Monthly Investment Review
Global liquidity is decelerating – Liquidity will remain ample, but its momentum declines. This will continue in H2 in the context of taper talks and of a strong recovery – draining investable liquidity.
Good global, but very heterogenous growth – Good global and synchronized growth in advanced economies in H2. China decelerating back to potential. Very weak / distressed emerging.
A delicate geopolitical landscape – Strong strategic alliance between China and Russia. The Indo-Pacific region is the new world strategic epicenter (Taiwan).
Abundant speculative capital flows – Rising risks for financial stability. Retail investors playing casino with government checks. China frontal attack on Crypto assets as a harbinger of other central banks actions?
Scarce and expensive quality assets – Financial repression still in place. US long rates to stay in a range (1.5% – 2.0%). Possible end to German negative rates.
High risk appetite, but no new trigger in sight – Consensual reflation trade losing steam in the current indecision phase. Q3 will bring more directional insight.
World growth: from recovery to expansion – ¨Peak growth was reached in China end 2020, is underway in the US and will take place by year-end in Europe. In 2021, the American cicada takes over from the Chinese ant. The multiplication of stimulus plans will boost US growth to 6 or 7%, at the risk of causing overheating. China is returning to its potential growth rate, probably around 5%. Europe should finally experience a good surge from H2, even more so if the pandemic continues to weaken and tourist countries can reopen this summer. Global recovery phase (peak growth) is underway. In principle, the inflation cycle will follow through, with a few quarters lag. But lots of post-pandemic disruptions are temporarily putting at risk these classical patterns. Data volatility and forecast insecurity will remain pretty high in 2021.
This base scenario – pretty consensual now – should allow for structural disinflationary and cyclical inflationary forces to compensate, without penalizing the global macro-regime. Indeed, the risks of ¨stagflation¨, i.e. an aborted business cycle, coupled with unbridled inflation appear remote. The unfolding of this base scenario definitely necessitates a stagnation of tensions between China and the US, a consolidation of global commodity prices and a measured rise of US wages in H2. Everything is far from guaranteed.
Developments of commodity prices and US wages deserve careful attention in Q3
H2 will be key to ascertain a benign transition from growth to recovery
Asset allocation conclusion – Western policymakers are getting closer to an inflection point, where their ultra-accommodative stance will face different reality checks, from markets, economic agents, and voters. Deficits and public debt management will be under growing scrutiny during pandemic end. Global liquidity is becoming less supportive.
So far, a surprisingly weak USD and calm long-term interest rates allow for a benign transition phase from recovery to expansion. But, after having won the first set, the Fed posture in Q3 will be key to apprehend the rest of the match with fixed income and currency markets. The assertiveness of a decoupling China adds to the dilemma. Stakes are getting higher and, consequently, risks of a policy mistake are on the rise.
USD trading range reaffirmed – The USD has been under pressure as risk appetite has stayed firm and Fed signaled little chance of a near-term withdrawal of stimulus. The Q1 USD rally focused on the reflation trade and higher US yields. The Q2 USD set back coincides with falling US yields and tighter government yield spreads. The April FOMC minutes opened slightly the door to a more hawkish interpretation of the Fed as the economy continued to make rapid progress toward the Fed goal. But, with the disappointing April employment report and the jump in inflation viewed as temporary, the market seems confident that the Fed is still far from its targets and sticks with its current policy stance.
More recently, US data have outperformed European ones. However, European data have continued to exceed expectations while US data tended to slightly disappoint. This has lifted the EUR up. If data remain robust and the US finally outpace expectations and its peers, this will support the USD. Similarly, if US data underperform, it will strengthen the view that the Fed will not alter its loose monetary policy and be USD-negative.
Furthermore, the USD will face headwinds until the Fed rhetoric starts to change. The USD is likely to be extremely sensitive ahead of the May employment report and inflation data. If data is on the strong side, market may expect the Fed to at least consider discussing tapering over the summer. Other central banks also play a role. The ECB may also influence the USD over the next months. The Eurozone economy and vaccine rollout have picked up, boosting confidence, encouraging some investors to speculate whether the ECB might reduce its emergency monetary support. However recent comments from ECB officials have erred on the cautious side. We are expecting a June dovish ECB tone.
The Fed inflation dilemma – Consensus among the FOMC members is that the economic outlook looks brighter due to mass vaccination, but the economic recovery still has a long way to go. The Fed has made it crystal clear that its decision will be outcome-based, or more precisely employment-based, before moving in a more hawkish direction. The April minutes showed some members signal that they would be open to discussing tapering. In April, the core CPI registered its largest monthly gain (0.9% m/m) since early 1980s. Inflation is expected to remain volatile as some factors contribute to intense pricing pressure, including supply bottlenecks and pent-up spending on services as the economy reopens.
Most Fed members think current inflation pressures are transitory and should pass. That said, they will not hesitate to adjust policy if inflation expectations become inconsistent with the 2.0% mandate. The sizable unemployment gap is one of the reasons the Fed thinks inflation is transitory. The pandemic could have altered the economy structure. Therefore, it will be worth watching inflation expectations and wages to assess whether inflation pressure could become entrenched. These 2 potential triggers might cause the Fed concern.
The Fed will be tested in its Average Inflation Targeting (AIT) regime this summer. Once the core CPI will have been above 2% for a prolonged period, the Fed will be forced to clarify its position and tolerance. We do not expect any significant policy change before Jackson Hole symposium in August. Upward yield dynamic remains underway. Our US 10-year yield range forecast (1.5% to 2.0%) remains valid
European economies reopening and inflation expectations – The ECB is currently reviewing its monetary policy strategy. Initially due to for 2020-end, it was postponed to mid-2021 because of the Covid crisis. The review will consider whether the ECB inflation aim should be reformulated. If the ECB wish to launch an AIT-regime, the shortest timing should not be before the Sintra conference in September. The Fed AIT launch was at a much better moment than the ECB will be able to. At that time, the Fed only needed to overshoot by 0.5 percentage point (pp) over the next 5 years to compensate for former undershooting. The ECB is only expecting an average inflation of 1.5% over the next 3 years. So, it will need to overshoot by 0.75-1pp over the next 5 years to be credible. In such a regime, we should expect a much more volatile bond market.
Most of this year, higher yields were driven by higher inflation expectations, but neither by tapering expectations nor by higher real yields. And the ECB seemed content. Ms. Schnabel confirmed that rising yields is precisely what the ECB wants to see when driven by a stronger growth outlook and rising inflation expectations. She said that the Pandemic Emergency Purchasing Program will only end once inflation will be back to its pre-crisis path. Bond market is currently discounting a 1.3% inflation in Germany over the next 5 years and a European 5y in 5y inflation at 1.6%, exactly what both the German and European inflation were in average between 2014 and 2019.
Chinese government bonds lead the race – Chinese government bond yield is heading for the lowest since January. The 10-year yield has dropped about 20bps from its mid-February peaks, bolstered by ample liquidity conditions. While EM central banks like Brazil, Turkey and Russia have hiked rates, Chinese fears have not turned yet into higher rates. According to ChinaBond, foreign buyers took a breather in March. International funds trimmed their holdings by 16.5bn yuan ($2.5bn).
The spread between China and US 10-year bond yield has narrowed to around 160bps, from a record high of 250bps in last November. The slower-than-expected inclusion in FTSE Russell’s flagship global bond index – over 3 years instead of 12 months – was part of the explanation. However, after Chinese government bonds suffered their first outflows in 2 years in March, foreigners added 52bn CNY ($8.1bn) in April to a record 2.1 trn CNY. While most EM debts are sensitive to US rates, China has maintained a different monetary policy from the Fed and foreign participation in renminbi bonds remains low.
In a game-changing shift, yuan-denominated debt has emerged as a refuge during this year’s global bond rout. The underlying case for Chinese bonds is still extraordinarily strong because of its low correlation to global rates, its high nominal and real yields. China’s debt market emerged more and more as a solid alternative.
Investors appear to be integrating transitory high inflation – The technical situation for indices is solid. The stock market valuation is fair and a slight shift in the inflation cursor in our model readjusts our target on the S&P 500 for year-end from 4,800 to 4,660 – The sharp rise in inflation in April at 4.2%, due in part to a base effect, only put pressure on the stock markets for two days. Some indices are at their all-time highs. The Breadth indicator, which measures the number of stocks up and down, remains very positive. The medium-to-long-term uptrend remains firmly anchored and the balance tilts in the direction of the increase in profits / fiscal plans / excess savings created during the pandemic.
At 20x 2021, 18.5x 2022 and 17x 2023 profits, the MSCI World is fairly valued, especially as we are at the start of a vigorous economic recovery in 2021 and 2022. A Goldman Sachs model (see below) shows that the US market is correctly valued, neither overvalued nor undervalued. So we have very consistent stock market valuations.
The equity risk premium for the MSCI World (earnings yield – US 10 years) is on the average of the last 20 years. Pending the publication of 2Q21 results and US GDP in July, as well as the US infrastructure plan, the stock markets should continue to behave well with the significant sector rotations that have prevailed since mid-February, Growth vs Value, Cyclical vs Defensive.
While profit growth in 1Q21 was much higher than estimated (+52% for the S&P 500 instead of +24% and +122% for the Stoxx 600), those for the rest of the year will remain impressive with the global economic recovery which will be coupled with a powerful base effect. Hardly measurable, the excess savings made by households during the pandemic, estimated at $ 5.4 trillion by Moody’s, could be a powerful booster for consumption. Profit growth estimates for 2Q21 point to +60% for the S&P 500 and +95% for the Stoxx 600. Analysts expect record share buyback programs in 2021.
Rising inflation makes investors more nervous, but the market is currently incorporating a transitory inflation. Investors are looking forward to the Fed meeting on June 15-16 and the release of the US CPI on June 10. The pressures on prices are partly due to disruptions in production and employment, linked to the pandemic which coincides with a strong recovery in demand. The impact will, in our opinion, be limited on margins, because 1) companies seem to be able to pass prices on to customers and 2) they have restructured, reorganized and/or changed their business model in 2020 which will translate in margin improvement in 2021. An environment of rising volumes and prices is very suitable for energy, oil refining, commodity chemicals and semiconductors sectors. Historically, the rise in inflation has been negative for real profit growth, and therefore for the stock markets, when the economy was contracting or in recession, but not in boom times, as is the case today because inflation can be absorbed.
The impact of inflation is different depending on sectors: the Value segment tends to outperform the Growth segment, blue chips outperform small stocks (since mid-March 2021 the Russell 2000 has underperformed the S&P 500 by 8.5%) and high dividend yield stocks like Utilities and Real Estate underperform. We are therefore maintaining our positioning, which began in September 2020, in Value and Cyclicals, banks, energy, semiconductors, materials, industry and consumer discretionary segments.
We favor the United States and Europe which should reach a vaccination rate at the end of June between 50% and 60%, while the Asia-Pacific countries, such as Taiwan, Japan, Malaysia, Singapore or India, face a wave of Covid infections, while their vaccination rate is low: India 11%, Japan 5.5%, Taiwan 0.2%, Indonesia 5.5%, Australia 12%, New Zealand 7%, Korea South 8%, Thailand 3%. China does not provide any data. Russia is at 11%.
domestic Chinese equities (A-shares) are attractive. The CSI 300 Index has broken resistance with upside potential of 10% in the near term. If financial assets of other emerging countries are correlated to the dollar and US interest rates, China is very decorrelated. US sanctions against China’s tech sector are pushing China to become independent and likely the world will be dominated by two technological universes, one dominated by the United States with its allies and the other by China with its allies. We don’t know how his two universes will communicate. If China concedes a technological delay in semiconductors, it is ahead in live streaming, e-commerce or mobile payments. With its new dual economic circulation model (reducing the importance of foreign demand and stimulating domestic demand), China will support domestic investment, wages and household consumption. To address its demographic problem, China has just announced that couples would be permitted to have up to three children.
Gold, an interest rates story – After falling between August 2020 and early March 2021, the price of gold has recovered with the bond rally and the fall in US real interest rates and industrial metals suffered some profit-taking. Below, the Copper / Gold ratio is positively correlated with the evolution of the US 10-year.
In the second half of the year, the publication of strong macro and micro figures should push long rates higher, favoring industrial metals over gold. Copper and other industrial metals are in a supercycle thanks to Chinese demand, US infrastructure spending, expansion of green energy, electric cars and supply at risk in Latin America. Goldman Sachs has characterized copper as the “new oil”. On the supply side, mining projects are non-existent, under pressure from politicians, banks, environmental standards, shareholders and green lobbies. Chile accounts for 30% of world copper production, Peru 10% and the Democratic Republic of Congo 7%. Mining companies and semi-finished metal producers are working at full speed. Glencore said the price of copper had to go up another 50% to open new profitable mines. As a result, concerns about future shortfalls in supply will persist. It is also true that mining companies have preferred to maintain high dividends to shareholders than to invest in new projects. Demand for copper will grow 40% by 2030, including a 900% increase for green demand.
In 2021, Rio Tinto, Glencore, Anglo American and BHP Group are expected to generate an operating profit of $ 140 billion compared to $ 44 billion in 2015 when the price of copper was at its lowest. Mining companies are cautious in their investments not to have the same overcapacity problems like in 2014-2015. It takes between 10 and 15 years for a mine to be fully operational. These underinvestments also affect cobalt, lithium and gold. The decarbonization of the economy will clearly be inflationary.
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