Investment Strategy Letter: May 2020
. The global economic recession linked to the Covid-19 pandemic is worse than expected and we are revising down our growth estimates for 2020. The recovery in 2021 will be strong, thanks to the stimulus policies put in place. Inflation will remain lacklustre.
The financing of the European stimulus programmes will give rise to a compromise in which the existing institutions/mechanisms will be widely used. We are positive on eurozone periphery bonds.
. We stick to our strategy of accumulating on weakness in the stock markets. The short term remains uncertain (extent and duration of the recession/lockdown, downward earnings revisions, high volatility) but in the medium term, the recovery will be on track and profits will start to grow again. We are positive on the United States, the emerging market countries and the eurozone.
. We turn positive on China and Taiwan by focusing on their domestic markets.
. We increase our gold target to $1600-1800.
In March, financial markets were hit by the worst health crisis of the past century: the lockdown of almost half the world's population plunged the global economy into a deep recession, and global stock markets plummeted by 34% in 30 days, the fastest bear market in history. In April, stock markets rebounded by 20% in Europe and by 25% in the US. The peak of the epidemic appears to have been reached in Europe, the reaction in terms of stimulative economic policies has been massive and rapid, and financial markets have begun to price in the rebound in economic growth. The start of May was difficult with the first two trading sessions recording sharp declines. So what will happen next? The short term is still very cloudy, and we would not be surprised if the consolidation movement seen in early May continues. More importantly, the long-term trend should be positive as we expect a gradual pick-up in activity in the second half of the year, and amplifying next year.
Our forecasts for the global economy
All economic forecasts (our own as well as those of international bodies or other companies) have been systematically revised down since the onset of the pandemic. Confinement measures are much wider and on a much larger scale than expected, and lockdown exit plans are not yet defined. For example we do not know how long governments will continue to keep whole segments of the economy at a standstill. Neither do we know how long it will take to return to a ‘normal’ pace of economic activity. China, the first country to exit the pandemic and lift confinement measures, is resuming its activity, but the return to normality is an uncertain challenge.
All states and central banks have put in place unprecedented measures on a large scale: tax deferrals, loan guarantees, aid for temporary layoffs/furloughs, massive liquidity injections etc. The idea is to limit business closures to keep the production tool intact, and it will get going again as soon as lockdown measures are lifted/relaxed. Hence a U-shaped growth profile with a recovery in the second half that will be amplified next year. See the table in the PDF for more details by country.
The risks to this forecast are mainly to the downside, in which case, we would talk of a W-shaped profile. What are the unknowns? The length of lockdown, the timing between political decisions and their tangible implementation, the impact of ‘deglobalisation' that is looming in several sectors deemed strategic, the likely rise in savings rates, all of which are unknown and which favour darker scenarios. Conversely, a vaccine or a new drug to treat Covid-19 would reduce uncertainties.
We are often asked the following question: “Isn't inflation likely to pick up as a result of these stimulus policies and massive liquidity injections?”. In our view, however, it is still too early to conclude that the risks of deflation are totally ruled out. Structural factors that limit the acceleration of inflation are still very powerful (price-cutting pressure with digital and e-commerce, low productivity growth, the ageing population). Certainly, less globalisation could increase prices in some segments. However, on the other hand, recession, rising unemployment and savings rates as well as the collapse in oil prices will push prices down over the coming quarters. There is still the monetarist argument of the creation of huge amounts of liquidity by central banks: Isn’t there a risk of mechanical inflation? In fact, as long as the money multiplier remains as low as it is presently (incidentally the level since the great financial crisis), central bank interventions do not boost inflation, but rather limit the risk of deflation.
In our forecasts, inflation will remain between 0 and +1% in 2020 and may accelerate towards +2% in 2021 if (as we believe) oil prices rebound towards $45-55 by year-end. Black gold will be supported by the combination of a recovery in demand for oil linked to the rebound in global growth at a time when crude production will be reduced (voluntarily by the enlarged OPEC, under duress of operating losses in the United States). We will ask ourselves later (in 2021?) the question of a possible acceleration in inflation if the global economy responds better than expected to the various stimulus measures.
Opportunities arising from the European crisis
Eurozone periphery bond spreads have widened over the past couple of months, particularly in Italy. The ECB's intervention has reduced the pressure on this country, especially as S&P has decided against lowering Italy's rating. There are important questions about the financing of all these stimulus programmes announced in the eurozone, particularly for countries that already have high levels of debt. The debate between Europeans on how to do this is undecided. We believe that this debate will bring a positive end for the eurozone, a solution that will result in a narrowing of peripheral spreads. Existing tools, for which an agreement has already been reached, will be used fully. The European Stability Mechanism, European Investment Bank and European Insurance Fund are expected to be operational as of 1 June. In addition, the European Commission must (within 2 weeks) develop a proposal for a new recovery fund, financed from the Commission's budget. So we are not talking about eurobonds.
The similar reasoning about good quality Corporate bonds prompts us to be positive on Investment Grade in both Europe and the US, mainly thanks to the support of central banks. The ECB and Fed announced that IG would be part of their QE, i.e. their bond-buying programmes on the market.
We stick to an accumulation strategy on stock markets
Volatility levels on stock market indices remain high: the VIX and V2X were close to 40% at the time of writing. Short-term uncertainty dominates; a) the pandemic is far from over, particularly in the United States; b) the magnitude of the recession is constantly being revised upwards, with disastrous economic data publications in March and April. The month of May is unlikely to be better; c) companies are currently publishing their first quarter results and logically analysts are sharply revising down their forecasts for the full year. But a host of companies are no longer providing ‘guidance’ (anticipation of their future results) because visibility is low.
We prefer to focus on a slightly longer horizon: in the second half of the year, macroeconomic data will improve as lockdown measures will be lifted gradually, and government stimulus measures will be implemented. This positive momentum will continue in 2021 and corporate profits will return to the growth path, while interest rates will remain low.
Our preferred markets are still the United States, the emerging countries (Asia in particular) and the eurozone, in that order. We recommend taking advantage of periods of hesitation to accumulate and strengthen positions. This month, we are adding China and Taiwan to our list of preferred markets. No change to our sector views: we are positive overall on health care and insurance. And positive too, in Europe, on energy, technology and building materials.
Changes this month
We are positive on the Chinese and Taiwanese equity markets and focus on the rebound in domestic demand in these two countries. The worst of the health crisis is behind us in these two economies where governments are pursuing reflation policies in a bid to boost local consumption. Manufacturing and exports are suffering in both countries because of the recession in the global economy. Valuations on these two stock markets are attractive, while profit forecasts have already been sharply revised down.
We raise our targets on the ounce of gold to $1600-1800 (from $1535-2735). Gold remains uncorrelated to other financial assets and plays a role of hedging against risk. Central banks are very accommodative, and are keeping real rates very low, which is a positive factor for gold.
Read more of this Investment Strategy Letter in the pdf ...