Déjà vu…

This is what investors may be feeling given the number of historical parallels between the current situation and the winter of 2020 health context in Europe, inflation at the end of the 1970s in the United States, or the situation in 2013 and the infamous “Taper Tantrum” for emerging assets...

Commentaire du Fonds
10 Déc 2021

This is what investors may be feeling given the number of historical parallels between the current situation and the winter of 2020 health context in Europe, inflation at the end of the 1970s in the United States, or the situation in 2013 and the infamous “Taper Tantrum” for emerging assets…

New COVID wave and the Omicron variant

First of all, from a health perspective, the current period is all-too reminiscent of the same period last year, also marked by the resurgence of yet another wave of COVID. Infections are on the rise again in certain European countries, some of which, like Austria – one of the first nations to lift lockdown in April 2020 – are now imposing new restrictions on their populations.

Initial concerns were quickly dismissed by markets, as with a 66% vaccination rate Austria was seen rightly amongst the worst performers in the European Union. The same cannot be said for the concerns regarding the new Omicron variant at the end of the month, as its various mutations could make it a more contagious virus and reduce the vaccines’ effectiveness. Bear in mind that it was the hopes raised by the Moderna and Pfizer / BioNTech vaccines in November 2020 which reassured and buoyed equity markets.

Today, as the antiviral treatments by Pfizer, Merck and Eli Lilly are soon to be approved, and with vaccination rates in developed countries over 60% – albeit with significant variations between countries – this new variant reminds us that the main risk remains new contagious and vaccine-resistant variants in emerging countries ex-China, in which vaccination coverage remains pretty low. For illustration, the vaccination rate in South Africa only stands at just 24%…

As scientists are working on sequencing the Omicron variant and assessing its impact on vaccines and treatments, the trends witnessed last year are making a comeback: safe-haven assets like Gold, CHF and JPY are in demand again, long term rates are falling and COVID-proof stocks (Streaming, eCommerce, pharmas) are outperforming again at the expense of reopening and cyclical plays…

Inflation and growth?

These health concerns at least have had the advantage of shifting focus away from the current debate of economic growth and inflation. The latter has gained significant momentum in the US in 2021, standing at 6.2% in the latest headline figure. First of all, this situation is largely explained by the sharp rebound in demand and the mismatch exacerbated by supply chain disruptions in the post-COVID environment.

Finally, four components alone explain 80% of the variation: the contributions of the most volatile components, i.e. energy and agricultural commodities, but also those relating to used cars and “shelter” aka housing. Before raising the spectre of stagflation then, it is important to remember that the inflationary risk remains profoundly linked to the rebound in economic growth. As Figure 1 shows below, we are a long way from the prevailing scenario at the end of the 1970s…

Graph 1: US GDP YoY vs US Core CPI YoY

GRAPH 1 : US GDP YOY VS US CORE CPI YOY

Source: Bloomberg, Bloomberg, Banque Eric Sturdza, quarterly observations, Q1 1960 – Q3 2021.   Red dots: Q1, Q2, and Q3 2021.

While the new inflation norm is likely to be higher in the post-COVID environment, we should nevertheless start seeing the normalisation of some of its components (energy, used cars) in H2 2022. The sharp fall in the oil price (-12% over the session on 26/11) reminds investors that this normalisation could occur more quickly than expected in the event of growth concerns.

Currency effects

Prioritising economic growth over inflation, the FED, which has just begun tapering, by the way, could be tempted to curb its efforts to normalise its monetary policy – as the BoE did. In a world in which interest rates remain largely administered by central bankers, currencies should continue to act as adjustment variables.

The US Dollar could then continue to be buoyed by a growth differential that remains substantial, and to some extent by its safe-haven status. While a strong dollar is seen as a clear positive from a US and European standpoints – limiting inflationary pressures for the 1st and boosting export demand for the 2nd – this issue is starting to become problematic for the emerging economies, which brings to mind the disappointing performance of EM assets during the infamous “Taper Tantrum”.

The comparison stops there, however, as today’s emerging bloc is very heterogeneous: China and Turkey have nothing in common. In China, the authorities’ regulatory efforts to slow and promote more balanced economic growth have brought Chinese stock markets to a standstill but have led to a further strengthening of the yuan.

For Turkey, unbridled growth (9.0% expected in 2021, better than China) has come at a high price: rampant inflation (17.5% expected) and led to the collapse of the Turkish lira (-41% YTD). It must be noted that the sacking of the Central Bank governor and further meddling by Recep Tayyip Erdoğan this month has clearly not helped (-12% for TRY/USD on 23/11 alone).

In this environment, which presents some similarities with certain past periods, yet remains very different, the message of diversification makes a lot of sense: Continue to favour equities in a constructive medium-term approach, but do not forget to keep some safe havens like Gold, Yuan and Swiss Franc in your portfolio.

Similarly, selectivity and a good mix of investment strategies also remain the order of the day in the fixed income and equity markets. Some of these aspects are further discussed in this newsletter.

 

Fixed-Income: US inflation at 6% and long-term rates at 2%

No surprises from the FOMC but the Bank of England makes a U-turn

The Fed unveiled its tapering programme, broadly in line with market expectations. Jay Powell stressed the absence of any direct link between tapering and a possible future rate hike, implying that the Fed does not intend to raise its rates in the near future, while the markets already see the Fed carrying out two Fed Fund rate hikes in 2022. The Federal Reserve will be reducing its asset purchases by $15 billion per month ($10 billion in Treasuries and $5 billion in MBS) as planned, but 100% of reinvestments of cash from maturing debt will be in Treasuries.

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The Bank of England decided to postpone a tightening of monetary policy because central bankers felt that this surge in inflation was less of a concern than the economic slowdown.

The main event of the month should have been the FOMC and the announcement of the long-awaited tapering, but the Fed’s thunder was stolen by the Bank of England, which took everyone by surprise by making a completely unexpected decision.

A rate hike by the BoE was anticipated by almost the entire market. Inflation in the UK is high, even higher than in the Eurozone and the US. The BoE’s mandate requires it to intervene when the price rises spiral out of control, and especially when the inflation rate exceeds 3%. The Bank of England decided to postpone a tightening of monetary policy because central bankers felt that this surge in inflation was less of a concern than the economic slowdown.

US inflation and COVID in Europe

6.2% inflation! Quite a flashback to the early ‘90s. It is interesting to note that inflation at 6.2% and a US 30-year rate at 1.9% give us a CPI that is 3.3 times higher than the long-term bond yield, which is exceptional. The last time the inflation rate hit 6.2% – in September 1990 – the 30-year rate stood at almost 9%.

The wave of COVID sweeping across Europe and the Omicron variant is once again the focus of attention. These risks must not be underestimated, but, as long as Wall Street does not see red, corporate bonds will still have a bright future.

In Europe, investors waiting for the Bund yield to move back into the black will need to be patient. In the medium term, we remain convinced that the US 30-year rate is strategically the best place on the curve to use as the basis for building a strategy for 2022.

Although we remain pragmatic and ready to change our tack according to the situation, we will approach the end of the year and the beginning of 2022 by being more cautious about credit risk, and by compensating for this by adopting a more dynamic approach to duration management.

 

Equities

Europe. Reason for some hopes over despair…

No day goes by without some discussion around US equity valuations and the extraordinary force with which key sectors including tech are pulling the market towards another record year. While indices such as the Nasdaq continue to outperform, breadth is deteriorating as internal divergences increase and the number of stocks making new 52week low increases – all of this against a backdrop of more persistent inflation and yield volatility.

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A structurally higher earnings growth market for years, the US has trounced Europe but has also garnered increasingly higher relative valuations.

With few alternatives to equities to offer the chance of real – i.e. above inflation – value for 2022, the search for reasonably priced segments with attractive set-ups remains high on investors’ minds. Where should one look for opportunities?

We believe that European equities could well be part of the solution. It is a well-known fact that the old continent has significantly underperformed the US for years, and with good reason. One of the most fundamental relationships in long-term investing is between returns and the underlying creation of value as usually represented by earnings per share.

A structural higher earnings growth market for years, the US has logically trounced old-world Europe for years – so far, so good. In the process, however, the US market has garnered increasingly higher relative valuations, in effect “pricing-in” this superior expected growth.

While structural issues keep us from believing in a full, long-term catch-up by Europe, we view the markets stand today at an interesting crossroads supporting our bullish mid-term views of European equities.

A setup reminiscent of 2017? It’s all about earnings growth.

As shown below the most recent significant outperformance of Europe took place in 2017, coming out of an economic slowdown led by China. With economic momentum building, the “value”-heavy European markets experienced an outsized rebound in expected earnings growth from depressed levels, catalysing a rally in share prices and outmatching the US by almost 25%.

Today, as investors grapple with US profit margin normalisation and the Fed’s tapering program reduces some of the monetary momentum, the old continent could well be in a position to once again ride an economic rebound should relative expected earnings growth return – especially as the valuation spread between the two regions has continued to increase.

The EUR-USD kicker

While still some distance away from the 2016 lows that preceded the 2017 rally, the Euro has underperformed the USD by close to 10% this year to reach the levels of 1.12 at the time of writing, further supporting the cyclical arguments in favour of a European continent where exports matter for aggregate GDP, operational leverage and profitability – all supportive for earnings growth.

Graph 2: Europe vs. US Valuation. Forward P/E STOXX 600 & S&P 500 (LHS) P/E Spread (RHS)

GRAPH 2 : EUROPE VS. US VALUATION FORWARD P/E STOXX 600 & S&P500 (LHS)P/E SPREAD (RHS)

Source: Bloomberg, Banque Eric Sturdza.

With a still accommodative ECB helped by lower inflationary pressures, supportive financial conditions are expected to continue supporting this positive context, potentially turning into an additional source of outperformance in USD terms should it follow 2017’s playbook in 2022.

Europe – a cyclical value play

For longer than we care to remember, looking to Europe for outperformance has been a losing proposition. While structural arguments remain in favour of the US in our view, Europe is emerging as an undeniable hunting ground for investors from a standpoint of valuation and currency, all the while the positive cyclical backdrop translates into earnings growth, the key vector of relative outperformance.

What could spoil the party? A resurgence of COVID in countries such as Austria, Germany and others are, in our view, a key risk should it translate into another false economic start. As ever, we thus favour quality within this value play.

As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio.

Adam TurbervilleAdam Turberville
Director
+44 1481 742380
a.turberville@ericsturdza.com

The views and statements contained herein are those of Banque Eric Sturdza SA as of 29/11/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.