The media and investment community at large have applauded Germany’s recent U-turn regarding the issuance of common debt to finance fiscal transfers within the EU. Indeed, the EUR 500 billion rescue plan initially put forward by Angela Merkel (whose turn it is to assume Presidency of the EU for the July to December 2020 term) and Emmanuel Macron has since been embraced by the EU Commission (led by Germany’s Ursula von der Leyen). Its projected size has even been expanded to EUR 750 billion, of which two thirds would serve to provide grants to member countries and one third is to be deployed in the form of loans.
Subject to approval at the Special European Council meeting of 17-18 July, this common EU debt, which is likely to be almost fully bought up by the European Central Bank (ECB), will bear no interest. Capital repayments – starting only several years down the road – are to be made from the European Commission’s budget, meaning that all member countries will be put to contribution (in proportion to their GDP), alongside potential new taxation competencies that could be given to the Commission. The idea, of course, is that if the grants/loans are put to good use, member countries will have greater financial means down the road to contribute to the common EU budget.
Just how did Angela Merkel “pull this trick”, in a country that has long been one of the strongest tenants of fiscal austerity? What some might see as a form of compassion, we would attribute rather to a mix of pragmatism and strategy. With governments across the globe opening their purses wide, and a German fiscal house that has very much been put back into order following the expensive reunification process, it makes no sense to remain restrictive. Rather, the time seems right for Germany to invest massively in its domestic economy, and thereby consolidate its position as the industrial leader of Europe. The decision to increase debt to 80% of GDP if necessary and to spend it domestically could, however, be viewed as somewhat provocative by economically struggling EU partners – who, incidentally, are prime buyers of German industrial exports. Hence, in our view, Germany’s simultaneous change of stance on the concept of common EU debt issuance to finance a pan-European recovery fund. The fact that the world is becoming increasingly multi-polar, with the US military retreating from Germany and non-democratic leaders entrenching their reign in China and Russia, no doubt also played a part in this strategic development – which helps assert Europe’s position on the global scene.
What does this new “Germany rules” framework mean for investors? It is of course still early days, but we would argue that, at some point, exposure to the German manufacturers and car makers will be a must. Over the next years, they will have the financial resources to invest heavily not only into the ongoing transition to electric vehicles, but also into the next, hydrogen-fuelled, generation. The sustainable energy space, as part of the broader “European Green Deal” initiative, should also bring about interesting investment opportunities – at a time when China and, especially, India are still moving in the opposite direction, having respectively approved/auctioned 2 and 41 new coal mines recently.
In the immediate, though, what investors need to contend with are bond markets that continue to offer little to no yield, a gold “safe haven” that recently posted an eight-year high, and equity markets that are flashing numerous warning signs. Among these red lights, we can mention rich valuations, the TINA (“There Is No Alternative”) factor, small investors that are flocking to trading (gambling?) platforms such as the new Robinhood app, a record number of IPOs and capital increases, as well as the just-unravelling Wirecard fraud – which is of course reminiscent of the Enron scandal back in 2001. To be fair, market exaggerations concern mainly the Nasdaq which, despite what will probably be the worst economic crisis since the Great Depression, is actually up 12% year-to-date (versus a ca. 12% decline for the broader US Russell 2000 index or for European equities).
As we have discussed in prior investment letters, a short list of high-tech names (now known as the FAAANM – acronym for Facebook, Apple, Alphabet, Amazon, Netflix and Microsoft) is powering the equity market upmove, the sustainability of their business models being effectively taken for granted by investors. There is absolutely no doubt that the economy is moving online, with Covid-19 even accelerating the trend away from the brick-and-mortar world. But that is not to say that valuations no longer matter or that the sales and earnings of today’s high-flying stocks are immune. Just consider the recent advertiser backlash against Facebook, or the growing regulatory constraints on activities of some other new economy flagships, such as Airbnb, Booking.com and Uber.
Yet, however concerning the bubble signs may be, and despite our reluctance to take a “this time is different” line of reasoning, we do recognise that there is one very singular aspect to the current investment backdrop: extreme central bank accommodation, veering towards yield curve control. So far, only the Bank of Japan has formally started to set longer term (10-year in its case) rates. But it now seems that some Federal Reserve (Fed) Board members are also toying with the idea. The big difference between the Fed/ECB’s current monetary policy and a move to yield curve control is the following. Under their ongoing bond-buying programmes, both central banks decide in advance what amount of money they will spend – leaving some space for other market participants. Under a yield curve control policy, they would buy as many of the bonds of the targeted maturity as is necessary to bring the yield to the targeted rate – crowding out other market participants and potentially implying unlimited money creation.
If yield curve control does indeed become the norm, then equities will really be the only remaining “free” area of financial markets, allowing for substantial further P/E appreciation. Which is why, despite the flashing red lights, we are making only a slight cut to our overall equity exposure. To be more specific, we are taking some profits on the recent top performers: “Nasdaq-like” positions and Chinese A-shares.