Carmignac: Wöchentlicher Marktausblick - KW19

Our framework to understand short term markets behavior is for the time proving relevant. Equity markets are by-and-large recovering from their lows. In the past seven days they were quite strong, as still policy makers’ action, plus some constructive outlook on the move towards deconfinement keeps reassuring markets. There is even a little change in the internal markets dynamics compared to the past weeks: the rally has not been driven any longer only by growth and defensives in the last few days, but by cyclical sectors, including banks, autos, industrials, which were, and still are by far the worst performing sectors YTD, and of course energy after the slump of the previous week. Logically, this outperformance of cyclicals, and value, led to European equities doing as well as US markets.

On the fixed-income side, credit, where we have selectively but meaningfully increased our investments, has done rather well too, but on a more pedestrian pace than equities. Conversely, on the peripheral debt side in Europe, the Union is not doing enough yet so that all the heavy lifting needs to be done by the ECB. So it will have to do more, starting with an increase in size of the PEPP, beyond the current 750bn, and in duration, beyond the end of this year, if it is to keep sovereign spreads under control. This should happen soon, but we have cautiously reduced our exposure to peripheral debt over the past weeks.
In this second phase of the market movements, which is highly driven by sentiment, for lack of concrete visibility or reliable forward-looking data, and massive liquidity injections, technical factors take over from fundamental analysis. In the last 48 hours, some resistance levels were broken, so we rose a little our equity exposure.
However, we do not expect to raise our risk profile much further, because of our fundamental interpretation of the situation has not changed. It explains the increasing disconnect between equity markets (which are on average back to less than 15% from their Feb highs, - and not even 8% in the case of the Nasdaq), and the economic reality, but points to a risk of renewed instability for markets.

The coronavirus crisis is not only creating a new situation for markets but also exposing the fragility of the system. To understand this fragility, one needs to remember that for some ten years after the 2008 GFC, central banks worked very hard, through Interest rates cuts and asset purchases, to prevent the economy and inflation from rolling over into recession, because a recession, in particular associated with falling inflation, would be devastating to still very leveraged economies, both in private or public sectors. This has worked but not very well, in particular in Europe, recession has been avoided but growth and inflation have remained very weak.  So that Central Bank intervention remained necessary.

The paradox that ever lower interest rates have encouraged financial leverage to keep rising. And the fall in bond yields and guaranteed support from central banks has encouraged investors to take more and more risk to capture yields, even if the economic reality was very mediocre. So it is obvious that markets benefited from central bank action a lot more than the real economy.

So a very unique type of equilibrium was reached: as long as central banks just managed to avoid a recession through on-going monetary support, risk assets could continue to rise, fueled by central banks permanent liquidity supply, and this rise in equity and credit markets, and even real estate, itself fueled a positive wealth effect, which in turn supported consumer spending, particularly in the US.

There are two problems however with this equilibrium: central banks support can never stop, as 2018 demonstrated it, otherwise very quickly the economy rolls over and risk assets sell-off, which reinforces the economic downturn. 2019 was in that sense a sigh of relief for markets, in that it expressed the comfort that central banks understood the lesson and low rates and QE were once and for all guaranteed. But the other problem with this awkward equilibrium is that a brutal recession, for whatever reason, which central banks support would not be able to stave off would topple it. This would be the nightmare scenario because it would suddenly make the whole house of cards collapse.
And the coronavirus crisis, was exactly that occurrence. The Black Swan was not the healthcare crisis itself, but the economic lockdown, which created a deflationary shock of historic proportion. Suddenly, the very sensitive balance needed between low but positive growth, low but positive inflation, and very high financial asset prices was broken. Leverage players, be they investors, private companies, or even some sovereign economies were likely to simply go bankrupt because of this shock. With then potentially devastating consequences globally.
In this context, the initial equity market stress, in February-March, made perfect sense. But what was equally inevitable was that States, ie central banks and government, would be doubling down on their support because they had and still have no choice. Policy makers will stop at NO limit to keep the house of cards standing. Hence the large equity market rebound since mid-March: because how could markets dare fight such determination by such powerful players as central banks and big governments? The rebound is nothing else than the continuation of the 10-year old logic, to the power of 10.

So here we are: markets are more expensive, in valuation terms, than at their highest levels last February, despite the horizon for economic growth being clearly lower still than three months ago. And the markets consider that this increased disconnect is solved, or “reconnected”, by policy makers’ limitless intervention. Another way to put it is that the liquidity-supply part of the equation is considered powerful enough, that it justifies much higher valuation multiples of risk assets. And naturally, it favors non-cyclical sectors.

The crux of the matter is to be conscious of the fact that the medium term outlook rests on the continuation of the very fragile equilibrium sponsored by policy makers whereby risk assets valuations can remain elevated because there is enough confidence that the medium term economic outlook will very slow, but neither recessionary nor inflationary, which will justify enough on-going monetary supply to support valuations.

And the point to understand is that, on the one hand, the more we flirt with extremely low growth, the more the relapse into recession is possible in case of any accident, and on the other hand, the more policy makers have to go to extremes to bridge the disconnect between asset prices and economic reality, the more markets may tempted to test their credibility. Hence the risk of instability, and at one point the risk of currency instability. That’s why we have added gold miners in our portfolios.

It is this fundamental understanding of this at-best slow growth horizon that explains two things: first our fundamental preference, in our equity portfolios for high quality, cash-flow positive, high visibility secular growers, in particular disruptors in the technology space that are actually gaining market share in this environment, and that also explains that we expect bouts of market instability to come threatening this fragile system now and again, hence our very vigilant risk management.
Passive fund management in our opinion is just not a solution for anyone any longer.

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