The Navigator provides insight into stock market events with an outlook.
03.10.2020
“Price & Value”. Record-high economic downturn, short-time work, and bleak prospects. Yet, stock markets are back at record highs. At least in the short term, this is not a contradiction, as the market environment forces capital into the stock market. Viewed this way, it is a rational decision, with the drawback that, due to a lack of alternatives, massive capital flows into risky assets such as stock markets.
Market review
The immediate crisis with the virus seems to be history after the market crash in March. There is hope for a cure or a vaccine, while simultaneously attempting to live with the virus. The advent of the virus has ushered in a new era. However, much of what has come to light due to the virus was already in motion. For example, geopolitical tensions, including those between communist China and the USA. China, which has skillfully attracted capital and technology from the West over the past decades, is advancing and challenging the USA as a hegemon. The virus appears to be helping to cement and further expand this status. The debt situation has also worsened. Since the 1980s, debts have been steadily rising worldwide, including in the supposedly wealthy West. With the virus, debts have soared to new highs in many places.
While credit growth initially supported economic expansion, it has now become indispensable. Without credit growth, a recession looms. With the virus and the mandated measures such as lockdowns, the economy has slipped into recession, at least in the short term. However, even here: there were already ample signs of a recession before the virus outbreak.
Monetary policy has been a recurring topic in our quarterly letter, as it attempts to avert or mitigate crises. Initially, central banks supported struggling markets with interest rate cuts (LTCM, Tech-Bubble-burst); later, more aggressive forms of open market interventions were added, where central banks directly purchase securities in the market. While initially government bonds, today it is already corporate bonds indirectly via ETFs (or even equities, as in the case of the SNB). Central bank balance sheets have swelled to unprecedented sizes (however, central banks have not been around for that long; the Bank of England since 1694, followed by the US about a hundred years later, and then the Swiss National Bank in 1907).
When a central bank buys securities, the selling commercial banks do not receive “real” money in return, but rather a credit to the reserves that commercial banks hold with the central bank. For this to become “real” money, the commercial bank must issue loans. Commercial banks have issued loans, but as the figures regularly show: too little.
With the so-called “Corona” crisis, a new development is that politicians are also issuing loans or providing guarantees for loans. Thus, “real” money is directly channeled into the economy. Unlike central banks, which cannot directly fuel inflation without commercial banks or active economic participation, a continuation or expansion of “Corona checks” or guarantees issued by politicians would likely breathe new life into inflation.
As shown in Figures 1, 2 & 3, the money supply (M2) has indeed increased, but the velocity of money has noticeably decreased and left its decades-long range downwards shortly after the start of QE in 2011. Furthermore, comparing the velocity of money with the ratio of total debt to Gross Domestic Product shows that when debt accounts for approximately 2/3 or more of the Gross Domestic Product, the velocity of money weakens. With the virus from China, it has almost come to a complete halt.
In short, it can be said that as a global economy, we seem to be deeper in the mire than before. The credit situation dominates events, and although central banks are doing everything in their power, the weak demand side for loans and investments appears to be a significant part of the problem. Growth stimuli are required.
Central banks are helping as much as possible, but whether they can timely withdraw the provided money should the economy gain momentum is an open question. The virus has disrupted or dislocated supply chains, which in turn can upend prices. What tends to look like overcapacity on the supply side and has a deflationary effect has also driven up costs. After years of disinflation and deflationary tendencies, markets are tentatively suspecting the first signs of inflation.
Stock Markets
Stock markets mainly consolidated over the 3rd quarter – or continued their recovery, albeit with less intensity than before. Yields on government bonds, specifically US government bonds, were also at a similar level at the end of the quarter as at the beginning of the quarter.
The drivers of the stock market recovery were primarily technology and growth stocks in general. Towards the end of the quarter, however, profit-taking began. Sectors such as industrial production were able to perform more strongly, partly due to weaker profit-taking.
Above all, consumers seem unfazed by the crisis, as they were able to save money during the lockdown. The sector is back at pre-crisis levels and near its all-time high.
Gold and silver broke out upwards and reached – in the case of gold – new record prices. Silver reached prices of almost USD 30, last seen in 2013. However, for both, a consolidation, or rather profit-taking, began towards the end of the quarter. The energy sector continues to suffer from the consequences of the oil price collapse. The economy is suffering from the virus, and so is the oil price. For many companies, an oil price below USD 40 per barrel makes things difficult, which also does not simplify debt refinancing. A surge in bankruptcies of companies from this sector is emerging.
Interest Rates & Capital Markets
On the interest rate front, some calm returned – volatility noticeably decreased. However, inflation expectations in the markets have been revived. Downward pressure on interest rates is likely to persist, even if bond sell-offs have recently occurred, resulting in a technical downward move and consequently rising yields. Whether a new trend develops remains to be seen. Much indicates that interest rates will come under pressure again and that this is a temporary weakness in bond prices.
On the other hand, much points to the persistent impact of deflationary tendencies. A kind of vicious circle is underway. With low interest rates, it is difficult to maintain credit expansion – which is necessary to prevent the money supply from shrinking. Furthermore, due to low interest rates, borrowers might increasingly use their liquidity for debt repayment instead of interest payments. Low interest rates also indicate subdued demand for loans. From this perspective, it is important to monitor banks’ lending activity. If more loans are taken out, this could be considered a “revitalization” of the economy, and inflation could pick up. This would herald a turnaround in interest rates.
Risk premiums diverged in the phase after the virus shock, which changed little in the third quarter (illustrated above by the price performance of the ETF for high-yield bonds with correspondingly weaker balance sheets vs. the ETF for high-quality bond issuers). The wheat is separating from the chaff, so to speak; quality has recovered, while companies with weak solvency are only hesitantly recovering during times of declining economic activity.
The yield curve has steepened slightly – at a generally lower level, as previously described. With the easing in the second quarter, the curve has flattened somewhat again compared to the market low of March 19.
Market Technicals
We still believe that the uptrend is intact. However, the current phase of weakness may still extend. For the DAX, we were at around 12250 on an important support line that must be held. A break could easily lead to further declines in percentage points. On the timeline, mid-November shows a point where a decisive impulse is quite possible.
Gold confirmed its uptrend with the all-time high in August, or rather, dispelled the last doubts. A correction within this uptrend is underway and has persisted at least until the end of this quarter.
Outlook
The virus and the measures put in place impact our lives – and the economic trajectory, in the third quarter and beyond. However, with regard to capital markets, one could argue that the virus has not introduced much new. The virus has accelerated an already existing development. Deflationary tendencies dominate events. For example, the US Fed is currently buying up about twice the amount of bonds in the market as are issued by the Treasury. This means that, on a net basis, the central bank money supply is being reduced. As long as banks do not issue enough loans, or the economy does not demand enough loans, deflationary tendencies will persist. The money supply is growing too hesitantly. As a result, we continue to see low interest rates. Due to the excessive reserves of banks at the central bank (Fed), one could say that everything needed for a flare-up of inflation is ready. Only the spark is missing.
Capital seeking yield is allocated to the stock markets – and continues to be invested there. Here too – similar to the situation with loans, where expansion is necessary to prevent deflation – new money or capital is always needed to sustain these levels. Because the winners of recent years were mostly growth stocks, including those without much substance. This is partly due to the low-interest-rate environment, which is favorable for financing such companies. But also, partly due to the increasing emergence of passive investment vehicles, which prioritize market capitalization and have thus contributed to an inherent momentum.
Long-term strategies focused on earning power and fundamental balance sheet strength are likely to pay off in the long run. Companies with solid balance sheets, pricing power, and healthy cash flow are well-equipped to weather difficult times such as the current economic weakness and a potential, deeper recession. The art is to create a well-balanced portfolio. For a peaceful night’s sleep, stocks with sometimes outrageously high valuations are not necessarily recommended, as they will sooner or later have to demonstrate their value. Because only prices are traded on the stock market; the value of a company reveals itself over time – and pays off.
“The dumbest reason to buy a stock is because it’s going up.” — Warren Buffett
EDURAN AG
Thomas Dubach