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MONTHLY INVESTMENT BRIEF

OCTOBER 2020

Let’s try to move away from a short-term view focused on the US elections or the risk of a one-off lockdown. A three-month recommendation, which is necessarily tactical in nature, is subject to too many uncertainties for the most conservative investors. What are now the key parameters that should dictate your asset allocation in a long-term investment outlook? We see two of them:

1. Risk premiums

Negative real bond yields will continue to prop up equities. The yield on 30-year inflation-linked bonds has fallen by more than 90 basis points in 2020. Even assuming that global profits will not return to their prepandemic levels until the end of the decade, the steep drop in the riskfree component of the discount rate has nonetheless raised the present value of future cash flows by almost 20% so far this year. We commented at length on this point in our investment strategy.

These exceptionally low real bond yields are keeping equity risk premiums high. The TINA mantra (“There Is No Alternative”) is spreading in the investment world. There is indeed no alternative to equities. To get an idea of how powerful “TINA” is, let’s look at yields in the STOXX 600. They currently average 3.3%. That may seem low by historical standards, but they are nonetheless 3 percentage points higher than the negligible aggregate 0.10% yield on 10-year government bonds. Imagine that you have to invest your money in either equities or in a basket of 10-year European government bonds. Assuming, pessimistically, that dividends per share remain unchanged over the next 10 years, the Stoxx 600 would have to fall by 27% over the next decade to come into line with the 10-year government bond yield. If we measure this by comparing the expected earnings yield (1/ P/E = 1/17≈ 6%), the Stoxx 600 would have to plunge by almost 45%!

Some of you will (justifiably) argue that high risk premiums are not generally enough to justify overweighting equities. A catalyst is needed as well. Alongside an end to the pandemic or the discovery of a vaccine, we feel that this famous long-term catalyst is a sustained decline in the dollar. A weaker dollar could indeed help propel international equities upward over the next 12 months.

2. A weaker dollar for some time to come

The US dollar will face a number of headwinds in the coming months:

• First of all, the gap has narrowed considerably between the 2-year US and 2-year European yield. It is no longer as favourable to the dollar.
• Second, as a countercyclical currency, the dollar is likely to weaken as the global economy improves, which is what our baseline scenario says.
• Third, the current accounts deficit is rising again. It exploded by more than 50% in just three months, from $112 billion in the first quarter to $170 billion in the second. According to the Atlanta Fed’s GDPNow model, the trade balance is likely to widen further in the third quarter.

This worsening in dollar fundamentals comes as the currency is still 11% overvalued based on purchasing power parity. Meanwhile, the drop in the dollar is helping foreign borrowers whose loans are denominated in dollars but whose revenues are denominated in local currency (there are many of these in emerging market economies). No wonder non-US equities have tended to outperform US equities when global growth strengthens and the dollar weakens.

As you may have guessed, we reiterate our overweighting of equities vs. bonds and of the euro zone vs. the US on a long-term investment horizon. The gap between European equities’ projected yields of almost 6% and the 10-year Bund’s negative -0.50% rate is more favourable than in the US, where the two equivalent figures are, respectively, 4.70% and 0.70%. Seen from this point of view, “Europe looks great again”.

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