Post-pandemic recovery is underway. However, concerns about Covid variants and low vaccination rates in emerging countries imply uneven recovery. In Asia they may put further pressure on supply chains and affect growth momentum. In addition, September is traditionally a sensitive month for equities and valuations, so far supported by low debt yields and corporate earnings upgrades, are high by historical standards.
In this regard, we had the pleasure to attend a webinar with Spain’s César Pérez Ruiz, Global Chief Investment Officer and Christophe Donay, Head of Macroeconomic Analysis at Pictet WM, where they gave their views on the challenges for the global economy and opportunities in financial markets.
Christophe Donay, Head of Macro Research and Chief Strategist at Pictet WM
Slower pace of earnings growth in the U.S. The US has recovered its GDP level and its pre-pandemic growth trajectory, which is remarkable compared to other recessions. Currently, fiscal-monetary support is declining, although consumption may remain resilient. The fact is that the pace of earnings growth has been slower since the second half of this year. On the other hand, we have to look at the obstacles in Congress to Biden’s $3.5 trillion “human infrastructure” plan. To this is adds tax increases risk for 2022.
Meanwhile, it is necessary to monitor whether the increase in prices of food, energy and semiconductors is transferred to the labour market. In the US the latest employment figure has been very bad, with low productivity, but increased labour costs. For first time in many years the market is realizing the problem is of supply, not demand. There is a lack of people to fill jobs, which can be inflationary. At the moment the US maintains the same GDP with six million fewer people working, so unit labour cost has fallen. But it can increase. Although we have cut forecast for US GDP growth to 6.1% in 2021, we have increased it for 2022 to 3.9%.
Euro Area in recovery
However, in the Eurozone the high vaccination rate facilitate its recovery and it is foreseeable that it will reach its previous GDP level by the end of the year. In the region we have revised upwards its growth forecast this year to 5% and we keep the forecast for 2022 unchanged at 4.5%.
In addition, the “Green Marshall Plan” implies ambitious greenhouse gas reduction targets, at least 55% by 2030 relative to 1990 levels and neutrality by 2025. So far only 10% has been deployed, so it is likely to have limited impact this year. But it has a long-term path. It involves a border tax on carbon, extension of EU’s emissions trading system and stricter emissions standards for new cars. Of course, in the short term we must bear in mind that the recovery occurs in the middle of next elections in Germany and France, locomotives of the Eurozone and there is uncertainty in both cases. The possible CDU/Green coalition is no longer a certainty and the results may affect economic policy for 2021 and 2022.
China can accelerate social financing
China has maintained a “stop and go” policy for years, which is expected to be maintained in coming months, even years. In doing so, its authorities can accelerate monetary and fiscal stimulus when they deem it necessary. Its currently zero-total social funding can be accelerated as needed. It should be borne in mind that the first priority of its authorities is social stability and that China currently shows a very high Gini coefficient – a measure of inequality-. Having eliminated poverty, their focus is shifting towards “common prosperity”. At the moment we expect its economy to grow 7% in 2021 and 5.2% in 2022, although we can lower these forecasts. In any case, China is likely to increase fiscal support sooner than credit.
In Japan, the industrial recovery is also slowing and catalysts are limited.
The nature of fiscal policy is changing
The fact is that the nature of fiscal policy is globally changing, aimed at taking into account negative externalities of the economy, as climate change. So governments will have to inject stimulus to achieve these goals. Another key long-term issue is how to finance fiscal deficits, either through central banks, even applying Modern Monetary Theory, in what would be the new style of monetary policy or through tax increases, to the rich and the business sector, for example.
Inflationary pressure may remain in the US and China
Currently inflation, including core (excluding energy and not processed food) is high in the US. But we must distinguish drivers of temporary from structural inflation. Temporarily, the level of inventories of companies is low because bottlenecks in supply chains globally remain. At the same time, demand is increasing. So average inflation this year may be 2.9% in the US and remain above its historical range in 2022 (slightly less than 2%). To this is adds the increase in prices of raw materials and shiping, which have multiplied between 2 and 5 times relative to the pre-pandemic level. Overall, inflationary pressure can remain in the US and China, being more mitigated in the Eurozone.
The fact is that delivery times are at maximums and inventories at minimums. The lack of semiconductors affects vehicle production, which in the 2nd quarter was 2.3 million less than normal and may last longer than expected, affecting stock indices, where the manufacturing sector is much more represented than services. However, low inventories will prolong the economic cycle.
Cesar Perez Ruiz, Head of Investments and CIO, Pictet WM
It’s hard to know what the risk premium is in China equities In China, “common prosperity” does not necessarily mean equality, but that it is time for the private sector to return profits. Hence the price control in the housing and education sector. It also wants to stop the monopolies and avoid markets characterized by “greed and fear.” That is why it tries to regulate private capital markets. It also wantd to be self-sufficient and quality growth, including ending the “9 to 9 six days a week” work system.
The fact is that, as Investors, all this makes it very difficult to know which sectors can be subject to regulation and the appropriate risk premium. To this adds a certain slowdown in its economic growth.
We prefer developed markets
The Delta variant has accelerated vaccination and herd immunity. It is very contagious, but its impact is lower. In this regard, developed markets are much more advanced. They have learned to live with the virus and close of heir economies requires saturation in hospitals. Moreover, in Europe and other Western countries the government is not blamed. However, in China the population abides by the rules, but expects the government to take over. So it is very difficult for China to get out of the zero tolerance for the virus. I there are new virus waves, emerging markets are likely to suffer more. So we are more conservative in emerging markets and prefer developed markets.
Chinese sovereign debt
At the Jackson Hall meeting this summer, Powell rightly delinked reducing asset purchases from rising interest rates, being very popular with the market. Currently, the current low real yield on government Treasuries is a result of a lower economic growth and technical factors. There has been little issuance, while the Federal Reserve has continued to buy $120 billion a month. Hence the imbalance between supply and demand. But negotiations to raise the debt ceiling are approaching and the situation may change. On the other hand, the cost of hedging inflation is very low, although it can be turned around and favor cyclical sectors.
However, we like Chinese sovereign debt. In fact, in China we are exposed to its currency and sovereign bonds, which are among the few uncorrelated assets.
The Chinese government has to take care of Evergrande
On the other hand, we must see how the situation of Evergrande evolves. We do not consider it to be something systemic, but the Chinese government has to deal with it, because it can affect other markets. It will be difficult that its entire debt be recovered and we must see who buys its assets. In addition, it must be taken into account that 50% of high-yield debt in China will go to the market between now and the end of the year to obtain financing and if such a cost increases it can affect growth more than expected.
In credit we see some opportunities, in “rising stars”, that is, debt of many companies that quickly lost their investment grade credit rating, which they can recover. In fact, the wave of downgrades is turning into a wave of improvements.
We also see attractiveness in the coupon in high-quality companies with high yield differential at maturity relative to government debt, covering duration. In addition, we prefer to go down in the capital structure of the balance sheet of companies and be selective to find opportunities in credit. We see opportunities in financial subordinated debt and corporate hybrid and we prefer Cocos (contingent convertible bonds) than CCC credit rating credit.
In addition, more than green bonds, we are interested in the debt of good companies, capable of generating impact and in which we can generate change through dialogue. This approach interests us more than that of exclusion.
Now, in emerging market debt we have to be very selective.
“Who pays the bill?”
The investment theme “Who pays the bill?” is still valid, as global debt is 20 to 30% higher after the pandemic. It is the case of the increase in energy prices in France and Spain. In France they have decided to provide money to consumers and in Spain to reduce profits of utilities.
Green Marshall Plan
In addition, we remain committed to the “Green Marshall Plan” theme. Governments, which account for 70% of global CO2 emissions, have committed to net-zero emissions targets and large expenditures to revitalize fragile economies undermined by the pandemic, much of which will go to infrastructures.
We want growth, with cash flow generation
This year the increase in profits has been fantastic. The fact is that the market has changed since the middle of the year, when the Federal Reserve indicated it could raise interest rates more than expected, which changed the dynamics of “value” investments, associated with the recovery of the economic cycle. Now, in addition, we want growth companies, but with cash flow generation, that can be less affected by the increase in bond yields. Another theme, as shareholder payment restrictions are lifted, are companies with sustainable and growing dividends, especially in Europe.
Companies with price enforcement power
The persistent bottlenecks in the supply chains make interest the topic “strong balance sheet companies with price-imposing power” in developed markets, as a protection against inflation, relevant in all sectors, not necessarily in the luxury sector, where valuations have risen a lot and are trading at multiple highs, that may be affected by its exposure to China’s growth.
Mergers and acquisitions
In addition, we are witnessing a boom in mergers and acquisitions, which we expect to increase and be more defensive in nature. This is the case of the banking sector in Italy or airlines in England. So we bet on alternative event-oriented managers, as risk diversifier, as they can offer an avenue to take advantage of the inevitable price inefficiencies in such operations.
In this inflationary environment we like real assets, such as REITS (listed real estate companies) for the liquid part of the portfolio. They are behaving well and have not recovered as much as other asset classes. Gold, on the other hand, should be trading higher considering the low real yield on ten-year U.S. Treasury debt.