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Covid-19 and the omicron variant

Covid-19 case numbers are currently higher than predicted a year ago based on high efficacy data from vaccine trials. Indeed, a number of parameters have changed during this year. In particular, vaccination protection has been declining much faster than initially assumed.

Since the end of November, the new coronavirus variant B.1.1.529 “omicron" has been a source of fresh concern. Due to many mutations (about 50, 30 of which at the spike protein, the target of vaccines and antibody treatments), the variant has the potential to be highly contagious and to undermine existing immunities (vaccination or recovery from Covid-19). In contrast, antiviral pills (especially Pfizer's Paxlovid, which is highly effective against severe disease, according to a pivotal study in November – though the treatment has yet to show its merits in practice) do not target the spike protein and should thus work regardless of the viral variant. There is little evidence regarding the severity of omicron disease progression.

Negative effects of omicron (beyond those of the now dominant delta variant) are therefore likely to be concentrated in the coming winter months. In spring next year, booster shots and the increasing availability of antiviral pills should help to contain hospitalisations. Whether adapted vaccines are necessary should be clear by mid-December at the latest. According to statements by the manufacturer Moderna, however, it is very likely that existing vaccines do not provide sufficient protection. New vaccines would be available in a few months (Pfizer, for example, promises "production and distribution in 100 days"). (December 2021)

US goods demand drives inflation

In the US, the monthly price increase in October was 0.6%. Unlike in the spring, when only a few product segments saw strong price increases, the rise in October was broad based. The preliminary estimate of the monthly inflation rate in November in the euro area was 0,1% (excluding energy), with industrial goods prices up 0,5% in the month and services -0,2%.

The enormous increase in demand for goods is a phenomenon that is largely confined to the US, so inflationary pressure is likely to remain highest there. Nevertheless, the resulting pressure on commodity prices, supply chains and transport also has global impacts. In addition, some bottlenecks in the labour market (for example, in the hospitality industry) are leading to some wage pressure.

We expect the imbalances in the goods markets to gradually reduce, though this process may not start before the spring 2022 if the omicron variant requires meaningful social distancing in the winter months. During that process, monthly US inflation rates will remain higher than usual. (December 2021)

Equity markets: Fundamental sensitivities

We have analysed how the MSCI World, its sectors and key market segments are performing in different fundamental environments.

The overall market rises when the economy is growing, but, on average, also when bond yields or inflation rise, and monetary policy is tightened. Financials are the best sector when inflation and interest rates rise. Industrial stocks also perform comparatively well in a rising yield environment. Conversely, consumer staples, healthcare and quality growth stocks are the preferred market segments when the economy is growing only slowly, and interest rates are low, which remains our base case for the medium term. (December 2021)

Energy market outlook

In the short term, energy demand tends to fall only slightly even if prices rise sharply as demand for heating, mobility and in industry, for example, is largely fixed. There are also few substitution possibilities, such as replacing gas with other energy sources. Thus, even a slight imbalance of supply and demand can lead to enormous price fluctuations. The longer the time horizon, the greater the price elasticity of demand (e.g. behaviouralchanges by private individual and adjustments to industrial processes). On the supply side, governments are currently trying to counteract bottlenecks (especially by increasing production in coal-fired power plants, especially in China but also in the UK). We expect some rebalancing in energy markets in the months ahead. Nevertheless, there remains a risk of another significant increase in gas prices, especially in the US, while the magnitude of potential setbacks is naturally much smaller (e.g. in the event of a warm winter in the northern hemisphere).

In the medium term, it should be noted that the energy transition is associated with considerable uncertainties for oil and gas companies. This is one reason why extraordinarily little has been invested in new fossil fuel production capacities in recent years. With rising demand in the coming years, caused primarily by emerging markets, the risks of price spikes for oil and natural gas likely will remain comparatively high. (November 2021)

Regional equity market trends

Among the most important stock markets, the US market (S&P 500) stands out from Europe and emerging Asia in terms of earnings and performance. Due to its sector and company structure, the US market likely will continue to perform well in an environment of comparatively low global economic growth. This is especially true as long as the technology super-cycle (this sector is very highly weighted in the US) continues.

Among the conditions for European outperformance are comparatively high global growth, higher bond yields (which would favour financials, especially banks and insurance companies, which are highly weighted in Europe) and strong commodity markets – which we believe to be an improbable scenario.

China and emerging Asia are supported by China's leading internet platforms, which are no longer growing as strongly as in the past but which are expected to post above-average earnings growth in the coming years, despite stricter regulation. After a phase of underperformance, there are opportunities in emerging Asia, even though market sentiment (as a contrary indicator) is not yet sufficiently weak for a significant buy signal. (October 2021)

Sharp rise in operating margins

Due to cost measures taken by a large number of companies last year, rising profit margins were to be expected this year as the economic recovery progressed.

In the second quarter, profit margins rose to the highest in 10 years in Europe (companies in the StoxxEurope 600) and the highest level in 15 years in the USA (S&P 500). Positive margin trends are likely to persist. (October 2021)

Inflation: Mixed outlook

After a significant rise in core consumer prices in the US in the spring (with monthly increases between 0.7% and 0.9% from April to June), the increase in July and August of 0.3% and 0.1%, respectively, indicates easing price pressures. Inflation components with sharply higher prices in the spring (e.g. hotels and used cars) reported declines in August. In contrast, prices in sectors affected by bottlenecks in supply chains (e.g. new cars) continued to rise in August. Given strong consumer demand and supply constraints, a resurgence of inflation would not come as a surprise. For example, prices for lodging likely will rise again, once Covid-19 case numbers drop. The recent rise in US house prices is expected to drive increases in rents (over 30% weight in the US consumer price index), leading to somewhat higher monthly inflation rates in 2022 than in recent years.

In the euro area, core inflation follows a pattern similar to the US with a lag, even though the rate of monthly prices increases has been much less pronounced (the spikes in 2020 and early 2021 were due to the temporary reduction in Germany's VAT in the second half of 2020).

On balance, the latest data from both the US and the euro area are consistent with the thesis of a mostly temporary increase in inflation. The recent strong increase in energy prices (natural gas and oil) likely will to lead to price increases in industry and trade, though this should prove to be a temporary phenomenon. (October 2021)

China: Tighter regulation of the economy

This year has seen tightening of the regulation of internet companies in China, with Alibaba (the world's largest e-commerce company with annual gross merchandise value of over 1 trillion US dollars, more than twice as much as Amazon), Tencent (social networks with over 1.2 billion active users, payment services, mobile games, news content, videos and music) and Meituan (the world's largest delivery service) among the most prominent targets. What started with the cancellation of the Ant IPO (Alibaba's payment service) in November last year has expanded into a comprehensive set of measures focused on competition, but they also include restrictions in areas such as online games. Separately, academic tutoring – a boom sector in recent years – has been banned for for-profit organisations. In August, China also passed one of the strictest data protection laws in the world, curbing the collection and use of data by tech companies (but not by the government). The latest regulatory efforts are part of the 2021-2025 plan released in August, indicating that regulation of the economy will be a greater governmental focus than in recent years.

More competition tends to lower the profit margins of monopolists and benefit consumers and smaller merchants (who use the large platforms to distribute their products), with strong network effects (which promote monopolistic market structures) likely limiting the impact on profitability. We also believe that the regulatory measures do not go so far as to negatively affect overall economic growth. (September 2021)

Central bank policy: ECB strategy review

The results of the European Central Bank’s (ECB) strategy review, its first since 2003, have been in line with expectations. Despite slightly adjusted wording, the inflation target remains 2% and is interpreted symmetrically (i.e. both higher and lower inflation trigger a monetary policy response). In the future, the cost of owner-occupied housing will be included in the assessment of inflation (which increases inflation by 0.1 to 0.2 percentage points). It is noteworthy that the strategy review does not show how the ECB intends to orchestrate an increase in inflation to 2% when the lower limit for nominal interest rates has effectively been reached (which has been the case in recent years).

Unlike in Europe, the end of the phase of zero interest rates is foreseeable in the US as the central bank forecasts two rate hikes in 2023. Such an increase in rates is supporting the US dollar. In contrast, it is largely irrelevant to the capital markets when bond purchases in the USA will be tapered. Chairman Jerome Powell's latest remarks do not suggest any rush, although it remains to be seen how the central bank will react if monthly inflation rates remain high. (August 2021)

Is «market breadth» a good stock market indicator?

In recent months, the equity bull market has broadened visibly, with almost all sectors and an unusually large number of companies seeing rising prices. There is an often-cited rule that a high market breadth bodes well for future returns.

As an indicator of market breadth, the proportion of shares reaching a new 52-week high is most often used (the difference between the number of new 52-week highs and new 52-week lows can also be examined. To analyse future returns we grouped market breadth into four equally sized buckets (quartiles), with the fourth quartile representing the best market breadth (i.e. the highest proportion of new 52-week highs). This year, the market breadth has been mostly in the third or fourth quartile.

We conclude from our analysis that market breadth does not give reliable signals for market direction. In particular, the share of positive stock market periods is largely independent of market breadth. Contrary to what is often portrayed, high market breadth is associated with below-average returns. High market breadth thus appears to be an indication of an advanced bull market rather than a signal for high returns or a particularly high probability of achieving positive returns in the future. The conclusions are the same if we analyse only positive market periods. (April 2021)

Interest rates and equities: Conceptual framework

In a simple earnings discount model, the relationship between the stock market value and its determinants can be represented as follows: P = E / (r + z - g). P is the price (the present value of future earnings), E the earnings of the current year (or a multi-year average, as used in the Shiller-Cape ratio), r the risk-free interest rate, g the earnings growth rate and z the equity risk premium. The risk-free interest rate r and the growth rate g are strongly correlated, both conceptually and empirically. Interest rates are high when real or nominal economic growth (and thus growth in corporate profits) is high and vice versa. If r and g are the same, the formula shortens to: P = E / z. The fair value of an equity index equals the underlying profit level divided by the equity risk premium. If the risk premium is high (i.e. uncertainties are high), P is low and vice versa. As indicators of the risk premium, inflation (i.e. current inflation and not inflation expectations as implied in longer dated government bonds) and the frequency of recessions have been empirically shown to be very important in the long term. In the short term, economic momentum plays a role, while changes in monetary policy have less influence. We conclude that a connection between stock markets and interest rates is conceptually far less compelling than often assumed. Empirically, it can be shown that both a decline and an increase in the returns of the 10 year US-Treasury of the past 20 trading days lead to an above-average stock market performance in the following 20 and 60 trading days (especially a strong increase of more than two standard deviations). In contrast, an increase in yields by one or two standard deviations indicates a slightly below-average, but by no means strongly negative, performance in the month immediately following the increase in yields. (March 2021)
 

Equity regions: Risk and return profiles

The US stock market is by far the largest, followed by emerging Asia, Europe and Japan (while Latin America and emerging European markets lag far behind).

With a view to returns and risk measures, it is striking that the US market enjoys a top rank for returns in each period and is also among the markets with the lowest risk (standard deviation, semi-deviation). Consequently, portfolios optimised for risk and returns have a very high US-weighting, with some allocation to Emerging Asia and Japan for diversification purposes. European investors, therefore, should hold a high share of equities outside their home region (primarily in the US and, to a lesser extent, Asia). In contrast, the case for international diversification for US-based investors is much less compelling. (January 2021)

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