Europe at a crossroads
GLOBAL CO-CIO &
GLOBAL HEAD OF FIXED INCOME
As soon as earnings expectations of corporates begin to brighten again, we can indeed return to normality. But until then, caution is still necessary.
In recent weeks, Europe has awoken from a Covid 19-induced coma after three months of stagnation. The street cafés and offices of the metropolises are slowly filling up again, the beach promenades are awaiting summer vacationers. The stock markets have also recovered after the shock losses of the spring. Almost all risky assets have recovered at least 50% of their crisis losses. While the crisis winners from the technology and health care sectors were in demand during the lockdown, from mid-May investors' risk appetite turned to cyclical industrial stocks. Long-term, structural investment trends such as digitization, AI and sustainability were even strengthened by the corona crisis. Thanks to support from central banks in Europe and the USA, high-yield bonds gathered large inflows worldwide. So, everything back to normal? Or have the capital markets once again decoupled themselves from macroeconomic reality?
Whether the rally after one of the shortest bear markets to date is sustainable will ultimately depend on whether we succeed in slowing down the further spread of Covid-19. In most developed countries, the number of new infections is declining. However, there are still regions with outbreaks of new cases and the risk of a second wave will certainly accompany us for quite some time.
Emerging stronger from the crisis?
As severe as the shock caused by the global containment measures was - 147 countries worldwide are in recession (compared to 88 during the Great Financial Crisis of 2009) – growth could now go up just as fast. This is indicated by the sharply rising figures from China for infrastructure investments and retail consumption. The decisive factor for the development in Europe was the reaction of governments and central banks, which acted quickly and massively. With the European Recovery Fund proposed by the European Commission with a volume of 750 billion euros, for the first time there is a chance of a solidarity-based balance between countries with fiscal leeway such as Germany and France and those without such leeway such as Spain and Italy. Europe is at a crossroads here - if it succeeds in reconciling solidarity with value creating investments, it could emerge stronger from the crisis.
Apart from the dreaded second Covid-19 wave - which we are carefully monitoring looking at high frequency data - there are, however, other risks that threaten to slow down the upswing. Apart from the US where fast job reallocation plans are made possible by the market structure, unemployment could prove more persistent than expected due to the structural changes triggered by the pandemic. If the recession turns out to be more severe than expected, more company bankruptcies will become inevitable. The US presidential elections in the autumn and the Brexit negotiations increase political uncertainty. Especially in the US, a victory of the Democrats will be accompanied by an increase in corporate taxes with direct impact on EPS. It remains to be seen whether current valuations adequately reflect these risks. How should investors position themselves in this environment?
Has the big rotation really begun?
Equities: Looking at the equity market performance and the P/E ratios, it seems to be as if 2020 were not part of the equation anymore. Interestingly, Value stocks have clearly outperformed Growth and Quality stocks since mid-May. Has the big rotation that many investors have long been waiting for finally begun? The large valuation difference between growth and value stocks in terms of price-to-book ratio could be an argument for this. Especially, IT stocks which were in demand during the Corona crisis, have achieved historically high valuations. However, with only modest signs of rising inflation and interest rates, support for a sustained value renaissance is limited. Typical value sectors such as automobiles or telecommunications also face burdensome challenges with necessary investments in e-mobility and the build-up of the 5G network. In this context, we continue to favor IT and healthcare stocks that are benefiting from long-term trends, industrial stocks that are supported by the economic recovery and banks that have already largely adapted to the tightened regulatory environment.
Fixed income: The rally in the high-yield segment has been fast, largely pushed by central bank support and tight supply (only partially offset by former investment grade bonds, so-called Fallen Angels). If we stay constructive in the medium/long-term, we consider there is maybe less potential in this segment in the short-term. By contrast, peripheral government bonds and investment-grade credit continue to offer at least some yield potential.
Currencies: Our conviction is that Euro may finally appreciate vs. Dollar. We think this upward movement is going to be driven by a limited interest rate differential, deepening twin American deficits, and an unprecedented European solidarity oriented towards growth and investment. Last, it is worth mentioning the pandemic, which is currently more problematic in the US than in Europe.
There is thus much to suggest that risky assets will continue to recover: falling infection figures, maximum support from governments and central banks, less volatility, businesses returning to normal at the end of the lockdown phase, first signs for an economic recovery. As soon as earnings expectations of corporates begin to brighten again, we can indeed return to normality. But until then, caution is still necessary.