Investment News August
- With over 714,000 deaths worldwide and over 19 million people infected in the beginning of August, the Covid-19 virus still is a worldwide health problem.
- As virtually all countries in the world, due to Covid-19, went into a lockdown in which large parts of the economy were shut down, the economic consequences are also significant.
- The three-month lockdown is expected to have caused a global economic contraction of -10% in 2020H1.
- Thanks to the (gradual) lifting of the lockdown in June and the enormous monetary and fiscal support measures, a V-shape economic recovery is already unfolding that might last well into 2021.
- Financial markets are already anticipating on this. Nevertheless, the MSCI World Index is still below the level at the end of 2019(-6,3% in Euro).
- Stock markets are not cheap based on 2020 earnings but may benefit from a strong earnings recovery in 2021 and 2022.
- Government bonds in Europe and America offer an extremely low interest rate and are expensive compared to equities.
- Corporate bonds offer an attractive interest rate and benefit from the economic recovery and purchases by Central Banks.
- (Government) Bonds from developing countries are relatively expensive and risky and do not benefit from purchases by central banks.
- Commodities usually benefit from an economic recovery but are however a very heterogeneous group. Oil benefits from an economic recovery, Gold benefits from an economic and/or financial crisis.
- The Euro benefits under the current conditions. The US dollar might benefit again as a Safe Haven in case Covid-19 and harsh (regional) lockdowns return in 2020H2.
Although in almost all countries of the world the lockdowns were reversed in whole or in part during the months of June and July and the “normal” life started to return, it cannot be said that the Covid-19 virus has been conquered. For example, in July, the number of people infected with the virus rose from eleven to eighteen million, and the number of people who died of the virus rose by 200,000 to 700,000. In North America, Brazil, Mexico and Iran in particular, the virus still causes many victims every day.
In addition, the number of infections has recently started to increase again in countries where the virus appeared to be “conquered”. The so-called and feared second wave seems to have started, especially in countries such as Belgium and Spain. Although this second wave mainly concerns young people who are less vulnerable to the consequences of the virus and the number of hospital admissions and deaths therefore remains relatively low, it does show where the greatest risks for the now-started V-shape economic recovery lie.
Until recently, the question was whether there would be a so-called V-shape, a U-shape or a W-shape recovery? A V-shape recovery occurs when the extreme economic contraction in the first half of 2020 will be followed by a relatively strong economic recovery in the second half of 2020 and in 2021. There is a U-shape recovery if the real economic recovery will only take place in the course of 2021. A W-shape recovery occurs when the initial recovery in the second half of 2020 will be followed by a new revival of the Covid-19 virus followed by new stringent lockdown measures at the end of 2020, early 2021.
Looking at recently released economic figures, a U-shape recovery now seems the least likely scenario. Everything currently indicates that a V-shape recovery has started, while a relapse to a W-shape recovery later this year, due to a new revival of the Covid-19 virus followed by new stringent lockdown measures, cannot be ruled out. In China, where the lockdown measures were already reversed in March, there is already a V-shape recovery. After the economic contraction of -6.8% in the first quarter of 2020, growth of +3.2% followed in the second quarter. In addition, Leading Indicators indicate that the recovery in China will continue in the third quarter.
Also, in the UK, where monthly figures are published, the economy grew by +1.79% from April in May and an economic recovery appears to have started.
In addition, Leading Indicators for the United States and the Eurozone also indicate that an economic recovery started in July.
Looking at the Purchasing Managers Index, countries such as France, the United Kingdom, China and Germany in particular seem to be at the forefront of the economic recovery.
The economic recovery in the United States seems to be lagging behind the recovery in China and Europe for the time being. However, according to the FED recession model, the probability of a new recession in 2021, and with that the probability of a W-shape scenario, is decreasing sharply.
This is partly because American households saw their income rise significantly, despite the Covid-19 crisis and the (temporary) unemployment, due in particular to the amounts of aid that the US government paid to households.
However, the graph above also clearly shows how substantial and how important the US government’s support measures are. It is therefore crucial whether the US Congress decides soon to extend the support measures or not. Until now the economic recovery has been triggered by consumers almost everywhere in the world. For example, retail sales have increased in almost all countries recently and have increased significantly in countries such as Germany (May +13.9%), US (May +17.7%), Canada (May +18.7%), Australia ( May +16.9%), Norway (June +13.7%), Japan (June +13.1%) and the Netherlands (June +9.8%) compared to a month earlier. Mainly supermarkets, do-it-yourself shops, web shops and parcel deliverers did benefit from these increased consumer purchases.
It looks like the main cause of the economic contraction in March and April has come to an end. In June, retail sales in North America were even slightly above the level of a year earlier.
Consumption is the most important component in the economy (Eurozone 60% and US 70%). In the second quarter, consumers were unable and unwilling to spend their money due to the Covid-19 virus and the associated lockdown. Savings balances therefore increased considerably among households.
As a result, the economic contraction in the second quarter compared to the first quarter of 2020 was significant in both US (-8.2%) and the Eurozone (-12.1%). In particular, countries where a stringent lockdown was implemented, such as Italy (-12.4%), Spain (-18.5%) and France (-13.8%), the economic contraction was unprecedented.
A major cause of the massive economic contraction in the second quarter of 2020 therefore seems to lie mainly in the fact that many households did not want or could not spend their money due to the Covid-19 virus and the lockdown, and not because they completely ran out of money.
Now that these negative factors are gradually disappearing, there is sufficient money available from households to enable a (relatively) strong economic recovery. Moreover, such a relatively strong economic recovery is made possible by the enormous amount of money that Central Banks and Governments have made available in the meantime to absorb the blows of the Covid-19 virus and the lockdown. In total, Central Banks and Governments have made more than USD 25,000 billion available together. An amount equal to almost 30% of the world economy and, moreover, many times greater than the economic contraction of approximately -10% worldwide in the first half of 2020.
A V-shape recovery of the world economy, as already developed in the second quarter in China (2020Q2 +3.2%), still seems possible and likely. However, the V in the graph below will in practice look like an economic contraction of -10% in the first half of 2020, followed by a (relatively strong) economic recovery, which will only bring the economy in the cause of 2022 back to the level before the Covid-19 crisis. So, it will take about two years to make up for the loss in the first half of 2020. However, it is crucial for this V-shape recovery to happen that the second wave of Covid-19 infections, which now appears to be developing, does not lead to new stringent lockdown measures. In that case, a W-shape scenario becomes inevitable.
In the first seven months of 2020, the financial markets performed as usual in the event of an economic recession and major uncertainty. Safe Haven assets such as gold (+23.6%) and government bonds in US (+10.2%), Italy (+4.0%), Germany (+3.7%) and Spain (+2.5%) together with Investment Grade Corporate Bonds (+1.5%) were the asset classes that generated positive returns, while High Yield bonds (-4.7%), Equities (MSCI developed Equities -6.3%) and Commodities (-25.3%) realized a negative return. However, oil showed the worst return (-37.7%).
Despite the strong recovery of the stock markets since March 23, 2020, the MSCI World Index (-6.3% in euros) at the end of June is still below its level at the end of 2019. For the German Dax (-7% in Euro) and the Dutch AEX (-10% in Euro) in particular this is the case. However, there are also equity markets such as the US S&P 500 (+1% in USD) and Nasdaq (+20% in USD) that are now higher than at the end of 2019. The main reason for the better performance of these US indices is the USD and the differences in the composition of the indices. Due to the depreciation of the USD (-5.1%) against the Euro so far in 2020, the return of the S&P 500 and the Nasdaq in USD is approximately 5% higher than in Euro. In addition, the composition of the indices is different. For example, where the energy and financial sector has a high weight in the AEX, in the S&P 500 and in particular the Nasdaq, the IT sector has a high weight. Partly due to Covid-19, the difference in sector performance in 2020 is significant. There are big winners, such as IT (+14.4%), consumer goods (+2.2%) and Healthcare sector (+ 0.2%) and big losers, such as Industrials (-14.9%), financials (-25.2%), and energy (-41.2%).
In addition, it can be concluded that, as a result of its good performance, the US stock market has become relatively expensive compared to indices in other countries.
Given the above, government bonds are expensive compared to equities. For example, the average dividend yield on equities in America (+1.2%) and Germany (+3.2%) is significantly higher than the yield on US and German 10-year government bonds.
It cannot be ruled out that interest rates and inflation will rise in the coming years as a result of the economic recovery and the current monetary and fiscal stimulation policies, which will lead to a decline in value if this interest rate rise occurs. German and US government bonds therefore can only have a function as a “safe haven” in a portfolio in the event of a crisis such as in 2001 (Dot Com crisis), 2008 (Lehman crisis) and 2020 (Covid-19 crisis.
Investment Grade Corporate Bonds
In contrast to US and German government bonds, Investment Grade Corporate bonds, in both the US and Europe, still offer a positive and attractive return. Although the risk premium has decreased significantly recently, it is still higher than before the Covid-19 crisis.
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Financial markets are particularly concerned that, as a result of the lockdown, many companies will go bankrupt during 2020. While we certainly recognize that, more than usual, companies will go bankrupt, we think the financial markets are too negative. First, we anticipate a relatively strong V-shape economic recovery in the next 24 months. Second, Central Banks such as the FED and the ECB have made huge sums available to prevent such bankruptcies as much as possible. The number of bankruptcies, as a result of Covid-19 and the lockdown, is therefore considerably reduced.
High Yield Corporate Bonds
High Yield bonds are bonds issued by companies with a relatively high risk of bankruptcy (credit risk). As the risk is higher, the risk premium (reward) is also higher. As with Investment Grade Bonds, the interest rate on High Yield Bonds has risen this year in both the US and the Eurozone.
Although the interest rate is certainly attractive at the moment and as these bonds are currently also part of the buy-back programs of the Central Banks, given the relatively high bankruptcy risk, we see this category of bonds mainly as a category where investments are made on an incidental basis.
Emerging Market Debt
While bonds from developing countries (emerging markets) typically offer a high interest rate, they are generally also relatively risky. In addition, interest rates relative to US Treasuries are currently relatively low.
The currency risk of these countries is relatively high. For example, losses on many of the currencies of developing countries against the US dollar and the Euro in the first seven months of this year were substantial. On top of this, these bonds are not a part of the buy-back programs of the Central Banks like the ECB and FED. All in all, Emerging Market Debt currently seems to be too expensive and too risky and therefore not attractive enough to be included in an investment portfolio. As soon as interest rates and prospects for developing countries improve, more opportunistic investments can be made in this category.
Commodity prices of, for example, Oil, Metals, Food have been under pressure for years as a result of overproduction, decreasing demand or an economic recession such as in 2001, 2008 and 2020.
However, there are major differences within commodity investments. For example, energy prices have fallen – and precious metal prices have risen sharply.
In particular, the difference between the price of oil and gold is enormous. This difference in price development also indicates exactly what is driving raw materials prices. The supply of oil has risen sharply in recent years, while the supply of gold has remained relatively stable. In addition, demand for oil fell sharply as a result of the economic recession, while demand for gold rose sharply as a result of increased uncertainty. The demand for gold increased also since governments and central banks made and make so much additional money available to fight the Covid-19 recession. Many investors fear that, just as in Germany in the 1930s, this will lead to a strong depreciation of money as a result of increasing inflation. While high inflation is certainly a long-term risk, it seems unlikely in the short to medium term.
All in all, the commodity market is a very diverse, complex and often even opaque market with high risks.
Noteworthy is the strength of the Euro. Whereas in previous crises the USD almost always acted as a “safe haven”, so far in the Covid-19 crisis this appears to be the Euro.
The Euro has been a relatively stable currency for years, mainly thanks to highly competitive countries such as Germany and the Netherlands and their large and structural surplus on the Current Account Balance. However, the appreciation of the Euro against the USD and virtually all other currencies in 2020 is exceptional. There are several reasons for this.
- The Euro is a “counter cyclical currency”. This means that the USD is usually strong in a crisis and / or recession, while the Euro is strong in an economic recovery, as is the case now.
- Particularly in the US, concerns about the so-called “twin deficit”, the current account deficit and the government deficit, are increasing rapidly.
- Inflation-adjusted interest rates in the US are falling much faster than in the rest of the world, making US government bonds in particular less attractive to (foreign) investors.
- As a result of the decline in interest rates in the US, the cost of hedging the USD has decreased significantly.
- The positive effect of the 2018 US tax measures is slowly coming to an end. Far fewer companies will still use repatriation and conversion of foreign assets and profits to USD in 2020.
- This time, the Eurozone economy is expected to recover from the Covid-19 recession faster than the US. This is mainly because the first wave of Covid-19 infections in the Eurozone has now largely been conquered, which is not yet the case in the US.
- This time, the ECB and the governments of the Eurozone responded in a timely and joint manner and stimulated the economy. This is in sharp contrast to, for example, after the Lehman crisis in 2008, when the Eurozone decided to unite only after the Euro crisis of 2012/13.
- The trade war between the US and China seems to be getting worse.
- The upcoming US elections in November 2020 causes a lot of uncertainty.
Despite this, the US economy remains one of the most innovative and dynamic economies in the world. In addition, a second wave of Covid-19 infections appears to have started in the Eurozone. Until now mainly among young people and with relatively few hospital admissions and deaths. However, it cannot be ruled out that new (regional) lockdown measures will soon be necessary again. It is therefore advisable to have a good spread in an investment portfolio not only across various assets, but also across various currencies such as the Euro, USD and JPY.
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