How 2020 is changing the game

Imagining the future is never an easy task when the shock wave from a blast is still propagating, and when people around you are still struggling to emerge from the wreckage. The 2020 public health crisis quite clearly fits that description. Daily news feeds on the still-rapid spread of the virus, endless details about successive emergency relief programmes and monthly updates on economic activity have a way of cluttering our mental space. At the same time, the last leg of the US presidential election campaign sometimes feels more like a bar-room brawl between two old geezers than a contest between rival political platforms.

And yet, due to its unique severity, the shock we’ve experienced in 2020 may well have momentous long-range consequences for investors.

Due to its unique severity, the 2020 shock is likely to have momentous long-range consequences

Those consequences are likely to determine potential GDP growth rates in Europe, the United States and the emerging world. They are also likely to influence future consumer price inflation and currency stability – issues that no one concerned with the outlook for equity, bond and foreign exchange markets can afford to dodge.

For the time being, virtually all the Covid-related loss of income in Europe and the US has been covered by the corresponding governments. This unprecedented public-sector support has helped produce heartening signs of recovery, bolstered in part by a restocking phase after inventories were depleted in the preceding months. The third quarter of the year has thus seen a powerful rebound that has given a boost to exports from China, where the economy is close to resuming its normal growth rate. Within a few months or even a few weeks, the US Congress should pass a new stimulus plan which, combined with the first tangible news on an effective vaccine, could provide further economic momentum and revive the animal spirits of financial market participants.

However, this newfound government interventionism has brought about a mind-bending increase in fiscal deficits that could be financed only by a no-less-extraordinary degree of central-bank intervention.

We would be guilty of wishful thinking, or at any rate undue optimism, if we expected that trend to continue without a hitch. The issue of fiscal deficit sustainability can’t be sidestepped indefinitely. And it’s being made that much more acute by the innate reluctance of central bankers – the people tasked with guaranteeing overall financial stability – to expand their asset purchase programmes without restraint. This suggests the need to build an “upper-bound scenario” for government spending into our long-term outlook.

The probable discovery of a vaccine will no doubt soon help us make our way back to some kind of “normality”. But we feel it would be wrong to underestimate the time lag until an ideal vaccine – requiring a single injection, storable at room temperature, at least 70% effective and generating antibodies that remain active for a long period – can be produced and administered widely enough to make the pandemic’s impact on our behaviour a thing of the past.

Moreover, the after-effects of the 2020 economic shock will continue to hold down production and investment – and therefore employment – particularly in such sectors as aviation, oil extraction, tourism, food service, commercial real estate and retail. At the same time, shifting workers out of those industries into high-potential areas like technology services and the energy transition will entail formidable career transition challenges. Such examples of fallout from the pandemic are in turn feeding into an underlying trend towards overleveraging, which has already been hindering a vigorous and sustainable economic upswing for over a decade.

This leads us to establish a medium-term decline in potential GDP growth as our baseline macroeconomic scenario. The implications for equity markets will be fairly straightforward. With central banks manifestly unable to tighten monetary policy, interest rates are set to stay rock-bottom, and will therefore provide support for stock valuations. And the sectors best suited to this low-key economic environment (see our September Note, “The unrelenting law of evolution”), for a discussion of the “Darwinian” consequences of the 2020 shock) will be well-equipped to increase their competitive edge – and with it their relative outperformance in the market.

Potential GDP growth rates have been weakened, making it impossible for central banks to tighten monetary policy

The prospect of a very arduous economic recovery has unsurprisingly given wings to “new monetary theory”, according to which there is no need to set a ceiling for the monetisation of fiscal deficits (i.e., expansion of the money supply to pay for them) because the more debt there is, the less it costs everyone. This postulate immediately raises the question as to the intrinsic value of currencies when money gets lavishly printed with no corresponding increase in wealth creation. It thus underpins our belief that we should maintain limited currency risk in our portfolios and even have significant allocations to real assets like gold.

The other question raised by a scenario of almost fully monetised deficits has to do with inflation. In the short run, there is certainly a strong case for rising prices, whether demand-driven (if consumers tap into the huge volume of currently available savings) or cost-fuelled (if the trend towards global supply chains recedes). Furthermore, both governments and central banks ardently advocate such a pickup in inflation, as it would lower the real cost of national debt. So it would seem to make sense for investors to lift their inflation expectations mildly, at least in the short term.

But as suggested above, central banks aren’t ready yet to relinquish their claim to independence and start taking all their cues from the government. And the long-term deflationary forces at work will be with us for quite a while. Moreover, colossal investments in cutting-edge technology over the past two decades have generated unprecedented economies of scale that are slashing the cost of the services delivered by that technology. This means that in addition to upending business models, new tech necessarily has a deflationary impact – thereby adding to the effects of overindebtedness. And in case we hadn’t realised already, the 2020 public health crisis has revealed that a wide range of technology solutions can now respond – with almost unlimited capacity – to even staggering hikes in demand for virtual communication, access to information and data storage.

So it isn’t because the ECB’s Christine Lagarde and the Fed’s Jerome Powell have stated their willingness to let inflation creep above their 2% target that it necessarily will – and especially not in the short term. What those statements do demonstrate, however, is that both central bank leaders are determined to keep real interest rates as low as possible. That provides bond markets with a fairly clear outlook and gold prices with additional support.

To sum things up: Though the prospect of a near-term improvement on the economic and public health fronts does argue in favour of some exposure to the “re-starting the economy” investment theme in our portfolios, the 2020 shock has strengthened our convictions on medium-term macroeconomic trends. Those convictions are what underpins our approach to portfolio construction. The backbone of our funds is accordingly made up of high-quality growth stocks (selected on the basis of the differentiated views provided by our equity analysts) gold miners, corporate bonds meticulously selected for issuers’ ability to get through these troubled times with no major difficulty, and low currency risk.

Source: Carmignac, Bloomberg, 6/10/2020