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Road to recovery
Although financial markets are behaving as if the pandemic is already behind us and that the vaccination program has allowed us to resume living as if nothing had happened, the real world is still in the midst of the pandemic emergency and the forecasts for the coming months are still not encouraging. The "UK version" of the virus has recently also arrived in the United States and it threatens to make an already complicated situation even more precarious. According to the below chart, we could reach about half a million deaths from Coronavirus in early February (from the beginning of the pandemic) if more stringent measures are not taken to contain the spread of the infection; otherwise, we could easily exceed 700,000 deaths; at the beginning of 2020, estimates were of about 450,000 deaths in the US alone, so it is getting worse than originally expected. Europe has effectively implemented a second "Lockdown" which will have the effect of pushing the European economy back into recession - "Double Dip". Fiscal and monetary policies will support economies, but surely the road is still long and tortuous.
Our preface may might suggest that it is better to have a cautious attitude towards financial markets, but in reality, global production has already shown a significant improvement for some time, evidence is the graph below. Manufacturing output is rebounding strongly and when consumers will be able to go out and spend the economic snap-back will be vigorous.
Financial markets are precisely looking beyond the peak of the health emergency that we have been witnessing over the last few weeks and are focusing on the fiscal measures to support the economy and the still very accommodative policies on the part of Central Banks. All these maneuvers will have an important impact on earnings growth in the second half of 2021 which will continue well into 2022. From an economic point of view, for financial markets, the worst is already behind us.
Interest rates are still very low and even continue to be negative in real terms; stock markets have a compelling earning yield, especially compared to corporate bond yields; the Federal Reserve's promise to maintain rates close to zero for a considerable period of time, even after inflation has steadily gone above the 2% target is favorable to a Risk-On attitude; we can see this in the graph below (orange line) where the percentage of stock markets that trade above the 200 day moving average is plotted, testifying to a very broad rise in equity markets globally.
Spreads on corporate bonds, particularly High Yields, are at the low end of the last 12 years; this makes the cost of capital very attractive for businesses and has important implications at least in the short to medium term:
- Interest payments are sustainable even at high levels of financial leverage.
- Many projects have a positive IRR, stimulating investments.
- Company margins remain high, particularly in some of the higher growth sectors.
Central Banks and governments currently prefer not to deal with the negative effects, leaving the burden to those who will have the helm of command when the inevitable bill arrives. If inflation will eventually pick-up leverage will be more difficult to sustain and company profitability will suffer meaningfully.
At the moment there are no inflationary pressures on the horizon, more than anything else we are witnessing a return to pre-Covid “normality”. The indicators that measure inflation expectations such as TIPS and the "Undelying Inflation Gauge" of the Federal Reserve Bank of New York show precisely that after the fear of deflation during the spring, due to the massive economic slowdown caused by the first round of lockdowns, we are returning to the average levels of the last 10 years. If we see an acceleration of inflation, it will probably not be before 2022 so risk assets, the stock market in particular, will be privileged asset class throughout 2021.
As almost every year, it will not be smooth sailing and prices will not raise gradually throughout the year, but we will experience weeks of high volatility; these periods should be used to increase the equity component of the portfolios; in the meantime a portion could be invested in gold, which with negative real rates helps stabilize the portfolio.