Quarterly investment review

October 08, 2020 - 15 min read


In Q2 and Q3 advanced economies managed to avoid disruptions of their capital / credit markets and to engineer a tentative recovery. The resiliency of the pandemic, as well as the growing cautiousness of consumers / firms necessitate further – decisive – actions.

A more solidary and reinforced Europe siding with a different US administration might address these challenges. But different, less favorable scenarios, are not to be completely excluded…

Base scenario: a long healing phase:

  • A sustained recovery / new business cycle thanks to new and different stimulus
  • Subpar growth and volatile inflation
  • Entrenched political tensions due to high income and wealth inequalities
  • A not so dovish Fed, yet
  • Beyond negative seasonality, Equities to resume outperformance vs. fixed income
  • A likely rebound in commodities

Alternative scenario, i.e. double dip:

  • Growing risks of a debt crisis
  • Panic-like Financial Repression 3.0
  • Higher risk premiums, markets disruptions


A deferred, but still inexorable, issue of debt

The odds of a serious deterioration of public finance, post Covid-19, are significant. In our base scenario, where pandemic is gradually contained in 2021, advanced economies would dig a hole with budget deficits to GDP more than 15% in 2020 and around 8% in 2021. The increase of the public debt to GDP ratio would approximate +30%.

The US economy features well this upcoming challenge. Based on a benign macro scenario of 4-5% nominal growth post-Covid, deficits should drive federal debt to unprecedented levels over the next decades. According to official sources, debt might even approach 200% of GDP by 2050…

The prospect that a government might not be able to roll over its debt is, basically, unacceptable. So, how should policymakers address it? Reducing prospective fiscal deficits would be a solution, obviously the most difficult to pull off politically. Therefore, the temptation will be strong to reduce debt through renewed “financial repression”. Let us review what – new – monetary policy and administrative tools could – ultimately – look like.

When it comes to central banks, unconventional policies have mushroomed in the last years (including recently in emerging countries). We are now accustomed to QEs and large-scale purchases of government bonds. A further leap happened lately with the purchase of other types of assets and the implicit (US) / explicit (Japan, Australia) control of the level of sovereign yields (YCC). The Rubicon of direct monetization of deficits might soon be crossed. A soon as central banks would underwrite Treasury bonds in the primary market, they would de facto and definitely lose their independence. This scenario is – very – likely if the current nascent recovery falters.

Beyond monetary rules, policymakers may use a mix of norms and regulations to cut the costs of debt service. This would actually mean capping the interest rates that financial institutions – including banks, pension and insurance funds – are allowed to pay. An interest-rate ceiling would enable governments to sell and roll over government bonds at lower interest rates, because savers could not obtain better returns elsewhere. Such strategy was successfully used after World War II to reduce the US debt-to-GDP ratio from 116% in 1945 to 66.2% in 1955 (and further thereafter). According to World Bank and IMF, the US liquidated debt amounting to 5.7% of GDP per year through this kind of financial repression, between 1946 and 1955.

The current – orchestrated – collapse of real yields features financial repression 2.0.
The euthanasia of the rentiers / savers is under way and will continue.

Financial repression diverts private savings from private investment /capex, into government securities. This process has historically been accompanied by rising inflation because of excess demand at the controlled interest rate. Therefore, it has historically fueled relatively slower real growth. Most experts acknowledge that “normal” growth cannot resume until the pandemic is brought under control. But even in this case, economic sustainability will require addressing the high debt-to-GDP ratio.

Hyper-active and adequate stimulus should engineer emergence of a new business cycle of moderate nominal growth could unfold in 2021.

As long as the disinflationary and contractionary effects of the pandemic dominate, budget monetization and extraordinary debt ratios will resemble more a cure than a problem…

early cycle + recession - 09.10.20

This framework would allow for benign developments of financial markets. After a long period of pessimism, investors have just started to discount such a positive outcome lately. This may explain the recent euphoria / speculative phase of risky asset that happened during summertime…



New Fed framework may not be as dovish as initially thought

Several central banks’ guidance cement lower rates for longer. The Fed announced it would keep rates near zero until 2023. However, the recent Fed announcement of its Average Inflation Targeting needs to be clarified. Kashkari recommended the Fed to express a clear stance like keeping Fed Funds unchanged until core inflation has reached 2% for at least a year. Then, inflation will be allowed to overshoot. We still do not know by how much and for how long. We can interpret it as a 2.4% target as PCE has averaged around 1.6% over the past 5-10 years. Only Kaplan has addressed this point fearing that the Fed will still be tempted to lift rates too early. Clarity is needed.


Why does the Fed want higher inflation?

Fed is aware that Japan endured a mildly deflationary situation over the past two decades. In a deflationary context, orthodox monetary policy becomes increasingly less effective prices are falling, central banks are not able to push real interest rates further down into negative territory, which is very stimulative. The BoJ adopted negative rates in 2016 with little visible effect on growth and inflation. Although the US economy is not experiencing deflation, the Fed wants to raise inflation before reaching negative territory.

Inflation expectations are a crucial determinant of the inflation rate. They could incentivize businesses and households to buy goods and services now at lower prices. There is a high degree of correlation between the core PCE and inflation expectations. It will be difficult for the Fed to engineer higher inflation if it fails to raise further inflation expectations.

So, if inflation and inflation expectations do not move shortly higher, what could the Fed do? It should turn even more accommodative. But how exactly? First, it will not go into negative territory. Many officials have downplayed this solution. Second, yield curve control, i.e. purchasing Treasury to keep long-end yields below some level, does not seem to be on the table either, according to the July FOMC minutes. That leaves more QE as the most likely policy tool. As of now, the Fed is buying at minima Treasuries and MBS. If it were to ramp up its QE purchases, by how much would it do? History may offer some clues. In 2009, the Fed bought $50 bn per month of Treasuries, then in 2010 it ramped up to $75 bn. So, the Fed could increase its monthly Treasury purchases to $100-$120 bn and more MBS.

One way the Fed could signal that it is committed to raise inflation would be by increasing its TIPS purchases or add commodity futures. For now, the Fed communication is simply too shaky to really trust it. If Kashkari is right, the Fed will start debating a lift-off as soon as PCE-prices breach 2.0%. 2021 could turn much more interesting for the US bond market.


Supply Demand dynamic

According to the Treasury department, over the past 6 months, the US government added $3.3 trn to its already huge Gross National Debt (GND) to reach $26.8 trn. Who are the US Treasury funders/buyers?

A. Foreign investors all combined (central banks, governments, companies, banks, funds, and individuals) added $287 bn in just one year to reach $7.0trn. Due to the incredibly spiking US debt, their share held steady at its lowest level since 2008 (27%). US biggest foreign creditors remain Japan and China which combined hold 9% of the US debt, their second-lowest share in many years. The next 10 largest foreign holders hold another 9%.
B. The US Government pensions funds shed $21 bn over a year to $5.9 trn or 22.2% of US debt. Even though their holdings have doubled in 20 years, their share has dropped to 22% from over 45% in 2008.
C. US banks added $228 bn over a year to reach $1.1 trn or just 4.3% of the US debt.
D. The Fed brought its total holdings to a record of $4.3 trn or 16.2% of the US debt. In a year, it has more than doubled.
E. The other US investors are individuals and institutions. During the market tumult, they all piled into Treasury bonds. But in July, they brought down their holdings down to $8.1 trn or 30% of total US debt.

The first 3 types of investors have limited appetite to increase their US Treasury holdings. The Fed has room to maneuver and has already mentioned its willingness to support the recovery. The latest category of investors seems to be already well exposed to bonds. Speculators (hedge funds) and long-only investors are already overweight.

US Government debt by holder category - 09.10.20


Multiple credit market drivers

During the March depth correction, it was legitimate to become more constructive on credit in the face of widespread panic. After a phenomenal spreads’ compression, this is far less straightforward. With markets rallying so strongly, companies have used the investors’ appetite to launch record volume of new issues. This prudent action, to park liquidity, has come alongside substantial leverage increase. Furthermore, the drop in EBITDA has mechanically pushed leverage ratio higher.

The risks are well known for a while and will not change. The most obvious are an already tight spreads level, an elevated corporate indebtedness, resurgent M&A activities, and a large amount of BBB-rated debt at risk of downgrade. However, the lack of alternative ($14tn of negative yielding government bonds) is still a source of support. The central banks involvement in the market will continue to drive strong inflows. Most of corporate refunding risks have been postponed thanks to the historical high supply. And finally, ratings downgrades and fallen angels are much slower than expected. As a result, one can remain broadly constructive on credit, even if spreads are trading near post-pandemic lows.



The drivers of the USD weakness are here to last

Over the short-term, the swing between risk-on and risk-off sentiment will influence the USD. However, over the long run, fundamentals stay essential. In 2008, the USD was the overarching currency, and the US was one of the only major economies with positive interest rates. During that time, the US twin deficits fell to -12% of GDP at worst and money supply was running at +10%. Now, interest rates are hovering near zero, the current twin deficits is deteriorating and flirting with the -25%, and M2 is growing at +25%.

US Twin Deficits - 09.10.20

A credible alternative to the USD is emerging, as the EU appears to be regaining strength, making it attractive to investors again. In a demonstration of solidarity, EU members’ decision to jointly issue up to €750 bn bonds for the EU’s historic stimulus plan signals reassuring unity. Overall, the EU developments can change how central banks’ reserve managers and asset allocators think. Furthermore, China is the only major central bank that has not monetized during the COVID-19 crisis. This difference in monetary policy has the potential to create a stark divergence in long-term interest rates between the two countries.


The EUR long-term credible alternative

Since mid-February, the Trade Weighted EUR has appreciated by more than 6%. The scale of that move appears to have raised concerns that such strength could impair the recovery and raise the prospect of ECB actions. In September, Lagarde made a rare reference to the EUR strengthening as it remains a source of concern for the medium-term inflation outlook. There is a serious debate to know whether it poses a downside risk to growth and inflation and, if so, what to do about it. In our view, the EUR level does not pose a material downside risk for economic activity or inflation.

Even a further appreciation from here is unlikely to have a palpable impact. We do not believe the ECB will act to curb any further appreciation.

The trade-weighted EUR is currently slightly above its long-term average and below its past 5 years average. So, the EUR does not look over-valued.

It is also hard to argue that the recent EUR rise is due to factors that could be negative for growth. It does not reflect a more restrictive monetary policy stance. The ECB key rate is one of the lowest in the world and the pace of its asset purchases is amongst the highest. And the reasons for the EUR’s appreciation since May are positive for the economy as illustrated by the correlation between the Italian-Germany spread and the euro area currency.



The September correction. A classic

After a powerful rally since mid-March, a pause, a consolidation or a correction was justified by technical factors – an overbought situation according to the MACD or RSI indicators – with strong exuberance on US technology companies and FAANG+. We learned that some institutional investors, such as Softbank, had bought huge amounts of call options in August to leverage the rise in stocks. To this was added the cash distributed to American households, coming from the authorities’ Covid support measures, and benefiting to Robinhood investors, coming from the name of the e-broker platform, who are day traders taking advantage of excessively low fees and the ability to buy fractional shares.

Historically, the seasonality of August and September is unfavorable for equities; it may spill over into October. See graph below. Caution in a bull market! August has been one of the best August since 1984! On the other hand, in September, we first had a correction on technology and FAANG, based on excessive valuations, then secondly on the cyclical segment, based on a resumption of Covid infections and targeted lockdowns.

SnP Average monthly performance over 30 years - 09.10.20


An overpowering liquidity effect

Let’s face it: the stock markets have benefited greatly from the liquidity effect of central banks, which could do much more as Jerome Powell has reiterated. There is therefore still an extraordinary potential to support the economy and financial assets.

However, in the short term, the Fed is holding back its ammunition to force the US Congress and the White House to accelerate fiscal stimulus. Neither the Fed, nor the ECB, nor the US and European governments have any choice but to adopt extraordinary monetary, fiscal and budgetary measures, and for a few years. This unknown situation could revive inflation, which could weigh on high valuations and favor the Value / Cyclical segment. For equities, we risk entering into a search for a balance between inflation (unfavorable) and economic growth (favorable) through the support plans.


Pension funds will have to take more risk

Median stock allocation by public pension funds - 09.10.20

Despite generous valuations, US pension funds are considering an increase in the weighting of equities due to better visibility since the Fed ruled out a hike in its benchmark rate until 2023 and possibly a control of long rates. Today, they own less equities than in 2013.

Pension funds, individual investors, including young traders using e-broker applications like Robinhood, and other institutional investors must take more risk to meet their needs of future cash flows. It’s the financial repression. Pension funds will have to increase their risks, raising questions of regulation and investment policy. For US pension funds, a 60% US equity and 40% US 10-year portfolio delivered an inflation-adjusted 7% annualized over the past 40 years and 8.1% over the past 10 years.

With historically high valuations for both stocks and sovereign bonds, analysts believe portfolio returns will be much lower over the next decade. Analysts are looking for higher yield alternatives, but with more risk, such as foreign stocks, value/cyclical stocks and emerging assets. The other alternatives would be private equity, real estate, infrastructure, inflation-linked bonds, high-dividend stocks and corporate bonds.

If the response to the pandemic proves to be inflationary, there would be need to revisit the allocation of stocks, as well as the risk taking and acceptance of higher volatility.


Profit recovery in V-shaped in 2021. For the moment

If stock market valuations are justified by the level of interest rates, the engine of the stock market remains the progression of earnings per share. They are still expected to increase sharply in 2021.

YY Growth rates - 09.10.20


Europe EPS Growth forecasts - 09.10.20

The stock market rise will be based on liquidity and expectations of rising profits in 2021, whereas in 2020 and 2021 there will not be supported by share buybacks and dividends. In 2020, US dividends are expected to decline 25% and share buybacks by 50%.



Gold’s bullish trend remains valid

The price of gold has declined with the appreciation of the dollar and the rise in real US interest rates. We believe the Fed is not going to let inflation expectations fall. The price of gold is expected to pick up again when the Fed buys TIPS to keep real interest rates low. At that point, the yellow metal should continue to rise.


China and industrial metals, a long friendship

There is no doubt that industrial metal prices track industrial production and construction in China. Indeed, China accounts for about 50% of the world demand for industrial metals. Without exception, their prices have risen sharply since mid-March. Chinese industrial production, copper price and ETF Mining & Metals including mining companies and intermediate producers (steel, aluminum) The economic recovery in China can also be seen in the evolution of domestic air transport in September 2020 compared to September 2019. China: +8%, while Europe is at -58% and North America at -53%. Infrastructure spending in the United States and Europe will support industrial metals.


Oil, a gradual normalization

Determining the price of oil is difficult, because it’s political and manipulated by producers, especially in Saudi Arabia. On the other hand, by referring to the budgets of certain states, such as Saudi Arabia, the other Gulf countries and Russia, the price should be between $60 and $80 per barrel to ensure a balanced budget.

Demand is gradually recovering and will remain higher than production, as long as the surpluses in world stocks do not disappear; normalization is expected in the first half of 2021. In the meantime, prices will rise step by step, with a $50 at the end of the year and $ 60 in the first half of 2021 thanks to the recovery in demand and the control of non-US production.

Note the resilience of the US shale oil: at the end of May, production had fallen by 21%, while it only fell by 12% at the end of August.

Asset Classes Equities Alternative investments - 09.10.20


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