Investment Strategy Letter: September 2020
. The Covid-19 pandemic is not over, the authorities are putting in place local health measures that will be effective in limiting the economic impact. In our scenario, there will be no new widespread lockdown but no vaccine will be available before the second half of 2021 at the earliest.
Our scenario, confirmed by the leading indicators, is a recovery of the global economy with a U-shaped pattern. Reflationary economic policies are widespread. A €750 billion European recovery plan was announced this summer.
. Monetary policies will remain accommodative, interest rates will remain low for a long while and long-term inflationary expectations are beginning to rise again.
We are changing our targets on the dollar to 1.16 in 3 months and to 1.22 in 12 months against the euro.
. On the equity markets we are bullish over the long term and we stick to our "buy on dips" strategy. A consolidation will provide an opportunity to strengthen positions.
The Covid-19 pandemic
In recent weeks, the number of new infections has grown again in Europe but has declined in the United States. In most mature economies where testing is now commonplace, these new infections primarily concern young people, and the number of people admitted to hospital (and especially deaths) remains stable. The situation is serious though, and health authorities are putting in place local measures. The latter have proved effective in curbing the spread of the virus in Asia, and we believe they will also pay off in the US and Europe.
Our baseline scenario is that Covid-19 will continue to have a significant economic impact on several sectors, but the authorities will not resort to general lockdown measures, as the economic cost is too high. Two more extreme scenarios exist: a positive scenario in which a vaccine becomes widely available earlier than expected (in 6 to 12 months in our baseline scenario), and a negative scenario in which a second wave of infections in the autumn leads to widespread lockdown measures.
Thanks to reflationary policies, we stick to our U-shaped recovery scenario
The signs of a pick-up in economic activity are clear; as soon as lockdowns were eased, economic activity mechanically rebounded. All leading indicators of activity (the ISM in the United States, the PMI in Europe and Asia) confirm this point.
Central banks and governments are pursuing very active stimulus policies and the scale of plans and liquidity injections is unprecedented. The €750 billion European stimulus package was announced this summer; it will have a major long-term impact on investment in several areas. Economies are recovering, but stimulus will take time before it has a full effect. In addition, certain sectors (tourism, airlines, etc.) are still hampered by the pandemic. Hence the idea of a U-shaped profile for the economic rebound (underway), which will continue into 2021.
In the present environment, consumers remain cautious and the level of precautionary savings accumulated during the health crisis is high. In the same way, companies have put a break on their investment programmes. Economic agents will need time to return to their pre-crisis behaviour.
It is therefore extremely likely that current economic policies will remain accommodative for several years. This is the nature of the message given by the Fed president at the Jackson Hole conference. The US Federal Reserve’s target is now an average inflation rate of 2% over several years. This means that since inflation is below that target today, the Fed will tolerate inflation above 2% before considering a hike in its interest rates. The key message from central banks now is that interest rates will remain low for a long time. We have mentioned the Fed, but the communication from the ECB and BoJ is along the same lines.
The impact of the Fed's new message has been felt on a particular segment of the bond market, i.e. inflation-indexed bonds. There are expectations that inflation will pick up over the long term. The very long part of the US yield curve (i.e. 30 years) has recovered a little and steepened.
The trend on the equity markets remains positive; we stick to our “buy on dips” strategy
Although economic growth and corporate earnings have been sharply down this year, the global stock markets have reached a new record, driven by a handful of large technology stocks. Equity markets anticipate that fiscal and monetary stimulus policies, and a vaccine (which will arrive sooner or later depending on the scenario) will allow economies to return to their previous growth path. That said, because interest rates are very low, and negative in real terms, ‘there is no alternative’ to equities. This is the famous ‘TINA’. These positive factors for equity markets are in place, and will remain so for a long time.
Yet the outperformance of the US market over the past few quarters is due to the stellar performance of a small number of technology stocks whose companies often have a quasi-monopoly on their respective markets. The fall in the dollar, which we will discuss below, was also a supporting factor.
If this positive phase on stock markets is to continue, changes in fundamentals must confirm the anticipation of an economic recovery, a rebound in profits and continued flows into equity markets.
This confirmation will come, but it will take time, and a consolidation should ideally bring stock markets back to their 200-day moving averages, i.e. a consolidation of around 10% (it started two days ago at the time of writing). The reasons for this consolidation may be manifold: excessive optimism at the moment, little cash in institutional portfolios according to the surveys, a tense environment in the run-up to the US presidential election and US-Sino tensions.
It will also be necessary for stock market leadership to expand (our scenario). That is to say, the rise in the stock markets will not be dominated by a small number of stocks. The sectors likely to rebound are cyclicals, in particular energy (especially in Europe), materials, health care (excluding pharmaceuticals, on which we are neutral) and insurance. No change to our country recommendations; we are positive on the US, the eurozone and the emerging markets.
This month’s changes
We are revising our targets on the dollar to 1.16 in 3 months and to 1.22 in 12 months against the euro. Interest rate spreads narrowed significantly during the Covid-19 crisis with a massive drop in Fed rates to 0. Yet the dollar did not fall during this phase as it played a safe haven role. Moreover, international demand for the dollar has been strong, with the Fed supporting it by increasing swap agreements with non-American central banks. Since June, the health situation and economic situation have stabilised, and fundamentals have regained the upper hand, pushing the dollar sharply up from 1.08 to 1.20 against the euro. We are revising our targets, to 1.16 in 3 months (a consolidation will be logical after such a move) and to 1.22 in 12 months. We maintain our scenario of a moderate decline in the greenback against the euro, bringing it back towards its Purchasing Power Parity (PPP): the fundamental equilibrium value of the dollar against the euro is at 1.36 according to the OECD.
We expect a $1900/2100 range for an ounce of gold in 12 months. In the context of the rise in gold, we revised up our targets in August (see flash of 7 August) as the factors pushing up the yellow metal are unchanged: low real rates, long-term anticipations of a rise in inflation, and a search for a risk absorber to decorrelate from the stock markets.
In Asia, we extend our positive recommendations to Indonesia