Euro zone and US bond markets in a deep sleep
A more or less uneventful third quarter on the European bond markets enabled a positive performance due to the purchases of securities by the European Central Bank (ECB). German government bonds gained 0.4%, government bonds from the euro zone gained 1.7%, corporate bonds gained 2.0% and high-yield bonds gained 2.6%.
The central banks in the euro area and the USA have put their government bond markets into a deep slumber in order to create sustained favorable financing conditions for companies and governments. Yields should therefore tend sideways for the foreseeable future. Only a surprising rise in inflation could cause prices on the bond markets to move again. We see inflation risks only in the USA, as private households and companies are hoarding money to a considerable extent. However, we assume that the money is being held as a safety buffer and not being spent due to the high level of uncertainty. However, the potential for a major decline in yields is also likely to be low. A study by the Federal Reserve Bank of San Francisco based on 5,300 banks in 28 countries has come to the conclusion that negative interest rates only stimulate the banks' willingness to lend in the first year; from the second year on, they inhibit bank lending and are thus counterproductive from a monetary policy perspective. Negative interest rates structurally reduce the profitability of the banking sector. Against this backdrop, no major central bank is likely to lower the key interest rate in the foreseeable future. Since we expect the upswing in the euro zone to continue, we still see moderate potential for narrowing corporate bond spreads until the end of the year.
Stock markets: the Trump bubble
The third quarter saw a positive trend on the global stock markets. The MSCI World Index rose by 6.8%, the MSCI Europe by only 0.4% and the MSCI Emerging Markets Index by 8.8% – all in local currency. The weakness of European equities is due to the fact that the second wave of infection significantly impaired the growth dynamics in the European service sector and clouded the economic outlook for Europe.
There are innumerable methods for analyzing stock market valuations. We prefer to use a broad definition of corporate earnings (Cash EPS = EPS plus depreciation). Moreover, we compute a moving average of profits over ten years. The idea behind the moving average is to eliminate the effects of the economic cycle on profits. In a recession, for example, corporate profits are temporarily very low and a price/earnings ratio based on trailing or forward earnings can then give a false signal with a value that is way too high. At present, valuation indicators provide an unusually mixed picture. In the USA, valuation has risen to its highest level since the beginning of 2001. Valuations in the European and emerging equity markets are close to their historical average, and the Japanese equity market is slightly undervalued. Valuation divergences have reached extreme levels and, in our opinion, should tighten again in the medium term. The US presidential elections in November could be a trigger for this. If Joe Biden wins the presidential election and the Democrats take over the majority in the Senate, there is a threat of tax increases that could weigh on the US equity market. On the other hand, investors in the equity markets in Europe and the emerging markets should breathe a sigh of relief, as the risks of a major trade war are likely to decrease. In contrast, an election victory by Donald Trump should not contribute to any narrowing of valuation divergence.
Euro zone economy: irreversible upswing despite second wave of corona and Brexit risks
At the beginning of the third quarter, there was still hope that European countries would be able to manage the pandemic as well as Japan, Taiwan and South Korea. Obviously, however, discipline declined during the summer vacation months, especially among young people, so a second wave of infection developed in many European countries even before fall had set in. High infection rates in southern Europe have hit the tourism sector particularly hard because many vacation destinations there are now declared risk areas. In 2019, the trade surplus in tourism was around 8.3% of gross domestic product in Greece, 6.2% in Portugal and 3.7% in Spain. These countries must therefore expect a noticeable slowdown in growth in the coming months. However, hotels, restaurants and the entertainment industry throughout Europe are also likely to suffer a setback in the coming months following only tentative signs of a recovery. Continued weakness in the services sector will probably slow down the upswing in Europe, but not reverse it. We expect governments will take enough countermeasures to counteract any economic weakness and the industrial sector will be able to continue its upswing unchecked. It remains to be seen, however, whether governments will manage to restore discipline and whether only limited restrictions like a far-reaching mask mandate will be sufficient to bring the pandemic under control. No country can afford a second national lockdown. After all, hospital occupancy and deaths have remained low in most countries. This shows that, so far, the second wave of infection has mainly affected young people, while the older population has been largely spared. Alongside the corona pandemic, Brexit also represents a risk for the European economy. Negotiations are currently going so badly that there is now a 60% probability of a "no deal Brexit". Such a scenario would hit the British economy hard, but would also burden the economies of continental Europe. We assume that continental European states will quickly take countermeasures with fiscal aid to prevent a major economic slump. The immense economic damage in Great Britain caused by a "no deal Brexit" is likely to force the British government to give in to negotiations with the European Union in the course of 2021.
US economy: adjustment of the Federal Reserve's inflation target – the implications
In the second quarter, the US Federal Reserve announced that it was adjusting its monetary policy objectives. This became necessary because new inflation dynamics have been observed since the financial market crisis. In the past, the issue was always the elevated risk that inflation could overshoot rather than a risk of deflation. Since the financial market crisis, however, the US Federal Reserve has been surprised by too low inflation almost every year. The risks of a noticeable overshooting of inflation also appear to have decreased and the risks of deflation have increased.
The reason often given for the change in inflation dynamics is that the real neutral equilibrium interest rate has fallen noticeably and monetary policy is therefore automatically much more restrictive than it used to be. The real neutral interest rate is significantly influenced by the growth potential of an economy and the propensity of the private sector to save. Both variables are in turn very strongly determined by demographic developments. As a consequence, the models of the US Federal Reserve show that there is now a much higher pro-bability than before of reaching the zero interest rate lower bound. Against this background, the US Federal Reserve wants to avoid being trapped in zero interest rates for a long period of time in the future. It therefore wants to build up an inflation buffer in future upswings – in other words, temporarily allow inflation to overshoot the inflation target.
This means that the US Federal Reserve will raise the key interest rate later in the cycle as it did due to the inflation target before the adjustment, but it can raise the key interest rate more strongly, so there is also a larger interest rate buffer to combat a recession. However, the inflation target itself remains unchanged at 2.0% – but the US Federal Reserve now only wants to achieve it on average over a longer period of time. Initial simulations show that in view of its newly defined inflation target, the Federal Reserve could raise the key interest rate again in 2025 at the earliest. However, a surge in inflation in 2021 would be a risk scenario that would entail earlier increases in the key interest rate.
In contrast to the financial market crisis in 2008/09 when the entire central bank liquidity remained within the financial system, in the Covid-19 crisis a surge in bank loans and immensely high government budget deficits, largely financed by the US Federal Reserve, ensured that companies and private households are swimming in liquidity. Our expectation is that liquidity will be hoarded due to great uncertainty and therefore will not trigger dangerous inflationary dynamics. However, scenarios are conceivable in which the money flows into the real economy and leads to high price increases. The risk of an inflation scenario will also depend on the outcome of the presidential elections. If the Democrats win the presidency and the majority in the Senate, they could adopt new, comprehensive fiscal packages. An election victory by Donald Trump, on the other hand, would create a high degree of uncertainty and would lead to the expectation of a renewed escalation of the trade conflict.
Asian economy: consumer spending expected to pick up in Japan; China with continued solid growth
On September 16, 2020, former Prime Minister Shinzo Abe passed the baton to his successor Yoshihide Suga, who has already announced that he intends to continue the Abenomics policy. Abenomics can only be described as a great success. Since Shinzo Abe took office in December of 2012, the Japanese stock market has achieved an average annual return of 12.2%. The number of employees also increased by about 3.6 million even though the Japanese population shrank by about 1.6 million in this period. Shinzo Abe also managed to conclude seven free trade agreements for Japan during his term in office, including one with the European Union. He also single-handedly rescued the Pacific Free Trade Agreement, which is now called the "Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP)" after the United States left the treaty. Pushing ahead with digitization in Japan is likely to pose the greatest challenge for his successor, Yoshihide Suga. Japan will also have to make greater use of renewable energies in order to achieve its climate targets. The first impression of the new Japanese Prime Minister is positive, as he is aiming for numerous important economic reforms in addition to digitization. Thanks to the reforms under Abenomics alone, Japan increased its productivity (GDP per hour worked) by an average of 1.2% per year from 2012 to 2019, overtaking the US with growth of 1.0%. However, growth was disappointing in the third quarter of 2020. In September, the purchasing managers' indices for industry (47.3) and the service sector (45.5) remained at recession levels. Japan has not yet been able to follow the upturn in the rest of Asia. Heavy rain in July and a brutal heat wave in August weighed on consumption.
However, household incomes have risen markedly in recent months due to state aid, and part of the money should be spent soon. In addition, analyses of Google data show that the decline in new corona infections recently contributed to a significant increase in mobility during the long holiday weekend in September. This is apparently a sign that the population now wants to go out and consume more again. The government is also planning to extend its subsidy program to restaurants and for travel to and from Tokyo as of October 1, which should further stimulate consumption spending and services in the fourth quarter.
Obviously, the Chinese government was surprised by the severity and consistency of the US measures in the trade and technology conflict. China seems to want to respond with greater technological, economic, geopolitical and cultural independence. China's government therefore strives to strengthen the domestic economy on the one hand and invest massively in the country's technological development on the other. In addition, those in positions of political responsibility currently seem to have postponed efforts in environmental protection somewhat and are stimulating the economy with very traditional infrastructure programs. The economic data shows that this economic policy has been successful in stabilizing the politically important labor market and that the Chinese economy continues to show solid growth.
Interestingly, monetary policy has played only a minor role in this process. In the future, too, hardly any impulses are to be expected from this side, as cuts in key interest rates could damage the profitability of the banking sector and even lead to an increase in private household savings. Experience shows that private households in China tend to strive for a concrete savings target and thus increase their savings when interest rates fall. The only remaining option of monetary policy is to lower the minimum reserve ratios and thus free up liquidity in the banking sector. The foreseeable stability of monetary policy suggests that the bond market should also remain stable. At present, the yield on a ten-year government bond is around 3.1% and on a one-year bond it’s around 2.6%.
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