MARKET CONTEXT: Biden’s New Deal: Stimulus for the World Economy
Global Macro:US President Biden has announced his US$2.25 trillion infrastructure plan, which comes on top of the recovery package of US$1.9 trillion. In total, stimulus measures announced since 2020 correspond to 25% of the US GDP. The infrastructure plan will be rolled out over the next 8 years with a large portion of the total spending to take place in the coming 3 years. The plan will have a number of consequences. First, as the stimulus package will be financed by US Treasury issues, we expect yields to keep rising, which would worsen the US ballooning debt. Second, the massive US dollar printing and deterioration of the US budget will cause the greenback to depreciate with respect to other currencies, thus contributing to the US dollar’s secular bearish trend. Third, taxes in the US will most likely increase. The Biden administration proposed to raise the corporate tax rate from 21% to 28%, which would have a negative impact on corporate earnings and therefore S&P 500 valuations. In addition, the US will need much more goods and materials than they can produce, so we believe US imports will increase significantly, favoring China in particular but also other trading partners such as the EU. Meanwhile, European countries like France are imposing new lockdown measures amid rising Covid-19 cases, thus delaying the economic recovery. China is leading the post-Covid recovery with economic indicators at higher levels than before the pandemic: industrial and service PMIs (Purchasing Managers’ Indices) have exceeded expectations while profits earned by Chinese industrial firms surged 180% in Q1.
Financial Markets:The equity market performance was driven by regions and sectors that benefited the most from the recovery. As such, cyclical sectors, such as financials and industrials, outperformed technology stocks. Markets with high P/E (price-to-earnings) ratios, such as the S&P 500, started to underperform with an average P/E of 40. This level was last seen in 2000, before the internet bubble burst. This rotation from highly valued stocks was accelerated by the rise in US Treasury yields, with the 10-year yield almost doubling from 0.90% in Q1 to 1.75%. Higher long-term rates weigh on high P/E stocks and benefit lower P/E stocks, such as financials and energy. Although we believe US stocks are expensive overall and at risk of undergoing a correction, short-term market indicators support the ongoing rally, including large inflows in Q1 as well as positive sentiment from both investors and corporations. In China, policymakers have highlighted the importance of reducing leverage in the financial system while new regulation on the financial business of Chinese e-giants has been implemented. However, the reduction of liquidity by the Chinese monetary authorities, in order to reduce leverage, spooked the market. The tighter liquidity in China resulted in Chinese equities losing more than 2% in March. Nonetheless, we believe China would benefit from a more stable economy with high-single-digit growth. The US has been rolling out stricter rules on Chinese equities listed in the US, increasing the risk of Chinese stocks being delisted from US exchanges. Subsequently, Hong Kong is already taking advantage of the listing of Chinese firms that cannot rely on US listings to access foreign capital.
Equity:Month to date the S&P 500 gained 4.3%, Euro Stoxx 50 +7.8% while the Hang Seng Index lost 2.1% on expectations of tighter monetary policy and decreased liquidity in China. Fixed Income:The 10-year US yield further rose 29bps in March to 1.75%. As a result, Emerging Market government bonds declined 0.8% in USD and 2.5% in local currencies. High-yield corporate bonds edged down 0.5% in EUR and up 0.5% in USD. Currencies:The US dollar continued to appreciate with respect to major currencies, underpinned by the rise in long-term interest rates: EUR -3.0%, CNY -1.2%, AUD -1.5%; safe haven JPY -3.9%, CHF -3.9%. Commodities:Oil prices declined in March amid concerns over rising Covid-19 cases worldwide while gold prices further contracted: WTI Oil -3.5%, Gold -1.5%.
Following Biden’s new deal, here is our updated list of risks:
Covid-19: New restrictions around the world would have a negative impact on the economic growth outlook.
Bankruptcy wave: Although government intervention has been able to limit the effect of the pandemic on business closures in some parts of the world, especially in Europe, the risk of a bankruptcy wave remains high. In the US, chapter 7 and 11 bankruptcy filings for public and private companies with liabilities over US$50m jumped 69% year on year in 2020, reaching a new high since 2009.
US Tech bubble & high US equity valuations:Tech stocks remain under pressure, given the highest valuations since the dot-com era and high market concentration, while the Biden administration is expected to take a much stronger stance on the tax and anti-trust treatment of Tech companies. Moreover, the 10-year average inflation-adjusted Shiller PE ratio of S&P 500 stocks has reached a new high since the bursting of the internet bubble in 2000, pointing to the expensiveness of US stocks and the risk of a potential correction.
Long-term interest rate hikes: At some point, central banks will reduce cash injections and taper their bond purchasing programs, which will result in higher interest rates and downward pressure on equity valuations. Meanwhile, investors are requiring higher yields to compensate for the risk of governments’ ballooning debt.
US-China tensions:US-China trade frictions remain strong, with increasing tension around Taiwan and the South China Sea. Although President Biden might be more inclined to adopt a multilateral approach with China than his predecessor, he has already sent signals that the US will remain tough on China on such issues as trade and technology. In addition, the US is maintaining its pressure on Chinese companies listed on US stock exchanges by implementing stricter rules targeting Chinese firms, which should curb their access to US investor funding.
China H-shares: Despite an equity market sell-off in March amid concerns of tightening liquidity as Chinese policymakers aim to reduce financial leverage in the economy, we believe H-shares’ upside potential remains intact given China’s growth dynamic and relatively cheap equity valuations, below their 2018 highs. Moreover, the composition of the Hang Seng Index is changing in 2021 with an increase in the number of components while the proportion of sectors participating in the digital transformation rises and cyclical stocks, such as financials and property stocks, remain a substantial part of the index. We expect the Hang Seng Index to benefit from the long-term trend of digital transformation, the cyclical sector rotation, and the reflationary recovery of 2021 and 2022.
Financials:Following the US election ‘blue wave’, investors are positioning themselves for higher long-term rates in the US and more generally the end of rate cuts. This is positive for the banking and insurance sectors where valuations continue to look attractive. We expect stocks of well-capitalized quality banks in the US, Europe, Hong Kong, and Japan to pay an above-market dividend yield following their central bank’s green light.
Oil & Gas:The sector partly recovered in 2020, yet still trades at half the book value of the market, its lowest level since 1928, and is lagging the oil recovery. We are seeing more interest from investors towards major energy players that are implementing green energy programs to transition from fossil fuels to clean, sustainable energy production, thus making them major decarbonization contributors.
Chinese Yuan:The RMB reflects the forward growth of the Chinese economy (IMF forecasts over 8% growth in 2021) and the increase in global trade and investments in RMB. The Yuan is also becoming an important reserve currency for central banks and financial institutions, underpinned by China’s strong economic fundamentals: a large positive commercial balance, growing domestic consumption, and interest rates at 3% vs close to 0% in Western economies. Moreover, the UN announced that China became the number one country in the world for Foreign Direct Investments in 2020, with growing inflows from investors buying Chinese stocks, bonds, and hard assets contributing to the strengthening of the renminbi and consolidating its role as a major trade currency.
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