In 2019, equity markets in “developed markets” grew between 20% and 30%. That wasn’t necessarily expected, after the 4th quarter of 2018 was characterized by a 20% decline in stock indexes. In 2018 central banks were affected by a restrictive monetary policy, which became an expansive one in 2019. While last year, central bank activity was marked by increasing interest rates and a reduction of their securities portfolios, due to the aggressive purchases of recent years, a money market-based expansion was resumed with the expansion of their balance sheets. Three interest rate cuts by the US Federal Reserve and one by the ECB were a visible sign for the capital market, which temporarily brought the yields on 10-year government bonds to new historic lows. The Swiss Confederation long-term bonds and those of the Federal Republic of Germany were recorded at minus 1.12% p.a. and minus 0.7% p.a. respectively.

Until the end of March, global equity markets had one of their best 10 yearly starts in history. From their lows in December 2018, stock indices rose, on average, by around 20%. During the year, this impressive increase in value was put at risk by fear of recession due, on the one hand, to the possible end of the 10-year economic cycle and, on the other hand, to political issues with potential to carry a lasting negative effect. Alongside the dominant political issues, the US-China trade war and the exit of the United Kingdom from the EU, constant unrest was present, with widespread participation by the populations, in different regions of the world, such as the yellow vest demonstrations in France and the climate activists of “Fridays-for-Future”. A common trait of all these movements was that the population is perceiving social inequality, which finds its expression in the establishment of new political nationalist and left-wing movements. Behind the legitimate protests for the recognition of climate change, often aggressive attacks against the market-based social system took place, such as the “Burn capitalism, not fossil fuels” by Fridays-for-Future activists.

In this context of increasing uncertainty, fluctuations in prices on the financial markets became significantly larger and with them, the price of gold rose from September 2018 levels at around USD 1,225 to around USD 1,550 a year later. At the same time commodity prices showed little movement, remaining at a level which continued to signal a weakening of the global economy. The economic indicators, which had been declining for more than 18 months, such as the Purchasing Managers’ Index, finally began their recovery towards the end of the 3rd quarter of 2019. Thanks to the stabilization of an economy which was continuing to grow, even if growth was less dynamic, the market players started to believe again that the latent trade conflicts could only have a limited impact on the economy. A contribution also came from the fiscal policy measures announcements in the form of a Green Deal by the EU Commission under new chairman Ursula von der Leyen and the accompanying support by the ECB with its new President Christine Lagarde.

… is looking to continue in the New Year

How sustainable is the current economic recovery and the trend of rising stock and bond prices? Since the 2008 financial crisis, stock indices have more than tripled on average, and bond profits increased by approximately 150%, i.e. by approximately 8.50% p.a. Stock valuations in relation to price-earnings ratios are high from an historical perspective – even if one considers 10-year averages, which are supposed to smooth short-term peak values. The lack of alternatives of other asset categories appears to provide further support to stock prices. Apart from the fact that no returns, or even negative yields, are to be expected on government bonds for a longer period of time, the confidence in the business models of private companies is greater than in countries where debt ratios are very high compared to their economic strength. In addition, aggressive stock buyback programs by successful companies have led to a shortage of stock. Thus, earnings per share remain attractive with an annual distribution averaging 3% p.a. which appears sustainable and therefore, profitable for the investor.

Where bonds are concerned, though, there seems to be far less capital gain expectation. Central banks are by far the largest buyers of government bonds (up to 80% of individual issues), some of which even have negative returns. Yield-oriented professional investors such as pension funds, insurance companies and investment funds have no interest in buying losses. Only hedge funds may be interested in long-term government bonds with excellent credit ratings, as a possible hedge in the event of an extreme crisis. Inflation expectations, however, which are well below the 2% target which central banks wanted, may further escalate due, among other things, to US trade disputes against China and all other countries. This, in turn, coming as a surprise for many, may force central banks to abandon their very supportive policies characterized by historically very low interest rates. As a result, there may be stagnation of the economy and deflation of prices (“stagflation”). A development which, historically, followed a big boom in Japan, but also in other regions, and could now take place in the US.

The EU Commission committed to ecological restructuring for Europe’s economic future, with the goal of reaching climate neutrality by 2050. The so-called “Green Deal” involves stricter emission limits for the manufacturing sector, adapted energy taxes, new rules for company subsidies, a more environmentally-friendly agriculture and possibly an environmental import tax. The ECB policy is also determined by the target of sustainability: its “Green Helicopter Money” encouraged renewable energy sources and infrastructure projects by means of earmarked green bonds. The financial markets could very well appreciate this interplay of monetary and fiscal policies. After a year marked by economic and political uncertainty, 2020 could manage to stabilize the global economy with an upturn already in fall 2019. In this economic cycle, once again, a rapid economic recovery could follow a slowdown. Therefore, one of the longest business cycles without a real recession is continuing, which is already called the “Peter Pan cycle” as it never seems to end. Since what is expected is a pacification, rather than an escalation, of political issues, and central banks and politicians are showing monetary and fiscal support, we can instantly see a positive continuation of the performance of securities such as stocks, real estate and gold.

However, within this perceived “goldilocks scenario”, potential developments which may spoil our current positive perspective for risky investments in the next few years should be mentioned.

The US dollar loses its leading currency status

Depreciations in currencies such as the Chinese yuan, the Brazilian real and the Argentine peso are repeatedly criticized by US President Trump, and customs duties are imposed or threatened on these countries. However, structural negative developments cause revaluations in the currency markets – unless it’s the United States, with the US dollar as world’s leading currency. According to Trump, the US central bank should act in order for these countries to no longer be able to benefit from the strong US dollar. In practice, the US dollar may be a soft currency, which can be manipulated, whilst maintaining, at the same time, the benefits its key currency status. Indeed, this status has a price to pay, which the United States is no longer willing to pay. Free access to the currency for all stakeholders in world trade and in the financial system, open markets, recognition of international legal regulations and of a multilateral system are no longer guaranteed. A process of decoupling from the US dollar has already started, especially in the emerging markets, and it is accelerating. In the first 11 months of last year, US new public debt increased more than USD 1.1 trillion. Should this be a knock-out for the euro-zone without key currency status, rating agencies would already have made drastic downgrades. An abrupt loss of confidence in the US dollar could trigger collateral damage greater than those of the 2008 financial crisis.

Escalation of the trade war between China and the United States and the Hong Kong protests

The trade war between the United States and China remains unresolved, punitive duties are still in place and are even increasing. To counteract the economic effects, China supports its own economy with massive investments. The budget deficit spreads to 8 percent, 10-year interest rates rise to 5 percent, as financing through government bonds is expanded. In turn, higher interest rates put pressure on private businesses and households, as their debt is sharply increased. Private consumption is falling, default rates are rising, banks and shadow banks are faltering. After a year from when they started, Hong Kong political protests have not subsided and the economic effects in the Special Administrative Region are becoming dramatic. Hong Kong is in a recession, which is even deeper than after the financial crisis. For this reason, China decides to deploy the army. While the EU is still discussing sanctions, US President Trump is reacting with further punitive duties and entry bans against China. China is slipping into a financial crisis and deep recession.

Euro crisis 2.0

Despite the fact that so-called peripheral countries such as Greece, Italy and Spain comply with EU requirements in terms of their expenditure, budget deficits increase massively, reaching 10 percent and more. International investors are pulling their money out of the eurozone, as the bonds of these countries are overvalued. Spreads on German government bonds widen dramatically, interest rates on 10-year bonds rise by 2.5 percent in Spain, 5.5 percent in Italy and 6.5 percent in Greece. The ECB’s bond purchasing program is greatly enhanced. In the short term, yields fall considerably at the long end, 30-year German government bonds trade at a record low of minus 0.7 percent. For banks, borrowing money in the short term and lending it in the long term in the form of loans becomes less attractive. The performance of banks in terms of earnings performance deteriorates dramatically. The ECB tries to support banks and increases the reserve requirement which can be parked at zero percent interest with the ECB from the current 6 times to 15 times. Thereby, the ECB triggers an interest rate shock at the short end, two-year government bonds’ yields approach zero percent. Short-term interest rates are higher than long-term ones. This completely brings to a halt long-term lending and causes a deep recession.

Return of inflation in the US and deflation in Japan

The punitive duties from the ongoing trade war with China and other countries lead to rising consumer prices in the US, inflation climbs to 4 percent, a 12-year high. For a long time, the Federal Reserve tries to ignore the problem by refusing to cut interest rates further. At the end of the year, the Fed has to increase the funds rate by 1 percent. 10-year US yields climb to 3.5 percent, an 8-year high. This pushes the US economy into recession. The Japanese central bank is the first among the western central banks to test helicopter money as a means to stimulate economic growth. Initially, successful, as the additional money is used for consumption purposes. The economy grows by 2.5 percent. However, with no further money distribution, consumption falls and both prices and the economy shrink dramatically.

The oil market uncertainty carries on

The US, Saudi Arabia and Russia are currently dominating the oil market. None of these three countries has any intention to cut production volumes in view of the cyclical downturn in demand. Oil prices falls below USD 30, as in 2016. Russia faces state bankruptcy: One Euro requires the payment of 100 rubles (currently approx. 69). In the Gulf States, all economic projects are either being postponed or canceled. Investments abroad need to be liquidated, a global downward spiral begins. Argentina falls back into recession with other emerging countries, unemployment rises to 15 percent. Citizens suffer from a 75 percent increase in the inflation rate. Countermeasures by the new government lead to a 10 percent budget deficit. The Argentine peso continues to depreciate: For the first time, 100 pesos are paid for one euro (currently 66). The high debt in foreign currency is no longer affordable, a new state bankruptcy is inevitable. The emerging market crisis, dominated by countries with high budget deficits and debts, leads to severe recessions and significant currency devaluations. For the first time, for one Euro, 6 Brazilian reals (currently around 4.51) and 120 Indian rupees (currently around 80) have to be paid.

Gold is banned as a safe haven

In the 1930s, US citizens, under the threat of severe penalties, gave up about a third of their gold to the state. US gold reserves increased, from 1930 to 1940, of more than 6,000 ton, to almost 20,000 tons. The Deutsche Bundesbank’s gold reserves totaled 3.370 tons at the end of 2018. Gold, above all, is considered as a safe haven asset and the ultimate vehicle for value preservation. When people do not have confidence in paper money currencies anymore, they will rush to invest in gold. At the beginning of 2018, the International Monetary Fund (IMF) presented the result of a study which showed that the price of gold increased massively during crises. Those who will ban cash will also want to ban gold. Compared to gold, paper currencies lose value over time. Both the euro and the D-Mark, previously very stable, fell sharply compared to gold purchasing power. Until now it was possible to buy precious metals anonymously in cash in Germany. From 2020, the purchase limit should drop to below 2,000 euros. From the new ECB President Lagarde, former Chair of the IMF, no support can be expected.

We expect two scenarios for 2020, the first one being considered by us the most likely:

I. Higher economic growth in the US, weaker in China and slow in the EU and Japan – stock prices continue to rise

The phase 1 trade deal between United States and China will increase business confidence and investment spending. The national economies of the United States, of the EU, as well as that of Japan, will grow. The labor market, consumer spending and the services sector remain strong. Fiscal policy measures are initiated, extending the longest economic cycle in history. China’s economic growth will continue to slow down because the transformation from an investment-driven to a consumer-driven economy inevitably leads to lower growth rates.

The biggest positive contribution will once again come from equities, those in the US being outperformed by those in Europe and in the Emerging Markets. As regards bonds, high yield- and government-bonds remain expensive. From an historical point of view, low interest rates make corporate bonds in the high non-investment grade category relatively attractive. The US dollar will weaken in favor of the Euro and of the Japanese yen.

II. Politics, with the spreading of trade and military conflicts, goes crazy – share prices fall by at least 20%

In this alternative scenario, a recession in the developed countries could not be avoided due to the fact that central banks have largely exhausted their countermeasure possibilities. The manufacturing sector does not recover, and this has a negative impact on the services sector. Business profits do not increase after a year of decline. Defaults by companies with low credit ratings spread to healthy companies. The sharp rise in unemployment reduces consumer spending and shrinks the gross domestic product.

Gold, the highest-rated government bonds and stocks of companies based on crisis-resistant business models and solid cash flows would be the preferred categories of assets. Large value stocks are to be preferred to growth momentum stocks. Japanese yen and US dollar will be sought as “safe haven” currencies.

In this sense, we can look forward to an exciting and challenging year 2020: we will be glad to take on these challenges with you once again.

 

Yours sincerely,

 

Mag. Christian Tury

Chief Investment Officer