Even as lockdown measures are progressively eased, all eyes remain focused on the Covid-19 public health crisis. Its economic impact is clearly huge, as are the various public support packages being deployed across the globe. But one should not forget that the economic and – especially – (geo)political situation was difficult already before the pandemic broke out. Brexit, US-China tensions, European Union cohesion: these issues, to name just a few, are still very much present.

“Extraordinary” monetary policies enacted during the 2007-2008 Great Financial Crisis (GFC) never actually came to be reversed – save for a brief attempt in the US, thwarted by President Trump. And this Covid-19 crisis is taking central banks a step further into uncharted territory, at the risk of becoming but the financing arm of (increasingly authoritarian) governments.

Photograph: REUTERS/Carlo Allegri

With almost half of the world population currently in confinement, the question is not whether recession will occur but how long it will last. In turn, this depends crucially on medical developments: might any of the ongoing tests of (combinations of) existing drugs soon be found to work or will a return to “normal” social and economic activities have to wait for a vaccine?

With the coronavirus having now spread well beyond the borders of China, governments across the globe are taking drastic action – under intense media pressure – to contain the epidemic. Scientists warn that these measures might not succeed, but also provide reassurance as to the potency of this new form of flu. One thing is certain, though: from an economic standpoint, the worst is yet to come. Which explains why stock markets have gone into panic mode.

How fast the mood can change in the space of just a few weeks. Having begun the new decade on a high note, financial markets have since had to contend with the spreading of the Chinese coronavirus, blatant US-Europe divergences on the subject of climate change at the World Economic Forum, the Brexit D-day and presidential impeachment proceedings in the US Senate. Still, from a fundamental perspective, the picture remains one of low interest rates and supportive government policies, meaning few investment alternatives to equities – for the time being.

2019 proved a most peculiar year, one of multiple and fast-evolving risks, as well as stark Wall Street/Main street contrast – making the ride for investors less easy than full-period financial returns would suggest.

Only a few days to go before the December 15 tariff deadline and still there is no sign of the touted “phase one” trade deal between the US and China. But with the US Presidential election looming and China walking a fine line between economic stimulus and financial stability, odds are high that negotiators will soon come to some form of agreement.

The US Federal Reserve just cut rates for the third time in as many months. Meanwhile, M. Draghi’s last moves at the helm of the European Central Bank were to restart quantitative easing and push the cost of money deeper into negative territory. The opportunity to revert to a normal monetary environment has been missed – a blessing in the short run, perhaps, but a longer-term curse.

October is upon us and still there is no clarity on Brexit. Various scenarios are possible, with the worst standing to seriously hurt the European economy – at a time when German woes are deepening, fiscal stimulus is but a hope, and no progress is visible on the US-China trade front.

Right now, from China’s perspective, intensifying Hong Kong protests arguably pose a greater problem than the trade dispute with the US. A repeat of the Tiananmen events, three decades ago, is to be avoided at all cost – for the sake not just of the Chinese, but also the global economy.

How the picture can change in just a month. After “promising” at the late June G20 summit to allow trade talks to resume and not impose any new tariffs on goods imported from China, President Trump abruptly reversed course – one day after the Federal Reserve announced its first rate cut in over a decade.

Tension ahead of late June G20 summit in Osaka was high. Would this gathering of world leaders put the final nail in the coffin of multilateralism or instead succeed in rekindling discussions towards a US-China trade agreement – not to mention global cooperation on the climate front?

The European elections have come and gone, without the feared populist victory but yielding a fragmented landscape – which promises intricate negotiations to form a majority in parliament and elect the EU Commission President. Meanwhile, financial markets have also been rattled by a new set of Trump missiles, targeting China and Mexico. Making investment decisions in such an unpredictable and geopolitically-driven context really is a delicate and difficult task.

With little risk that central banks deviate from their accommodative stance – save perhaps a scenario of victory of the left in the European elections and subsequent German takeover of ECB leadership – risky assets look set to pursue their upward path, at least through the end of this year and of course conditional on a good outcome to the difficult, but still ongoing, trade talks between the US and China.

The one central bank that had embarked on the monetary policy normalisation route has just stopped dead in its tracks. The US Federal Reserve’s March 20 decision not to hike interest rates at this point – nor indeed probably for the remainder of 2019 – and to go easy on balance sheet reduction provides a clear signal to financial markets: low yields are here to stay, so the risky asset rally is welcome to continue.

Helping financial markets extend their rally late February was an unexpectedly solid 4th quarter 2018 US GDP report. With the Fed now on pause, a trade deal with China seemingly at hand and Trump-promised infrastructure investments to possibly finally materialise, the largest world economy looks set to continue growing this year, breaking its post-war cycle length record.

A look at the recent performance of shipping stocks – or the Baltic Dry index (BDI) for that matter – would suggest that the end of the world is nigh. After all, transportation is typically considered a leading economic indicator, with shipping its most volatile segment. Should we really be readying for a disaster scenario?

The first day of 2019 saw the NASA spacecraft “New Horizons”, launched in January 2006, reach the Ultima Thule comet in the Kuiper Belt, at the outer limit of our solar system. “New Horizons” took some 900 amazing pictures per second during its flyby, before continuing its voyage at a dazzling speed into the unknown territory of the wider galaxy.

Photograph: Alexander Nemenov/AFP/Getty Images

Have financial markets been correcting because of underlying weakness in the real economy? Or could it be that market turmoil will be what bring this long-lasting economic upcycle to its knees? As we turn the last page of 2018, the eternal “chicken or egg” question is very much open.

October certainly lived up to its adverse reputation, with the S&P 500 index posting its worst monthly decline since 2008, equities losing ground across the globe and bond yields nearing multi-year highs. Still, rather than marking the start of a deeper and broader downturn – one that extends even beyond financial markets – we view the recent corrective episode as a drill for what awaits investors, once the tipping point is eventually reached.

What if the main victim of US-promoted trade barriers were its own domestic economy? The European Central Bank recently made such a suggestion, which is also starting to be buttressed by economic data – be it in terms of the US trade deficit or inflation.

The current outperformance of US equity indices goes beyond an investor craze for Facebook, Apple, Amazon, Netflix and Google (collectively known as the FAANG stocks). It reflects a new versus old economy battle, which is starting to have serious real-world implications. And this battle is being fought on uneven terms, with still cheap and plentiful money providing an undue advantage to new economy companies.

The market is wrong in thinking that the US have nothing to lose in a trade war with China – just as it is wrong in expecting the world’s largest economy to weaken already next year.

Trade disputes are monopolising investor and media attention, with tough talk unlikely to abate before the US mid-term elections. But what if the more serious issues for financial markets were actually mounting inflationary pressures in the US and failing political unity in Europe?

Image Credit : Carlo Botta

European political waters were supposed to be calmer this year, after the many electoral hurdles of 2017. But investors’ nerves were tested again in late May with the ousting of the Spanish Prime Minister (leaving his successor at the helm of a very fragmented parliament) and complicated negotiations with respect to the formation of a populist government in Italy.

An important milestone was reached on April 24, when the US Treasury 10-year yield topped 3%, threatening to undermine the form of “equilibrium” that equity markets had settled into during the past few months.

Ten years have gone by since the Great Financial Crisis. The sequence of events that unfolded during this decade has profoundly transformed the world – not only for investors but for society at large. Democracy and free trade are under attack, technocrats have become very powerful, international institutions are unable to fulfil their historical role, and « peace for our time » is no longer assured.

What if the early February episode of market stress was not just a “healthy correction” within equities’ relentless upward march, but rather the onset of a more troubled environment?

The February 2 US labour market report sounded a warning bell, jolting equity markets out of their long-time state of sweet euphoria and blindness to budding inflationary pressures.

As we step into 2018, there is little question as to the direction of the global economy – barring an unexpected external shock. For the first time since the Great Financial Crisis, the OECD in aggregate is operating above potential, thanks to years of easy monetary conditions and the ending of fiscal austerity. Momentum appears to be particularly strong in corporate investment spending, with the compromise on tax cuts signed last month by the US Senate and House of Representatives only to add fuel.

As 2017 wraps up, investors’ quest for return is becoming ever more desperate. The money flooding to private equity and venture capital funds is mind-boggling, as are the valuations at which some managers in these spaces are making transactions. Paying up to a hundred times sales for a recently-founded unprofitable company cannot in our view be called investing – rather it is a gamble. «But hey», even sophisticated investors are saying, forgetting prior discipline about double-digit portfolio internal return rates, «perhaps this one company will be the next Google?»

Complacency rules in this “Goldilocks” environment of improving global activity with no flare-up (so far) of inflationary pressures. The investor mantra is that markets are expensive but no severe correction is to be expected in the near future, thanks to never-failing central bank support.

We begin this letter on what might seem an incongruous note for a financial publication: the end of the ban on women driving in Saudi Arabia. We are even tempted to paraphrase Neil Armstrong, considering it “one small step for Saudi women, one giant leap for Saudi Arabia”. Yes, we view this development as momentous, in so far as it underlines the speed at which the Kingdom of Saudi Arabia (KSA) is evolving under the influence of the young Crown Prince. A more acceptable form of society to “developed world” eyes will allow the KSA greater support from Western countries. Ties with US have already grown noticeably stronger during the past year.

The month of August was certainly noisy, with Hurricane Harvey and escalating North Korean military provocations dominating the headlines. Such commotion should, however, not detract investors from what we consider to be the crucial longer-term development: the normalisation of monetary policy – assuming of course that a dire scenario will be avoided in North Korea.

Numerous are the concerns that we have written about in recent letters – all the while striving to make the most of the ongoing sweet spot for the global economy and financial markets. Rich equity valuations, eventual wage-driven inflationary pressures, high correlations due to ETF and quantitative hedge fund proliferation, (geo)political uncertainties, build-up of Chinese non-performing debt: these matters (and more) have long featured on our worry list.

However enjoyable the ongoing upward ride in risky asset markets, we confess to becoming increasingly worried about the longer-term outlook. By this we do not mean that we fear a market crash. That, to put it bluntly, would be the better scenario – rapidly aligning valuations with intrinsic company worth and opening a new investment window. No, what we dread is a slow grinding process, whereby risky assets produce poor returns for many years. Alongside slowly rising bond yields, aka negative bond returns, this would be nightmarish for investors.

The money currently flowing into the private equity space is quite astounding – and a testimony to how desperate investors have become for returns in a world of zero rates. Not only are they willing to entrust massive amounts to newly established private equity funds, but they are also requesting that their money be put to work fast. The ensuing competition between private equity firms to find investments means not only that target company prices are bid up well above the level suggested by standard valuation tools, but also that proper due diligence is not always performed.

At the risk of repeating ourselves, let us begin this letter by pointing out the striking dichotomy between solid – indeed improving – European economic fundamentals and a political agenda that is rife with potential pitfalls.

Economic indicators are virtually unanimous in pointing to (very) strong global growth in the second quarter. Confidence is high at both the consumer and business levels, with Purchasing Managers Indices particularly buoyant – typically reliable leading indicators.

Politics rule our investment letter again this month, albeit shifting focus from the US to Europe. With the first episode of a heavy 2017 electoral agenda just around the corner, investors are understandably concerned that a populist backlash could undermine the European construction. Our position, taking a hard look at each of the countries involved, is that the European Union (EU) will likely not only survive the political challenges of 2017, but perhaps even emerge more united – thus in a better position to rethink its future.

The first weeks of the Trump term have been animated, to say the least.
Far from “rising to the function” as many were hoping, the new US President has kept to his Twitter style and set about running the country as if it were a company. We are convinced that institutions will eventually constrain him, be they the Congress (manifestly in no hurry to confirm the nomination of several Trump candidates), courts of law (as is occurring on the issue of immigration), the Federal Reserve or state governors. Pressure from the US corporate sector is also already evident. In domestic affairs, Donald Trump will thus have to start to compromise.

The economic picture is looking good as we enter 2017 – and stands to get even better in 2018. Growth is accelerating globally thanks to less austere fiscal policies and large infrastructure investments. After decades of trial and error, central banks have found the holy recipe to avoid recessions and keep inflation at a moderate level: durably low interest rates and episodic money printing.

Having begun 2016 in an extremely pessimistic mood, equity markets are ending the year on a high note. Brexit vote, Trump election, OPEC agreement to cut production (pushing the oil price upward), political disruption in Italy: no event has been “bad” enough to derail the upward march of most equity indexes for more than a few hours or days.

Last month we wrote about a number of black swan events that could generate financial market volatility over the coming weeks and months. Many of the short-term risks that we are monitoring actually share common roots – roots that reach back several decades. Reflecting on how the world has arrived to the current maelstrom of voter unrest, debt-strapped governments, distressed banks and increasingly impotent central bankers is key in our view to understanding the drivers of future investment returns.