest hit. One difference is that many countries are no longer fighting their currency declines. Instead, they are easing monetary and fiscal policies which could create potential capital outflows and exacerbate currency declines.

But it is not all bad news. The central banks emergency policy actions are supportive for fixed income markets. The Fed moves aim to ease financial conditions and provide ample liquidity. It can spill over to the EM world.

We remain out of EM local debt given risks of further currency depreciation and keep hard-currency EM at neutral. Overall, we see EM as a place for income source, but we favor IG and HY credit at this point.



Stock markets in a rebound process

The economy is going through an extremely violent moment with the cessation of activity in Europe and the United States. Stock indexes fell sharply, by around 35%, between mid-February and mid-March with confinements. But the experience of the 2008 financial crisis prompted central banks and governments to react quickly and in a coordinated fashion, with massive support for the economy.

The monetary and political world intervened at the peak of volatility and panic; a week later, the stock market started to rise again, confident that the astronomical sums committed could allow a rapid recovery of the economy and that of corporate profits.

The months of April and May will be a phase of national deconfinements, allowing the financial markets to count on in a gradual normalization of the economy and social life. Deconfinements and unlimited financial support should support the stock markets. It is true that there is a liquidity effect on the financial markets of unprecedented power. Equity markets also evolve, to a lesser extent, according to the discoveries of drugs treating the disease and to advances in a vaccine (not before mid-late 2021).

In general, the stock market indices hit lows 2 quarters before the recovery of profits. In the internet bubble crisis in 2000, the indices had hit the lowest 2 quarters before the rise in profits and in the financial crisis of 2008, 3 quarters before. In this health crisis, profits should rebound in the 1st quarter of 2021.


Investors look toward 2021

In the United States, profits will fall between 15% and 18% in the 1st quarter of 2020, then from 30% to 35% in the 2nd quarter, -13% in the 3rd quarter and -5% in the 4th quarter. In 2021, profits will rebound sharply from the 1st quarter with an increase close to 20%. In Europe, the decline in profits will be more significant, as companies are more sensitive to economic and financial shocks; on the other hand, the recovery should be more pronounced in 2021. Investors are looking towards 2021. In terms of stock market valuation, the S&P 500 stands at 19x trailing profits after a 2-month rebound, a situation comparable to 2000-2003 and 2008-2009. Despite rising indices, the sentiment indicators for investors are not euphoric, meaning that there is no runaway.

The Market Breadth indicator for the US market is at a low level: the S&P 500 is 17% from its peak, while the median of the S&P 500 members is 28% from its peak. According to Goldman Sachs, this indicator would signal a correction in stocks. But this situation can last for a few months with a strong dispersion in performance: investors will continue to search for winners and losers in the pandemic. Historically, correlations have declined and dispersion has increased when stocks rebounded out of a bear market.


Overweight US stocks

We are overweight US stocks despite a halt to share buy-back programs. Stock buybacks were one of the drivers of the increase in earnings per share, but not the major factor either, since they only contributed up to 20% in 2018 and 2019. Share buybacks will be stopped for companies that will benefit from state aid. Dividends should also slow down. Companies have other priorities today: ensuring liquidity, keeping operations and employees, managing uncertainty about the length and magnitude of the economic impact from COVID-19. We favor US stocks. The composition of the S&P 500 is increasingly focusing on growth and defensive companies: Microsoft, Apple, Amazon, Alphabet and Facebook account for 20% of the index. The coronavirus has generated a “digital bomb” where US companies are most exposed.


Underweight Europe and EM

Europe is sensitive to external shocks and disruptions in global production chains. Three countries, Italy, Spain and France, were particularly affected by the pandemic, with extremely strict confinements. As always, in the event of crises, financial, economic, migratory, and today health, Europe shows its weaknesses and the gap which separates North Europe and South Europe, penalizing European equities (in relative terms) and the euro.

Emerging stocks are suffering from the strength of the dollar, falling prices of commodities, especially oil, the downturn in the global economy and disruptions in supply chains. Nor can emerging countries have the same monetary and fiscal responses as those of the United States and Europe. Health systems are also more fragile, although this has yet to be seen given the scale of the crisis in Italy, Spain and France.


Sector rotation

We are gradually more constructuve on Value and cyclical sectors. In the rally, these sectors partially caught up on defensive and growth sectors, Health, Staples, Communication, Utilities and Technology. National deconfinements are being put in place, very slowly, and in a very heterogeneous manner depending on deficiencies in the health systems, the availability of masks and tests. Investors therefore play the economic recovery.



Oil. A crisis without comparison

A double shock of supply and demand of an extraordinary magnitude made oil prices crash.

Supply shock. The United States continued to increase production to 13 million bpd in late March. Due to no-agreement in February within OPEC+, Saudi Arabia decided a price war and significantly increased its output. This oversupply has led to the maximum use of storage capacities on land and at sea.

Demand shock. The EIA forecasts a fall of 25-30 million bpd in April and May, or 30% of the global demand. A tsunami of an incredible violence. From June, demand should start again at the speed of national deconfinements. Over the year, the EIA estimates a decline of 10 million b/d.

The consequences :
Brent prices have dropped sharply from $69 in January to $20 today.
On April 12, OPEC+ decided to reduce its production by 9.7 mbd in May and June, then 8 mbd until the end of the year and 6 mbd until April 2022.

In 1 month, US production lost 800,000 b/d. The number of drilling rigs has dropped. Shale oil production, which accounts for 70% of total US production, will also drop. The shale industry needs a price between $35 and $55 to be profitable. The WTI is at $14.

This oversupply and full storage capacities caused a crash in the prices of WTI futures contracts, with a negative price of $ 40, during the rollover of the May maturity on the June one. It was a technical shock and the losers were retail investors.


Gold, an excellent asset for a financial protection

Gold is benefiting from this health crisis and from the gigantic monetary and fiscal programs which will result in a significant increase in the indebtedness of the States and higher budgetary deficits.

The rise in the price of gold reflects purchases by retail investors in ETFs. See graph. Since 2016, the first quarter of 2020 has been the strongest quarter in terms of gold purchases in ETFs.

The uptrend should continue with a 1st target at $1,800 an ounce. In addition, the two largest buyers of gold, India and China, which account for 40% of the demand for gold, are almost absent due to confinements and the ban on weddings and other festive and family celebrations.

Asset allocation - 05.05.20



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