Short comments

China: Tighter regulation of the economy

This year has seen tightening of the regulation of internet companies in China, with Alibaba (the world's largest e-commerce company with annual gross merchandise value of over 1 trillion US dollars, more than twice as much as Amazon), Tencent(social networks with over 1.2 billion active users, payment services, mobile games, news content, videos and music) and Meituan(the world's largest delivery service) among the most prominent targets. What started with the cancellation of the Ant IPO (Alibaba's payment service) in November last year has expanded into a comprehensive set of measures focused on competition, but they also include restrictions in areas such as online games. Separately, academic tutoring – a boom sector in recent years – has been banned for for-profit organisations. In August, China also passed one of the strictest data protection laws in the world, curbing the collection and use of data by tech companies (but not by the government). The latest regulatory efforts are part of the 2021-2025 plan released in August, indicating that regulation of the economy will be a greater governmental focus than in recent years.

More competition tends to lower the profit margins of monopolists and benefit consumers and smaller merchants (who use the large platforms to distribute their products), with strong network effects (which promote monopolistic market structures) likely limiting the impact on profitability. We also believe that the regulatory measures do not go so far as to negatively affect overall economic growth.

Central bank policy: ECB strategy review

The results of the European Central Bank’s (ECB) strategy review, its first since 2003, have been in line with expectations. Despite slightly adjusted wording, the inflation target remains 2% and is interpreted symmetrically (i.e. both higher and lower inflation trigger a monetary policy response). In the future, the cost of owner-occupied housing will be included in the assessment of inflation (which increases inflation by 0.1 to 0.2 percentage points). It is noteworthy that the strategy review does not show how the ECB intends to orchestrate an increase in inflation to 2% when the lower limit for nominal interest rates has effectively been reached (which has been the case in recent years).

Unlike in Europe, the end of the phase of zero interest rates is foreseeable in the US as the central bank forecasts two rate hikes in 2023. Such an increase in rates is supporting the US dollar. In contrast, it is largely irrelevant to the capital markets when bond purchases in the USA will be tapered. Chairman Jerome Powell's latest remarks do not suggest any rush, although it remains to be seen how the central bank will react if monthly inflation rates remain high. (August 2021)

Equity markets: Normalizing returns

Stock markets generally follow economic momentum and the associated news flow. The underlying drivers of the stock markets, especially economic growth and corporate earnings, are positive. The monetary environment, evident in record-low central bank rates and bond yields, is also supportive.

The peak in economic growth likely will be reached soon (in the USA somewhat earlier than in Europe), which implies a normalisation of equity market momentum. Such an environment tends to make the markets somewhat more susceptible to corrections, especially stocks that are strongly geared to the economic cycle. Less likely – but not entirely off the table – is the risk of new virus variants significantly reducing the effectiveness of vaccines. Inflation in the US may well contribute to increased market volatility. Nevertheless, at this early stage in the economic cycle, equity market corrections should be viewed as buying opportunities.

High market valuations rarely trigger a correction in their own right, with not even all valuation metrics elevated. The free cash flow yields, for example, are still in normal ranges (see the bottom chart).

Overall, a defensive equity market positioning is not indicated. Overweighting of the cyclical sectors and the value segments is much less advocated in the coming months than earlier in the year (we would not underweight these segments, however). We continue to see potential to outperform for smaller and medium-sized companies in the coming years, however. (July 2021)

World economy: Solid rebound

The normalisation of economic activity is proceeding largely according to the script laid out last autumn. Vaccine penetration is progressing, especially in the US economy, which is central to the capital markets. US credit card data show that also the segments that were hit hard by the pandemic (restaurants/hotels, transport and leisure) have been recovering. Supply bottlenecks have some negative impact but do not jeopardise the overall economic recovery.

Supported by massive spending programmes (stimulus checks and additional benefits for the unemployed), US retail sales are now over 20% higher than two years ago (i.e. before the pandemic), the highest growth in recent history. The massive US stimulus programmes are likely to have exacerbated bottlenecks in commodities, global supply chains and in some goods categories.

So it is hardly surprising that inflation is currently picking up, especially since there is also some catch-up demand for service prices. We expect this price pressure to ease towards the end of the year and inflation to return to levels in line with those in recent years. The Fed's change in strategy announced last year might lead to somewhat higher inflation rates (around 2.5% instead of 1.5%) in the next few years, although this scenario should not be interpreted as negative for the capital markets. (June 2021)

Is «market breadth» a good stock market indicator?

In recent months, the equity bull market has broadened visibly, with almost all sectors and an unusually large number of companies seeing rising prices. There is an often-cited rule that a high market breadth bodes well for future returns.

As an indicator of market breadth, the proportion of shares reaching a new 52-week high is most often used (the difference between the number of new 52-week highs and new 52-week lows can also be examined. To analyse future returns we grouped market breadth into four equally sized buckets (quartiles), with the fourth quartile representing the best market breadth (i.e. the highest proportion of new 52-week highs). This year, the market breadth has been mostly in the third or fourth quartile.

We conclude from our analysis that market breadth does not give reliable signals for market direction. In particular, the share of positive stock market periods is largely independent of market breadth. Contrary to what is often portrayed, high market breadth is associated with below-average returns. High market breadth thus appears to be an indication of an advanced bull market rather than a signal for high returns or a particularly high probability of achieving positive returns in the future. The conclusions are the same if we analyse only positive market periods. (April 2021)

Interest rates and equities: Conceptual framework

In a simple earnings discount model, the relationship between the stock market value and its determinants can be represented as follows: P = E / (r + z - g). P is the price (the present value of future earnings), E the earnings of the current year (or a multi-year average, as used in the Shiller-Cape ratio), r the risk-free interest rate, g the earnings growth rate and z the equity risk premium. The risk-free interest rate r and the growth rate g are strongly correlated, both conceptually and empirically (see the charts). Interest rates are high when real or nominal economic growth (and thus growth in corporate profits) is high and vice versa. If r and g are the same, the formula shortens to: P = E / z. The fair value of an equity index equals the underlying profit level divided by the equity risk premium. If the risk premium is high (i.e. uncertainties are high), P is low and vice versa. As indicators of the risk premium, inflation (i.e. current inflation and not inflation expectations as implied in longer dated government bonds) and the frequency of recessions have been empirically shown to be very important in the long term. In the short term, economic momentum plays a role, while changes in monetary policy have less influence. We conclude that a connection between stock markets and interest rates is conceptually far less compelling than often assumed. Empirically, it can be shown that both a decline and an increase in the returns of the 10 year US-Treasury of the past 20 trading days lead to an above-average stock market performance in the following 20 and 60 trading days (especially a strong increase of more than two standard deviations). In contrast, an increase in yields by one or two standard deviations indicates a slightly below-average, but by no means strongly negative, performance in the month immediately following the increase in yields. (March 2021)

Value with catch-up potential

The total return (price changes plus dividends) of value stocks (i.e. stocks with below-average valuations, often slow earnings growth but high dividend yields) in the MSCI World was only slightly worse than that of growth stocks (stocks with above-average earnings growth) between 2006 and 2019. In terms of price performance, value shares have significantly underperformed, however.

With the coronavirus crisis, massive outperformance of growth stocks set in. Even though we consider part of the valuation expansion as structural, the impending normalisation of the economy indicates catch-up potential in the value segment. Indeed, the value segment has no longer underperformed in recent months, but an outperformance has not yet clearly materialised. (February 2021)

Investors eye inflation risks

The reported inflation rates currently are somewhat distorted due to uneven trends in economic activity. Inflation expectations (as derived from inflation-linked bonds) have increased in line with the improved economic outlook since November 2020 (vaccine efficacy studies), though they have remained in normal ranges.

As long as important economies operate below their productive potential, there is very limited inflationary pressure (except in selected segments where product supply is insufficient in the short term due to pent-up demand).

There, however, is fairly limited empirical knowledge about the secular drivers of inflation. As in recent years, the supply of central bank money is exceedingly abundant, though it is offset by sufficient production capacities and competitive pressures worldwide. In addition, the US experience shows that even after a prolonged period with a historically low unemployment rate (less than 4% from early 2018 to early 2020), inflationary pressures have largely been absent.

To hedge against possible inflation risks, cyclical equity segments, commodities (especially oil but also industrial metals), inflation-linked bonds and – for investors with a more medium-term view – gold are options. (January 2021)

Equity regions: Risk and return profiles

The US stock market is by far the largest, followed by emerging Asia, Europe and Japan (while Latin America and emerging European markets lag far behind).

With a view to returns and risk measures, it is striking that the US market enjoys a top rank for returns in each period and is also among the markets with the lowest risk (standard deviation, semi-deviation). Consequently, portfolios optimised for risk and returns have a very high US-weighting, with some allocation to Emerging Asia and Japan for diversification purposes. European investors, therefore, should hold a high share of equities outside their home region (primarily in the US and, to a lesser extent, Asia). In contrast, the case for international diversification for US-based investors is much less compelling. (January 2021)

World economy: Vaccines allow normalisation

Already during the lockdowns in spring 2020, early progress in the development of vaccines against Sars-CoV-2 contributed to a recovery in equity and corporate bond prices. Without knowledge of the vaccines’ efficacy profiles, the scenario driving capital market prices through the autumn was continued restrictions (e.g. in travel and entertainment) and structural change (e.g. home office). In November, several vaccine candidates achieved unexpectedly high efficacy of over 90%. This news paved the way for the scenario of an essentially Covid-19-free world in the course of 2021.

Even though a number of questions regarding vaccines remain unanswered, normalisation of economic activity beginning around the middle of 2021 is now the most likely scenario. The path towards normalisation will not be straight. Vaccinating significant parts of the world's population represents uncharted territory, although we assume that the associated logistical challenges generally are manageable. Increasingly stricter distancing rules in Europe and the US will lead to a dip in economic activity in the near term, even though this does not affect expectations of normalisation in the second half of 2021. Among the major economic areas, we expect China’s growth to be the most stable throughout the year.

In the medium term, we assume a similar global economic scenario as in recent years, characterised by somewhat subdued economic growth and low inflation. Demographic factors and labour productivity remain central to real economic growth. There is currently little evidence of sustained acceleration in labour productivity growth, although many companies tend to boost efficiency during crises (such as the 2020 pandemic). What the pandemic likely will do is accelerate structural trends, such as digitalisation, home office and e-commerce. Demographic factors will weigh somewhat more heavily on growth this decade (to the tune of 0.1 to 0.2 percentage points) than in the last decade. Macroeconomic conditions continue to support the thesis of moderate inflation. While the supply of central bank money is extremely high, sufficient global production capacity and global competitive pressure likely will continue to keep inflation in check. (December 2020)

Equity Markets: News flow the key driver

Since November, when the leading vaccine candidates showed surprisingly high efficacy, a broad-based return to business as usual has been priced into the world stock markets. Against this backdrop, anything other than normalisation of the economy in the course of 2021 would be a disappointment.

Past experience shows that stock markets rarely are weak when the news flow is unchanged or positive. The latter is in line with our baseline scenario for the year as a whole, although occasional setbacks – with regard to both vaccines and real economic development – are to be expected. We see some potential for positive surprises in corporate earnings as many companies have optimised their cost structures during the pandemic. Consequently, margins could exceed pre-pandemic levels as sales continue to recover.

Valuations are now high in some sectors and in the markets as a whole, although high valuations generally only become a problem when the news flow, especially regarding the economy, deteriorates. In contrast, there is little solid empirical evidence that low interest rates lead to higher stock market valuations, but interest rates close to zero are unprecedented in the key US market. Therefore, "Tina" ("There is no alternative” to equities) does not suffice as the sole reason for equity investments in our view, but it can be used as an argument for higher than usual weighting.

Based on our medium-term scenario – subdued growth, hardly any inflation – growth companies (i.e. companies with a convincing track record in the low-growth environment of the past few years) should tend to continue to perform better than more favourably valued but subdued or no growth companies. However, 2021 likely will be a transition year in this medium-term trend, characterised by further catch-up potential for market segments that lagged behind in 2020. In addition, with economic normalisation largely priced in, the overall potential for equity returns appears somewhat limited. (December 2020)

No structural increase in inflation expected

The reported inflation rates are currently somewhat distorted due to uneven trends in economic activity. After dropping sharply during the lockdowns in the spring, inflation expectations (as derived from inflation-linked bonds) have returned to pre-crisis levels.

Economic conditions continue to support the thesis of moderate inflation in the medium term. Although the supply of central bank money is abundant, it continues to be offset by sufficient global production capacities and competitive pressures, as in recent years. The US tax cuts in 2018 have had a slightly deflationary impact, but less deflationary pressure does not necessarily imply a structural trend towards higher inflation. While not our baseline scenario, there is some risk that pent-up demand during the pandemic will temporarily exceed supply in 2021, which would lead to higher prices. 

The structural argument against low inflation is that the forces that have kept inflation in check in recent decades – demographics and globalisation – are no longer at work. Ageing means that labour supply gets less abundant, and globalisation is in retreat. It is worth noting, however, that these trends turned almost a decade ago. When – if at all – they will have an impact on inflation is almost impossible to predict. All in all, we believe that the case for the low inflation paradigm remains intact. (December 2020)

Sars-CoV-2 vaccines: Efficacy surprisingly high

November 2020 was a crucial month in the process towards approval of vaccines against Sars-CoV-2. Pfizer and BioNTechsaid that their vaccine prevented 95% of Covid-19 cases (162 people in the placebo group contracted the disease vs. 8 in the group who got the jab). No serious side effects were reported. Pfizer also said that efficacy was more than 94% in people over age 65, a group at high risk of severe disease. Modernasaid that its vaccine was more than 94% effective and seems to prevent severe Covid-19 infections (though this statement is based on a very small sample). AstraZeneca/Oxford University reported 90% efficacy in one of the dosing regimes tested. Several vaccines thus are on track to receive regulatory approval before the end of the year.

Production capacity is ramping up at high speed. Logistical challenges remain, though we suggest not over-emphasising them. While the Pfizer/BioNTechvaccine requires storage at -70 degrees Celsius (with a refrigerator sufficient for one week at the point of use), only refrigerator temperatures are required for the shots of Astra/Zeneca and Moderna(up to one month). Experts expect that a vaccine can be deployed to the part of the US population wishing to be inoculated in the first half of 2021 and in Europe a few months later.

The efficacy results were significantly better than expected (the FDA had set the bar at 50% and EU authorities lower). Efficacy, together with the portion of the population who will seek vaccination, can make a big difference. With efficacy at 90% and, say, 70% of a population inoculated (the global average of those willing to get a shot, according to an Ipsossurvey in October), 63% of a population is immune (a value often considered sufficient for herd immunity). Viewed differently, with the natural Sars-CoV-2 reproduction number R0 around 3 (i.e. every person infected passes the virus on to three people if no distancing rules apply) and 63% of the population immune, R0 would drop to close to 1 and modestly below that when accounting for the share of the population that has already contracted Covid-19. In such a scenario, modest measures (e.g. hygiene) would be sufficient for R0 to drop to an extent that allows Covid-19 to disappear from everyday life for all practical purposes (though not fully). Conversely, a vaccine with efficacy 50% that is taken by 50% of a population would reduce R0 only by 25% (i.e. from 3 to 2.25 – with levels less than 1 required for a disease to disappear). (November 2020)

Equity markets: Momentum

The stock markets have shown typical correction and recovery behaviour in recent months. The stock markets usually take direction from economic momentum, i.e. whether the economy is improving or worsening (or is less weak than before). Once the lockdowns were foreseeable in late February, stock prices corrected but then recovered once economic improvements began to materialize. Meanwhile, the implied volatilities (e.g. VIXand VDAXindices) have returned to fairly normal levels as well.

The trends in the coming months will be determined primarily by the economic momentum (and thus indirectly also by the Covid-19 case numbers) and the prospects of widely available vaccines in the first half of 2021. (September 2020)

Gold surpasses 2011 highs

Gold tends to outperform in uncertain times, even though positive returns are not assured in a crisis. The marginal buyers of gold are financial investors, with ETFs (exchange trade funds) showing very strong inflows in recent months. Indeed, the correlation between the gold price and ETF gold holdings is very high. 

Gold mining companies have, on average, depleted reserves in recent years. Given solid cash flows resulting from the currently high gold prices, we expect investment spending to pick up.

Except for gold, we remain medium-term cautious with respect to commodity investments.(August 2020)

Containing the spread of Covid-19

Global new Covid-19 cases have been on the rise in recent weeks (driven primarily by a sharp increase in Brazil). In the USA, cases have started to rise again after the easing of lockdown measures, while they have remained low in Europe.

If all social distancing measures are eased and contacts reach pre-outbreak levels, the reproduction number (R0) of the novel coronavirus will increase to pre-lockdown levels (minus the proportion of people who are immune, with most estimates suggesting a low level of herd immunity). In order to keep the reproduction number low and, even more importantly, to prevent hospitals from reaching their capacity limits, a number of measures are needed. The better high-risk groups protect themselves, the lower the pressure on hospitals. Observance of hygiene and personal distancing rules (including masks) will help to limit the rise in R0, even as personal contacts normalise. An effective contact tracing infrastructure (plus sufficient testing capacity) and quarantine discipline are other key elements of a containment strategy. Contact tracing is easier when case numbers are low (such as in Europe).

Behind the marked increase in case numbers in the USA lies an increase in R0 in the heavily affected states to only around 1.2 to 1.3, which implies a significantly slower exponential spread than in March (when R0 was between 2.5 and 3.0). (July 2020)

The low inflation conundrum

In the euro area, the consensus forecast for core inflation (which excludes the volatile energy component) has fallen from 1.7% to 1.3% since the beginning of the year. Looking back further, J.P. Morgan’s forecast revision index has been in steady decline the past seven years.

While European inflation might be explained by the weak economy, the same is clearly not an argument in the USA. The U.S. unemployment rate is near a historic low, with a number of additional indicators pointing to tight labour markets as well. It thus is striking that U.S. inflation forecasts have also been revised down over the past two years. This drop has been repeatedly cited by the Fed as causing its lowered interest rate outlook. (August 2019)

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