Quarterly investment review

July 07, 2020 - 17 min read


US equity markets finish best quarter in more than 2 decades

US stocks wrapped up their best quarter in more than 20 years, a remarkable rally after the coronavirus pandemic brought business around the world to a virtual standstill. Just three months ago, investors were lamenting the end of the bull market—and the longest economic expansion on record—after major US stock indexes lost about 35% of their value in less than six weeks. The subsequent rebound has been nearly as brisk. The S&P 500 finished the second quarter up 20%, the Dow Jones up 18% and the Nasdaq Composite up 31%.

S&P 500, Quarterly Performance

Partly thanks to an unprecedented $1.6 trillion stimulus package from the Fed and Congress and a surge in trading among individual investors, the rally has lifted everything. But there is a perceived disconnect between what the market has done and the economic recovery. The reality is that the second half of the year may see a lot of choppiness, especially with the November presidential election now coming into view. A second wave of coronavirus cases was cited as the most prominent risk facing stocks for a fourth consecutive month, according to a survey of 190 fund managers by Bank of America in June.



Asset Allocation:

  • A period of extreme uncertainty
  • Major challenges to free market economy
  • End of Moderation: high volatility of growth and inflation in sight
  • Engaging in New Monetary Theories / YCC
  • Unbridled debt creation paving the way for an eventual indigestion
  • Liquidity orgy bails-out financial markets
  • End to USD exorbitant privilege
  • Anti-fragile assets will continue to thrive

The Great Monetary Orgy

It is an understatement to say that the liquidity injections by central banks, guided – and supplemented – by governments are unprecedented. Not only the magnitude is off charts, but also the means of action. Now subjugated to incumbent administration, the Fed, the Banks of Canada and Australia, as well as several emerging central banks transgress unthinkable limits. The ECB is following closely, despite the threat of the German Constitutional Court. National issuing authorities compete in ingenuity to by-pass their rules. Special investment vehicles, originated by governments, mushroom; and private sector intermediates are used to conduct massive assets’ purchases. The implicit purpose of policymakers is three-fold: 1) Ensure credit markets’ proper functioning, 2) impose punitive (negative) real rates across the whole yield curve and 3) maintain a favorable wealth-effect. At any cost!

We have fully entered the very first chapter of New Monetary Theory. This very controverted journey may contain many more chapters: yield curve control, outright monetization by central banks, public debt cancellation, restructuring of central banks’ balance sheet, etc. No doubt that they would be visited over next years, provided the economy relapses into recession… This would trigger major financial markets’ reactions / convulsions. This is a low odds / dark scenario. In another blue to rosy scenario, the issue of a debt indigestion / confidence crisis towards profligate / insolvent governments remains possible over the next 3 to 5 years. At least, the debt overhang of the private sector will weigh on investment spending for the foreseeable future.

Hyper-active policymakers succeeded to avoid the worse. But, but, but…

The Fed and Co succeeded in suppressing volatility and restoring calm in financial markets. They have built a bridge to cross the very tumultuous paths provoked by the Covid-19. But liquidity and grants will in no case restore the former prevailing landscape. It will take a lot more effort and chance for world economies and markets to exit this crisis relatively unscathed!

The restoration of several pre-Covid correlations is underway. For instance, the disconnect between equity and fixed income (credit) markets is over. The abnormal positive correlation between USD and gold is also dissipating. It was namely caused by the pain experienced by emerging countries, suffering from USD liquidity shortage, currency weakness and oil price collapse.

Continuation of a regime of entrenched disinflation and financial repression is likely
But, ultimately, the odds of a slippage either into debt deflation or into resurgent inflation are significant
In the meantime, liquidity floods will continue to support financial markets



The deepest global recession in eight decades

According to World Bank, the global economy is expected to shrink by more than 5% in 2020, despite unprecedented policy supports. Namely, GDP is expected to contract -6% in the US, i.e. less than in Europe -9%, while it will stay positive +1% in China. Emerging countries should contract by 2,5%. This is their first output contraction in 60 years. In the past 150 years, previous global recessions were driven by confluences of a wide range of factors. Among them financial crisis (5x), policy mistakes – monetary or fiscal – (2x), oil prices (2x), wars (3x). The current recession is the unique episode to have been triggered solely by pandemic. It also features the highest synchronization ever, i.e. more than 90%.

The Great De-coupling

One of the symptoms of globalization and synchronization is trade. Actually, global trade has been decelerating for a few years already. The Covid-recession precipitated its collapse. Global trade is now on track to fall more than during the global financial crisis. Many governments, stunted by their high dependency on centralized supply chains, will incentivize relocation of ¨strategic¨ ones. Even in the case of a new Democrat administration in the US next Fall, the de-globalization trend will continue. A strong cyclical upswing of activity in 2021/2022 would not be sufficient to resurrect global trade.

China will slowdown markedly in 2020 but escape to the global economic meltdown. This resilience has nothing to do with a ¨superiority¨ of its economy. Its authoritative political regime rather allowed for a hyper-active management of the pandemic and facilitated an early – commanded – re-start of activity. China’s quest for a lower codependency with the US and a higher autonomy is a long-term trend. It is reinforced by the rising tensions with the unilateralist Trump administration and even more by Covid-19. In the past years, Beijing has been preparing for a gradual phasing out of the US dollar currency zone. The internationalization and the stabilization of the Yuan feature it. Maintaining an orthodox monetary policy – as a quasi-dogma -, despite the collapse of growth, is a striking confirmation of it. PBoC claimed loudly that QE and asset purchases will remain banned.
China and US decoupling will accelerate

Consumers hold the key

The prominence of consumers for GDP trend is a classical pattern, linked to the maturation of economies (Western countries). It is even more the case following last decades’ take-off of emerging countries (China). The shutdown of lots of businesses disrupted many supply chains and increased unemployment. Consumer confidence plummeted. If sanitary conditions remain uncertain and volatile (second wave), then the psychology of the private sector may be durably impacted. Cautiousness and frugality would take root and fuel higher savings rate. In this – black – scenario, the potential growth rates would be durably impaired. Oppositely, if re-openings of economies are not too disrupted, and or if a treatment / a vaccine arise in H2, then pent-up demand would develop. A much more sanguine cyclical recovery would ensue. In this – rosy – scenario, this strong upswing, in the context of unprecedented fiscal and monetary stimuli, would turn into an unexpected rebound of inflation.

What we know now: consumers have been hit hard globally, with a surprising – relative – resilience of the US (see graph). Both in China and in the US, it appears that the propensity to re-consume proved pretty high immediately after conditions of safety and adequate supply were available. But let us face it: we know nothing about a) the sustainability of this catch-up spending and b) the pattern of next year spending, if sanitary conditions were to remain delicate…

Basically, we consider that it will take long to suppress outbreaks of Covid-19, at heterogenous paces in different parts of the world. Durable social distancing will prevent many sectors to ramp-up to pre-crisis capacity soon. The re-opening of impaired global and national supply chains will be uneven across countries, regions, and sectors. China gradual normalization, which started from Q2, will be damped by the depressed external demand.
World growth is expected to rebound by about 4% in 2021, hence less than current year contraction



USD exorbitant privilege needs to be earned, not taken for granted

The era of the USD “exorbitant privilege” as the world’s primary reserve currency is coming to an end. French Finance Minister Giscard d’Estaing coined that sentence in the 1960s. For almost 60 years, the world complained but did nothing about it. Those days are coming to an end. Currencies set the equilibrium between domestic economic fundamentals and foreign perceptions of a nation’s strength or weakness. The balance is shifting for the USD. The seeds of this problem were sown by a profound shortfall in domestic US savings that was glaringly apparent before the pandemic. In Q1 2020, net national saving fell to 1.4% of national income, its lowest reading since late 2011 and only one-fifth of its 1960 to 2005 average.

A weaker USD is what every country need

According to the Congressional Budget Office, the Federal budget deficit is likely to soar to a peacetime record of 18% of GDP in 2020 before hopefully receding to 10% in 2021. A significant portion of the fiscal support has initially been saved by unemployed US workers. That has reduced the immediate pressures on national saving. However, monthly Treasury Department data show that the crisis-related expansion of the federal deficit has far outstripped the fear-driven personal saving surge. The April deficit was 50% larger than the personal saving increase. In other words, intense downward pressure is now building on already sharply depressed domestic saving. According to many economists, the situation could be worse than during the global financial crisis, when domestic saving was a net negative for the first time. A much sharper drop into negative territory is now likely. And that is where the USD will come into play. According to the BIS, the broad USD was up 7% from January to April in inflation-adjusted trade-weighted terms to a level that stands 33% above its July 2011 low. The coming collapse in saving points to a sharp widening of the current-account deficit.

Reserve currency or not, the USD will not be spared under these circumstances

The US withdrawal of the Paris Agreement on Climate, Trans-Pacific Partnership, World Health Organization, and traditional Atlantic alliances are all painfully visible manifestations of US diminishing leadership. The coming USD collapse will have key implications. A weaker USD will be symptomatic of an exploding current-account deficit, due to a sharp widening of the trade deficit. The Washington poor trade negotiations will lead to lower funding by China and peers.

Short-term, the EUR strengthening is granted by stimulus

The USD supports are waning mainly due to the rapid return of real yields into negative territory after a brief positive episode by mid-March. The 5-year US real yields have reached their lowest level since the Fed taper tantrum in 2013 at -0.8%, while German real yields have sharply rebounded to -1.0% from -2.5%. So, the real yield differential has significantly tightened.
Furthermore, thanks to the ECB stimulus increase and even more the prospect of a large-scale European support, if not debt mutualization, European spreads will continue to tighten. This represents a potential EUR long-term support.



Fed towards a Yield Curve Control

The Fed balance sheet has already grown by $3trn since mid-March and is now surpassing $7trn. It could conceivably exceed $10trn by year-end. This would be more than double the peak that the 2008-09 financial crisis peak. What next?

The NIRP is not the solution. Markets have suddenly been pricing a risk of negative Fed Funds in early May. The 2021 Fed Funds futures were briefly trading above par, implying negative Fed Funds rate. The main certainty is essentially a 0% risk of a hike over the coming 12-18 months.

So, if the Fed were to go negative, it would be a favor to the rest of the world and emerging markets mainly. Weakening the USD would be the main reason for going negative. On the other hand, it would be a slap in the face for US savers and US banks. Just look at the European banks’ underperformance vs. peers or global markets since the ECB rate turned negative. The Chicago Fed has ranked down NIRP when evaluating the still available solutions. This is also in line with former IMF researcher, Raghuram Rajan, who argued that negative interest rates only work to weaken the currency.

So, what could force the Fed into pondering NIRP given how firmly Powell has rejected them? Inflation. Import prices are already declining, core inflation will likely follow. The last thing the Fed needs is a stronger USD as it could lead to a damaging disinflationary spiral. Everyone is incentivized to support measures that could weaken the USD. This is exactly why it is not 100% out of question. But would the USD weaken if the Fed introduced NIRP? It is not straight forward.

Judging from empirical evidence in Japan, the Euro zone and Sweden, it is not crystal clear whether a currency depreciates or not after the introduction of NIRP. The JPY jumped by 20% vs. USD in 6 months after BoJ introduced negative rates. The EUR weakened ahead and after the NIRP introduction, and the SEK weakened just after.


YCC far more likely

Fed chairman Powell emphasized at the latest FOMC meeting that the Fed is in no hurry to raise short rates. The Fed is considering the possibility of not only targeting very short-term rates but also medium-term maturities, like 2Y-3Y rates. This is quite different from the Bank of Japan, which is targeting 10Y yields. Implementing YCC, for example keeping 3Y rates close to zero, would testify to the Fed’s commitment to keeping policy rates at current levels. The Fed would probably not need to buy a significant volume of short-term bonds, given current economic conditions. As such, QE could focus on longer-term yields and, not least, the mortgage market, securing cheap funding for American households. However, with a gradual US economic recovery set to take off in H2 2020, we do not expect the Fed to implement a YCC shortly.

Central banks have clearly supported the credit market

The central bank has taken measures to try to shield the US economy from the pandemic and related lockdowns, including buying corporate debt for the first time. The Fed spelled out in greater detail how it will execute a $250bn program to buy corporate bonds that had investment-grade ratings as of mid-March and began purchases in the secondary market. It is also introducing a separate $500bn program for newly issued debt. The Fed’s actions signaled its willingness to keep credit flowing. At the same time, the European Central Bank has followed the Fed, by increasing the scope and the size of its different asset purchasing programs. However, it is indeed necessary to distinguish between market actions and real economy. Most of the highly indebted companies, that were already facing troubles before the crisis, will not been able to restore their margins. Default rates will continue to increase.



Fed vs coronavirus

After a strong rally of 43% for the MSCI World thanks to a massive support from central banks and governments, indices have consolidated and volatility has increased for 3 weeks with an overall re-acceleration of COVID infections following gradual deconfinements, necessary for social and economic reasons and possible thanks to advances in patient care, more efficient use of medicines to treat and the availability of tests and masks.

The liquidity effect is more powerful than COVID, if we refer to stock market performances. Investors are maintaining their bet for a vigorous recovery in economy and in corporate profits in 2021. Soft PMI indicators show a V-shaped recovery. Profits are expected to fall by 22% in the US and 32% in Europe, to rebound in 2021 by 28% in the US and 35% in Europe. We believe that the violent and fast correction between March and April incorporated the shock to profits. Unlike 2008, central banks and governments reacted immediately and in a concerted manner, explaining the stock market rebound. The current consolidation is justified by high valuation levels, but not shocking either, given the environment of low interest rates, low inflation and expectations of an economic recovery.

Since March 2009, falling interest rates have pushed up stock valuations, which have greatly contributed to the performance of stock indexes. See graph below. The high FAANG market valuations can be explained and therefore justified by low rates, in addition to their defensive nature and the exceptional quality of their fundamentals. Apple, Microsoft, Amazon, Alphabet and Facebook account for 22% of the S&P 500’s market capitalization and generate cash of $ 570 billion. On the other hand, higher inflation and higher interest rates would require a downward readjustment of stock market valuations.

Investors are also not afraid of the hardening of the trade, technological, political and financial wars between the United States and China, while the strong interdependence of these two countries and their weight in the world economy could have a major impact.

Fear of missing out (FOMO)

In June, cash in money market funds was taken out to go for better-paying investments such as credit. Despite the uncertainties, investors do not want to exit stocks, favoring the big growth stocks in technology / communication / e-commerce; FAANG stock prices hit all-time highs in June. The data also show that investor positioning remains very defensive: the weighting of equities in a diversified allocation has rarely been so low, which reduces selling pressures on equities.

At the beginning of June, there was a strong divergence between the bearish sentiment of investors (AAII) and the CBOE Put/Call ratio (betting on a further rise in stocks). The new outbreak of the pandemic in the world, in the United States in particular, reduces this divergence. Good news about a vaccine would undoubtedly be a trigger for better clues.

Growth vs Value

Before the 2010s, the Cyclical segment was differentiated from the Defensive one, a distinction relatively easy to grasp, the evolution of revenues and profits fluctuating according to the economic cycle. The notions of Growth and Value is less understandable, because the criteria are based on absolute, relative, current and historical valuations, taking the PE ratios and the net book value (intrinsic value), ie expensive values versus cheap values.

Basically, in the US:
1) The Growth segment includes Big Tech/Media (with a weight of 30%).
2) The Value segment includes banks, energy and electricity producers.
3) Staples, Healthcare, Industry, Discretionary and Telecom operators fall into the two segments.

In 2020, the Value segment tried to catch up from mid-May to June 8 with deconfinements. But the complicated health situation prompted investors to return to the Growth segment, in particular the US Big Tech.

Since 1995, the Growth segment has experienced 2 periods of very strong outperformance: in 2000 with the IT bubble and today. If current valuations have certainly increased, they remain at reasonable levels, and we do not detect a bubble situation. Especially since the fundamentals have nothing to do with those of 2000.



“Towards infinity and beyond”

Gold holdings in the funds / ETFs invested in physical gold by investors continue to climb – up 25% from the previous high in late 2012 – and central banks remain net buyers.

Gold is the best safe-haven asset in a diversified portfolio, which enables a barbell strategy by investing in equities, and is adapted to an environment of negative real interest rates. The massive indebtedness of the states to support the economy because of the coronavirus will force the central banks to maintain extremely accommodative monetary policies.



A rebalancing without surprise

As expected, May will most likely be the lowest point in demand for this health crisis. A point that we will never see again. From June, demand will gradually increase and a return to above 95 million barrels / day is expected in the 4th quarter of 2020 at the latest.

As for the level of supply, it’s not a surprise either. OPEC + has kept its promises with a drop in production of 10 million bpd. Its production will normalize only very slowly, the time for world inventories to return to normal. We maintain our assessment of a break-even price between $ 50 and $ 60 in the second half of 2020.




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