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3rd quarter 2020

N°

Perspectives Financial markets analysis Macroeconomic environment 3

Financial markets 9

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In 2020, the global economy will see its deepest recession in the post-war period.

The explosion in public debt rules out any monetary tightening, however small.

Central banks are destroying the foundations of the market economy, thereby jeopardising the advances in prosperity achieved in recent decades.

The scale of the equity market rebound is astonishing given the economic damage.

Companies able to deliver sustained growth are the main beneficiaries of a low interest rate environment.

The decline in real interest rates will continue to support the gold price.

A BLI - Banque de Luxembourg Investments S.A. publication


MACROECONOMIC ENVIRONMENT

N ° 1 6 4 — 3 rd q u a r t e r 2 0 2 0

Macroeconomic environment

G L O B A L R E A L G D P G RO W T H

Due to the lockdown measures that were implemented to contain the COVID-19 pandemic, the global economy will post its largest post-war decline in activity in 2020. According to the latest IMF projections at the end of June, global GDP is expected to contract by 4.9% this year, with the decline in activity affecting both advanced countries (estimated at -8%) and emerging market countries (estimated at -3%). Forecasts about the future are riddled with uncertainty even in normal times, but visibility is particularly poor in the current circumstances. A second wave of coronavirus after the partial easing of lockdown, the potential return of more severe social distancing measures, the impact of temperature on the spread of the virus, longer amounts of time spent indoors as autumn approaches, and the lead time to develop an effective, safe and widely available vaccine are all factors of uncertainty but also vital elements for the future path of the global economy.

8

6

4

%

2

0

-2

-4

-6 1980

1985

1990

Annual change

1995

2000

2005

2010

2015

2020E

Average

Source: IMF

U S R E TA I L S A L E S

The partial easing of lockdown and government support programmes have produced a faster-than-expected improvement in economic activity. While most analysts (including us) believed at the start of the pandemic that a V-shaped recovery was unlikely, most economic indicators in May and June showed a stronger rebound than had been anticipated. Admittedly, some statistics are difficult to interpret, such as the purchasing managers' activity indices that measure the prevailing direction of economic trends, with the threshold of 50 separating expansion from contraction month-on-month. According to this indicator, economic activity in the United States appears to have been weaker in June than April, with the composite index for manufacturing and services coming in below 50 throughout the second quarter (27 in April, 37 in May, 47.9 in June). However, that interpretation would contradict the message conveyed by retail sales, which rose sharply in May compared to the previous month’s depressed level. The fact is that economic activity seems to have picked up considerably from the April nadir, although it remains very subdued compared to the pre-health-crisis period.

550

500

billion USD

450

400

350

300

250 2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Source: U.S. Census Bureau, fred.stlouisfed.org

3


Perspectives

4

US STUDENT AND CAR LOANS 1800

1600

billion USD

1400

1200

1000

800

600

400 2006

2007

2008

2009

Student loans

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

Financial markets analysis

Before the COVID-19 pandemic, excessive debt levels were already an almost universal problem. In the United States, the mortgage level is the only area of debt that is not particularly worrying since the housing market has not repeated the same follies as those that led to the subprime crisis in 2007/2008. In sectors other than real estate, recourse to debt has increased considerably over the last decade, as shown by the escalation of car loans and, above all, student loans. Student loans have rocketed to such an extent that Bernie Sanders, Joe Biden's main competitor in the Democratic presidential primary, had even proposed writing them off. In the corporate sector, debt ratios are extremely worrying, as the financing techniques invented during the real estate bubble have been partially replicated in corporate funding by the private equity sector in recent years. Finally, public debt is off the scale, with the Trump administration’s budget deficit expected to reach nearly 18% of GDP in 2020 following the numerous support measures adopted under the CARES (Coronavirus Aid, Relief and Economic Security) Act at the end of March.

Car loans

Source: Board of Governors of the Federal Reserve System (US), fred.stlouisfed.org

N E W C O V I D -19 I N F E C T I O N S 10000

60000

50000

New cases (7-day moving average)

8000

40000 6000 30000 4000 20000 2000

0 02/01

10000

0 02/16

03/02

Italy (LHS)

03/17

04/01

04/16

Germany (LHS)

Spain (LHS)

05/01

05/16

05/31

06/15

06/30

France (LHS)

United States (RHS)

In the short term, visibility regarding the sustainability of the last two months’ recovery is very limited. Improvements in the economic situation will depend among other things on health conditions, which differ considerably from country to country. Of the developed countries, the situation appears most alarming in the United States, where a second wave of infections is firmly underway. President Trump's trivialisation of preventive measures, the American people's greater sensitivity to measures restricting freedom, and the involuntary risk-taking by a precarious and disadvantaged population unable to afford to comply with social distancing measures make the world's leading economic power particularly vulnerable to a second wave, jeopardising the recent recovery. In this context, the expiry of the increased unemployment benefits at the end of July and the disagreement between Republicans and Democrats on the extension of this measure are not very reassuring. In emerging markets, the Brazilian President Bolsonaro's ideological blinkers are particularly staggering given the country's incapacity to care for the high proportion of the population living in hyper-precarious economic and sanitary conditions. In Europe, Japan and China, the health situation currently seems to be under control, although the number of new infections is expected to rise again after the summer.

Source: Oxford Economics, Haver Analytics

E U RO Z O N E R E TA I L S A L E S 120

Volume of goods sold (2015 = 100)

110

100

90

80

70

60 2015

2016 Germany

2017 Netherlands

2018 France

Italy

2019

2020

Spain

Source: Eurostat

Within the eurozone, the impact of the pandemic once again highlights the significant divergence between North and South. For example, the evolution of retail sales shows a much more pronounced improvement in Germany and the Netherlands than in France, Italy and Spain. The Southern countries are not only suffering from their high exposure to a depressed tourism industry, but also from their limited capacity to increase public spending because they already have excessive debt levels. These differences mean that discussions on how the recovery fund proposed by the European Commission could work are proving difficult, despite Germany's support. Given the exceptional nature of the crisis, Germany is prepared to accept the Commission's proposal that €500 billion of the total €750 billion would be given as grants, while €250 billion would be available as loans. So far, this proposal has met with opposition from the so-called frugal four, the Netherlands, Austria, Denmark and Sweden, demanding that conditions be attached to the distribution of the funds. With Germany taking over the Presidency of the Council of the European Union on 1 July, its support for the plan should make it easier to reach a compromise in the near future.


MACROECONOMIC ENVIRONMENT

N ° 1 6 4 — 3 rd q u a r t e r 2 0 2 0

J A PA N : I N D U S T R I A L P R O D U C T I O N

Following the VAT hike in October 2019, the Japanese economy had fallen into recession even before the advent of COVID-19. Obviously, the pandemic has not helped to improve the situation. Despite an extremely low number of infected people, Japan has not been able to escape the general economic weakness. After the economic collapse in March/April, the recovery is even weaker than in countries that have been more severely affected by the health crisis. Industrial production continued to decline in May, with the country's heavy dependence on external demand once again proving to be a hindrance. Corporate investment is down sharply and increasing public spending to over 10% of GDP is not enough to offset the weakness of the other components of GDP. Overall, rising unemployment, falling wages, lack of confidence, the slowness of government support and the general vulnerability of consumers after last year's hike in consumption taxes suggest that the recovery will be long and onerous.

130

Volume of the output (2015 = 100)

120

110

100

90

80

70

60 2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Source: Ministry of Economy Trade and Industry Japan, Bloomberg

C H I N A’S C R E D I T G R O W T H

The economic recovery seems most advanced in China. It was one of the first countries to ease lockdown measures, becoming something of a leading economic indicator for the rest of the world. To stimulate activity, the Chinese authorities eased monetary conditions by slightly reducing interest rates and encouraging banks to grant loans to SMEs and support infrastructure development. These measures are having a favourable impact on economic activity, with industrial production and infrastructure spending returning to positive annual growth rates since April. Domestic consumption is also improving, although the ever-present fear of infection and the reintroduction of drastic social distancing measures at the slightest rise in new cases are hampering a stronger recovery in service activities. Exports have also stabilised, increasing at an annualised rate of 0.5% in June and remaining stable over the second quarter after a 13% fall in the first three months of the year. Exports are expected to continue to recover in the second half of the year.

20

Annual change (in %)

16

12

8

4

0 2015

2016 Core bank lending

2017 Non-bank lending

2018

2019

2020

Total social financing

Source: Oxford Economics/CEIC

V E L O C I T Y O F C I R C U L AT I O N O F M O N E Y I N T H E U S 18.0 2.2 16.0 2.0

14.0 12.0

1.8 10.0 1.6

8.0 6.0

1.4 4.0 1.2

2.0 1990-1994 Velocity (LHS)

1995-1999

2000-2004

5

2005-2009

2010-2014

2015-2019

Money supply (M2), billions USD (RHS)

Source: Cornerstone Macro, Bloomberg

The longer-term outlook for inflation is increasingly uncertain. In the short term, steep price increases are hardly compatible with deteriorating labour markets, despite massive government support programmes. Instead of circulating among economic agents, the liquidity injected by central banks is ‘sleeping’ in bank accounts due to generally weak demand for goods and services. This is not a new phenomenon. It follows a trend that set in during the early 2000s and has become even more pronounced recently. The greater the amount of debt, the more the liquidity injected in each crisis is merely fire-fighting since the imbalances at the root of the economic fragility are never addressed. In the meantime, companies in industrialised countries are reducing their investments and hence, their stock of productive capital. If, for geopolitical, health or other reasons, supply chains are interrupted, insufficient local production capacity could lead to a considerable increase in the general price level. That would result in an environment of stagflation, characterised by low growth coupled with high inflation. Although this scenario does not appear imminent, it would not take much to trigger it sooner than expected.


Perspectives

6

US FEDERAL RESERVE BAL ANCE SHEET

Having taken unprecedented expansionary measures in March (cutting the fed funds rate to almost 0%, embarking on an unlimited purchase programme for government bonds and mortgage securities, establishing several credit facilities, reducing the bank reserve requirement to 0%, intensifying liquidity swap operations with other central banks), the US Federal Reserve has since announced some additional measures, such as including high-yield bonds in the asset purchase programme and extending municipal lending to hitherto-excluded smaller cities and counties. The Federal Reserve's balance sheet has swelled by about USD 3 trillion since the beginning of March, which is around the same amount as the total balance sheet increase between 2007 (before the collapse of Lehman) to early 2020 (before the pandemic). After the last FOMC meeting in mid-June, Chairman Jerome Powell said that yield curve control was an additional monetary policy measure currently under consideration.

8000 7000 6000 5000 billion USD

Financial markets analysis

4000 3000 2000 1000 0 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 Total assets

Source: Board of Governors of the Federal Reserve System (US), fred.stlouisfed.org

ECB BAL ANCE SHEET 7000

6000

billion EUR

5000

4000

3000

2000

1000

0 2000

2002

2004

2006

2008

2010

2012

2014

2016

2018

2020

Total assets

In Europe, the ECB increased the envelope for its pandemicrelated emergency purchase programme (PEPP) in early June. Having set it at €750 billion in March, the target volume was increased by €600 billion to a total of €1,350 billion. In addition, the deadline for the PEPP was extended to the end of June 2021. The European monetary authorities have also eased the conditions for banks to access liquidity by reducing the interest rates charged for its longer-term refinancing operations (LTROs). Overall, the ECB seems determined to pursue its unconventional monetary policy despite the ruling of the German Constitutional Court. In May, Germany’s highest court asked the ECB to carry out a ‘proportionality assessment’ of its purchases of government bonds and demonstrate in a substantial and understandable way that their economic and fiscal policy effects would not outweigh the monetary policy objectives. It threatened that the Bundesbank would no longer be allowed to participate in the execution of the programme unless the ECB did this within three months. The ECB seems to be providing the government and the Bundestag with supporting documents to satisfy the requirements of German ministers and parliamentarians, paving the way for the Bundesbank's continued participation in the asset purchase programme.

Source: European Central Bank, fred.stlouisfed.org

COST OF LIVING 1600 1400 1200

%

1000 800 600 400 200 0 1978

1982

1986

Consumer Price Index

1990

1994 New car

1998

2002

Medical care

2006

2010

2014

2018

College tuition & fees

Source: advisorperspectives.com

Taking a step back from the rash of statistics published day after day, it is clear that the long-term outlook for the global economy is very unfavourable. In each of the four major crises of the last 20 years (dot-com bubble, property bubble, sovereign debt crisis, COVID-19 pandemic), the authorities ended up massively easing monetary conditions in order to stabilise the financial markets, without worrying about the long-term impact on the real economy. However, this policy simultaneously has serious consequences on the purchasing power of money, debt and the economic system. For example, the loss in the purchasing power of money has accelerated considerably since recourse to unconventional monetary policy measures, even if this loss in value is not reflected in the official inflation rate. The latter has become increasingly unrepresentative of the real level of the cost of living since it does not include actual housing costs, which are by far the largest source of expenditure for an ordinary household. Categories affected by significant over-capacity such as transport and electronics appear to be over-represented in the index, while higher quality products, high value-added services, healthcare and tuition fees are not adequately taken into account. The moderate increase in the official inflation rate cannot conceal the acceleration of the real loss in the purchasing power of money.


MACROECONOMIC ENVIRONMENT

N ° 1 6 4 — 3 rd q u a r t e r 2 0 2 0

200

Iraq War

Gulf War

Vietnam War

Korean War

World War I

American Civil War

250

World War II

P U B L I C D E B T I N T H E U N I T E D S TAT E S

% of GDP

150

100

50

0 1800

1820

1840

1860

1880

1900

1920

1940

1960

1980

2000

2020

2040

7

The second impact of unconventional monetary policy is the perpetuation of excessive debt ratios. Since the central banks started to introduce asset purchase programmes, the financing capacity of governments has become virtually unlimited. Government debt issuance is no longer restricted by the resources of private savings, but depends solely on the willingness of the central banks to create electronic money, as their independence now exists only on paper. In such an environment, it is unrealistic to hope for any budgetary discipline, especially since the structural weakness of economic growth requires increasing – some would say exponential – recourse to new debt issues. In the United States, the Committee for a Responsible Federal Budget (CRFB), a non-partisan, non-profit organisation committed to educating the public on issues that have a significant impact on fiscal policy, estimates that, based on current trends, the debt-to-GDP ratio will rise to 120% of GDP in 2020 and to over 200% in 2050, which shows that a return to a normalised financial situation is simply a pipe dream.

Estimate

Source: Congressional Budget Office, CRFB

P E RC E N TAG E O F Z O M BI E C O M PA N I E S ( * ) I N T H E U S 20

%

15

10

5

0 1990

1995

2000

2005

2010

2015

2020

(*) Firms whose debt servicing costs are higher than their profits

Source: Datastream, Worldscope, DB Global Research

The main impact of unconventional monetary policy is the gradual demolition of the market economy. A prolonged period of zero interest rates and the central banks’ massive interventions through asset purchase programmes are profoundly disrupting the capital allocation process. Zombie companies, which would otherwise disappear due to insufficient demand for the goods or services they offer, continue to be propped up because the self-regulating mechanism of Schumpeter's creative destruction has been nullified. Some studies estimate that the percentage of zombie companies in the United States had risen to almost 19% at the beginning of this year, even before the appearance of COVID-19. Given the massive imbalances, it is astonishing that the political and monetary authorities are trying to make people believe that the increases in budget deficits and the financing of them by central banks are the royal road to a new, stable and sustainable balance. This is reminiscent of the quote generally attributed to Abraham Lincoln, the distinguished president who put an end to the Civil War and slavery in the United States in 1865: “You can fool all the people some of the time and some of the people all the time, but you cannot fool all the people all the time.”


FINANCIAL MARKETS

N ° 1 6 4 — 3 rd q u a r t e r 2 0 2 0

Financial markets

GLOBAL EQUIT Y INDEX

In the second quarter, equity markets recorded their strongest rise since the third quarter of 1998. The rebound in share prices was fuelled by the gradual recovery in economic activity, the measures implemented by the authorities to stimulate growth and support financial assets, and more encouraging news on the COVID-19 front. However, it is worth noting that a great proportion of the market rally was only due to a limited number of stocks. Between 23 March and 10 July, the world equity index rebounded by over 40%. Half this increase can be attributed to just 5% of the stocks in this index, and 30% to the top 1%.

7000

6500

In USD

6000

5500

5000

4500

4000 01/2016

06/2016

01/2017

06/2017

01/2018

06/2018

01/2019

06/2019

01/2020

Source: Bloomberg

U S E M P L OY M E N T

The fact that the US market is back to its early December level is quite astonishing given the economic damage caused by the lockdowns. Investors could be misled by the publication of economic statistics that seem to indicate a marked recovery in global growth. For example, employment in the United States has reverted to its 2005 level and some of the job losses of recent months will be permanent. Similarly, in many cases, the level of earnings in 2019 will not be exceeded until 2023. The divergence between the economic fundamentals and the performance of equities has led to talk of a speculative bubble on stock markets.

160 158 156 154 152

in millions

150 148 146 144 142 140 138 136 134 2001 Q3

2003 Q3

2005 Q3

2007 Q3

2009 Q3

2011 Q3

2013 Q3

2015 Q3

2018 Q3

2019 Q3

Source: Bloomberg

9


Perspectives

10

U S N O M I N A L A N D R E A L 10 -Y E A R I N T E R E S T R AT E S

Financial markets analysis

The level of interest rates is one of the key fundamentals for equities. Lower interest rates justify higher valuation multiples, unless the lower rates reflect an economic situation that is so bad it would jeopardise corporate earnings. For now, investors seem to have come to the conclusion that interest rates are set to remain very low for a very long time, but they do not (yet?) seem ready to fundamentally question the economic outlook. Instead, they are banking on the continuation of an environment similar to that which followed the 2008 financial crisis, which saw relatively low (but positive) growth and contained inflation.

16 14 12 10 8

%

6 4 2 0 -2 -4 -6 1900

1910

1920

Nominal

1930

1940

Real

1950

1960

1970

1980

1990

2000

2010

2020

Recession

Source: Minack Advisors

U S M A R K E T ' S O U T P E R F O R M A N C E M A I N LY D U E T O 6 S T O C K S

In this environment, companies that are capable of delivering sustained growth are few and far between. They are the chief beneficiaries of low interest rates and they are all the more sought after. The technology sector is the starkest example of this situation, especially since it is a sector that readily inspires the imagination of investors. At the end of the 1990s, the prospects opened up by the Internet fuelled a speculative bubble in the sector. Today, the sector’s valuation is still considerably lower than it was then, but it is nonetheless somewhat concerning that five tech stocks in the S&P 500 (i.e. 1% of its constituents) account for more than 20% of the index. Furthermore, it is mathematically virtually impossible that over the next 10 years they will grow at the same, or an even faster, rate as over the last 10 years. At the same time, their valuation is now much higher than it was then.

375

Index, 1/1/2015 = 100

325

275

225

175

125

75 2015

2016

2017

2018

2019

2020

2021

6 stocks (Facebook, Apple, Alphabet, Amazon, Netflix, Microsoft) S&P 500 ex. FAAANM

MSCI AC Ex-US

Source: Minack Advisors

S & P 5 0 0 I N D E X C O M P O S I T I O N

More generally, the post-financial crisis economic environment has been favourable to companies that tend to be categorised as 'growth' and unfavourable to those usually categorised as 'value' (even though these categories are really rather meaningless). This also explains the marked outperformance of the US market over this period. Companies in the value segment have a much lower weighting in the S&P 500 index than in the European or Asian indices (while technology has a much higher weighting). The US market has thus benefited from the dual effect of higher earnings growth and a low interest rate environment that boosts the valuation multiples of growth companies.

80

70

%

60

50

40

30

20 1925

1935 Growth

1945

1955

1965

1975

1985

1995

2005

2015

2025

Value

Source: Cornerstone


FINANCIAL MARKETS

N ° 1 6 4 — 3 rd q u a r t e r 2 0 2 0

U N D E R P E R F O R M A N C E O F ‘ VA L U E’ S E G M E N T I N E U R O P E 130

Index, 1/1/2018 = 100, MSCI Europe universe

125 120 115 110 105 100 95 90 85 80 75 01/2018

04/2018

07/2018

10/2018

Growth/Europe

01/2019

04/2019

Value/Europe

07/2019

10/2019

01/2020

04/2020

07/2020

11

A number of financial commentators have noted that, given its extreme underperformance, the value segment’s discount relative to the growth segment is historically high. This undervaluation is regularly put forward as an argument for sector rotation. It is certainly possible, if not probable, that the value segment will enjoy periods of outperformance. However, unless there is a fundamental change in the economic environment, they are unlikely to last. In the past, the value segment's performance has often been positively correlated with inflation, and periods of rising inflation have generally been beneficial. But the current context appears to be very different. Even if inflation were to rise, it is far from certain that the authorities would let interest rates rise. Real interest rates would then fall even further, strengthening the argument for growth companies whose future cash flows would continue to be discounted at low interest rates, while a sector like banking that needs a steeper yield curve would continue to suffer. Meanwhile, it is worth noting that the business models of many companies in the value segment are now seriously challenged.

Quality/Europe

Source: DataStream, Kepler Cheuvreux

L I M I T E D N U M B E R O F C O M PA N I E S D E L I V E R I N G H I G H P R O F I TA BI L I T Y 35

30

Return on invested capital (in %)

30

25

25 20 20 15 15

The qualities that long-term investors should look for in the companies they buy are ultimately quite independent of the economic environment. First and foremost, these qualities include a sustainable competitive advantage, a low capitalintensive business model and a strong balance sheet (often the result of the previous two qualities). If inflation remains low, the high level of free cash flow generated by such a company will enable it to benefit from a low interest rate environment. If inflation rises, the first quality will allow the company to raise its prices, the second will ensure that maintenance capex is restrained, and the third that the company will not be particularly affected by a potential increase in the cost of debt.

10 10 5

5

0 90

92

94

Top 10%

96

98

00

02

04

06

08

10

12

14

16

18

0 20

Bottom 90%

Source: Minack Advisors

EQUIT Y RISK PREMIUM IN THE US

A speculative bubble in the financial markets is usually the result of a good idea that has been taken too far. The main argument currently put forward to justify higher valuation multiples for equities is the fact that interest rates are low. But while this argument certainly has its merits, it should not be exaggerated. History shows that artificially low interest rates do not contribute to higher valuation multiples. In the United States, for example, the financial repression that marked the 1942 to 1951 period did not lead to higher multiples, but rather to an increase in the equity risk premium. Similarly, current examples from Europe and Japan show that low interest rates do not necessarily increase equity multiples. The Japanese market is trading at a discount to other markets despite more than 20 years of ultra-low interest rates. Empirical studies indicate that the ideal level for multiples is a long-term interest rate close to the economy's trend rate of growth.

21 18 15 12

%

9 6 3 0 -3 -6 1900

1910

1920

Risk premium

1930

1940

1950

1960

1970

1980

1990

2000

2010

2020

5 year average inflation

Source: Minack Advisors


Perspectives

12

1-Y R A N D 10 -Y R U S E Q U I T Y R E T U R N S W H E N A D J U S T E D P R I C E / E A R N I N G S R AT I O E XC E E D E D 3 0

Another important point to note in relation to equity valuation multiples is that the corollary of saying that low interest rates justify higher multiples for equities is that low interest rates justify much lower returns for equities. This corollary is sometimes forgotten by investors who think that they can pay more but expect the same return. History has shown that there is no correlation between equity multiples and their short-term return. However, the correlation between these multiples and long-term return seems to be well established. History thus shows that when the US market has traded at a valuation level close to the current one, its return over the next 10Â years averaged around 3%, and in about 45% of cases, the return was even negative.

40 35 30 Number of occurrences

Financial markets analysis

25 20 15 10 5 0 -50/-40

-40/-30

-30/-20

-20/-10

1 year return distribution

-10/0 0/10 10/20 Equity return range

20/30

30/40

40/50

50/60

10 year return distribution

Source: Minack Advisors

N E T D E B T O F C O M PA N I E S I N J A PA N A N D T H E U S

Japan is an interesting market, especially in the event of accelerating global growth based on an increase in public spending. The Japanese market is more cyclical in nature but is also home to a large number of high-quality companies. During the 1980s and 1990s, the profitability of Japanese companies was much lower than that of their US and European counterparts, but this gap has narrowed significantly since then. Japanese firms have improved their capital allocation while being more reticent to invest. This has allowed them to generate more free cash flow and substantially deleverage. Despite this, they are trading at a discount to other markets.

7

6

5

4

3

2

1

0 1970

1975

1980

Japan

1985

1990

1995

2000

2005

2010

2015

US

Source: Japan Ministry of Finance, Deutsche Bank, Dalton Investment

A N N U A L G R O W T H I N T H E M 2 M O N E Y S U P P LY I N T H E U S

One of the main consequences of the recent crisis seems to be the gradual abandonment of fiscal rigour and central bank independence. Such an environment is obviously conducive to a return of inflation, especially as a number of other factors that have contributed to disinflation in recent years also seem to be reversing, starting with globalisation. A rise in inflation would be harsh for bond markets and cash: interest rates will either rise, leading to a (highly visible) loss in bond prices, or interest rates will not be allowed to rise, leading to a (less visible) loss in purchasing power.

24 22 20 18 16

%

14 12 10 8 6 4 2 0 1962

1966

1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

2018

Source: Bloomberg


FINANCIAL MARKETS

N ° 1 6 4 — 3 rd q u a r t e r 2 0 2 0

S I N C E 2 0 16 , J A PA N ’S 10 -Y E A R B O N D Y I E L D H A S F L U C T U AT E D AROUND 0%

The only two scenarios in which government bonds from industrialised countries still make sense for investors are deflation or central banks anchoring their long-term interests rates to even lower levels, as the Bank of Japan did in 2016, when it anchored the 10-year interest rate to zero. In these scenarios, already very low interest rates (United States) could fall further and already negative interest rates (Germany) could become even more negative. Investors would then be compensated by rising bond prices. For this reason, government bonds still have a role to play in a balanced portfolio. However, as the principal investment for private investors, they have become far too risky.

0.15 0.10 0.05 0.00

%

-0.05 -0.10 -0.15 -0.20 -0.25 -0.30 2016 Q4

2017 Q2

2017 Q4

2018 Q2

2018 Q4

2019 Q2

2019 Q4

2020 Q2

Source: Bloomberg

G O L D P R I C E A N D S & P 5 0 0 I N D E X S I N C E T H E F I N A N C I A L C R I S I S

Since the start of the year, the gold price has risen by nearly 20%. But while gold has outperformed equity markets for several months now, this outperformance should be seen in the context of its marked underperformance since the end of the financial crisis. An investment in the yellow metal is clearly in tune with the idea of preferring real assets to monetary assets, an idea that should underpin any investment strategy in the current context. Gold's advantage is that, unlike other currencies, its supply is limited and not subject to counterparty risk. It is closely correlated to real interest rates (adjusted for inflation) but also has the advantage of being an 'anti-fragile' asset, capable of protecting a portfolio against other risks, primarily geopolitical risk.

340 320 300 280 260 240 220 200 180 160 140 120 100 80 60 40 20 0 -20 2010

2011

Gold price

2012

2013

2014

2015

2016

2017

2018

2019

2020

S&P 500

Source: Bloomberg

Since they generally amplify movements in the gold price, gold companies provide leverage for investors who are confident in the yellow metal's medium and long-term prospects. However, selectivity is crucial in this segment as many companies have tended to destroy shareholder value in the past. Potential investors must also be prepared to bear the volatility that is a feature of this segment. Goldmining companies with a superior business model (such as royalty companies) are generally less volatile and are also the first to see their share price rise when the gold price rises. Volatility is particularly high for small and mediumsized producers, whose share prices usually only start to rise once the upward trend in the gold price is well established.

G O L D A N D G O L D - M I N I N G C O M PA N I E S 180 150

Yearly percentage average

120 90 60 30 0 -30 -60 1974

1978 Gold price

1982

1986

1990

Gold companies

1994

1998

2002

2006

2010

2014

2018

2022

Recession

Source: Minack Advisors

13


Summary

In summary, the financial markets seem to be disconnected from economic fundamentals. Low interest rates and the perception that the monetary authorities will continue to do whatever it takes to prevent another decline in prices seem to be at the root of this disconnection. However, the rise in equities and the gold price also reflects concerns over the debasement of paper currencies. This fear seems justified in view of the unprecedented increase in public debt and the gradual erosion of the dividing line between fiscal policy and monetary policy. An investment strategy designed for the long term should manifestly favour real assets to the detriment of monetary assets. In concrete terms, this means preferring equities to bonds and gold to paper money. It will also mean challenging the popular belief that equities are risky and government bonds are riskfree. In the current environment, risk should no longer be seen as volatility but as the possibility of a definitive loss of capital. An investment in equities must not be governed by the tyranny of benchmarks. The reference indices are increasingly dominated by a small number of stocks. As a result, they are less and less aligned with the principle of diversification and can no longer be regarded as an accurate reflection of the equity market.


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No.164 – 3rd quarter 2020 Perspectives Economic data and market information contained in this issue are the latest available up to 15/07/2020 Editor - Publisher: BLI - Banque de Luxembourg Investments S.A. 16, Boulevard Royal L-2449 Luxembourg Tel.: (+352) 26 26 99 33 18 info@bli.lu www.bli.lu

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Perspectives 164 EN  

Perspectives 164 EN