Retrospective

Central banks are fighting inflation
Central bankers tell us that failing to restore price stability is currently a bigger risk than generating recession. Following the surprising higher than expected inflation data in the US in June at 8.6%, the Fed has raised Fed Funds rates by 75bps, a rare move.

More surprisingly, the Swiss National Bank has acted and taken the lead in Europe. It raised rates, for the first time in 15 years, by 50bps to counter inflationary pressures which reached their highest level since 2008 at 2.9%. After years of fighting deflation, inflation is now too high and the SNB has decided to act quickly. This rapid shift is also explained by a mindset change. After being seen as overvalued for years, the CHF is no longer seen as highly valued. By raising rates before the ECB, the SNB indicates that a stronger CHF is no longer a problem. It is possible because the strong CHF has allowed inflation to be more moderate than in Europe.

On the opposite, despite the ECB held an emergency meeting only 6 days after its June regular one in response to higher Italian bond yields, it did not act. However, the ECB has already pre-announced a rate hike for July by 25 or 50bps.

 

Bond shock has continued
The larger than expected Fed move in June has triggered a new wave of volatility on the bond markets. The US 10 -year government bond yields has continued its move higher and spiked to its highest level since May 2011. Even more surprisingly, the US 2-year yield reached its highest point since 2007. The Swiss Confederation 10-year yield have visited the 1.0% mark for the first time since 2013.

Credit markets have been shaken too. The spreads have sharply widened across the board. The US and EU investment grade credit have widened by 60bps and 100bps respectively in 2022, of which 30bps and 50bps in June. In the High yield space, US and EU spreads have both skyrocketed by 300bps in 2022, included 180bps in June.

 

Largest equity market de-rating since 1970
The first half of 2022 has gone down in history as a period when we saw the fastest rise in US yields, inversion of the yield curve with the first rate hike and one of the fastest de-rating of US equities on record. World equities have lost 12% over the 2nd quarter according to MSCI. Most of developed markets have delivered very close performance. However there were some exceptions. The most negatively impacted index has been the Nasdaq which has lost 18% in Q2. The main reason is the highest sensitivity for Big Techs to higher yields. The most resilient market has been once again the UK due to its high exposure to the energy and healthcare sectors.

 

Gold disappoints
In a context of risk aversion, gold price has gradually slipped to $1’800 from $1’900. However, it has remained resilient to rising expectations of aggressive rate hikes and a stronger USD, which historically was painful for gold prices. However, equity market weakness and ongoing geopolitical uncertainty would have support investor demand. It has been a relevant diversifier once again in a balanced portfolio to mitigate equity market losses.

 

Currencies - Q2 2022 performance

Currencies - Q2 2022 performance

A hawkish Fed, hiking rates aggressively to curb inflation, has pushed the USD to its highest level since early 2000s. In the developed world, the JPY has been the big looser due to a reluctant central bank to tilt to a more restrictive stance to fight inflation.

Emerging currencies have remained under pression, except the RUB., in a context of economic slowdown risks and lower commodity prices.

 

Bonds - Q2 2022 performance

Bonds - Q2 2022 performance

Another awful quarter for bonds. Higher inflation, hawkish central banks and fears of economic slowdown have pushed yields and spreads up. Bonds have delivered their worst semester in history.

The only exception, once again, is the Chinese market which has confirmed its lower correlation with international bond markets.

 

Equities - Q2 2022 performance

Equities - Q2 2022 performance

Another quarter of loss on equity markets. A prolonged war in Ukraine, elevated energy prices, higher yields and risks on corporate margins have pushed global equity markets down.

Emerging stocks were once again the biggest losers. China has been an exception thanks to easing Covid restrictions.

 

Commodities - Q2 2022 performance

Commodities - Q2 2022 performance

A big reversal happened in Q2. Excluding energy prices, most of commodities are down. Energy prices remained supported by the lack of supply to compensate the Russian offer. Other commodities have been penalized by the growing recessions fears.

 

Macroeconomy

Growth concerns

Manufacturing output

Global macroeconomic leading indicators nudged lower in June to their lowest levels since mid-2020. The deterioration took place despite an easing of COVID-19 restrictions in China - which allowed mainland manufacturing activity to rise at the fastest rate for over a year - and reflected weakened factory trends in the US, Europe and across much of Asia.

More encouragingly, the alleviation of China's pandemic restrictions contributed to a further easing of supply chain delays, which - alongside a stalling of global demand growth for manufactured goods - helped cool price pressures, albeit with energy providing further upward pressure on costs.

 

Improvement limited to China

Manufacturing trends excluding China

Production trends varied markedly around the world. Of the major economies, only mainland China reported an improving production trend, with output rebounding sharply from three months of lockdown-induced contraction, to register the strongest expansion since November 2020. It was also one of the strongest expansions seen for over a decade.

In contrast, output fell into decline in the eurozone for the first time in two years and came close to stalling in both the United States and United Kingdom, where steep slowdowns led to the worst performances for over two years. Japan likewise reported near-stalled production growth, its worst performance since January's Omicronrelated restrictions.

Growth of new orders likewise generally deteriorated, with declines registered in the eurozone, US and UK. Even China only saw a modest revival of demand, and near-stagnation was seen in Japan and across the rest of Asia as a whole. Notably, in all cases, new orders growth fell below that of output.

Excluding the rebound recorded in China, the global factory trend therefore looked less impressive. In fact, excluding China, factory output growth came to a near standstill in June, registering the weakest performance since June 2020, while new orders fell for the first time in two years..

 

Strategy

Suffocation

Equity to Bond correaltion

The magnitude of the inflation surge in G10 and its stickiness has impacted major asset classes in depth. Global equity and bond markets fell in synch, in a crucial challenge to the two decades’ prevailing - negative - correlation.

A global recession seems inevitable, putting a definite end to the current unusual business cycle. The question of its magnitude and intensity will gradually take over the fears of an unbridled inflationary regime change.

We consider that equity to bonds correlation will remain highly volatile this year but should not remain durably in positive territory. From a cyclical perspective, the left tail risk of a deflationary shock, due to the confluence of the durable energy shock and inevitable consumers’ retreat, not to mention the huge debt burden, is rising. It is becoming at par with the right tail risk of a runaway
inflationary regime as in 70/80’s.

Markets have now rebuilt a risk premium consistent with the - dangerous - G-Zero landscape.

The ongoing brutal repricing of risky assets’ valuation is well underway. The necessary drying up of excess liquidity and the onset of the severe economic downturn will continue to weigh
on risky assets.

 

Investment landscape

Central banks balance sheet

Stagflation is entrenching in G10. Such a landscape hasn’t prevailed since about 5 decades. Markets have acknowledged for that in suffering: both equities and bonds have cratered, for two quarters, in sync. Not only are these framework conditions difficult for investors to cope with in themselves. Worse, they are completely new to almost two generations of investment professionals
and further overshadowed by the pandemic and geopolitics. Making forecasts in this environment becomes particularly uncertain! A future return to some form of calm / neutrality is illusory.

The range of possible outcomes for the economy and markets has become particularly wide and opaque.

 

Currencies

Central banks tackled the pandemic head on but are now fighting inflation

Dollar trade weighted

With higher yields, elevated volatility and wider spreads, the bond market is sending warning signals that the FX market is listening. The global economy is hit by supplychain shocks, China zero-COVID policy, higher energy prices and the war in Ukraine. Recession fears are growing, and the USD has been the principal beneficiary of the longest period of high volatility we are living in
since early 2010s.

The USD is reaching its 3rd peak in 40 years. The first episode in 1985 was straightforward, the Fed tightened aggressively to cool down strong growth and accommodative fiscal policy, just before the Plaza Accord. The 2001 peak came after a lengthy period of heightened volatility. The USD was boosted by the Asian crisis, the Russian default, the LTCM collapse, the Dotcom burst, and the 9/11 attacks. The 2008 peak followed the global central banks easing to counter the Global Financial Crisis.

Dollar performance (weeks around recession)

Since then, the investment environment has been a secular stagnation (low growth and little inflation). Looking ahead, a more permanent stagflation (low growth and elevated inflation) seems a more likely scenario. The focus may move towards elevated energy prices winners, or predictable cash flows such as profitable tech, healthcare, and energy sectors. The US economy looks well positioned than any other (industry, banks).

According to history, there is no consistent USD pattern when the US enters recession. In contrast, there is a very consistent pattern when the market has fully priced in the recession: the USD has historically always weakened when the equity market has troughed, around the midpoint of the recession.

The next large move is likely to be down but not until tangible signs confirm that inflation is peaking, growth slowing, Fed tightening taking a break and markets calming down. Until then the USD will stay firm.

 

Bonds

Global central bankers hawkish shift

Central banks and CPI rates changes in 2022
The Fed remains unconditionally committed to bring inflation down but recognized that without price relative calm, macroeconomic or financial stability are unlikely. If inflation remains high, the Fed will be reluctant to cut rates in respond to deteriorating macro context. The Fed target of reaching 2.0% inflation and a strong job market would be challenging. Achieving a soft landing is not
going to be easy. The Fed has no intention to cause a recession but acknowledged that is a possibility. This contrasts with the previous testimony when achieving a soft landing was more likely than not.

The Fed remains committed to reduce its $9.0trn balance sheet by 30%. More importantly, Powell pushed back on the possibility of the Fed raising its 2.0% inflation target. Several Fed officials are promoting another 75bps hike in July. Although 75bps hikes are rare, it was not the first time the Fed implemented such moves. Since 1971, the Fed has raised rates 5x by 100bps, 4x by 75bps and 9x by 50bps.

Most central banks are still behind the curve, with very few still dithering. The world hawkish twist will last at least until a recession starts.

 

High Yield market passiveness

Economic activity indicator and HY spread

Since the GFC, investors have been conditioned to buy on the dips across risky assets, including HY. The pandemic reinforced this practice and thanks to fiscal stimulus, monetary intervention, and Fed facilities. That promoted complacency and raised questions as to how investors would react to a real recession. Logically, default rates increase, and issuers are less likely to cover interest payments and debts.

Spreads have always widened in a higher macro uncertainty and equity volatility environment. Their spikes occurred when volatility suddenly jumps. For now, US HY spreads at 500bps are pricing in a moderate economic slowdown. In a recession (ISM Manufacturing below 50), the US HY spread should be closer to 700bps and above 900bps in a deeper one (ISM below 45). The probability of a protracted slowdown and even a true recession is much higher now than before the war in Ukraine and the rapid unwinding of Fed stimulus.

 

Equities

A Bear market, from inflation to recession

S&P500 earnings and recession periods

The 1st phase was the compression of multiples, the second should be the correction of profits. Over the past 12 months, stock market valuations have contracted by around 40% with the sharp  upturn in inflation. Multiples contract when inflation rises. See graph below. In the two oil crises of the 70s and 80s, US inflation had risen above 12% and the PE ratio of the S&P 500 fell to 7x.

The Growth segment and disruptive stocks with high PER generally do not withstand these periods when inflation returns and interest rates rise; in relative terms, their stock market valuations have fallen much more than those of the Value segment, characterized by low PE ratios. This explains the outperformance of the Value segment vis-à-vis the Growth segment in recent months. Since 1975, we have witnessed the largest decline in stock valuations on an annual basis.

The downward readjustment of multiples due to rising inflation is coming to an end, as we believe that inflation peaked mid-year due to falling demand caused by the rising prices and consumer caution in the face of an uncertain future..

Macro models show a decline in profits

According to the correlation model between the PER of the S&P 500 and US inflation, the PER of the S&P 500 should be between 10x and 12x if inflation were to remain between 8% and 10% in the coming months. Today it stands at 16x, which is high and inappropriate based on the model below; unless, as we think, the market is anticipating a return of inflation towards 5% by the end
of the year. Otherwise, PERs will continue to contract.

Since its peak at the start of 2022, the MSCI World index has lost more than 20%, validating its entry into the bear market, through the drop in PERs. Indices could continue to decline with the contraction in profits. Equity indices never rise when profits fall. By a bottom-up approach, which is lagging, US profits are expected to rise by 10% both in 2022, 2023, and in 2024, which seems (very) optimistic given the probable recessionary orientation of the economy in the coming months. By a top-down approach, which is leading, profits should fall by 20%.

If the US economy were to go into recession, profits would fall, even in an economic downturn.

 

Commodities

Cyclical pause in the Supercycle

Bloomberg Commodities Index

The global recession is becoming more threatening and inflation of energy prices is pushing consumers to reduce their demand. With the sharp decline in Russian gas exports, Europe is on the verge of a major energy crisis; measured rationing could allow gas reserves to be filled to 100% for the coming winter and reduce pressure on prices. The sharp decline in industrial metal prices signals that the Chinese economy and its real estate sector are not doing very well, despite the authorities' optimism and supporting measures.

We will therefore move from a historic supply shock, due to Covid, then to the war in Ukraine, to a gradual process of falling demand due to the economic slowdown/ recession and alternative measures taken by consumer countries. In this major energy disruption, coal is regaining “color”, with a reactivation of coal-fired plants to produce electricity in Europe, India and China.

We believe in high but stable energy prices. Demand is expected to weaken in the coming months and OPEC may add capacity to the market, but the market remains tight and a problem at a major producer could push prices higher. For some years now, experts have been warning of a lack of investment in production capacity. These crises show that the green transition will have to be done in a more coherent way and have very solid alternative solutions to fossil fuels before doing without oil and gas.

 

Industrial metals

Long term gold price dynamic

Industrial metal prices have fallen significantly since March 2022: -35% for Bloomberg Industrial Metals, dominated by copper, aluminum, nickel and zinc. Metals are suffering from Chinese Covid lockdowns and the restrictive monetary policy of the Fed which prefers to sacrifice economic growth to control inflation.

Nobody talks anymore about the great needs of metals which are arising for the energy transition. Yet they are very real and huge. Energy and Industrial Metals sectors could be less attractive in the coming months, as investors are focused on the risk of recession. But China and the green transition remain two major factors for a resumption of the Commodities Supercycle after this economic pause.

 

Allocation

Allocations - Julliet 2022

 

Disclaimer – This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis contained herein is based on numerous assumptions and different assumptions could result in materially different results. Past Performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

Retrospective

The Russian invasion triggered a risky assets sell-off
The pandemic is not even over as the latest lockdowns in China illustrate, and the war in Ukraine started. It is putting global supply chains through another test. Distortions in supply because of the destruction of war and disabled supply chains, sanctions, and voluntary self-sanctioning all hit trade.

Although Russia and Ukraine’s global trade share in exports and imports does not exceed 2%, both countries are crucial commodity exporters. In addition to energy exports, Russia and Ukraine export agricultural products such as wheat, corn, and sunflower oil and large amounts of industrial commodities such as steel palladium, platinum, and nickel, amongst others. Delays and congestion suggest longer-lasting problems for supply chains.

The Russian invasion has triggered a sharp spike in volatility and risky assets have collapsed
Global equities (MSCI World) have experienced a fall of c. –14% between early January and early March. Concomitantly, safe even assets have spiked. Gold price has jumped by +16%, and the USD by +4%. Energy prices have benefited from geopolitical tensions and sanctions to reach new highs: oil and natural gas up by +65%, industrial metals by + 40% and agricultural goods by +25%.

Since March 8th, risk appetite has resurfaced. Most of those segments have dropped from the highs.

More surprisingly, the US treasury bonds failed to be the asset of choice. Given high realized and expected inflation, the US yields have strongly moved up to 2.40% form 1.50% on the 10-year. The US government bond index has delivered its worst quarter since 1980. European bonds have followed and printed their worst quarter since the launch of the EUR. 10- year German and Swiss yields are back into positive territory for the first time since 2019 and 2018.

Fed tackling inflation head on
In March 2021, the Federal Reserve told us that inflation was largely transitory. It was primarily the result of postpandemic re-opening frictions, and in an environment of significant labor market slack, it would not need to raise interest rates before 2024.

Fast forward 12 months and the story could not be more different. The economy is now 3% larger than before the pandemic struck, the unemployment rate is below 4%, and inflation is proving to be far more durable, running at 40- year highs and still rising.

The Fed has just started its tightening monetary policy cycle with a 25bps rate rise at its March meeting and signaled that 50bpswb rate hikes are firmly on the table at upcoming meetings.

All equity markets and segments are equal
In such a complicated environment, the US equity market has once gain outperformed peers. The Dow Jones dropped by –4.1%, the S&P 500 by –4.6%, and the Nasdaq has lost –8.9%. The latter being more sensitive to interest rates moves. Euro equities have lost –8.9% and Japan –4.3%. The UK market has been the most resilient given its exposure to pharmaceuticals, oil & gas and metals & mining companies, which have been the main gainers in this context. It was up by +2.9%.

 

Currencies - Q1 2022 performance

Currencies - Q1 2022 performance

Currencies have had a bumpy ride. Within developed countries, the EUR is the big loser due to its geographical exposure and its energy and food dependence on Russia and Ukraine.
Within emerging currencies, performance was very balanced.

 

Bonds - Q1 2022 performance

Bonds - Q1 2022 performance

Nowhere to hide. The vast majority of bond segments posted negative performances. The reason is the sharp surge in inflation and the aggressive response from the US Federal Reserve.
Once again the Chinese sovereign market demonstrates its diversification characteristics.

 

Equities - Q1 2022 performance

Equities - Q1 2022 performance

After a sharp correction at the beginning of the Russian invasion, developed markets have recovered. They are slightly down given the context. Europe underperforms the US.
Emerging stocks were the biggest losers. China is the big loser.

 

Commodities - Q1 2022 performance

Commodities - Q1 2022 performance

Unsurprisingly all commodities have delivered strong performance, whether food, energy or metals. The current conflict having a significant impact on the supply side.

 

Macroeconomy

Developed world growth slows

Energy price pressures
Inflationary pressures were sustained, with the number of manufacturing firms worldwide reporting higher prices for raw materials nearly four-and-a-half times higher than normal. A fresh series record of higher prices was reported for semiconductors, while reports of rising energy prices were also at a record high amid surging gas prices.

In the wake of the Russian invasion of Ukraine the cost of energy became especially volatile, with the benchmark for global oil prices exceeding $130 per barrel at the start of the conflict. Moreover, given the dependence of European economies on Russian gas and existing price and supply pressures, reports of rising energy costs and strained supply are likely to continue throughout the year.

 

Pandemic-induced supply shortages ease but remain a driver of global inflation

Semiconductor prices and shortage
As has been the case since 2021, manufacturers globally reported severe disruption in electrical components amid stronger demand. Semiconductor and electrical item shortages have plagued the global manufacturing sector recovery. While there were tentative signs of easing pressures at the turn of the year, the rise of Omicron variant has forced a renewed rise in the number of
companies reporting shortages.

Firms have reported surging price pressures for these inputs have led to sharp rises in costs. Moreover, price and supply pressures for semiconductors especially has had a knock-on effect across the global manufacturing sector. This is most prevalent in key sectors such as automotives, as car production has become increasingly reliant on semiconductor technology.

The outlook for global inflationary pressures appears skewed to the upside due to escalating energy prices and renewed disruptions to international supply chains. While COVID-19 restrictions have been lifted across much of the world, supply chain disruption is expected to continue feeding into purchasing prices.

The pace at which price and supply pressures return to stability will be contingent on how quickly logistical disruptions are resolved and capacity is rebuilt, or in some instances "re-shored" to help resolve supply and demand imbalances.

 

Strategy

Landing with sticky inflation

US Financial conditions
It is a painful reminder: in Q121 the Fed expected average (transitory) inflation in 2021 to range around 1.5%! Twelve months later, even the slightly more realistic G7 central bankers (such as Canada and the UK) are eating their hats and seriously increasing the pace of monetary tightening. They have little choice if they do not want to lose control and the little credibility they have left!
Fortunately, Hyper-inflation is not around the corner.

A global recession is not a base scenario, though its odds have become significant lately (say 30% in 2022, 50% in 2023). But still, removing the ¨patch¨ when the economy decelerates will prove a very delicate path. Even more so considering the unpredictable trajectory of commodities’ prices. If history is any guide, energy shocks of the current magnitude, when they last a couple of quarters, have irremediably provoked hard landings…

Investors’ consensus has rapidly acknowledged for the deterioration of growth perspectives. According to recent surveys, the consensus now expects a macro framework comparable to 2008/9, 2018/20. Interestingly, the wave of pessimism started long before the Ukraine conflict. A geopolitical risk premium has built lately. Fears of nuclear war in Europe have pushed oil and gold to
stratospheric levels.

 

Investment landscape

Investors brutal bearish shift
A premature end of the business cycle is as likely as a soft-landing scenario. Still, negative real rates will prevail. Risk premia will continue to progress, as markets will endure contracting global liquidity. Policymakers have no choice but to tighten financial conditions, until ¨something tentatively breaks¨.

The global landscape for financial markets is becoming gradually more adverse. Uncertainty and volatility will prevail. A lot is already discounted by investors, though a ¨full capitulation¨ did not occur.

 

Currencies

Fed hawkish repricing is no longer the trigger

USD performance around Fed tightening moments

Past price actions have demonstrated that this is not necessarily good news for the USD. In 4 out of the past 5 tightening cycles, the USD has appreciated in the 6 months before the first rate hike. However, it has only once continued to strengthen in the 6-months after. This reflects the fact that the Fed has not always delivered on expectations of promised tightening cycles. The nearterm inflation threat may mean 2022 is different, but at the same time the hurdle to beat current expectations are high, they have already risen above the neutral rate.

For now, all is about inflation, central banks' exit strategies and yield expectations. All those factors are at the benefit of the USD, but the real economy developments could become more of a driver in the year.

Surprisingly, this could support EUR bulls. The US economy will experience a net fiscal tightening this year while the European Union will get another boost from budget spending. A significant help will come from the EU Recovery Fund. It is expected to boost GDP by 0.5% in 2022 and 0.6% in 2023 and 2024.

 

Excessive USD strengthening

Long-term purchasing power parity vs. USD

When the pandemic hit the world in March 2020, the major currencies were all close to their fair values. But the recovery has been very uneven. The USD is at its most expensive level in at least 6 years according to purchasing power parity (PPP) metrics. PPP is an economic theory that compares different countries’ currencies through a “basket of goods” approach. Two currencies are in equilibrium when a basket of goods is priced the same in both countries, considering the exchange rate.

The USD is now more than 25% overvalued against the JPY and almost 10% against the Euro.

The GBP is fairly valued.

Only the CHF is stronger.

 

Bonds

Negative yielding bonds have vanished on aggressive tightening talks

Long-end yields and Fed Funds expectations

Such aggressive pricing Fed tightening in terms of speed and magnitude has never happened. The market expects the Fed to hike rates up to 2.75% by June 2023, in line with the Fed own expectations for 2023, and above the median long-term dot (2.4%). The terminal rate pricing (2.75%) is already above the previous Fed terminal rate (2.50%) and close to the previous market expectations peak at 3.0%. This time the market believes the Fed will have time to reach restrictive area.

Historically, market expectations tend to overshoot what the central bank eventually delivers. This happens in late cycles, and terminal rate expectations tend to peak when the end of rate hikes is in sight. The market is now pricing the end of the Fed tightening in a little more than a year.

 

Challenging credit environment not over yet

Moody’s default rates and 12-month forecast

Emerging Credit markets saw some respite after the first Fed Fund rates hike, due to some buying activity, driven by investors comforted by more clarity on rate hikes and the Fed's decisive action against surging inflation. This relief is expected to be short-lived as uncertainty to engineer a soft landing will weigh on the riskiest part of the fixed income universe.

The current situation shows default rates are very low. Moody’s default study indicates only a mild deterioration in the next 12 months, the US default rate will rise just above 3.0% by January 2023. Their base case looks a bit optimistic. A worst scenario is more likely given the large increase in the CCC-rated bonds.

The bigger issue now is what second-round effects from higher inflation, rising energy costs and supply chains disruptions. We are already seeing some effects. However, we also believe that central banks and governments are much more proactive now than in the past when it comes to supporting the market amid external shocks.

In the current context (war, sanctions, disruptions), HY default rates are set to rise much closer to 2016-2018 levels. Credit spread will follow.

 

Equities

Despite a hostile environment stock market indices are holding up

S&P500 post curve inversion Performance
The stock exchanges have been resilient with corrective phases and rapid rallies because of the algorithms, which are removing the emotional character of investors. The market is efficient: since March 2021, the start of the inflation recovery, the indices PE ratios have contracted by 30%. Now, there remains the profits development. The US yield curve flattening signals a risk of an economic slowdown .

Data from the Dow Jones Market (see chart below) shows that the S&P 500 rises 13.5% on average in the 12 months following an inversion of the 10yr-2yr curve. Some analysts point out that the 10yr–3m curve has a better ability to predict recessions and today we are far from inverted. Historical analysis shows that stock markets can rise up to 18 months after the yield curve inversion.
2022 begins with record US share buybacks, a sign of corporate health and expectations that business conditions will remain supportive.

 

Seasonality

S&P 500 Midterm election year pattern
In terms of seasonality, we are entering a more favorable period. There are 4 periods:

In 2022, the United States will vote for midterm, which usually is a source of higher S&P 500 volatility, particularly between May and October. The US stock market behaves less well when the president is a Democrat. Most of the time (18 of the last 21 midterms), the president's party loses seats in Congress. It is therefore likely that the Democrats will lose the majority in Congress with Republicans led by Donald Trump, reigniting the divide, political aggression, and conspiracy theories.

But history also shows that the S&P 500 rebounds strongly after the midterms: +15% over 1 year vs. +7% in a year without a midterm.

 

Commodities

The Russian war will decisively change the energy market

EU Energy imports by countries

The timing coincides with an already tight oil and gas market. The damage is done, Russia will lose its first customer and Europe will give up its first supplier of fossil fuels.

The European shift will be quick: Germany wants to do without Russian coal from autumn 2022, Russian oil by 2022-end and Russian gas by 2024-end. It signed contracts in early March for the construction of LNG terminals. The United States and Europe have set up a task force to ensure Europe's energy security and significantly reduce its dependence on Russian fossil fuels, mainly with the increase in US LNG exports (doubling in 2022) and the acceleration of the energy transition. Europe will have to reorganize by building LNG terminals for regasification.

The big winners from the Russian shock will be liquefied natural gas, US oil and gas, Qatar, energy transition, and possibly Algeria, Norway, and Australia. The United States is in the process of becoming the 1st LNG exporter in the world.

 

Industrial metals

Long term gold price dynamic
The war in Ukraine and the massive sanctions against Russia have exacerbated the already existing supply shock due to the pandemic. The problems are not only related to Russian production, but also to the domino effect on all global production and transport chains.

Russia is a major producer of nickel, palladium, and platinum, a little less for gold, silver, and copper. On the other hand, Russia is a major producer of (semi)finished metals such as steel and aluminum intended mainly for Europe. As with oil and gas, Russia was THE supplier to Europe. Of course, in the short term, European countries will suffer from such dependence. Neon gas, of which Ukraine accounts for 70% of global production, could cause significant stress in the semiconductor manufacturing process.

For many metals, supply deficit was already the case before the pandemic.

 

Gold
The price of gold follows the evolution of real interest rates. Gold is a good decorrelated asset in this current macroeconomic (inflationary) and geopolitical (war) situation. Will it follow the same path like in the 1970s?

 

Allocation

Allocation

 

Disclaimer - This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis contained herein is based on numerous assumptions and different assumptions could result in materially different results. Past  Performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

Risky assets’ quarter

Retrospective

Risky assets have experienced varying degrees of success in Q3. The reopening of economies has been hampered and the economic recovery has stalled. After hitting records, the US stock market consolidated in the wake of the Chinese real estate developer Evergrande default.

 

Back to the job market in the United States

The unemployment rate in the United States keeps dropping. After laying off more than 20 million workers in 2020, US companies are still hiring and struggling to find skilled workers. After peaking at over 15% in March 20212, the unemployment rate fell to 5.20%. However, it remains well above its prevailing level just before the pandemic at 3.5%.

Earlier in the year, employers hoped to see the workforce return as early as September, in part because of the end of the payment of subsidized unemployment benefits for 12 million beneficiaries, as well as the reopening of schools.

Instead, the economy slowed in September due to an increase in infections linked to the Delta variant. Some workers prefer not to return physically at work. Schools and daycares have also been forced to send scores of children home to quarantine, which has made the task more difficult. for many parents to consider jobs outside the home.

 

Oil prices continued to hit new post-pandemic highs

Global growth is expected to be around 6.0% this year and 4.5% next year.

Long-term interest rates in the United States and in Europe continued in their downward trend started in April before rebounding in early August on the eve of the announcement by the US Federal Reserve of its wish to reduce the amount of its monthly bond purchases.

The equity markets stalled. The S&P500, the flagship index of the New York Stock Exchange, set a new high at the end of August at more than 4,500 points. It consolidated in September and is back to late June levels. It still shows an increase of over 15% since the start of the year. As interest rates hiked, the technological sector suffered big profit takings.

Gold did not show a clear trend, as industrial metal prices contracted following the Evergrande story and the risks of slowing Chinese demand. The price of oil continues to advance, it appreciated by + 4.5% over the quarter to reach $79 per barrel, gas prices have soared by almost 60%.

 

Currencies - Quarterly performance

Currencies - 10.21

In the wake of a less accommodative central bank, the USD appreciated strongly against all currencies, both from developed and emerging countries.

 

Bonds - Quarterly performance

Bonds - 10.21

Chinese government bonds continue to exhibit a clear decorrelation with those of developed countries. High Yield continues to perform well, while emerging hard currency bonds continue to experience massive outflows.

 

Equities - Quarterly performance

Equities - 10.21

Quarter without a big momentum in developed markets, after reaching new all-time highs in the US market in the summer. Asian emerging markets are not catching up interests.

 

Commodities - Quarterly performance

Commodities - 10.21

Gas was the big winner during this period, as industrial metals were penalized by the Chinese economic slowdown.

 

Macroeconomy

Global manufacturing prices spike higher amid supply constraints

Manufacturing input costs rose at an accelerated rate in September, increasing at one of the sharpest rates seen over the past decade as supply shortages were exacerbated by ever-higher shipping costs. Demand growth cooled, however, alleviating some of the upward pressure on prices, linked in part to less companies building safety stocks compared to earlier in the year. Worldwide manufacturers reported a steepening rate of input price inflation in September, linked primarily to ongoing shortages of components and higher shipping prices.

Manufacturing demand, supply delays and prices - 10.21

 

Price pressures lift higher

The JPMorgan Global Manufacturing PMI, showed average factory input prices rising at the third-fastest rate recorded over the past decade, the rate of increase accelerating from August to equal that seen in July though fall slightly short of May's recent peak.

Higher shipping costs - 10.21

The rise in costs was first and foremost again linked to suppliers being able to hike prices amid widespread shortages, creating a sellers' market for many inputs from electronics components through to basic raw materials used for construction industry products. Average suppliers' delivery times continued to lengthen globally at a rate unprecedented in almost a quarter of a century of survey data, exceeded only by those recorded in the prior three months, underscoring the unparalleled supply chain delays being recorded in recent months as a result of the pandemic.

Not only has the pandemic seen surging demand for many goods, the health crisis and associated lockdown measures has seen production of components and logistical capacity hit hard, with the recent Delta variant placing additional pressure on production capabilities in many important export-oriented Asian economies in particular, notably China, where manufacturing output has now fallen for two successive months .

 

Strategy

Elevated macroeconomy volatility

Macro volatility will continue in the aftermath of the pandemic. Growth will converge from 2022 towards its long-term potential, while inflation will be resilient above Western central banks’ targets. Decoupling between the G7 and China will intensify. The containment of China's housing crisis will require a significant easing of its economic policy. The generous valuation of most assets, the surge in commodities and real estate, the financial leverage represents potential vulnerability in times of macro and economic policy transitioning.

Volatile Macro/Geo-politic will challenge, but not derail the Asset Price Inflation regime.

Disappointing economic surprises - 10.21

Long-term drivers

We consider three secular disruptors. 1) Climate – rapid – changes, which impose hectic transitions towards green (er) economies. This will fuel large investment packages, but also higher inflation, new regulations, corporate requirements, and taxes. Europe is leading the charge. 2) Technology. The relentless shift towards digitalization has a long-lasting impact on labor markets. 3) High Inequalities generate more labor friendly policies to regain a higher share of GDP.

 

Investment landscape

Stagflation fears are taking root. Rising inflation fears have irritated markets and fueled changes in assets’ correlation. The volatility of negative real rates, the global mushrooming of stricter regulation, and perspectives of (US) higher taxes add to uncertainty. The decrease of risk appetite favors a stronger USD. Further strength would accentuate drying-up of investable liquidity and upset risky assets.

Stagflation fears should dissipate by year-end. Supportive financial conditions will continue in H1 2022.

Global investment framework remains relatively supportive, though less so.

Towards a new correlation regime - 10.21

 

Currencies

The almighty USD

The QE tapering will happen in November and a first rate hike in S2 2022 accordingly to the median Fed forecasts. That would coincide with a pickup in cyclical inflation, as opposed to the transitory lift we have seen this year from the combination of base effects and supply disruptions. Clearly, the Fed is looking ahead to a reacceleration in growth in 2022.

Forward Fed Funds rates - 10.21

While a S2 2022 rate hike would not be shocking at this point, it still looks too early. According to historical forecasts, both the Fed and markets failed to predict the first rate hike in the right timing. Investors have usually been more hawkish than the FOMC, this time is the opposite and could cause a big shift in positioning.

Furthermore, the Fed central tendency terminal expected rate, still according to dots, is quite high at 2.5% compared to other central banks foreseeable rates paths. That divergence in policy rates between the Fed and other funding central banks like the ECB, BoJ, and SNB in the coming years will drive USD outperformance.

While the pandemic purchases will moderate, the overall ECB QE envelope will remain unchanged at €1850bn until March 2022 at least. The ECB intents to maintain favorable financing conditions to perpetuate the recovery narrative. Therefore, the central bank will consider pandemic purchases transitioning into the Asset Purchase Program. Although headline inflation risks testing 13-year highs, the ECB will look through short term price spikes, especially as core prices are expected to remain relatively well contained. Alongside expansionary fiscal policy will favor persistently low interest rates, and as a result, a weaker EUR in 2022. This will be the main support for the USD.

EM ex-China monetary policies tightening - 10.21

 

Bonds

Solid credit performance

Rating performance is improving in the corporate sector. The number of issuer upgrades exceeded downgrades in 2021. Most of them are not reversals of rating actions taken in 2020. Last year was a record deterioration in corporate ratings, with the highest number of downgrades in 20 years or 20% of the universe, and with 7% of issuers downgraded by multiple notches. However, as pandemic-related restrictions have relaxed and as many economies return to growth, the most severe credit pressures have abated. Positive ratings actions have started to rise. The ratio of corporate upgrades to downgrades in developed markets is 1.3x in 2021, while the balance is almost neutral in emerging markets.

Improving credit ratings - 10.21
This dynamic is well spread across the bond universe. The number of potential fallen angels (issuer leaving the investment grade space to the high yield) has begun to shrink, and potential rising stars (the opposite way) continue to climb.

The 2022 US High Yield bond default rate will reach 1.0%, down from 2.5%-3.5% original projection, according to Fitch. This will result in just a 7% cumulative default rate for 2020-2022, well below the 22% registered during the 2008-2010 global financial crisis. These forecasts coupled with a very low near-term maturity wall and continuing improvement in fundamentals remain supportive for low credit spreads, even more as refunding remains easy.

Even if defaults risks are lows, the overall HY market is offering the largest negative real yield in history and more than 80% of the US HY market is yielding below the CPI. Higher government yields will not derail credit market, the amount of debt to roll-over in the next 2/3 years is manageable. Even with improving fundamentals  credit spreads remain at unattractive levels

Unattractive real yields - 10.21

 

Equities

Supportive year-end seasonality

Since August, some investors have been worried about a significant stock market correction due to unfavorable seasonality (statistics) in August, September and the first two weeks of October, and expectations of smaller injections of liquidity from central banks. As observed recently, rising interest rates are still shaking the stock markets as they challenge stock valuations. Investors may be more worried now, because the origin of the latest hike is more inflation fears and potential cuts in central bank liquidity than expectations of an economic recovery.

US stock market seasonality - 10.21

 

Stagflation risks are mounting

In the short term, the market has to integrate a possible new paradigm with the return of inflation and the implication of a reduction in liquidity by central banks. Added to this is the brawl in the US Congress over stimulus plans and the debt ceiling, as well as the real estate problems (Evergrande) in China.

In the medium to long term, we remain positive on equities and believe that investors will look beyond this current period of acute disruption.

The positive arguments for 2022-2023 are:
• A gradual normalization of world trade and less pressure on supply.
• Massive restocking, with new demand coming from the energy transition and 5G (involving the use of new applications).
• An acceleration in demand thanks to the savings accumulated during the pandemic and the return of a normalized supply for clients/households.
• US and Chinese budget plans (forthcoming).
• Green investments, with perhaps more visibility after COP26.
• Investments dedicated to increasing production capacities (semiconductors) and new production capacities (electric vehicles, batteries, etc.)

The emerging zone should continue to underperform in a period of Sino-US confrontations - technological, commercial, geopolitical, financial -, questioning the globalization, the strengthening of the dollar and higher US interest rates.

First equity funds outflows - 10.21

 

Commodities

Geopolitics is a source od stress

Geopolitics is becoming more complex, such as the rapprochement of Russia towards OPEC (Saudi Arabia) to control oil prices or Russian pressure on Europe with gas to make the Nord Stream 2 pipeline (Gazprom) indispensable, a great tool for Russian soft power. Gazprom is the only company that Europe can turn to in case of urgent need for gas and the International Energy Agency calls on Russia to ensure sufficient storage for the next winter season. We have to wait until the end of the year for the exploitation of Nord Stream 2 and Russian gas will therefore have to pass through Ukraine, which Russia does not facilitate due to the tense UkrainianRussian relations and international sanctions against it.

Commodities prices - 10.21

Gas and coal prices are skyrocketing. Demand for gas is picking up sharply in a context of an economic rebound, while inventories are at their lowest. Weather phenomena, several breakdowns (in Norway in particular), the Covid and a global maintenance delay on the installations during the year 2020 have contributed to the slowdown in global supply. China is caught off guard - one could even say that it is facing an energy crisis -and must ration electricity consumption.

 

Metals have clear different drivers

In precious and semi-precious metals, production of platinum and palladium for catalytic converters has declined along with that of cars due to the shortage of semiconductors.

Too low Capex - 10.21

The next few years will be marked by a structural increase in demand for metals and a weak supply response. Investments in new mines are slowing down because the profitability of projects is no longer guaranteed due to (geo) political, climatic and legal risks.

Precious metals are not sought after, gold and silver, as absolute protection, but as decorrelated diversification in a portfolio. Their prices moves with US interest rates and/ or the dollar. Gold is a financial asset that can protect in the event of a financial (debt) or monetary crisis. This is not the case today. If rates go down, it favors stocks, if rates go up, it favors bonds. However, a negative real interest rate regime is good environment for gold and offers cheap protection in a diversified portfolio.

 

Allocation

Allocation - 10.21

 

 

Disclaimer

This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

 

Retrospective

Risky assets performed well over the quarter with the focus turning to the reopening of economies and rebound in growth in an environment where central banks liquidity remains a tailwind. Long-term US interest rates have declined, the USD has stabilized and the equity markets have reached new historical highs, driven by the United States, while gold price has enjoyed a rollercoaster period.

The most notable change is on the US yield side. After several months of unchanged wording, the Fed has surprisingly made an abrupt shift. Powell positively switched-on growth and labor market recovery. While the Fed still believes the current elevated inflation will prove transitory, its concern has shifted to the upside. Most of the Fed governors are now favorable to higher Fed Funds in 2023.

 

A new economic paradigm is looming

Global Tax overhaul endorsed by 130 Nations. The world took a big step toward sweeping changes to global taxation as 130 countries and jurisdictions endorsed setting a minimum rate for corporations along with rules to share the spoils from multinational firms like Facebook Inc. and Alphabet Inc.’s Google. After years of missteps and setbacks, the deal brokered in negotiations at the Organization for Economic Cooperation and Development sets the stage for Group of 20 finance ministers to sign off on an agreement shortly.

President Biden reached an agreement with a bipartisan group of senators on a $ 579bn infrastructure plan, though passage is not assured. The bill will move in tandem with a larger Democrats-only reconciliation package containing tax and spending measures Republicans oppose. Nancy Pelosi said the House will not consider the former without taking up the latter.
Stock markets set again new record highs

After contracting 3.5% in 2020, the global economy is expected to grow 5.6% in 2021, 4.1% in 2022, before returning to its long-term potential in 2023 at 3.5%. The main factors behind this rebound will be basis effects as well as the numerous stimulus packages.

Global interest rates have reversed part of the upward move of Q1. The US 10-year interest rate has consolidated in a tight range between 1.40% and 1.70% and more recently the yield curve has sharply flattened on a more hawkish Fed.

The equity markets have continued their impressive rise. The S&P500, the flagship index of the New York Stock Exchange, has fragmented the previous quarterly top around 4000 points. It is now trading up by 15.2% on a total return basis since the beginning of the year. Even if during the quarter sectors’ evolution were very heterogenous, over the quarter performance were very similar.
Gold has also experienced two distinguish periods. In April and May, the gold has strongly appreciated before reverting the early quarterly gains.

 

Currencies

Thanks to lower US long-end yields, several emerging currencies have strongly recovered from their last year lows. At the same time, the EUR has benefited from a much quicker vaccination process than in the rest of the developed world.

 

Bonds

Most of segment have delivered positive performance. Emerging and Corporate bonds have lead the pack. Only European yields have increased over the quarter leading European government bonds lower.

 

Equities

The risk-on sentiment has helped risky assets to deliver positive performance. Coupled with lower long-end yields, high duration and high risk segments have outperformed amongst them Latin America stocks and Nasdaq.

 

Commodities

Most of commodities have continued to improve driven by global risk appetite and shortages resulting form the Covid-19 pandemic

 

Macroeconomy

Global manufacturing economy reels from intensifying supply shortages

Although global manufacturing output growth ran at one of the fastest rates seen for over a decade in June, capacity constraints continued to develop, reflecting a lack of labor and a record worsening of supplier delivery times. Prices continued to rise sharply as a result.

The survey data also reveal a widening disparity between strong growth in the developed world and a near-stalling of output in the emerging markets; a divergence which can be largely attributed to differing vaccination rates and further waves of COVID-19.

 

Factory output still close to 11-year high

The JPMorgan Global Manufacturing PMI registered another strong rise in factory output during June, rounding off the best quarterly expansion for a decade. The upturn was largely attributed to surging demand as many economies around the world continued to open up from COVID-19 related lockdowns and restrictions, while rising vaccination rates also lifted sentiment and demand among businesses and consumers alike, notably in Europe and the US.

 

Shortages limit production growth

However, new orders rose even faster than output for a fourth month running in June, indicating that demand over the past two months is running ahead of production to a degree not witnessed since 2009 with the exception of February last year .

The scale of staff shortages was reflected in global growth of employment running behind order book growth to one of the greatest extents for 11 years in June. The shortfall of payroll numbers to new orders was especially acute in the developed markets.

Rising shortages of inputs were meanwhile reflected in an unprecedented lengthening of suppliers' delivery times in June.

Average prices paid by manufacturers for their inputs continued to rise at one of the fastest rates for a decade in June, due principally to this sellers' market environment.

 

 

Strategy

Towards less Financial Repression and Asset Price Inflation?

  1. We are shifting from sanitary crisis and recovery to healing and expansion. The timing for global herd immunity remains uncertain. While developed countries should reach it by end-2021, a few large emerging countries will still suffer into 2022. While global growth will clearly remain above long-term potential in H2 21 and H1 22, the jury is out for the following quarters.
  2. The Biden administration is kind of a game-changer. It is clearly shifting to the left with a more redistributive policy. Complementary plans in H2 would exacerbate tensions of market’s (long-term) interest rates. The Democratic administration will continue to be a big spender, whatever the formula, in the run-up to the mid-term congressional elections. New taxes - less markets’ friendly - seem unavoidable. A different foreign policy is also in the making.
  3. Cyclical inflation will clearly remain above comfort level (say >2,5%) in H2. Input prices are heating up, because of the sharp rise of commodities and wages. This tension is not over, as supply chains bottlenecks will continue in Q3 if not Q4, re-stocking is just starting and labor market has experienced tenacious disruptions (closed schools, virus fear, generous checks), which will need time to disperse. While the pronounced Q2 base effect will gradually disappear.
  4. Bubble formation. Financial repression and ample liquidity have favored speculation and leverage. Anglo-Saxon and Chinese policymakers have become growingly concerned. The frontal attack by China against crypto-assets is serious and durable, as a) linked to the upcoming launch of the digital Yuan b) indirectly linked to the tightening of the screws on the FinTech / shadow-banking sector. The SEC is also preparing for a more stringent supervision of household financial transactions, including margin debt. The challenge will be to regulate without causing a financial crisis or a shortage of transaction liquidity.
  5. In the next 5 years, we will experience a broad adoption of digital - central bank - currencies. The launch of the digital Yuan will come first (Olympic games in Beijing 2022 latest). The global fight against cash is accelerating. Euro and Yuan will growingly challenge the supremacy of the USD.

 

 

Currencies

Next Fed tapering will not lead to a tantrum

During the 2013 Fed taper tantrum episode, the USD only really started to embark on a rally 6 months after the Fed had started its tapering. In 2013, the USD on a real effective exchange term was relatively cheap and trading with a discount of c. 20% compared to its long-term fair value. At the same time, emerging currencies were at their most expensive level of the past decade and trading with a premium of 15%. The tapering led to higher US yields, both nominal and real, and drove strong inflows into USD-denominated assets, finally pushing the USD up.

The USD will remain dependent on the Fed's speed of adjustment

Nowadays the situation across the FX space is by far different. Long-term valuation indicators are pointing to a different picture. Emerging currencies are still trading with a premium. Most of it can be attributed to the Chinese yuan. It is trading in real terms with a premium of 25%, while HUF, MXN, ZAR, RUB, and BRL are all trading with a discount of more than 20%. The USD is much closer to its fair value.

 

 

A new attitude from EM central bankers

The race to top of the EM currency pack will be determined by proactive central banks. The principle is singling out those ready to turn rhetoric into action. In this recovery period, EM central banks are surprisingly adopting another approach than in the past. They are already tightening their key rates to ensure inflation does not get out of hand, as it often has in the past. EM central banks aggregated rate increases reached 205bps in June, up from 109 in April and May. Recent winners are currencies whose central banks raised rates amongst them Mexico, Brazil, Russia, or Hungary. However, hawkish rhetoric alone is not always sufficient, as illustrated by Turkey, where investors remain concerned about the central bank autonomy from political interference.
Over the long-term, markets will favor the combination of currencies which are supported by responsive central banks in terms of fighting inflation, and solid balance-of-payments positions.

 

Bonds

Will the 2013 tapering playbook work?

Looking at the 2013-2018 period could provide a good indication for the coming policy normalization. In 2013, the Fed tapering announcement drove markets into a long-term bond sell-off, as it came as a surprise. A few months in, the trends went the opposite way. The yield curve kept flattening even as the Fed reversed QE in 2018 amid rising rates. However, the expected labor market normalization should be more rapid this time. In 2013, near a year of internal discussions and 7 months of market communication occurred before the Fed formally announced a tapering in December. The tapering ran from January to October 2014 and then the 1st rate hike happened in December 2014.

This tapering cycle should start in Q4 2021. The Fed will be able to cease quicker its asset purchases over 6 months instead of 10 months in 2014. It should also lead the Fed to start the rate hikes with a shorter delay. Subsequently, if the Fed is right in its assessment that inflation will only be modestly above target in 2023, there will be no rush to push on with a string of rate hikes. Looking beyond, the 2.5% Fed longer-run projection suggests a peak in the coming cycle, in line with that of 2018.

 

High Yield at historical low dispersion

All the government and central banks stimuli bear fruit. Fitch, like others rating agencies, has lowered its 2021 year-end HY default forecast to 2% from 3.5%. It will be the lowest since 2017. It could potentially finish the year in a 1%-2% range, challenging the 1% mark from 2013. They also reduced their 2022 default forecast to 2.5%-3.5% from the previous 4%-5% expectation.
In such a context, HY spreads have strongly compressed. US HY spreads are currently trading at their lowest level since 2007, just a few bps above record low reached some weeks before the TMT bubble burst. Within BB, added spread comes with a duration extension and liquidity concerns. Almost 2/3 of the market is trading inside 300bps, including almost 28% that trades below 200bps. There are just 9% of the index, which is still trading wider than 500bps.

Few options remain in the fixed income space to achieve some carry as the market is very polarized and focused. However, history shows that once we reached lowest percentiles, risk reward on HY is no longer compelling even with a benign expected default rate. Credit is essential but often too expensive

 

Equities

The reflation trade has eased

The market will remain cautious in the run-up to the Fed meeting in late July and the Jackson Hole summit in late August, with weaker stock market volumes during the summer. We rather consider odds of higher volatility and sector rotations than that of an equity correction.

Equities move between relatively high, albeit not extreme, valuations and favorable short to medium term factors, such as the technical situation (although there is starting to be some divergence in participation), investor sentiment indicators, share buybacks, dividends, liquidity, low interest rates and rising profits.

The Buffet Indicator (BI) - the market capitalization of the Wilshire 5000 divided by the US GDP - shows an excessively high ratio at 236%, while it should be at 120%, in theory. Among other things, the ratio rose recently due to the temporary contraction of US GDP due to the pandemic. The BI is not a market timing tool, but its predictive value shows that returns tend to be negative over the next 5 years if overvalued (a ratio greater than 2 standard deviations) and positive in the event of an undervaluation (a ratio less than 2 standard deviations). Currently, the ratio stands at 3 standard deviations. But the correlation between BI valuation and future returns is weak. The first criticism of this indicator is that it does not take into account other asset classes, such as today with the very low level of interest rates; the US 10-year average is 6% over the last 50 years compared to 1.5% currently. The ratio is at about the same level as in 2000, but the US 10-year was over 6%. The current BI level does not signal a correction of equities. The BI can remain abnormally high as long as interest rates remain abnormally low.

 

 

 

Less compelling valuation indicators

The S&P 500's 22x 2021 12-month PER is higher than the 17x average, but this is less dramatic at the start of an economic cycle, considering the pandemic disappears in 2022, as substantial growth in corporate profits is expected, +35% in 2021 and +15% in 2022 for the S&P 500, and +65% in 2021 and +12% in 2022 for the Stoxx 600.
The Equity Risk Premium is also less attractive. After being very favorable to equities in March 2020, the US 10-year US/Dividend yield ratio has returned to average.

 

Commodities

Gold is a financial asset

Its price remains strongly inversely correlated with real interest rates.

However, the price of gold has weakened as the real US rate has fallen. The ounce of gold should have gone up, but its price also depends on the dollar, which appreciates, and the Fed. The Fed implicitly alluded to an increase in Fed Funds earlier than expected.

Gold has new competitors, cryptocurrencies, although they are more volatile, more speculative and less safe. Cryptocurrencies could also be a hedge against currency debasement.

 

Economic recovery supports oil

The Bloomberg Commodities Index is up 57% from the lows of April 2020, which was also a low since 1974 !, and 20% in 2021. The performances are remarkable. Since April 2020, the price of oil has increased by 270%, copper by 88%, the industrial metals index by 65%, the agricultural index by 56%, while gold is up only +2 %.

It looks like a post-Covid restart with a strong recovery in demand, coupled with disruptions in production and logistics linked to the pandemic. Producing countries have often been hit hard by the Covid, as in Latin America, where restrictive health measures have reduced production.

The current consolidation since May reflects fears of a delayed economic recovery due to the emergence of variants and the lack of a global vaccination strategy. However, this period of weakness presents long-term buying opportunities.

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

Retrospective

The financial markets have continued on their Q4 2020 momentum. Long-term interest rates have continued to rise, the equity markets have reached new multi-year highs, in the United States, but also in Europe and in Japan, and gold price has continued to decline.

The most notable change is in the US dollar. After several months of steady weakening, the trend was abruptly reversed with the official election of Joe Biden as the new president of the United States and the announcement of new stimulus packages.

 

The US government is taking over from the central bank

Central banks - led by the US Federal Reserve - flooded the market with liquidity throughout 2020. The Fed has repeatedly called on the Trump administration to take over. Just seven weeks after his inauguration, newly elected President Joe Biden signed a $ 1.9 trillion stimulus package. The pandemic has claimed more than half a million lives in the United States, and the world's largest economy contracted 3.5% last year, its worst year since World War II.

With the green light from Congress, millions of Americans will receive direct aid checks totaling some $400 billions. The plan also extends exceptional unemployment benefits until September, which were due to expire on March 14th. The law also devotes 126 billions to schools, from kindergarten to high school, to support their reopening despite the pandemic, as well as 350 billions in favor of states and local communities.

 

Stock markets set new records

After contracting 3.5% in 2020, the global economy is expected to grow 5.6% in 2021, 4.1% in 2022, before returning to its long-term potential in 2023 at 3.5%. The main factors behind this rebound will be basis effects as well as the numerous stimulus packages.
Global interest rates continued to rebound. The US 10-year interest rate has already erased the panic phase of 2020, and is back close to the level that prevailed in 2019. It is currently trading around 1.70% after flirting with 0.3% at the worst of the crisis last year. European long rates are slowly coming back to 0.0%, with the German 10-year rate trading at –0.30%. The stock markets continued to rise. The S&P500, the flagship index of the New York Stock Exchange, is flirting with the 4000 points mark and is trading at its highest level ever. However, the contributors to this assessment have not been the same as last year. The energy, banking and telecoms sectors outperformed the tech and automotive sectors. Gold continued to decline in the wake of the rise in real interest rates and the rebound in the USD. In a context of sustained economic recovery and return of interest rates to satisfactory levels, the need to hold gold is less justified.

 

CURRENCIES

Currencies

The announcement of new plans to support the US economy has favored the recovery of the US dollar against all currencies. The two big losers are emerging currencies and to a lesser extent the EUR. The ambient risk appetite in Q1 allowed the CHF to finally depreciate.

 

BONDS

Bonds

Rising global interest rates led to a general pullback in bonds, with the government component taking precedence over everything else. Only the European and American high yield segments managed to post a positive performance. The other exception being Chinese government bonds which benefited from their natural decorrelation.

 

EQUITIES

Equities

The MSCI World index, the global equity index, posted a positive performance of +4.5%. The so-called "value" markets clearly outperformed the US market, led by Europe and Japan. At the same time, emerging markets have been penalized by the USD rise and political and geopolitical tensions.

 

COMMODITIES

Commodities

Oil price also continued its rebound in the wake of production cuts announced by the OPEC+ countries. Gold, for its part, fell sharply and posted its worst quarterly performance since the 4th quarter of 2016.

 

MACROECONOMY

Global trade resumes

Global trade rise

Global trade was estimated to be 15.0% higher than a year ago in January. It is the first time that growth has reached double digits since the early 2010s. The global economy is fully recovering.

However, growth was driven in the main by a surge in Chinese exports. Recent data indicated an average increase in Chinese exports of 60% over the first two months of 2020.

Regional divergences are also notably apparent, with growth seen in key Asian exporters (Japan, South Korea) but some weakness persist amongst European nations.

Global trade is nonetheless up around 10% on equivalent 2019 volumes.

 

Growth disparities

Leading indicators are rebounding

Leading economic indicators point to the US outperforming among the largest developed economies. Growth resumed in the UK and Eurozone leaving only Japan in decline. The growth disparities reflect differing COVID-19 containment measures, but also vaccine roll-out progress. Stimulus measures likely also played a key role, notably in the US.

Economic indicators showed business activity in the US rising sharply in Q1 2021, rounding off the economy's best performance since Q3 2014. Indicators are pointing for a strong economic growth of around 1.5%, or approximately 5% on an annualized basis.

Impressive growth was also recorded in the UK as business activity rebounded. Indicators are pointing to a modest decline of GDP after the 1.0% expansion seen in Q4 2020. Growth also perked up in the eurozone, led by Germany. The eurozone should deliver a stable economy growth, improving from the 0.7% fall in GDP seen in Q4. Japan lagged the other major developed economies.

A common theme among all developed economies is the persistent recovery of manufacturing led by a record surge in the eurozone. Japan's producers reported the second-strongest gain since 2018. The UK saw a marked expansion of production. The US printed a contrasted image in this improving manufacturing trend, recording the weakest expansion of production since last October. However, the slowdown appears temporary, linked mainly to supply disruptions - which hit a record high.

 

STRATEGY

Towards less Financial Repression and Asset Price Inflation?

  1. Higher odds to exit Pandemic and crisis management. The timing to achieve a global herd immunity is uncertain, featuring significant disparities among countries / regions. While developed countries should reach it by end-2021, a few large emerging countries will still suffer into 2022.
  2. The Biden administration is revisiting its economic (redistributive) and foreign policies (coalition for China containment). The adoption of ambitious complementary plans in H2 would exacerbate tensions of market’s (long-term) interest rates. New taxes - less markets friendly - are unavoidable.
  3. Cyclical inflation. Oil and other cyclical raw materials prices are resurgent. Supply chains bottlenecks continue. A pronounced base effect will happen from Q2. We may experience an unbridled pickup of headline CPI in H2 2021, if pent up demand resurges strongly.
  4. Bubble formation. Financial repression and unabated liquidity injections have favored speculation and leverage. Policymakers have become growingly concerned about retail investors’ frenzy, SPACs, as well as sky-high property prices. Some central banks (Japan, Canada, New-Zealand) are preemptively reducing the intensity of ultra-accommodative stances, while the Fed is trying to dodge the issue. Noticeably, the PBoC and ECB will maintain their current stance.
  5. In the next 5 years, we will experience a broad adoption of digital - central bank - currencies. The launch of a crypto/e-Yuan is close (Olympic games in Beijing 2022 latest). The global fight against cash is accelerating. Euro and Yuan will growingly challenge the supremacy of the USD.

Financial conditions are still accommodative Liquidity pick Is close

 

CURRENCIES

New USD driver

US outperformance is USD supportive

Historically, large US Twin deficits have driven the USD lower. Over the past 50 years, each time the twin deficits have worsened, the US economy has rebounded.

The 3 last episodes were under the Reagan, Bush Jr and Obama administrations. Most of the times larger twin deficits have pushed the USD significantly lower. The only exception was under Reagan. At that tie, the main reason was that those deficits have been strongly productive. The US GDP growth sharply turned back above the 5.0% hurdle while in the 2000s it failed to achieve a significant economic boost.

The Fed just confirmed it is not in any hurry to hike rates or taper its bond purchase program. This puts the Fed in a more hawkish camp when compared to its peers such as ECB or RBA which are promising to become even more aggressive.

The recent $1.9trn Biden administration plan has pushed a lot of strategists to lift their economic growth forecasts. According to Bloomberg, it has been revised up to 5.6% from 3.9%, in less than 3 months, for 2021 and to 4.0% from 3.1% for 2022. The latest $2.2trn Biden support plan announcement should cause another upward revision to US growth.

 

Tide is turning for USD/CNY

Chinese yield pick up is reducing

The Yuan has recently outperformed most of its partners. The only exception is the USD. In S2 2020, tailwinds have supported Chinese assets, the winds are changing direction. In fact, the path may turn into a steeplechase with a growing number of obstacles in front of the Yuan. The slow vaccination rates, a lower international demand for equities, and a less compelling relative value of Chinese government bonds are all negative factors. Now, trade and geopolitical tensions are popping up on the radar again. Exports require two sides, and as many parts of the world still struggle to overcome the pandemic, foreign demand for Chinese assets will struggle to revolve at the same pace.

 

BONDS

Has the Fed a yield cap in mind?

Relationship between long-end yields and Fed scenario

The US Treasury index are off to their third-worst start to a year since 1830 pushing yields back to their one-year highest levels. Powell had one opportunity to quell investors’ nerves. The US 10-year yield is already up 75bps since January. Could it soon reach 2.0%, or 2.5%, or even 3.0%?

The Fed only controls short rates, while longer-term ones are more prone to move based on economic growth and inflation expectations. But that is not to say the Fed has no role to play. Since 2012, its favorite forward-looking tool is the “dots,” which shows the Fed funds policymakers’ expectations for the next few years and longer term. The long-term neutral rate is also influenced by non-monetary drivers like workforce growth, labor productivity, global supply, and demand for safe and liquid financial assets. Economic growth this year will be good if not spectacular. Pent-up demand and savings could revive long-dormant inflation and get the Fed away from the zero-lower bound within the coming years. Few would argue that the neutral rate should be higher than it was just a few months ago.

 

Credit spreads big squeeze to continue

Credit spread per unit of leverage

With fixed income, it is not always easy to determine whether investors are appropriately compensated for the level of risk they are taking by providing liquidity to issuers. Equity investors have ratios such as PE. Credit investors generally look at spread levels and financial leverage to assess the attractiveness of bonds.

Spreads are not too far off their tightest levels of the past 20 years. Given the amazing amounts of central banks supports, resulting in $14trn of negative-yielding debt, and ample fiscal stimulus, it is not beyond the realms of possibility to see spreads to tighten more this year.

Therefore, we focus on fundamentals to assess long-term debt sustainability. Leverage deteriorated considerably in 2020. Net debt slightly increased while earnings collapsed. As it is a backward-looking measure, we are yet to see the earnings improvement in corporate balance sheets. Consequently, using spread per unit of leverage i.e. the median net debt to EBITDA ratio, spreads appear to be stretched.

 

EQUITIES

From a liquidity (2020) to a fundamentals driven market (2021).

Equity risk premium

The formalized regime change from disinflation to reflation, the sharp rise in earnings, with positive surprises, will support stocks, even if interest rates rise. The equity risk premium (1/PER - US 10Y) is in neutral area even with sharp increase in equity indices and in interest rates.

Studies show that a rise in interest rates often coincides with a bullish stock market, up to a certain level. According to an analysis by The Leuthold Group over the period 1900-2020, stocks most often rise when the US 10-year is below 3% and rising. According to Bank of America, the last 19 rate hike cycles since 1920 have seen the S&P 500 rise 74% of the time with an average performance of 13.3%. During the last 5 cycles of the US 10-year increase since 1998, the S&P 500 has recorded an average performance of 30.2%, with banks leading the way. Other analyzes, like that of Robecco (see graph below), show that US inflation between 2.5% and 3% is not a negative factor. On the other hand, inflation above 4% is starting to weigh on indices. Today, US 2/5-year inflation expectations stand at 2.7%.

 

A normal volatility rise in the current phase of the cycle

Value-Cyclical should outperform

To fund these stimulus measures, increasing the corporate tax rate from 21% to 28% and penalties for companies that park their profits in tax havens should result an underperformance for FANGs, we are thinking at Amazon, Apple, Facebook, Alphabet, and some pharmaceutical companies.

In 2020, risky assets benefited from extraordinary liquidity injections from central banks. A pure liquidity market, resulting in low volatility. Then, the prospect of a gradual exit from the health crisis with the arrival of vaccines triggered a rise in interest rates and revived inflationary expectations, causing a significant sector rotation from Growth/Defensive to Value/Cyclical. The phase of rising rates and inflation expectations precede the recovery in corporate profits. Unless the pandemic drags on with its dangerous variants, cash injections, which peaked at the end of 2020, should make room for fiscal stimulus, meaning more volatility and outperformance of cyclical stocks.

 

COMMODITIES

Gold is facing headwinds

Gold, silver and inverted real yields

Expectations of a strong economic recovery in the United States are reflected in a rise in long-term interest rates and the dollar. Investors maintain their bias on risky assets. This environment is not favorable to gold, a defensive, monetary and non-yielding asset. Investors continue to exit ETFs and other funds invested in gold. The negative correlation between gold and US real interest rates continues.

Between September 2017 and August 2020, gold rose 75% and outperformed silver thanks to strong demand from central banks in emerging countries. Russia had sold all of its US Treasury bonds in favor of gold. Turkey, China and Kazakhstan had also been major buyers. However, since the second half of 2020, they have slowed down or stopped their gold purchases.

Since September 2020, gold has been in a corrective phase. Silver seems willing to break away from gold. A number of structural and cyclical (economic recovery) industrial factors (industry accounts for 50% of demand) should allow silver to outperform gold.

The industrial demand for silver will increase with the policies of decarbonization of the planet, the electrification of cars, solar panels and 5G. Silver is irreplaceable in the development of photovoltaic cells thanks to its excellent stability and high conductivity. The Silver Institute predicts a 9% increase in demand for gold in 2021.

 

Economic recovery supports oil

fiscal break-evens

The price of oil is gradually rising with the recovery of the global economy, the OPEC+’s output squeeze (45% of world production) and the reduction of world inventories.

Global commercial inventories have eased after a peak in early 2020. A brent price between $65-70 is in line with the current level of inventories.

OPEC+ maintains its restrictive production quota, considering the overall economic situation still fragile. It expects demand to increase from 5.8 million b/d in 2021 to 96 mbd, which is still below the 100 mbd of 2019.

 

ALLOCATIONS

Allocation

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

ASSET ALLOCATION

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:

Alternative scenario, i.e. double dip:

 

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…

 

BONDS

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.

 

CURRENCIES

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.

 

EQUITY

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%.

 

RAW MATERIALS

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

 

Disclaimer
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis con-tained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are ex-pected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.

RETROSPECTIVE

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.

 

STRATEGY AND MACRO

Asset Allocation:

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

 

MACRO  PERSPECTIVES

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

 

CURRENCIES

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.

 

BONDS

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.

 

EQUITIES

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.

 

GOLD

"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.

 

OIL

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.

 

ASSET ALLOCATION

ALLOCATION D'ACTIFS - En

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RETROSPECTIVE

Economic data starting to indicate the gravity

The coronavirus outbreak which began in China but has since spread to encompass over 140 countries worldwide continues to wreak havoc in the global economy, and looks set to continue to do so for some time to come. There remains a great deal of uncertainty regarding the global consequences. All major economies now look set to be afflicted by their own localized outbreaks. Italy, Iran and Korea have the highest number of reported cases after China, but there have been rapid spreads in the US, Spain, France, Germany, and many other key markets also. The growth outlook for these countries was already fairly lackluster, and it seems fair to say that this crisis has come about when the global economy was not in a position of particular strength from which to endure it. Many countries are recession-bound in 2020, and the negative impact will take many sectors to breaking point.

 

Central banks have shot their bullets

In such an extraordinary environment, it is little surprise that there has been an extraordinary response from central banks, most notably from the Fed. On March 15th, the Fed made its 2nd irregular 50bps rate cut in 2 weeks, taking the Fed funds to 0.25%, equaling the lows of the global financial crisis. Other countries to have implemented cuts include the UK, Canada, New Zealand and Australia. China cut its one-year prime rate to 4.05%. The notable outliers are the ECB and the BoJ, which have both maintained their benchmark rates at -0.5% and -0.1% respectively. However, that is not to say that they have not been active. The BoJ is buying more assets, double the pace of its ETF purchases, and introduce a new zero-rate loan facility. The ECB has widened the TLTRO - for 3 years at -0.25% -, implemented a temporary envelope of additional net asset purchases of EUR 120bn until the end of the year and launched a EUR 750bn Pandemic emergency purchasing program. In its surprise March 15th move, the Fed decided to boost bond holdings by at least USD 700bn.

Strategy and Macro

Asset Allocation:

 

The “State” is back. For good!

When elected President, Trump promised to “drain the Swamp”. Actually, he reduced significantly the size of several departments of the US administration, namely that of the Foreign Office (diplomats) and Health. Layoffs in both prove today problematic, in the context of international political tensions and of the sanitary crisis. Anyway, this is barely reversible now! Beyond this, Trump accused the US State of being fundamentally unproductive and flawed. Therefore, for “ideological” reasons, the US administration has been downsized, and its scope reduced. But the emergence of the Covid-19 / sanitary crisis features a tipping point. Trump and Co no longer want to dismantle US State, quite the opposite... In short, we are ahead of tentative nationalizations, if not of sort of a TARP 2.0. The Fed is logically taking part to this process, featuring a major shift from its - poorly aborted - normalization of interest rates (2018-9). For now, their joint action against a major threat is a priority. Logically, the current crisis relegates the issue of the central bank’s independence to a later stage.

 

Central banks were the only game in town

Now, the State is making a dramatic come back. Europe is also at the cross-roads. Maastricht treaty’s criteria just exploded. Talks are going on about the mutualization of risks, i.e. euro-bonds. The ECB is expanding gradually the scope of its purchase of private assets (like commercial paper), up to - ultimately - banks’ bonds? The political barriers against a green new deal diminish, thanks to a dramatic shift in the German political landscape. The support for austerity is weakening in sync with Merkel and her governing coalition in polls.

State bailouts are broadly contemplated, including in the capitalist bastions
Helicopter money and New Monetary Theory are no longer anathemas

 

Covid-19. A major threat for top leaders

Up to early 2020, China and Xi were the spotlight, as the epicenter of the sanitary crisis. An existential challenge for the Chinese politburo was considered. A quarter later, things seem to have dramatically changed. China seems not only on the verge of containing Covid-19, but also of re-igniting its economy / supply chains with “limited” damages.

Europe has then become the next epicenter of the sanitary crisis. Solidarity among EU members has been limited to say the least. As a collateral damage, Maastricht treaty has collapsed and existential questions are reappearing, like risk mutualization, banking union, fiscal transfers, etc. A - much - more fragile Germany holds the key to engineer the revisiting of the basic nature and structure of the Eurozone. Will it proceed? A political status-quo would probably spell major dislocations in the EU over next couple of years. US is gradually taking over the leadership in terms of magnitude of the viral infection. The initial denial of Trump administration might ultimately backfire and play a role in next Fall Presidential elections. The US society is particularly divided, and inequalities have risen a lot in past decade. Serious social unrest might occur should the economy / employment were to suffer long lasting and dramatic developments.

The current crisis is particularly threatening Western politicians

 

A new investment framework

The eventual involvement of the State to bail out private companies will spell at least medium-term interruption (if not the end) of the hyper-active financial engineering of corporates. Share buybacks, special dividends, stock options have become political evils. The fiscal advantages linked to debt versus equity, as a means of corporate financing, might even be reconsidered. A long phase of corporate deleveraging might open-up. This might spell structurally lower EPS growth, namely in the US.

Passive management and investment vehicles have probably past their Nadir. The dysfunctional trading of fixed income ETFs, where discounts to NAV have become the norm, are a symptom of the mismatch between their theoretical and practical liquidity. The Fed, in a well-targeted emergency move, is intervening by purchasing such investment vehicles. Let’s hope it will manage to address the issue!

This is nevertheless reminiscent of what happened with the financial engineering linked to subprime mortgages during the last crisis. The incriminated investment products and derivatives (CDOs, CLOs, etc.) experienced a long phase of delusion following the 2008/9 crisis.

Asset Price Inflation regime is over
Resurgent volatility will result in higher risk premiums
The omnipotence of passive investment strategies and products is under a serious test

 

Macro perspectives

Unstable macro regime

The longest ever US business cycle ended up abruptly late 2019. A global recession, possibly of short duration but high magnitude, is unfolding. The conjunction of two external shocks, a sanitary and oil crisis, finally won over the latest phase of Great economic Moderation. By chance, the world economy is not in a situation of major imbalances (like over-investment, or high inflation). But the - very - important debt burden amassed last decade, renders it clearly vulnerable. As well as the entrenched lack of consumer price inflation and the unusually high wealth and income inequalities. Contrarily to last crisis, over-indebtment neither comes from households, nor from the financial sector. We are rather facing a Corporate debt indigestion. This is therefore a precursor of an inevitable credit crisis. The crucial question is about its ultimate magnitude.

A “contained” credit crisis would of course trigger corporate defaults, massive layoffs and reinforced disinflation. It would primarily impact on investors’ wealth and portfolios. As long as the banking system remains ring-fenced (this is a bold assumption in Europe), a brand-new cycle, à la Schumpeter, would take place in 2021. This seems the most likely scenario at this stage, considering the quick and strong involvement of policymakers in G7 countries plus China. But still, this is contingent to the Covid-19 not proving too severe in a few countries having delayed their protective measures (say the US and UK). A severe “uncontrolled” credit crisis would indeed result in (debt) deflation. This is a worst-case scenario resembling the 1929-32 episode.

The bad news is the lack of global cooperation, in our G-Zero world, where unilateralism definitely prevails. Still, there are early signs that we are shifting towards a currency truce, courtesy of the US and China.

A global recession and a “contained” credit crisis are inevitable
A U shape recovery is quite possible, but a more severe crisis too (lower odds)
Expect unstable inflation developments

 

Currencies

It’s all about the king USD

The music for risky assets has abruptly stopped and concerns about the USD funding markets have rekindled FX volatility. One of the features of recent market carnage was that investors sold anything they could, including gold and Treasuries. Deleveraging relative-value trades also led to a malfunction of the Treasury market. On top of that, risk parity unwinds led to selling of both equities and Treasuries. That left the USD as the go-to asset to buy i.e. the only one safe-haven asset. Because most market participants fund in USD, it has triggered $12trn of margin calls. Incredibly, the 8-day USD change around March-end was the largest on record. The DXY has rallied nearly 6% since its annual lows in early March, and close to 10% at the top. According to all the classical metrics (PPP, REER, NEER), the king dollar remains the most expensive currency in the world.

Since then, the Fed has addressed these issues with its unlimited QE following the ECB Pandemic Emergency Purchase Program announcement. But restoring confidence will take time. Have we entered another round in the currency war? For sure, the White House does not welcome the USD strengthening. However, it may be reluctant to intervene to weaken the USD too. In the current context, no intervention is better than a failed one. Furthermore, the US administration has passed an historic $2trn stimulus bill. Fiscal and monetary measures and signs of reducing USD funding squeeze suggest that FX markets may be about to exit the period of profound, indiscriminate moves, where the USD appreciates abruptly. Speculative pressure on the USD intensified. The USD sentiment soured significantly following the Fed announcements amid rising financial market turmoil. This led investors to run the first overall bearish USD positioning since mid-2018. The aggregate USD position went from flat to a net short.

 

Funding squeeze pressure fading should benefit to healthy currencies

The EUR/USD and USD/JPY basis have fully normalized. Following the Fed FX swap programs implementation, the EUR and JPY should rebound. The unlimited Fed QE will take a toll on the USD in a better functioning market environment. The CHF remains “penalized” by its still strong fundamentals. The NOK has been the key victim of the latest market and oil rout as the NOK low liquidity heavily exaggerated the currency downfall. Oil prices will remain depressed for some time suggesting that a meaningful NOK rally is unlikely. The GBP suffers from the worst current account position in the G10 FX space, and the external funding needs lets the GBP vulnerable, despite its cheap valuation.

 

Bonds

Central banks aggressive support will keep markets functioning

The Fed wishes to avoid a credit stress contagion to the real economy
The longest economic expansion has ended abruptly. The end is not a surprise; but the exogenous shock, its speed and its magnitude are. The US economy will enter a recession this year, but the latest Fed announcements may help avoid longer-term damage and accelerate the recovery. The recent risk aversion spike and unprecedented volatility in Treasury markets – the ultimate safest asset – exacerbated the search for liquidity, and propagated price dislocations in credit markets.

Fed goes nuclear

The Fed announced an open-end program to buy unlimited amount of Treasury and MBS. Unlike 2008, the non-financial corporate sector is the epicenter of this crisis. The Fed announced it will create a SPV to provide medium-term loans directly to corporations, buy existing high-quality corporate debts in secondary markets, and make loans against ABS held by a broader range of investors. These measures will further support short-term corporate lending and ensure that money market funds have ample direct access to liquidity to fulfill redemptions. The Fed balance sheet has already exceeded the $4.5trn maximum level reached after the 2008 crisis and should surpass $6trn. This came in the wake of the €750bn ECB bazooka to stabilize credit markets.

 

From search for liquidity to search for yield… again

IG and HY spreads moved from late bull market tights to recessionary levels within just 4 weeks. We have seen true capitulation in the last weeks, with massive outflows across ETFs and funds. Credit curves have inverted. Short-end spreads have widened more than long-end ones as short-dated papers were used as a cash proxy. Since investors needed cash, they have sold them. The key problem, unlike 2007-08, is liquidity rather than leverage. So, markets are clearly dysfunctional. Liquidity is poor and it is challenging to assess where market prices really are. Current spreads levels have been seen only 3 times since the 1930s, in October 2008-June 2009, October 2002, and the early 1980s. Investment grade spreads have doubled in less than 3 weeks.

Everything is happening faster, including monetary and fiscal responses. Authorities have learned from the 2008 experience and were prepared to go further and faster. The Fed announced two facilities - the Primary Market Corporate Credit Facility and the Secondary Market Corporate Support Facility - which could translate into $200bn IG corporate bond purchases before September-end skewed to the front-end. This will reduce refinancing risks and lower non-performing loan risks for US banks. This is a risk transfer from the private to the public sector at the expense of huge fiscal deficits, funded by central banks. Such public sector risk sharing is exactly what stopped the 2008 crisis. The recent dislocation in corporate credit markets will reduce.

Over time, credit spreads should compensate for default, downgrade and liquidity risk. Spreads already compensate for huge illiquidity premia and recession. In a severe downturn scenario, HY default rates should spike to 10%, with recovery rates as low as 20%, translating into a default loss of 8% per annum. A 1’000bps spread on a 5-year maturity horizon generously compensates for such case. Spreads equate to those of late September 2008 – a few weeks after the Lehman failure. Valuations are clearly cheap. We are close to the widest in spreads. It is rare to see these spreads levels in any category. It is time to adopt a contrarian stance and to add risk. Furthermore, given the banks capacity to replace bond investors by printing loans, as they were doing before the financial crisis. This could create a bond shortage and support credit.

 

Equities

The decline in indices has especially shocked by its speed

The equity markets established a record in decline speed: -36% for the Dow Jones between February 20th and March 23rd. But the absolute record remains -30% in 5 working days from October, Tuesday 13th to October, Monday 19th, 1987, during the bear market of 1987 which had lasted 78 days, from August 25th to November 11th, 1987. In magnitude, with the recent rebound, the decreases in indices do not go beyond -30%. On March 24th, the stock markets give early signs of a stabilization, thanks to the extraordinary monetary (infinite), fiscal and budgetary measures of central banks and governments to avoid a depression and hope for a rebound in V or in U of the global economy.

 

A "technical" shock for corporate profits

Of course, profits will collapse in any case during the first half of 2020, or even in the third quarter if the containment measures continue. Goldman Sachs forecasts a 33% drop in profits for the S&P 500 in 2020 and Credit Suisse -24%. With a bottom-up approach, Bloomberg analysts estimate a 14% decline in earnings per share for the S&P 500 in 2020 and Lipper Alpha by -15%. The drop in profits is accentuated by the drop in oil prices which will weigh on the energy sector. Take China, which was a month and a half ahead of the restraint and partial shutdown of production lines. Chinese industrial enterprises saw profits fall 38% in January and February, and even -87% in the electronics sector, -80% in the automotive industry and -68% in electrical machinery / equipment. Smartphone sales have dropped 56%. In March, Chinese industrial activity restarted very gradually, but demand has remained very weak, with households preferring to conserve their liquidity in the event of a second wave of coronavirus. The Chinese government is considering measures to stimulate demand.

Today, it is impossible to estimate the extent of the drop in profits. This will depend on the duration of the confinements. They will decrease, for sure, and probably beyond -20%. If we try to make estimates, it is certain that we will be 100% false. We consider a technical shock, because we expect a very sharp rebound in profits at the end of this crisis. The 2008 financial crisis was difficult for the profit cycle with a 49% contraction from the peak, but the stock market indices rose 205 days before earnings per share recovered.

To cope with a short-term liquidity problem, some companies stop paying dividends, which is easier for American and British companies that distribute them quarterly or semi-annually. They also stop share buyback programs. Bank of America has calculated that over the past 5 years, US companies have carried out share repurchases for $ 2,700 billion, mainly financed by an increase in debt of $ 2,500 billion; between the summers of 2018 and 2019, share buybacks exceeded free cash flow, resulting in a $ 272 billion reduction in cash for non-financial corporations. There is therefore a debate in the United States as to whether the taxpayer should pay for the excesses of companies, which have benefited shareholders. For the year 2018, according to Bank of America, share buybacks contributed to 20% of the increase in profits per share. In any case, the counterpart to assistance from the federal government is to stop these share buyback programs for a few years.

 

Stock valuations discount a recession

The correction in indices has reduced stock valuations, which are at levels of a recession. We exclude a depression thanks to the (infinite) monetary, fiscal and budgetary measures taken by central banks and governments. In addition, very low interest rates support higher stock market valuations, unless there is a depression. Signals from the Breadth indicator (number of decreases and increases), volatility and credit spread are showing signs of stabilization as the indicators were in panic mode. Investor sentiment indicators point to a higher probability that stock market indices will perform positively within 12 months. Over the past 20 years, see chart below, S&P 500 stocks have bottomed out on average 23 days after the Breadth indicator bottomed out. A strong return on the 85% of the Breadth indicator generally indicates that the bear market has bottomed out. The powerful response from the Fed, the White House and Congress coincided with the peak of panic (see the 2 graphs below), observed on several indicators, and it should allow the stock markets to react more quickly than in 2008 when the authorities had been slower to react. Authorities benefit from the experience of the 2008 financial crisis.

 

Favor growth, defensive sectors and companies overflowing with liquidity

In this current phase featuring the massive intervention of central banks and governments, one should obviously be tempted to buy cyclical sectors. Monetary, fiscal and budgetary measures are dedicated in the short term to sectors most sensitive to this major crisis, such as airlines, cars, tourism, hotels, restaurants, aircraft manufacturers and their suppliers, …. and also to specific companies that represent an absolute interest in national security such as Boeing or United Technologies. But still , we favor defensive bias, growth companies and those with significant liquidity in their balance sheet, such as the non-cyclical technology, health, communication and utilities sectors.

We remain cautious on emerging stocks, with the exception of China, which is gradually emerging from its confinement. Europe and the United States are in an exponential acceleration phase of the crisis. Most of the emerging countries of Asia, Latin America and Africa are late and will be in the European and American situation within 2-3 weeks. India confined 1.3 billion people last week. Brazil and South Africa are entering a critical period. The World Bank and the IMF have asked creditors to suspend payment of the debt of the poorest countries and, with WHO, fear that the developed countries will concentrate only on their national problems. The damage in emerging countries could be harder and longer. India is one of the most vulnerable countries; during the 1918-19 Spanish flu, India had the most deaths in absolute terms and as a percentage of its population.

 

Oil

The worst oil crisis in the last 100 years for oil-producing countries

The oil output reduction agreement, starting in December 2016, between OPEC, especially Saudi Arabia, and Russia, has not withstood the increase in U.S. oil production, which stands at 13 million barrels / day, allowing the United States to be the world's leading producer. The deal was supposed to support prices, but it didn't work, as the United States was gaining world market share in exporting. Unbearable for Russia, which in addition, is attacked by the United States on its Nord Stream gas pipeline connecting Russia to Germany. Russia and Saudi Arabia will increase production. The watchword is "Gain market share". It was a really bad time in the midst of a health crisis when demand for oil will drop. Normal demand stands at 100 million bpd, but the latest estimates anticipate a decline between 10% and 25%, -10.5 million bpd in March and -18.7 million bpd in April. Russia cannot close its wells because it could damage them. In the short term, some analysts predict a crude price of around $ 10 or even lower, which could lead to a permanent destruction of supply capacity.

In the longer term, the price situation is not as hopeless. It resembles that of 2008. Today, the oil industry is in contango, that is to say that future prices are higher than spot prices, thus favoring the storage of oil (as long as the costs of storage are not too high) on land and at sea to resell the crude later at a better price. The problem is that there will not be enough storage capacity and the most expensive productions will have to stop and the weakest producers will disappear. This situation suggests a strong rebound in oil prices when demand returns.

The United States is pressuring Saudi Arabia to stop this new price war, but at present, no producer is able to reduce supply to cope with such a shock in demand. The shock will affect shale gas and oil in the United States, in particular Texas, North Dakota and Pennsylvania (gas). Many shale oil producers are on the verge of bankruptcy and US production will fall if prices stay at these levels. The price of WTI must be between $ 35 and $ 55, depending on the region, for the US shale to be profitable. Analysts predict US production will drop 3 million bpd in 2021. Investment spending is expected to fall by half to $ 60 billion in 2020. The US oil industry is very clear: it does not want any financial aid from Washington; it wants to remain independent according to the sound foundations of American capitalism: we live well, we survive or we die!

The oil majors will try to save dividends, as they did in 2015-2016, with a reduction in investments and the end of share buyback programs. But BP has understood, the priority today is not to protect dividends, but the need for new perspectives, such as accelerating the energy transition. In the short term, the oil majors' dividends are protected by the significant generation of free cash flow, except for Exxon Mobil. But it is not the high dividend yields that drive oil majors' share prices, but oil prices; and in the short term, the environment is unfavorable to them. Above all, petroleum service and equipment companies should be avoided.

 

Gold

An environment very favorable to physical gold

In March, the price of gold suffered from profit-taking driven by margin calls and a panic that favored liquidity. Then gold recovered following the Fed's announcement of an infinite asset purchase program and a weaker dollar. Interest rates will stay low for a long time. In the current shock of flooding of liquidity to support the global economy, gold reinforces its character of safe haven in a potential currency debasement shock.

There is a physical gold disruption, as the refining factories are closing (Switzerland, South Africa, Singapore) and the means of transport have stopped (planes, boats). Even though the London and New York markets remain confident that the physical gold supply will be sufficient, traders report that the market is squeezing, seeing supply disruptions. Future gold prices higher than spot prices are a signal that there is a risk of a supply shock as demand increases.

If there is a lack of physical gold, investors could turn to physical silver. The recent widening of the Gold / Silver cross could favor the silver metal, while bearing in mind that gold metal is the ultimate financial safe-haven asset.

 

 

Disclaimer
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