Monthly Investment Review
Global liquidity has reached the peak of its cycle in Q1 2021 – Liquidity will remain ample, but its momentum will decline. China has started to contain its credit cycle (shadow banking). Stronger economic recovery from Q2 will further drain investable liquidity
Good global, but very heterogenous – Cyclical growth. Strong US recovery from Q2, rising inflation. Advanced economies lagging 1 to 2 quarters; lower magnitude. China decelerating back to potential. Very weak / distressed emerging.
A new geopolitical landscape gestating – A stronger strategic alliance between China and Russia. US forging a coalition through the Quad. The Indo-Pacific region is the new world strategic epicenter (Taiwan)
Large capital flows into risky and speculative assets – Retail investors playing casino with government checks. Signs of complacency abound
Quality assets remain scarce and expensive – The recently threatened financial repression remains in place. US long rates will fluctuate in a short-term range (1.5% – 2.0%). Support comes from institutional demand for high quality assets
High risk appetite, but no new trigger in sight – Consensus for a weak USD and reflation trades have been under attack. The current indecision phase will prevail until hard data confirm the recovery, probably not before H2
Biden discreetly engages bold turns – ¨Sleepy Joe¨ created the surprise by his dynamism and his voluntarism. Anything but soft, he is driving major changes in both foreign and economic policy. He speaks loudly and clearly to both China and Russia, putting his money where his mouth is. Incidentally, he is regaining better relations with Europe, while maintaining some pressure. He is multiplying initiatives to coalesce in the broadest sense, fueling a shift of the geopolitical center of gravity to the Indo-Pacific region, like the recent renaissance of the Quad.
The Covid-19 pandemic has exploded the boundaries of economic and political conventions. Not only J. Biden demonstrated his sense of urgency with his outstanding management of the vaccination. As we sensed in the first quarter, he develops a grand vision of societal rebalancing and is directly in line with Roosevelt. Despite having one of the highest world wealth per capita, the US society has been derailing: it is the only G7 country where life expectancy has declined in recent years! After WW2, taxes on individual incomes and social insurance receipts made up about 50% of federal tax revenues and corporate tax 30%. Lately, the former represented 85% and Corporate share around 10%. US corporate profits are reaching new highs, while the labor share of national income has declined in the recent decades from 66% to 58%. In a skillful strategy of salami-slicing, allowing him to prioritize and divide the opposition, Biden made multiple announcements of major plans. The sums and means he intends to mobilize are unprecedented. Minorities and the most disadvantaged classes of American society will be the main beneficiaries.
A short or long cycle ahead? – The short-term picture is truly clear: an exceptionally good momentum. After reaching 6,4% in Q1, growth will be double digit (possibly +12%) in Q2 and very solid (around 7%) in Q3. This outstanding performance is due to the joint impact of base effect (2020 contraction) and stimulus packages. All in all, 2021 growth should approach 7 to 8%, more than erasing the shortfall of last year. So far so good. But a key question emerges: is the US economy going to I) boom in 2021 and 2022 to such an extent that it would severely slowdown (if not bust) then / short cycle, or is it rather going to experience a II) sustained period of prosperity / long cycle?
Too much of a good thing makes you sick! If Biden manages to have all his plans approved before 2021-end, we may experience overheating and unbridled inflation early next year. Even more so if, for obvious electoral reasons, he adds other dose(s) of stimulus before mid-term elections (November 2022).
A long cycle is more likely because of Democrats’ narrow majority at the Congress and non-cooperative GOP
But the risks of a short US cycle are not negligible
Monetary policy divergence is coming – The Bank of Canada scored first. While it kept its key rate unchanged, its greater economic confidence has allowed it to taper its QE program, reducing it to CAD3bn per week from 4bn. It expects the slack in the economy to be absorbed slightly quicker than previously assumed, but not before H2 2022. Policy rate should not be raised before next year.
The Fed made few changes to its language, apart from recognizing that the recovery is now on firmer ground. Rates and bond purchases were left unchanged, with substantial further progress towards its policy objectives. This more positive message means that the risks are skewed towards an earlier reversal of the Fed’s loose policy stance than its guidance suggests. The Fed is prolonging the period of deeply negative real interest rates. The main factors for a higher USD remain intact. The real yield spreads across the curve are still favoring a stronger USD and relative growth/inflation developments as well. The UK economy will outperform too, as it is vaccinating much faster. High Brexit uncertainty has now vanished. The Bank of England will be able to tighten monetary policy earlier than the ECB, mirroring what happened after the financial crisis. The BoE QE program is set to expire by year-end.
At the opposite extreme, the ECB President Lagarde highlighted the diverging trend between the Fed and the ECB. Despite some rumors about an ECB being more hawkish on the future path of its asset purchases, the latest ECB meeting proved a non-event. The ECB continued to sound cautious and committed to preserve financing conditions. Furthermore, the ECB has not discussed phasing out stimulus and reaffirmed that negative rates remain an effective tool to provide stimulus. Even after the recent decision by the US to stop labelling Switzerland a currency manipulator, the sight deposits – a gauge of the SNB interventions – continue to suggest that it is not aggressively acting against the highly valued CHF.
The bond market is increasingly believing the Fed, for now – Strong demand for fixed income had been the dominant rationale for rates coming off the March highs. However, they had been creeping higher before the latest FOMC, not because anything material was expected, but more on a lack of catalysts to test lower levels. Demand for fixed income can push yields lower, but when the macro data are persistently pointing in the other direction, it becomes difficult for the bond market to resist. The 5-year area had re-cheapened, another sign pointing to upside pressure for inflation.
Powell acknowledged that things have improved, it is also clear that the Fed will maintain its accommodative monetary policy stance short-term. The long end of the curve is quite unprotected to unexpected inflation. The Fed remains confident that medium-term inflation will remain at 2%, and the market is respecting the Fed forecasts.
Any surprise to the Fed conservative and gradual scenario will shake markets
Expectations of a new German coalition could trigger the end of negative yields – In September, the German elections will be the first in decades without the outgoing Chancellor. While the CDU/CSU was clearly ahead last year, recent polls highlight its weakening. The Greens have caught up. Still, a lot can happen. The outcome will also depend on the vaccination campaign results. Economic topics (climate change, education, investments) will matter too. So, what to expect on the fiscal front? Like in the Netherlands, a broad consensus for more public investment emerges.
The most probable outcome is a CDU/CSU and the Greens coalition, whoever are the winners. This would favor more fiscal stimulus via investments. It will not let go of the constitutional debt brake but will rather find a workaround like a SPV to finance investments in digitalization and to tackle climate change.
With this most probable coalitions likely to favor public investment and European integration, it is legitimate to question the negative German yields paradigm. The fiscal response to the pandemic has already somewhat remedied the insufficient amount of German government bonds available. But the ECB has absorbed more than the newly issued debt since 2020, resulting in negative yields. It would take a sustained commitment to run long-term deficits to alleviate that chronic shortage. At the margin, a return to a sustainable public investment and growth would unwind some of the scarcity premium.
Otherwise, a new coalition looking towards more European integration, especially if it enshrines the EU recovery fund in a more permanent form of EU budget, would contribute to greater fiscal spending. European integration and its redistributive nature would reduce disparities among EU members, and the credit risks. Investors would feel more comfortable investing outside Germany. This would ease pressure on the ECB to maintain an exceptional degree of monetary accommodation.
Further debt financing would also alleviate the scarcity of safe bonds and push yields up
An expensive HY segment – It is not incorrect to say that trillions in stimuli have literally killed all fears of credit defaults. According to S&P Global Ratings, the US HY default rate was below 6% last year. It was much lower than the previous crisis peaks at c. 10% in 2008, 2001 and 1991. Investors have raced to lend billions of dollars thanks to the central banks supports. The CCC-rated segment, or the spiciest end of the credit market, is enjoying its cheapest borrowing costs (in spreads and yield terms) in history. All the segments of the HY (BB, B and CCC) are trading in their respective lowest decile of the past quarter-century.
Given both strong growth and massive amounts of liquidity available, the default rate should stay low. However, with an average spread of 335bps, the risks are no longer paid.
Equities have a symmetric risk profile while junk bonds have an asymmetric one! At this point, favor equity risk over high yield
EM sovereign are swimming against the tide – While most of highly risked fixed income products have exhibited positive performance this year, the EM bonds performance drivers (technical factors and fundamentals) are not supportive. What happened over Q1 could shortly resume when EM sovereign bonds were hurt by a steeper US yield curve. Emerging sovereign bond indices have a longer duration (7.5) than the US Treasury index (6.8). The highly rated emerging sovereign bonds have the most to lose, as they are exhibiting a longer duration.
However even in a risk friendly environment, BBB-rated EM sovereign bonds have underperformed top-rated peers this year. This is mainly linked to fundamentals, internal factors and mainly their failure to deal with the Covid variants waves. While most of the highly leverage firm ratings are stabilizing, if not improving, EM sovereigns remain a source of potential stress. There have already been 3 emerging sovereign downgrades so far this year. Even if it is well below the pace seen in 2020, there were no upgrades. Negative outlooks still exceed positive ones by 21, signaling that further downgrades are likely this year.
Indicators resist variants – The overall health situation remains worrying, but developed countries are making progress with vaccination with the target of at least 50% people vaccinated by the end of June. We are moving from a market of pure liquidity in 2020 to a market of fundamentals, which translates into more volatility and more doubts. Stock indices continue to advance with the economy and profits rebounding strongly, under pressure from inflation and rising interest rates.
Central banks are still present, but they will not be there forever and they will take advantage of the strong economic rebound to normalize their monetary policies. Governments are taking over with gigantic fiscal stimulus programs. In 2021, the United States validated a support plan of $ 1,900 billion to which will be added the American Jobs Plan of $ 2,000 billion and the American Families Plan of $ 1,800 billion, if they pass the Congress ramp. Europe is implementing its € 750 billion recovery plan, not counting social shock absorbers during the pandemic (salary payments for unemployed employees, compensation for affected sectors such as restaurants, culture, etc.). According to Moody’s, the global excess savings created during the pandemic amount to $ 5.4 trillion, including $ 2000 in the United States. We therefore have all the ingredients for a strong economic recovery, beyond 2021, and a significant rebound in corporate profits, estimated at + 30% in 2021 and + 15% in 2020 for the S&P 500, and + 53% in 2021 and + 15% in 2022 for the Stoxx 600. Surveys and travel bookings confirm that households are ready to consume generously as soon as possible.
Stock market valuations seem to us to be at their fair level in relation to the expected progression of profits and the beginning of a new economic cycle, at 21x 2021 and 17x 2022 for the MSCI World, at 23x 2021 and 20x 2022 for the S&P 500 and at 18x 2021 and 16x 2022 for the Stoxx 600. But they will be under pressure mainly due to four factors:
- Inflation. Rising demand, the cost of the pandemic, disruptions in production chains and rising commodity prices are translating into higher producer prices, and probably later into retail prices. Inflation is harmful if businesses cannot pass it on to customers. But the results for Q1 2021 show that companies are able to pass higher prices on to their customers, thus maintaining or improving margins.
- Interest rates. Rising interest rates have an immediate impact on valuations and compress PE ratios. So, there is going to be a balance between rising interest rates and rising profits. The difficult exercise in forecasting the evolution of the stock markets will be knowing which side the scales will tip.
- Taxes. The costs of the pandemic and the stimulus packages will be financed by higher taxes, on the wealthiest and on businesses first as announced in the United States.
- Negative comparative base effect. This factor should not be overlooked and could trigger a consolidation of the indices. There will be a base effect on April and May inflation, and on 2Q21 profits for companies that benefited from early lockdowns.
In the immediate term, investors are becoming more cautious, after the S&P 500 rose nearly 90% since March 2020. The last week of April, weekly money market flows were the strongest in a year. Investors are starting to position themselves on higher taxes and inflation, as well as a “tapering” of the Fed. Strategists are increasingly talking about “peak growth earnings”, which will be between 2Q21 and 3Q21, but growth rates will remain high until the first half of 2022. The bull market is not over.
The most pronounced backwardation situation since 2007 – This situation shows how strong demand is and how tight stocks are. This concerns industrial metals, petroleum, agriculture and timber. In a backwardation situation, spot prices are higher than future prices. Conversely, in a contango situation, spot prices are lower than future prices, which translates into more storage to sell the commodity later at a higher price, obviously taking into account the cost of storage. We were talking about Supercycle for commodities a few months ago and the signals are mounting to confirm this trend. Corporations, analysts and traders are also seeing a powerful groundswell that is not just affecting industrial metals, but oil, timber and agricultural products as well. For the moment, demand comes mainly from the United States and China, but the global post-Covid economic recovery is still ahead of us, as many countries are still suffering from health problems like India and Latin America. We believe the Supercycle will be about industrial metals, while the prices of other commodities will fall back to normal when the pandemic is behind us.
In industrial metals, supply pressures come from disruptions in mining and logistics due to the pandemic and increased demand from China and fiscal stimulus. The ecological transition will exacerbate this supply / demand imbalance with the needs of electric vehicles, batteries, solar panels, wind power for example.
For Brent, the $ 70 area is a strong resistance, but it could break out to move back into the $ 70- $ 90 range. Demand is gradually returning; after falling to 82 million barrels / day, it stands at 95 million bpd. At the end of 2020, oil demand was 101 million bpd. On the supply side, OPEC +, which accounts for 45% of world production, continues to show discipline. A more sustainable rise in the price of oil could come from difficulties in finding sources of financing to exploit new rigs: under pressure from shareholders, customers and politicians, banks are less willing to lend for the development of fossil fuels. Many large international banks have decided to stop financing fossil fuels from 2030.
The price of gold remains correlated to the real US 10-year interest rate. In April, the price of an ounce climbed back to $ 1,800 as real rates fell. Retail investment in financial products invested in gold continues to decline; since the November 2020 high, gold holdings in financial products have fallen by 12%. With macro data in the US, the dollar, interest rates, and sharp divergences in gold price targets among major banks, the price of gold may remain in a narrow range.
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