Monthly investment review

June 29, 2020 - 18 min read


Asset Allocation

  • Rosy scenario more likely than dark one
  • 2020 recession will deeply impact economies
  • Great Unknown for 2020-2021
  • Huge debt and deficits are not an issue yet
  • Risky assets consider pandemic as temporary
  • Liquidity driven Equities are ahead of fundamentals
  • Sovereign bonds still in crisis mode

Once again, the tidal wave of central banks liquidity tamed volatility and restored the decent functioning of – funding – markets. Consequently, risky assets, be it equities, high yield bonds and to a certain extent oil, rebounded. They implicitly discount a contained sanitary crisis (say limited to 2020) and a decent recovery, perhaps a normalization for 2021 and onwards. The US yield curve has gradually steepened.

But below the surface, things remain much less trivial. Investors’ participation has remained thin. Indeed, the pretty low visibility has resulted in significant outflows from high yield and equity ETFs as well as mutual funds. Tons of liquidity have been parked on the sidelines into money market funds. Gold remains – unusually – positively correlated to USD.

Early signs of FOMO (fear of missing out) are emerging again
We maintain our allocation unchanged


Macro perspectives

Pandemics is a kind of an economic gamechanger

Global activity has been put on an induced coma for an indefinite term, hopefully short… Pandemic reinforces economic decoupling and imbalances. It drives up uncertainty, inequalities, and precariousness. It penalizes primarily low-wage earners. This is a major shock of unprecedented magnitude. It impacts sequentially the different continents. First Asia, then Europe and the US, and now developing countries. It particularly affects the service industry, formerly the most resistant. Labor-intensive industries risk being durably impaired, if not victims of an acceleration of automation and robotics. The brutal incursion of the State, as the ultimate tentative deliverer, spells a major U-turn following decades of de-globalization, de-regulation and financialization. That is the consensus thinking of most economists and incumbent administrations now.

For sure, pandemic will leave deep imprints, if not partly modify the “evolution of civilization”. Globalisation, urbanisation, and trade have suffered major set-backs. Supply chains, labor migration, and investment flows could also be seriously disrupted. Productivity and job creation in the population-dense coastal areas are at risk of being durably impaired. But what if a vaccine emerges in H2 2020? Will all / some of the above-mentioned structural changes actually continue? Or, is the world rather going to ¨just¨ revert to the former economic model, with eventual scars and painful restructuring?

Current recession will deeply impact world economies
But it is too early to envisage an irreversible structural change of economic model

Tug of war between Prodigality and Frugality

Never before did we experience joint fiscal and monetary stimuli of such a magnitude in a brief period of time. Monetary printing presses are heating up. Central bankers have become sorcerers’ apprentice of modern financial engineering. Incumbent administrations daily cross the lines of unthinkable. Maastricht pact is dead, and Europe is even considering risk mutualisation / euro-bonds! The tentative Recovery Fund (over €750bn) is the moment of truth for EU. A make-or-break summit will take place in June. Let us hope that A. Merkel will finally make history as Europe deliverer… A waltz of $ trillions is underway in the US Congress. Altogether, the response has equaled nearly 14% of U.S. GDP. More, Congress is discussing a next phase of economic relief. So-called Phase 4 could include additional money for states and municipalities, small business program (the Paycheck Protection Program), and stimulus checks to individuals. It could be in the range of $1 to $1.5 trillion. In China, fiscal stimulus climbed to about 16% of GDP, i.e. 5% budget deficit and 6% in a special government bond financing investment. Though the fiscal impulse should add up to 5 percentage points to GDP, but the multiplier effects for corporate and household are limited. There is not a single suicidal enough politician to contest that the end justifies the means.

Forget austerity, welcome prodigality!
Stiff consequences and the bill will come later


Psychological shock

Skyrocketing unemployment – in the US – and confinement result in a major psychological shock for consumers. It may result in a structurally higher savings’ rate. Social distancing adds to the problem, by reducing mechanically the potential level of activity, independent of the strength of the potential demand. Very few sectors will be able to raise prices enough to defend margins.

All in all, global activity is likely to follow a U-shaped recovery in H2 2020
The public life-support will avoid a corrosive deflation to morph into depression


Expansion 2021-2022: still the Great Unknown

Are we going to experience sanitary aftershocks? Of what magnitude, duration? Will new shutdowns be imposed, fueling the risks of a depression? Or, if a vaccine emerges, are we rather going to experience significant pent-up demand, rising commodity prices and resurgence of a cyclical inflation? Not to mention all intermediate / hybrid scenarios.

Asia, namely China, seems to be first in having COVID-19 under control. Activity is gaining pace, as a restocking process has started for companies, while consumers execute some catch-up purchases. Gradual deconfinements are underway in Europe. The extremely cautious mood from policymakers and citizens is dissipating. Gradually even the most affected countries are opening. The US is somewhat behind the curve, while attempting to open-up quite rapidly. In the developing world, namely Brazil, India, and Russia are in a precarious situation, considering the lower development of their health system, extremely high concentration of disadvantaged people, and a late reaction to the infection. Approximately half of humanity will remain under some degree of lockdown in 2020 at least.

The tragic experience of last months will leave scars and behaviors change. Masks, social distancing and protective gestures will prevent new outbreak to happen with the virulence prevailing, compared to surprise, denial, and slow Q1 2020 reaction. Pandemic accelerates the integration of technology into our daily lives. From online shopping to virtual workplaces and video conferences, it has become a larger necessity. Across major economies, estimates of internet usage are up 40% since the start of the year, especially in retail, education, healthcare, leisure, and entertainment sectors.



The USD will give back some ground

The USD is still holding onto some of the flight to safety strength that it picked up during the pandemic. And while it may retain that in the near-term – especially considering the reignition of tensions with China – the USD will slowly give up some ground over the course of the year. Having been the winner when pandemic fears were at their height, the USD has room to give ground.


The EUR a path to recovery

Accommodative monetary policy, allied to ongoing fiscal spending, should support a positive spill-over of the German rebound, which together should provide a more constructive backdrop for the EUR. The Franco-German proposal for a €500bn rescue fund plus the EU €750bn fiscal stimulus package are absolute game changers. All the major players in Europe seemingly back the plan, and Germany has belatedly acknowledged that fiscal conservatism is no longer appropriate. Fiscal support should lessen the reliance on negative rates in the medium-term, helping the EUR grind back towards the mid-point of the long-term trading range, near 1.16.

A too extreme CHF bullish sentiment

The FX positioning highlights the jump in the CHF net positioning. The CHF is the biggest long among G-10 currencies (+23% of open interest). This move is a signal of how markets are increasingly betting on the possibility that the Swiss central bank will stop defending the 1.05 EUR/CHF psychological floor. For sure, it will be complicated for the SNB to match the expansion of the ECB balance sheet. However, most of the news are already in the price.


EM currencies will struggle to regain ground

EM are becoming an epicenter of the pandemic. Four EM countries (Russia, Brazil, Turkey, and Iran) are now among the top 10 countries with the largest number of confirmed cases. The situation remains highly fragile. Countries were already facing numerous structural and political challenges. We remain cautious with regards to EM currencies. To become more positive on them, we need to see some sustainable signs of the global economy returning to an up-ward path, which is highly unlikely to happen until S2 2020.

EM authorities are mobilizing the available policy tools to soften the blow for their economies. The combination of fiscal versus monetary policy response varies quite a lot from country to country depending on the availability of easing space. Stimulative measures taken make us skeptical to EM’s near-term FX prospects. The economic recovery after the pandemic looks set to be very gradual and geopolitical risks remain elevated.

EM economies with the lowest key rates tend to be more generous, as higher indebtedness is more affordable
Fiscal stimulus packages in EM were often smaller than in developed peers



Positive or negative bear steepening

After months of yield curve flattening, from 2014 to 2019, the yield curve is steepening again. The front-end yields will stay low for longer. The Fed is committed to support, by all the means, the economy. However, Powell clearly dismissed the risks of negative rates. The long-end yields will be pushed higher.

Traditionally, a bear steepening (i.e. widening of the curve due to long-term rates increasing faster than short-term ones) is a sign of higher growth and/or inflation, or of the supply indigestion.
The 1st scenario is the best one as the Fed keeps rates on hold, and the market expects higher forward rates.
The 2nd scenario is more worrying and could be a reason for the Fed to consider yield curve control.

Normally, a larger government bond supply would trigger a strong spike in long-term yields. Rising yields in a fragile economy would be detrimental to companies rolling over their debts and may dampen the economy. So, the Fed is likely to remain involved. Traditional investors will not be able to absorb such a large sale of new bonds. However, the enormous QE programs will counterweight the government bonds supply. According to official data, the Fed purchases will outstrip Treasury issuance by $900bn until year-end. So, the supply is not expected to be the source of market stress.

If the Fed reacts to a bear steepening, it could use the Yield Curve Control. It may be more efficient than the QE. Japan has been doing this for years, and Australia adopted the idea in March. The Fed would have several options like setting a yield level on a specific maturity, like 2 or 3-year. Alternatively, it might target a certain slope of the yield curve level.

Once the economy performs better than expected, long-end yields will jump higher. This may occur like during the 2013 Taper Tantrum episode, when yields climbed by 110bps over just 6 weeks and the curve steepened by 90bps. For now, the Fed has already tapered daily Treasury purchases to $6bn from $75bn without any meaningful market impact. The Fed presence alone will keep a bid on yields.

Yield curve control will only be considered if ballooning Treasury issuance is out of control

High-yield bond market kicks into overdrive

The US high yield default rate will reach 5.5% this month, up from 4.2% at April-end, its highest level since 2010 driven by weak energy and retail sectors. The market was already pricing it in this slowdown earlier in the year.

The demand is improving again

The Euro Area 4 biggest economies have already syndicated debt sales of almost €85bn this year amid the challenging environment. Orderbooks at the sale of the latest 20-year French notes were in excess of €56bn for an issue size of “only” 8bn.

High yield new issues in May reached $35bn after a near $38bn record in April. BB-rated issues account for 60% of the 2020 volume, compared with 42% last year. In average, the demand surpassed 3 times the supply.


A year of record EM downgrades, the 3rd time since 2000

The record number of sovereign rating downgrades this year has not translated into record amounts, 22 EM countries have been downgraded for $7.4 trn or 10% of the government debt outstanding. Most of these downgrades have been in lower-rated hand, 17 were rated B or lower and represents less than 3% of the market.

Over the past 12 months, the sum of EM sovereign debt downgrades has just reached $4trn or 23% of EM sovereign debt market, compared with a $4.7trn 2016 peak. The early 2000s crisis involved much smaller amount.

However, the relative magnitudes of the 2 previous crises are reversed when comparing the share of outstanding debt downgraded. In the early 2000s, Argentina, Brazil, Colombia, India, Peru, Turkey, and Venezuela were all downgraded, affecting 60% of the EM market. The 2016 crisis involved more countries, but a smaller share of outstanding EM debt, at 36%. However, this year, amongst the 15 largest EM debtors only Argentina, Mexico and South Africa have been downgraded. The all-time peak in the 12-month total sovereign debt downgraded was $25trn during the eurozone crisis of 2011-2012, when downgrades were focused on highly indebted developed countries. In-deed, this was the only period in which sovereign rating volatility was caused by developed markets rather than EM rating changes.

Still out of favour


A classic stock market rebound

The pattern of the current rebound is similar to that of previous major corrections, such as 2003 and 2009: after a peak in volatility and panic, indices rebounded sharply, then consolidated, and now are rising again.

The start of the rally on March 24th coincided with massive central banks and governments interventions. The rising of indices is part of the progressive national deconfinements and the borders opening, a necessary process with the proximity of summer holidays to avoid numerous bankruptcies in the three main countries of European tourism, France, Italy and Spain.

Investors are not fearing a second wave of the coronavirus. But will it come, knowing that in 2003, SARS CoV-1 had suddenly disappeared in June, without warning? And if a second wave should happen, thanks to their experiences and equipment (tests, masks, …), governments would react in a different way: no more strict confinements for social, economic, and financial reasons, but cluster strategies.


Need for a rapid recovery in profits in Q4 2020 or Q1 2021

Stock valuations are equivalent to the 2003 and 2009 rebounds, i.e. in the range of 17x-20x historic profits. But expectations of an economic and profits recovery must materialize in H2 2020. Some sectors, such as automotive, should experience a V-shaped recovery. Others where social distancing is important, such as restaurants and airlines, should rather have a step-by-step recovery.

The expansion of multiples is observed when the FED injects liquidity (QE). It has deployed a program of almost $4,000 billion and could do more if necessary. So, central banks are present, and we know that since the 2008 financial crisis, it has been difficult to fight against them.


FAANG against rest of the world

Some are trying to oppose blue chips to small and medium caps. If we look at the S&P 500 performance, we would be tempted to come back on smaller and domestic stocks, the Russell 2000 for example. But if we take the S&P 500 Equal Weight (all holdings at 0.2%), the performance is the same as for the Russell 2000. The conclusion: FAANG explain the entire S&P 500 outperformance.

Microsoft, Apple, Amazon, Alphabet and Facebook account for 20% of the S&P 500 making it difficult to avoid these stocks, knowing that a significant part of fund/ETF management is passive. The quality of these companies, with their oversized liquidity, is well established. However, during periods of economic recovery, the small and medium caps and value/cyclical segments tend to outperform.

The US and Japan outperformed Europe in this rally thanks to major fiscal and monetary support plans. Europe has also been penalized by its lack of solidarity, coordination, and North-South divergences ; one would be tempted to say “once again”! But the Franco-German plan of €750 billion, supported by a mutualised European debt, is a significant step for a return of confidence in European assets. We are therefore getting more positive on European equities which are offering a more global value/cyclical profile than the US market which is dominated by growth stocks (FAANG). In 2020, the S&P 500 and the Nikkei fell 7% while the Euro Stoxx by 20%. So, there is a potential catch-up for Europe.

In terms of stock market valuations, Europe seems more attractive at 18x 2019 profits. Japan is more expensive at 24x. Over the past 9 years, the average PER has been 18x for the S&P 500 and the Euro Stoxx, and 20x for the Nikkei.

Our allocation to Swiss equities is neutral. The Swiss Performance Index outperformed other indices in 2020 thanks to its defensive bias (Nestlé, Roche and Novartis), but stock market valuations are starting to get expensive. We favor the segment of small and medium-sized companies, which is lagging in terms of performance and market valuations.

Slower share buybacks and dividends are not an issue for now

In 2018 and 2019, the two main stock market drivers were share buyback programs and dividends. For the S&P 500, share buybacks accounted for 20% of the increase in earnings per share. In 2020, they will obviously be less significant, in the United States, Europe and Japan, constrained by governments following governments aids or on a voluntary basis to keep cash.

In 2020, the significant decline in share buybacks and dividends will not be viewed negatively. It is not related to corporate mismanagement, but to an uncontrollable external factor. Rather, it is seen as sound management to keep cash during a crisis.


Enjoy your summer!

Despite the rally, investors have still a lot of cash available. Since February, outflows from equity funds / ETFs into monetary products were regular. With the prospects for an improving economy, we should see net inflows back to equity products.

After the holidays, high unemployment could generate social tensions and reduce expectations of a strong economic recovery. Fiscal and monetary perfusions should slow down this fall, an unfavorable trend for equities, especially after a strong equity rebound. Then, the September-October-November period is often volatile and characterised by some famous corrections. Not to mention the US-China tensions and slippages in the US presidential campaign.


Chinese equities suffer from US Administration’s wars

Commercial, technological, financial, these wars have an impact on Chinese equities which underperformed. The recent Communist Party decision to enact a security law in Hong Kong calling into question the “One country, two systems” principle will result in American and European sanctions. Hong Kong will probably lose its status as a financial center and would affect H-shares.

The new financial war will make the listing of Chinese securities on the American stock markets more complicated. After the Lufkin Coffee scandal, Chinese companies listed in the US will have to pass more serious audits. To further strain Sino-US relations, the United States contemplate signing a law to punish Chinese abuses in Xinjiang internment camps, bringing together thousands of Uighurs Muslims.

On the other hand, the low weighting of Chinese equities in the global indexes and the authoritarianism of the Central Government on the domestic stock exchanges result in a low correlation with the main world indices.

China’s weaknesses, pressures on multilateralism, nationalism, the repatriation of production lines from emerging countries to developed ones and the commodity prices fall are elements that do not argue in favor of emerging stocks.



Gold holdings in ETFs at record levels

In Q1 2020, the demand for gold jewelry fell, with India and China accounting for 20% each, due to confinements and higher gold price, but it was offset by massive investors inflows into ETFs. Central banks increased their net purchases compared to Q4 19 and Q1 19. Russia has announced that it will stop buying gold. Turkey contributed half of central bank purchases in Q1 20.

The recent weaknesses in prices coincide with renewed optimism about economic growth, announcements of deconfinements and opening of borders, as well as the return of investors to riskier assets such as cyclical sectors.

This consolidation of gold could last during the summer, to regain color in our opinion in September, when we will have a more precise view of the impact of the pandemic and the speed of the decline in unemployment in the United States.


Oil, the supply-demand balance will gradually adjust

As expected, demand for oil fell 23% in April. This is likely to be the low point of this pandemic cycle.

Supply will decrease. At the end of April, the drop was due to the reduction in production in the United States. Then, according to the agreement within OPEC+, there will be a drastic reduction of 10 million barrels / day in May and June, then 8 million until December 2020 and 6 million between January 2021 and April 2022. OPEC hopes that Canada, Norway, Brazil, and the United States will also join the effort by lowering their production by 5 million barrels / day. We therefore expect a healthier balance in July around 90 million barrels / day for supply and demand and a price of Brent between $ 35 – $ 45 in September.

US shale oil is not doing well. In Q1 20, the 39 largest independent groups reported $ 26 billion losses and $ 38 billion write-offs, announcing a wave of bankruptcies.

Investments will be concentrated on large companies, even if Royal Dutch Shell launched the dividend reduction process to finance its ecological transition. BP and Total will follow. But the energy sector is no longer a source of concern as it accounts for only 3% of the S&P 500 compared to 30% in 1980!

Asset allocation - June 2020


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