The ECB this week drew a horizon of at least three more years for interest rates in the euro zone to zero, with all the burden of difficulties that lie ahead to get out of the current crisis and with the direct implications for investment that it supposes. If the discovery of the vaccine had unleashed the buying euphoria in the stock market, which has largely anticipated an end to the pandemic still very uncertain, the message from the ECB on Thursday has given a whole bathroom of reality. Faced with the second wave of the coronavirus, growth in the euro zone and the rise in prices will be lower than expected months ago and it will not be until well into 2022 when it will really be possible to start turning the page.
Before the end of the year, investors will have the most up-to-date vision from the major central banks on the true state of health of the economy. The ECB has just announced measures with which it guarantees intensive support to the governments of the euro zone so that they can continue to obtain financing at balance prices and has advanced that it will continue to provide liquidity to the banks so that credit is not paralyzed. Next week will be the turn of the Fed, which is expected to make a renewed commitment to the recovery of the US economy, soon under the leadership of Joe Biden.
The messages from both central banks will therefore continue to set the pace for investment on the way out of the crisis, in a market in which their decisions have become the great reference and in which monetary stimuli have distorted until make it difficult to recognize compared to a decade ago.
“Monetary policy conditions us radically”, acknowledges Lucas Maruri, manager of European equities at Gesconsult. The most recent example is this Thursday, in which the manager reduced positions in banking due to the long perspective of zero rates pointed out by the ECB. But the monetary policy, the most recent and that of the last few years, has caused a much deeper movement of tectonic plates, whereby the plummeting fall in sovereign debt yields has pushed investors hopelessly towards the stock market and other risky assets in search of profitability. “The ECB’s policy has had a major impact on the debt side. How is it possible for Spain to issue negative 10-year debt in the midst of a crisis and with a large volume of debt? ”, Reflects Maruri.
The powerful intervention in the market of central banks has created serious distortions in the market and requires taking more risk
The ECB’s sweeping debt purchases have had the power to completely anesthetize risk premiums. Otherwise, the enormous public spending with which governments are responding to the crisis, which will leave deficit and debt levels soaring this year, would have been impossible. “What started as a novelty in 2015 with government bond purchases has long since become the new normal,” says Ulrike Kastens, Europe economist at DWS.
Distortion in the Stock Market
But the obvious intervention of central banks in the debt market has also been transferred to equities, as zero rates are pushing towards higher risk taking. “Perhaps the novelty in 2020 (and that we are convinced that it will continue in 2021) is that, as the Fed joins the 0% club, the distortion of negative real rates is also permeating the valuations of companies”, explains Roberto Ruiz-Scholtes, strategist at UBS Private Banking in Spain.
This distortion can be seen in a very widespread indicator in equities, such as the weighted cost of capital, or the discount rate with which future cash flows are applied to the present. “The low cost of Spanish debt means that the cost of capital is reduced. The value of future cash flow increases and that justifies a higher valuation, ”explains Lucas Maruri.
In short, the yardstick in the market has been modified with the intervention of central banks and, according to Ruiz-Scholtes, “now most strategists accept that the equilibrium multiples in the Stock Exchanges are well above the historical average, because the cost of capital has fallen, the discount rate applied to future profits ”.
Sovereign debt served as protection this year but, without interest rate hikes in sight, it does not offer profitability
And in a changing world, in which low interest rates have already become structural and which is witnessing profound technological transformations, the comparison of stock market multiples has also ceased to have the usefulness of years ago. “Wall Street may not be expensive at a PER of 20 (times that a company’s stock market value includes its profits) and Spain is not at all undervalued at a PER of 15 times,” adds the UBS expert.
Given the new playing field that central banks have defined in fixed income and equities, investors can rest assured that the rules will not change in the medium term. In the opinion of Ulrike Kastens, the measures announced by the ECB this Thursday are very generous and should be seen as a kind of insurance. “With the current unused volume of the pandemic buying plan and the slower pace of bond purchases since the summer, there are enough funds available to respond to risks with the necessary flexibility. This should give security to the market until the end of 2021 ”, he adds.
Guillaume Menuet, Eurozone economist at Citi, believes investors can be “completely sure” that central banks will continue to support the economy and the market in 2021. “The message from the ECB is that it will be there to maintain financial conditions. favorable in the near future ”, he adds.
But Covid-19 has accelerated structural changes already underway, such as digitization, and will force central banks to prolong low interest rates in the absence of inflationary pressures. In fact, the ECB does not foresee that inflation will be at 1.4% until 2023, far in any case from the objective of approaching zero. “Our central scenario for the first rate hike in the US is early 2025, as we expect inflation to rise only gradually,” they say at Goldman Sachs. With such a perspective, does it make sense to have sovereign debt in your portfolio?
Options in fixed income
In the view of Nick Hayes, debt manager at AXA IM, sovereign bonds continue to play an important role in portfolios, despite their minimal returns. “In the context of a diversified portfolio, high-quality government bonds also provide a natural hedge against the volatility of risky assets and provide liquidity, something investors might find desirable,” he explains. Sovereign debt has in fact been a permanent refuge for investors this year. “In 2020 it has once again demonstrated its ability to cushion the damage of crises,” they defend from UBS.
Managers move cautiously towards cyclicals: banking and tourism still generate many doubts
Looking ahead to 2021, however, the recommendations for fixed income focus on other types of assets, such as emerging debt or subordinated bank debt, where to scratch some more profitability. The US manager BlackRock maintains its commitment to Italian sovereign debt, in parallel with a bearish position in the German one, and a selective position in European corporate debt and in emerging markets. The recipe that managers agree on is to choose debt assets with a positive yield but without assuming excessive risk, although if there is a unanimous investment bet for 2021 it is equities.
The stock market will have a free hand to test for new increases thanks to the economic recovery that is expected with the vaccine, and without losing sight of the continuous support of central banks and access to cheap financing. “The end of the pandemic, continued support for policies and attention to green investments should help improve prospects. Equities should benefit, ”explains Chris Iggo, chief investment officer at AXA Investment Managers.
Strong earnings per share growth is expected in 2021 relative to the 2020 recession. “Currently, however, the level of projected earnings for the end of next year is not much higher than that of the end of 2019.” Iggo adds. And the recovery planned for next year will not be free of shocks: as the ECB pointed out this week, immunity against the coronavirus that allows us to think about a return to normality would not be achieved until the end of 2021.
Meanwhile, in the generalized bet by managers on cyclical stocks, with which to take advantage of the recovery, prudence also dominates. The preference is for industrial, construction, infrastructure and automobile companies. In banking and tourism, sectors that have been hit hard, the recovery will continue to be highly uncertain.