Investment News July
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- With more than 500,000 deaths worldwide and nearly 11 million people infected, the Covid-19 virus still is a worldwide health problem.
- Because virtually all countries in the world, due to Covid-19, went into a lockdown in which large parts of the economy were locked, the economic consequences are also significant.
- A three-month lockdown is expected to cause a global economic contraction of -9%.
- Thanks to the (gradual) lifting of the lockdown in various countries in June and the enormous monetary and fiscal support measures, a V-shape economic recovery will be possible in the second half of 2020 and in 2021.
- Financial markets are already anticipating on this. Nevertheless, the MSCI World Index (-5.8%) and the S&P 500 (-4.0%) are still below the level of the end of 2019.
- 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 the US 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 (quantitative easing) 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 a very heterogeneous group. Oil benefits from an economic recovery, Gold benefits from an (economic) crisis.
- The Euro, US Dollar and Japanese Yen are fundamentally stronger currencies and are therefore a strategic part of an investment portfolio. In times of crisis, the US dollar always is a default Safe Haven.
At the end of June 2020, more than 6 months after the Covid-19 virus first appeared in the Chinese city of Wuhan, nearly 11 million people have been infected with the virus and more than 500,000 people have died from the virus worldwide. Because almost all countries went completely or partially into a lockdown because of the Covid-19 virus, the economic consequences of the virus are also significant. As a rule of thumb, we can take that if an average of 35% of the economy is in lockdown, it will result in about -3% (35% divided by 12 months) economic contraction per month. Consequently, if we assume that the lockdown will last three months on average globally, as was the case in China and seems to be the case in Europe, then the contraction due to Covid-19 in the first half of 2020 will be about – 9%.
Since the first half of the year can therefore be considered as lost, it is crucial what will happen in the remaining 6 months of 2020. Will there be a so-called V-shape, a U-shape or a W-shape recovery? A V-shape recovery is 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. A U-shape recovery is when 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 lockdown measures at the end of 2020, early 2021.
In our opinion, a V-shape recovery remains the most likely scenario and is therefore our Central Scenario. This is mainly because the number of Covid-19 infections has been declining drastically for some time and the lockdowns around the world are gradually but steadily decreasing. The graph below shows the course of the infections per country up to and including 30 June 2020.
In many countries, the peak in infections was reached at the end of April, beginning of May, and we have seen a rapid decline since then.
Of concern, however, is the recent rapid increase in the number of Covid-19 infections in the US. Unlike almost all other countries in the world, the Covid-19 virus in the US is still not under control after three months. Although President Trump says this is because more testing is being done than before, it is mainly due to the fact that the Covid-19 virus is moving in the US from the Northern states, such as New York, to the Southern states such as California, Texas, Georgia and Florida. It is therefore to be expected that the reduction of lockdowns in Europe and Asia will go faster than previously assumed, while in the US this will happen more gradually, and will differ per state. Normal life is therefore expected to resume faster in the Northern States of the US compared to the Southern States.
Despite the fact that the Covid-19 virus has still not been conquered, there now seems to be an (imminent) economic recovery worldwide. Two indicators that clearly indicate the economic recovery for Europe and China, are the European ZEW index and the Chinese Purchasing Managers Index. Both indices, in the graphs below, predict a V-shape recovery for both the European and Chinese economies. Which also seems logical after the lifting of the lockdown and the enormous support measures of Governments and Central Banks.
The US economy also seems to be recovering quickly. An important indicator of this is the surprisingly strong growth in employment in both May and June, with over 3.2 million and 4.7 million new jobs respectively. In addition, despite the Covid-19 crisis and rising (temporary) unemployment, US households saw their disposable incomes rise significantly, thanks to the Covid-19 transfer payments of the US government to households.
As a result, retail sales in the US increased significantly in the month of May (+ 17.7% month on month), while at the same time, US households increased their savings substantially.
An important cause of the economic contraction in March and April of 2020 therefore seems to be the lack of spending as a result of the Covid-19 virus and the lockdown, and not the lack of money. Now that these negative factors are gradually disappearing, there is therefore enough 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 to absorb the negative impact of the Covid-19 virus and the lockdown. In total, Central Banks and Governments together have made slightly more than USD24,000 billion available. An amount equal to 28.1% of the world economy and, moreover, many times greater than the expected economic contraction of -9% worldwide in the first half of 2020.
A V-shape recovery of the world economy therefore still seems possible and perhaps even more likely today. However, the V in the graph below will in practice look like an economic contraction of -9% in the months of March/April/May, followed by a (relatively strong) economic recovery that will only bring the economy back in the course of 2022 at the level before the Covid-19 crisis. Hence, it will take about two years to make up for the loss in the first half of 2020.
In the first half of 2020, the financial markets showed performance as is usual in the event of an economic recession and great uncertainty. Safe Haven assets such as gold and government bonds in the United States and Europe were the asset classes that generated a positive return, while equity markets, High Yield bonds and Commodities delivered a negative return.
Currencies also generally showed performance as is usual in periods of great uncertainty.
The US Dollar, the Euro and the Japanese Yen hardly changed in value against each other but appreciated significantly against the British Pound and the currencies of developing countries.
Despite the strong recovery of the stock markets since March 23, 2020, the MSCI World Index (-5.8% in euros) and the US S&P 500 Index (-4.0% in USD) are still below their 2019 year-end levels at the end of June. While there are stock markets that have performed better and worse than the S&P 500, this is often the index investors look at. Not only is the US, with over 25%, still the largest economy in the world, with 57.7%, the US is also by far the largest part of the MSCI All Country World Index. Number two Japan follows at a long distance with 7.28%. The developments in the US are therefore always of great influence on the movements on the stock markets.
If we look at the equity markets in more detail, we see that they have become more expensive since the start of the Covid-19 crisis. Despite the price falls this year, the price/earnings ratio has risen.
In addition, 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 policy, which will lead to an additional loss in bond portfolios if a rise in interest rate occurs.
German and US government bonds therefore only have a function as a “safe haven” in an investment portfolio. In the event of a crisis such as in 2001 (Dot Com crisis), 2008 (Lehman crisis) and 2020 (Covid-19 crisis), these government bonds are a safe investment. It may therefore be better to invest in government bonds of countries such as Norway, Australia and Canada. Countries that not only offer a slightly higher interest rate on their government bonds, but also countries that, as exporters of raw materials, often see their currencies appreciate against the Euro in an economic recovery and an increasing demand for oil, metals, etc. On balance, government bonds should only play a defensive role in todays’ investment portfolios.
Investment Grade Corporate Bonds
Unlike US and German government bonds, Investment Grade Corporate bonds still offer a positive and attractive return. Although the risk spread has decreased significantly recently, it is still higher than before the Covid-19 crisis.
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 foresee a relatively strong economic recovery over the next 24 months. In addition, Central Banks such as the ECB have made huge amounts available to prevent such bankruptcies as much as possible. The ECB itself buys large amounts of corporate bonds and lends money to banks at an interest rate of -1.0%, provided that the banks in turn lend this money to governments, companies and / or households. The number of corporate bankruptcies in 2020 might therefore be considerably less than currently still discounted for by the bond markets.
High Yield Bonds
High Yield bonds are bonds issued by companies with a relatively high credit risk (i.e. a high risk for bankruptcy). As the risk is higher, the interest to be paid is also higher. As with Investment Grade Bonds, the interest on High Yield Bonds has increased on average this year.
Although the interest rate is certainly attractive at the moment together with these bonds now being part of the buy-back programs of the Central Banks, we see this category of bonds mainly as incidental investments other then structural investments for long term defensive portfolios.
Emerging Market Bonds
While Emerging Markets bonds typically offer a high interest rate, they are generally also very risky. In addition, interest rates relative to US Treasuries are currently relatively low.
In addition, these bonds do not benefit from the buy-back programs of Central Banks such as the FED and the ECB and the currency risk of these countries is relatively high. As the table at the beginning of this chapter showed, the losses on many of the currencies of developing countries against the US dollar and the Euro in the first half of this year are substantial. All in all, Emerging Market bonds currently seem too expensive and too risky and therefore not attractive enough to be structurally included in an investment portfolio. 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 and 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, the oil price has fallen sharply while the gold price has risen considerably.
This huge difference in price development also indicates exactly what is driving commodities. 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. All in all, the commodity market is a very diverse, complex and often even opaque market with high risks.
At the beginning of this chapter, the exchange rate table already showed that in the first half of 2020 the Euro together with the Japanese Yen (+0.7%) and the US Dollar (-0.1%) were among the strongest currencies. The Euro has been a relatively stable currency for many years, mainly thanks to very competitive countries such as Germany and the Netherlands and a large and structural surplus on the Current Account Balance of Payments. The US economy is one of the most innovative and dynamic economies in the world. In addition, in the event of uncertainty, such as the “Dot Com” crisis in 2001, the Lehman crisis in 2008 and the Covid-19 crisis in 2020, the US dollar will also benefit from its “safe haven” status. Finally, the Japanese Yen, like the Euro, is a relatively strong currency due to a structurally large surplus on the Japanese Current Account Balance of Payments. For the above reasons, the Euro, US Dollar and Japanese Yen are suitable to be a strategic part of an internationally diversified portfolio. In addition, a more tactical investments can be made in currencies of countries such as Norway, Australia and Canada that will benefit from the economic recovery and a rise in commodity prices.
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