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2020 will certainly go down in the annals. The dramatic health crisis, which has claimed more than 1.5 million lives worldwide, has turned our lives upside down. What is the outlook for the coming year?

Read the analysis by Damien Petit, Head of Private Banking Investments at Banque de Luxembourg, published in the December issue of Agefi.

In economic terms, the pandemic has caused an unprecedented exogenous supply shock. The very strict lockdown measures that were applied first in Asia, then in Europe and the USA during the spring, led to a collapse in activity. Services, which are traditionally more resilient during periods of recession, were particularly impacted by restrictions on movement.

Unprecedented response by governments

The unprecedented scale of the support measures taken by the monetary and fiscal authorities – resulting in a significant expansion of the central banks’ balance sheets in developed countries and an explosion in public deficits – paved the way for a robust economic recovery in the third quarter, once the lockdown measures were lifted. However, the second wave of the pandemic forced governments to embark on a new round of restrictive measures to limit people’s movements, particularly in Europe, a region which will see activity contract again in the last three months of the year.

Assuming that potential new outbreaks of the pandemic can be controlled and that effective vaccines will gradually be distributed in 2021, we can expect global activity to benefit from renewed economic confidence and bounce back in the coming quarters.

Assuming that potential new outbreaks of the pandemic can be controlled and that effective vaccines will gradually be distributed in 2021, we can expect global activity to benefit from renewed economic confidence and bounce back in the coming quarters.

Caution needed

The recovery could be seriously undermined if the fiscal support measures are not extended. In the United States, public support measures boosted household income during the first wave of the pandemic, but many have now expired. If they are not renewed, consumer spending, which is the main driving force of the US economy, could suffer because the labour market is still convalescing. Only just over half of the job losses recorded in March and April have been recovered and the rate of recovery has slowed significantly in recent months.

At the same time, the end of the health crisis will be accompanied by even greater structural imbalances, particularly in terms of debt. The explosion in debt ratios has encouraged the public authorities to resort to an easy solution: relying on central banks to finance public deficits. A perilous tangle of monetary and fiscal policies limits the possibilities of raising interest rates to any significant extent. The negative consequences of artificially low interest rates are manifold – disempowering the public authorities, undermining the profitability of the financial sector, increasing social inequalities, stalling productive investment by profitable companies, and durably weakening the potential for growth.

What are the prospects for investors?

The low interest rate policy is not without consequences for investors, especially traditionally defensive investors.

They have had to accept a structural loss of purchasing power in recent years, equating to a slow and inexorable impoverishment. Despite currently being contained, inflation cannot be offset by a zero or even negative return on money market products. Investors are effectively suffering a tax on savings. Investment-grade sovereign bonds have also lost all appeal for private investors. The sovereign bond yields of the financially strongest countries are entrenched in negative territory. In Germany, for example, yields are negative up to a maturity of 30 years! This makes the risk on such an investment totally asymmetrical. On the one hand, the yield to maturity is negative, which means that the holder of the bond is paying the German government for the loan of cash. On the other hand, the holder is exposed to potentially significant capital losses if interest rates rise during the holding period of the bond. Meanwhile, the protective role historically played by investment grade debt in a diversified portfolio has largely been eradicated due to such bonds having limited upside potential.

More dynamic investors who opt for exposure to corporate bonds will have to be satisfied with very low risk premiums. They may be tempted to switch to high-yield bonds for superior performance but will be exposed to significant permanent loss of capital in the event of defaults. Where risk tolerance and capacity for risk-taking allow, investors would do better investing in equities. However, in view of the markets’ relentless rise over recent years, there are ongoing concerns about (i) equity market valuations and (ii) investment ‘timing’. In absolute terms, equity valuations now look very high, suggesting that the long-term performance of this asset class is likely to be lower than that recorded over the last decade. But, in relative terms, risk premiums – which measure the relative valuation of equities compared to bonds – remain very favourable to equities.

In absolute terms, equity valuations now look very high, suggesting that the long-term performance of this asset class is likely to be lower than that recorded over the last decade.

 

Futility of market timing

It is pointless to try to predict future market price movements. Wholesale efforts to buy into or sell out of the markets, sometimes completely, in an attempt to anticipate their reaction to various events (political, etc.) are structurally value destroying.

For example, a negative reaction was widely expected from the markets in the event of a very close result in the US elections. But this did not happen. The absence of a Democratic wave – the Senate majority will only be known in January after a second round in Georgia – seems to wipe out the prospect of radical measures being enacted, especially concerning taxes, which could have been detrimental to the equity markets. Stock markets were also boosted by November’s encouraging announcements on the efficacy of the Pfizer and Moderna COVID-19 vaccine candidates. So investors who exited the markets in October for fear of an unfavourable result in the US elections missed out on a record November for the global equity market!

Nevertheless, equity market investors are subject to the inherent volatility of this asset class. But they can substantially reduce the risk of permanent loss of capital by choosing only to invest in high-quality companies, which have sustainable competitive advantages, strong balance sheets and pricing power. This will enable investors to maintain their purchasing power over the long term and capitalise on the regular payment of dividends.

“High-quality companies have sustainable competitive advantages, strong balance sheets and pricing power.”

To conclude, despite growing structural imbalances, 2021 is likely to see a rebound in activity. The highly expansionary monetary policies of over-indebted countries will continue to keep interest rates exceptionally low, severely limiting the yield prospects for traditionally defensive investors. Of the traditional asset classes, only equities offer any hope of decent returns over the long term.

Article published in the Luxembourg financial journal, Agefi, December 2020

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