Market report December 2020
Low interest rates and massive stimulus packages to increase public debt raise Investors’ concerns about potential long-term side effects
When the cost of capital is low, funding for innovation increases, which in turn creates powerful opportunities, especially in technology. Many Investors fear an environment of zero interest rates and the global economic impact of aggressive stimulus measures. Some of the concerns are understandable. In fact, there is a positive impact on the lower cost of capital generated by this environment. First, the environment helps generate affordable financing for innovative companies and promising start-ups. In addition, it can reward companies that actively invest in research and development (R&D).
Venture capital and R&D work together
This year, equity Investors who focus on innovation were awarded. There are many examples of how the pandemic accelerated innovation that was already on the path to success before the crisis (digital migration and financial technology – Fintech). The pandemic has also helped draw attention to innovative startups with long-term potential.
Given the historically low cost of financing, VC providers are more than willing to invest in promising businesses. By contrast, in technology, healthcare and other R&D intensive sectors, global VC flows are approaching record levels. This helps to provide a larger and promising list of potential future winners.
Chart: Low interest rates a boon to venture capital – global VC financing in key R&D intensive sectors
As of June 30, 2020
Source: CB Insights Venture Funding reports, Goldman Sachs
Low rates also support investment in R&D – an absolute must for any technology leader wishing to stay in business. Making Smart Investments helps improve their prospects, creates opportunities and adds tangible long-term value, especially in the minds of Investors.
In fact, companies investing in R&D are rewarded by the market much more than those that resort to financial engineering. The intensity of R&D, as measured by research and development/sales, has a significant positive impact on future share prices. This bodes well for the technology outlook in particular, as more technology leaders rightly spend on research and development to stay ahead of consumer needs and market trends.
Diversify your risk of a bubble through active stock selection
Could easy money chasing too many opportunities lead to market bubbles? Of course. Will the year 2000 and the bursting dot-com bubble happen again? Perhaps, but not necessarily for selective Investors. Many dot-com stars stopped shining after 2000. But that era also gave birth to persistent icons like Google and Amazon. Active Investors, who then focused on the basics, saw the eventual winners better. This is also true today, when the low cost of capital can make the strong even stronger. As long as they’re fundamentally robust, even selected relatively expensive companies still have room for expansion.
Overinvestment is another risk in a low interest environment. Unlimited access to cheap capital may encourage some firms to invest in the wrong initiatives for the wrong reasons. Cheap capital can spur unhealthy competition for larger investments. Active Investors must constantly monitor for innovators to become future leaders.
Market pessimists believe that low interest rates and aggressive fiscal policies have created too much money by using too many opportunities throughout the global system. However, the value of future growth is almost always higher in a low interest environment. This time, the climate creates even richer breeding grounds for new generation innovators, also for Investors who can identify them early.
What is the current role of central banks?
Globally, interest rates have fallen over the past thirty years. Central bankers believe this is partly due to a decline in the “interest rate equilibrium”. It is the interest rate at which monetary policy is neither expansionary nor contraction, with the demand for money matching the supply of money. Much of this decline can be explained by structural factors such as the aging of the global population and the slowing of productivity growth. Reference rates were significantly lowered in the wake of the global financial crisis in order to support growth and inflation and have remained historically low since then. The economic shock caused by the virus pandemic caused growth and inflation to plunge further, causing many policymakers to cut interest rates even further. If interest rates cannot fall below zero, this gives central banks limited room for maneuver. If interest rates are allowed to drop below zero, central banks clearly have more room.
At a given rate of the alloy, policymakers theoretically reach the “effective lower bound” (ELB). This is the level below which it is judged that interest rate cuts cease to fuel inflation and growth, or that the negative effects in areas such as the financial sector outweigh the economic benefits. For example, the Bank of England has historically believed that this ratio is above zero in the UK. As the policy rate was close to the ELB, the Bank of England used other monetary policy tools (once called unconventional tools) in the wake of the global financial crisis. The ELB can change over time due to changes in economic structures, financial or prevailing economic conditions and is likely to vary with economy. It is worth mentioning that Denmark, Sweden, Switzerland, Japan and the European Central Bank have introduced negative interest rates in recent years.
What do negative interest rates mean in practice?
In some respects, negative rates can affect the economy in the same way as positive rates. Lower (more negative) interest rates encourage borrowing, current spending and investments, and discourage saving and deferred spending and investments. Lower interest rates also increase the present value of assets. Lower interest rates can also weaken the currency, temporarily increasing inflation through the channel of rising import prices and increasing the availability and therefore export sales.
In some respects, the transmission may be different, including through the household deposit channel. Commercial banks cover their costs by paying less from savings than from loans. This is called interest margin. The analysis shows that in periods of negative rates, the interest rate on household deposits usually did not fall below zero. Commercial banks may not attract or hold deposits at negative interest rates. It is more likely that the interest rate on corporate deposits will turn negative. If deposit rates cannot fall below zero, and some of the commercial bank’s existing credit portfolios are tied to interest rates that have fallen below zero, banks’ interest margins fall, harming bank profitability. The more a bank is dependent on funding for household deposits (as opposed to other forms of funding that can be linked to a benchmark rate), the greater the impact on its profitability. In the UK, smaller banks and building societies are generally the most exposed to these risks. In order to maintain interest margins and profitability, banks may choose not to pass on the full rate cut when setting new interest rates or restrict lending. This would reduce the expansionary impact on the rise in negative interest rates and could even limit the availability of credit.
Progressive work on the vaccine
The UK became the first country to approve a vaccine, developed in collaboration of Pfizer and the German company BioNtech. The vaccine is proven to be over 90% effective in a provisional trial, which means that it stops the development of Covid-19 symptoms. This is above the 50% threshold required by the US Food and Drug Administration (FDA) for vaccine approval. We do not yet know how long this vaccine will provide protection, or whether so-called virus antigen mutations will require a periodic vaccine change, similar to the annual flu vaccines.
What does this mean for the markets and the economy?
The introduction of an effective vaccine is good news for the economy, as without an effective vaccine it is difficult to lift social restrictions that are very costly to the economy. Significant progress can be made on vaccination programs in developed countries in 2021, enabling a return to ‘normal’ as such. A faster than expected introduction of the vaccine could accelerate global growth by 0.5 percentage points in 2021.
Progress on vaccines will not be fast enough to contain the current wave of viral infections, which has forced social constraints in most developed market economies. These measures appear to have slowed the spread of the virus in the UK and Europe, but by the time vaccination becomes widespread, the number of cases is likely to increase again as social constraints ease. With this in mind, the immediate economic data is likely to remain weak. Economic segments remain closed, straining the labor market.
When Pfizer released data on the effectiveness of its vaccine, markets saw spectacular growth. The market areas most affected by the pandemic were the biggest beneficiaries, including travel and leisure, while companies that benefited from pandemic-induced changes in living habits sold out. The move supports global growth, benefiting companies exposed to the economic cycle. It also means that Investors may be less likely to pay a premium for stories based on structural growth. Long-term inflation and interest rate expectations have also revived, although neighborly bond yields remain low, reflecting the fact that interest rates are likely to remain low for some time.
Corporate spreads in the European Monetary Union EMU and in the US
Following an initial market downturn in March, corporate spreads have been swinging sideways for months. Two recent events paved the way for a second wave of spreads narrowing, bringing them closer to pre-pandemic levels. The trend reversal was especially noticeable when the main stock strategy was reversed, where market participants started selling the top to buy the bottom. This means that growth stocks (so far leaders of economic recovery) were sold, and stocks of companies presenting value and cyclical ones were purchased. This reversal of the equity strategy is of particular interest for corporate loans as spreads are generally negatively correlated with stock market movements (as stock prices rise, corporate spreads tend to decline). This strong dependency is of particular importance in extremely volatile periods, as is the case today. In other words, the correlations between capital and corporate spreads tend to be ~ -1 during periods of high capital volatility, giving you almost no diversification benefit during market peaks.
Chart: Correlation of US capital and corporate loans (y/y changes)
Source: S&P, Refinitiv, Allianz Research; IG: Investment Grade; HY: High efficiency
Chart: Correlation of equity and corporate loan in EUR (y/y changes)
Source: Stoxx, Refinitiv, Allianz Research; IG: Investment Grade; HY: High efficiency
How to explain the relationship between capital and credit spreads while recognizing the exacerbated relationship in times of high volatility? To achieve this, I use two capital implied volatility indices (VIX for the US and Vstoxx for the Eurozone).
When delving into the determinants of corporate credit spreads, one might expect a structural relationship between trends in corporate credit spreads and business cycle indicators. It turns out that this relationship can be measured by the economic convergence index, an index of consumer confidence. Consumer confidence indicators appear to be a relatively good proxy for corporate spread trends, especially in uncertain times. It is also worth noting that there is insufficient historical evidence to justify a significant and lasting detachment of the corporate credit spread from its underlying economic factors over an extended period of time. Is there an exogenous factor responsible for this discrepancy? The most important candidate is monetary policy measures. These exceptional measures, more or less aggressive and more or less active, have successfully reduced corporate credit risk as both central banks and relevant treasury departments have assumed the role of the lender of last resort, indirectly eliminating the traditional measures of credit risk.
Central banks and treasury departments were actively aided by market participants as official announcements managed market expectations so efficiently that led to massive capital inflows into this asset class and subsequent recompression of corporate spreads. In conclusion, the existence of this type of exogenous shock is no stranger to capital markets, as they previously experienced a similar market derailment during the Great Financial Crisis and the Eurozone Crisis. But is this situation permanent? And most importantly, will central banks keep artificially compressing spreads? Hopefully not, as Investors want to earn a fair risk premium that offsets the risk. It is important that central banks and treasuries institutions start thinking about a comprehensive exit plan so that market dynamics slowly settle on their own. However, given the current context of Covid-19, I do not expect it to happen in the near future or at least until economies are back on track and markets can withstand the withdrawal effect.
Monetary and fiscal policy will continue to be active in the near future, easing most of the existing underlying pressures that are unlikely to disappear by the end of 2021/early 2022. Against this background, I believe that investment-grade firms will remain anchored close to current levels but will show moderate an extension by 20 to 25 basis points by the end of 2021 and then stabilize. In the case of high yields, I expect further bankruptcies will weigh on investor sentiment, spiking spreads significantly at the start of the year but stabilizing at higher levels towards the end of the year (100 to 200bp higher than current levels).
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The views expressed in this document are not research, investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.