169

N°
4th quarter 2021

Perspectives
Financial markets
analysis
Macroeconomic environment Hopes that robust economic growth will
3 continue in 2022 may be disappointed.
There is ongoing debate as to whether the current
inflationary pressures are transitory or permanent.
The US Federal Reserve will begin to taper its
asset purchases in the fourth quarter.

Financial markets The most important question for the financial markets at
9 the moment is whether or not inflation is here to stay
The main conclusion to be drawn from the current high
valuation multiples is that future returns are likely to be low.
Changing economic fundamentals and much more
reasonable valuation multiples continue to point
towards a gradual shift from West to East.

Visit our website at A BLI - Banque de Luxembourg Investments

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 N ° 16 9 — 4 th q u a r t e r 2 0 2 1 MACROECONOMIC ENVIRONMENT 3

Macroeconomic
environment

G L O B A L P U R C H A S I N G M A N AG E R S’ I N D E X The first signs of a moderation in global economic growth

are on the horizon. Although most activity indicators are
65
holding up, they seem to be starting to turn around from the
very high levels of previous months. For example, the global
manufacturing activity index appears to have peaked in the
60
summer, after a period of almost uninterrupted growth since
May 2020. Nevertheless, the moderation in manufacturing
55 activity appears to be more the result of the ongoing
disruptions in supply chains than any major weakening of
50 demand. The global services PMI also fell slightly, mainly
due to the rise in coronavirus infections, although this should
Index

45 prove temporary. The slowdown in global growth could be

exacerbated by recent trends in China, following the tightening
of regulatory measures in almost all economic sectors, a
40
power shortage and the financial difficulties of the Evergrande
Group, the country's second largest property developer.
35

30
2000 2003 2006 2009 2012 2015 2018 2021

Manufacturing sector Services

Source: Oxford Economics, IHS Markit, JP Morgan

GROW TH IN US CONSUMER SPENDING SINCE W W2 In 2021, US consumer spending will have recorded the
strongest growth since World War II as American households
have benefited from exceptionally favourable financial conditions
10
throughout the year. Government support measures in the wake
of the pandemic have resulted in household disposable income
8 2021: 8 %
being higher than it would have been without the health crisis.
In addition, the surge in house prices and equity markets,
6
fuelled by the Federal Reserve's ultra-accommodative monetary
4
policy, has produced an unprecedented wealth effect. Low
interest rates have also minimised the debt burden and financing
Annual change (%)

2 costs for new acquisitions. However, the different economic

sectors have not been equal beneficiaries of the consumer
0 spending spree as the social-distancing measures to contain the
pandemic tended to shift consumption towards discretionary and
-2 durable consumer goods, at the expense of services activities.

-4

-6
1948 1958 1968 1978 1988 1998 2008 2018

Average growth 1948–2019

Source: Oxford Economics / Haver Analytics
 4 Perspectives Financial markets analysis

US JOB OPENINGS US economic growth is set to remain robust in the short term.
Although recent signs of moderation in several key economic
12000 indicators suggest that the peak in growth is behind us,
their continuing high levels do not point to a major cyclical
weakening in the immediate future. The decline in the number
10000
of coronavirus infections after the deterioration of the health
situation in the summer, the need for the distribution sector to
replenish depleted inventories, the record number of vacancies
in the labour market and increasing wage pressures due to the
8000
labour shortage even suggest a slight acceleration in growth
in Thousands

in the fourth quarter compared to the moderate pace recorded

in the summer. The scenario of continued robust growth in the
6000
short term assumes that the dithering in the Senate and the
House over raising the debt ceiling, the public infrastructure
renewal programme, and the Biden administration's plan to
4000
increase social spending do not lead to a deeper political crisis.

2000
75 80 85 90 95 00 05 10 15 20

Monthly number of vacant posts

Source: Oxford Economics

GOOD TIME TO BUY A HOUSE GOOD TIME TO BUY A CAR Visibility for the growth outlook next year is much more limited.
Advocates of the scenario that robust growth will continue point
to the strong recovery in corporate investment as companies
strive to increase their production capacity. The hope is that
85 80
this additional expenditure will trigger a virtuous circle similar to
the usual pattern for a post-recession period – translating into
an improvement in the labour market, wages and productivity
75
70
gains, which will trigger a non-inflationary growth cycle.
Although this favourable scenario cannot be ruled out, it does
65 not seem very likely in the current circumstances. The end of
60 the exceptional pandemic-related public support measures,
Index

the unequal distribution of excess savings concentrated among

55
an increasingly small minority, the non-recurrent nature of the
50 acquisition of furniture and other durable goods amassed during
45 the lockdowns, and the general increase in prices (including in
key sectors such as real estate, cars and energy) will reduce
40 household purchasing power and thus stifle the virtuous
35
circle set in motion by the recent recovery in investment.

25 30
University of Michigan Consumer Sentiment Index
Source: Cornerstone Macro

DISPOSABLE INCOME OF EUROZONE HOUSEHOLDS The economic recovery remains more moderate in Europe.
In contrast to the US, the European authorities limited their
7400 public support measures to levels that only compensated
for loss of income caused by furlough whereas, across
the Atlantic, the scale of public support ratcheted up the
7200
overall level of household disposable income. Greater fiscal
discipline is therefore the main factor behind Europe's
7000 more moderate growth rates. A second element that has
a stronger effect on the European economy is its greater
In EUR Billion, annualised

6800 dependence on manufacturing production, which, compared

to services activities, is heavily affected by disruptions in
supply chains and component squeezes, such as the shortage
6600
of electronic chips in the automotive sector. Finally, the
recent surge in energy costs in general, and gas prices in
6400 particular, will affect the already tight budgets of households
struggling to make ends meet and considerably add to
6200 production costs in the industrial sector, jeopardising the
continuance of the economic recovery in the winter months.
6000
2015 2016 2017 2018 2019 2020
Fiscal support measures Household nominal disposable income
Implied path for household disposable
Source: Crédit Suisse, European Central Bank
income based on total hours worked
N ° 16 9 — 4 th q u a r t e r 2 0 2 1 MACROECONOMIC ENVIRONMENT 5

J A PA N E S E G O V E R N M E N T B O N D S H E L D BY T H E B A N K O F J A PA N In Japan, the recent release of the National Survey of Family

Income and Expenditure conducted every five years provides
550 50
detailed information on the evolution of the financial situation
of the population from 2014 to 2019. The survey assesses
500
the impact of the Abenomics programme launched by the
450 40 former Prime Minister at the beginning of his second term in
400 2012. The objective was to put an end to the deflation that had
hung over the Japanese economy for two decades through a
350
30 programme based on three arrows: a significant expansion of
300 the money supply, a considerable increase in public spending,
JPY billions

%
250 and the implementation of reforms to improve the country's
20 competitiveness. One year on since the end of Abe's reign,
200
the facts show that the targeted objective has hardly been
150
achieved. Inflation remains close to 0%, consumer spending
100 10 is below the level it was at the start, average household
50
net wealth fell by 3.5% from 2014 to 2019 while average
household nominal income rose slightly by 3.6%. The main
0 0
consequence of the programme was the accumulation of
1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021
Japanese government bonds by the central bank, which now
holds almost half the total of all outstanding government bonds.
Volume of government bonds held by the central bank (LHS)
% of total outstanding bonds (RHS)
Source: Jefferies, Bank of Japan

M E N T I O N O F T H E T E R M 'C O M M O N P RO S P E R I T Y ' BY C H I N E S E Chinese President Xi Jinping appears to be taking the

PRESIDENT XI Middle Kingdom in a new direction that could prove to be a
80
paradigm shift. Never tiring of invoking the goal of ‘common
prosperity’, President Xi says he wants to return to the
essence of socialism aligned with the original intentions of
the Communist Party. The following quote illustrates the new
focus: “The Chinese Communist Party is the vanguard of the
60
Chinese working class, the Chinese people and the Chinese
nation. To serve the people wholeheartedly is its permanent
mission. The country is the people and the people are the
country. The Party's struggle to found a new China and
40
develop it is for the people. Of the people, by the people, for
the people – this is what has guided the CCP from victory
to victory over the past century.” In order to better serve the
interests of the people, President Xi has announced a series
20
of regulatory measures affecting virtually every economic
sector: education, the internet, technology, finance, the
gaming industry, cars, entertainment, culture, advertising and
property, to name but a few. Increased regulation is likely to
0
2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 slow the country’s economic growth in the coming years.
Number of mentions
Source: Cornerstone Macro, Bloomberg

HOUSING ACTIVITY IN CHINA One of the first consequences of the Chinese Communist
Party’s new direction is the financial difficulties of the
30
Evergrande Group, China’s second largest property developer.
Following Xi Jinping's words that "houses are for people
20
to live in, not for speculation", Vice-Premier Han Zheng
recently added that the property sector should not be used
10
as a short-term tool to stimulate the economy. The desire
Change (%) from same month in 2019

to keep property prices affordable in the long term may

0 explain why the Beijing government has not yet come to
the rescue of the giant Evergrande, which is more than
-10 $300 billion in debt and on the verge of defaulting on its
commitments to creditors. Although the government will
-20 not let the situation escalate into a full-blown property or
banking crisis, it seems ready to set a clear example to
-30 curb property speculation, which is regularly mentioned by
policymakers as one of the main sources of social inequality.
-40

-50
2020 2021
Floor space sold Floor space started Residential property investment

Source: Oxford Economics / CEIC

 6 Perspectives Financial markets analysis

P R I C E O F N AT U R A L G A S I N T H E U S A N D E U RO P E Inflationary pressures are surging from all directions. Due

to the ongoing disruption of supply chains and the low level
6 100
of investment in previous years, companies are unable to
meet the growing demand. The imbalance between supply
and demand is no longer limited to electronic chips, demand
5 80 for which surged during the pandemic as the process of
digitalisation accelerated, but now extends to almost all
economic sectors, including sensitive industries such as
4 60 food and energy. As winter approaches, the sharp increase
in gas prices is of particular concern. A longer and colder
winter in 2020, depleted gas stocks that were not replenished
3 40 in the summer months, unfavourable weather conditions
for wind power production, the gradual reduction in the
operation of coal-fired power stations, and increased energy
2 20 needs as the economy recovers are a combination of factors
that have led to a widespread shortage of available energy
resources. Europe's heavy dependence on gas imports and
1 0 the lack of port infrastructure make the European economy
particularly vulnerable if energy prices fail to normalise.
20

05 0
20

06 0
20

07 0

08 0

09 0

10 0

11 0

12 0

01 0

02 1

03 1

04 1

05 1

06 1

07 1

08 1

09 1
1
02

02

02

02

02

02

02

02

02

02

02

02

02

02

02

02

02

02
0

0
/2

/2
/2

/2
/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2
01

04
02

03

Gas price in the US (LHS, USD/MMBtu) Gas price in Germany (RHS, EUR/MWh)
Source: Jefferies, Bloomberg

C O N T R I B U T I O N O F T H E A U T O M O T I V E S E C T O R T O U S I N F L AT I O N The question as to whether the current inflationary pressures

are transitory or permanent is difficult to answer. Over the
5 5
next year, inflation rates will probably be slightly below the
current high levels. Several factors are likely to come into
play. In the United States, the sharp increase in automotive
sector prices was one of the main sources of the upturn in
4 4
inflation but they are expected to cool off within a year at the
latest. The likely decline in automotive prices will be partly
offset by rising rents, which generally slightly lag house prices
Annual change (%)

3 3 and account for almost a third of the consumer price index

excluding energy and food. However, supply chain disruptions
are expected to gradually ease, suggesting that inflation
2 2 could decline in 2022. In contrast, the tight labour market
with record job vacancies and minimal layoffs points to an
acceleration in wage costs that companies will try to pass
1 1 on to the end consumer. Given the multitude of conflicting
factors, it is impossible to draw a reliable conclusion.

0 0
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021 2023
Inflation excluding energy and food Inflation excluding energy, food and the automotive sector
Source: Minack Advisors, U.S. Bureau of Labor Statistics, National Bureau of Economic Research

P U B L I C D E B T I N T H E U N I T E D S TAT E S Even in the longer term, visibility on price movements remains

limited. The main argument for sustainably higher inflation
200 200 is the opening of the Pandora's box of unlimited government
spending since the outbreak of the pandemic. In a recent
180 180 speech to the House Committee on Financial Services, US
Treasury Secretary and former Federal Reserve Chair Janet
160 160
Yellen argued for the permanent abolition of the debt ceiling,
140 140 citing the example of Japan, whose economy was doing well
despite a public debt ratio of around 250% of GDP. If the
120 120
state becomes the main source of growth, companies tend to
% of GDP

100 100 keep investment at structurally low levels, leading to a gradual

erosion of the capital stock and, consequently, an insufficient
80 80 increase in production capacity. Periods of inflation and
deflation could therefore alternate, with demand outstripping
60 60
supply when government spending accelerates, and supply
40 40 outstripping demand when government spending normalises.
In the long run, economic growth potential would be reduced
20 20
and there would be a structural upward shift in inflation.
0 0
00 10 20 30 40 50 60 70 80 90 00 10 20 30 40 50
Public debt Congressional Budget Office forecast

Source: Minack Advisors, Congressional Budget Office, Federal Reserve, Bureau of Economic Analysis, Historical
Statistics of the United States 1789-1945
N ° 16 9 — 4 th q u a r t e r 2 0 2 1 MACROECONOMIC ENVIRONMENT 7

U S S H O R T-T E R M R E A L I N T E R E S T R AT E S Although US inflation is at its highest level since the early

1990s, the Federal Reserve seems in no hurry to normalise
12 monetary conditions. Viewing the current price surge as
transitory, the Fed is taking small steps towards exiting its
10 ultra-accommodative policy. At the last FOMC meeting in
September, Chair Jerome Powell signalled his intention to start
8
tapering asset purchases from mid-November. The current
$120 billion of government bond and mortgage purchases
6
would be successively reduced by $15 billion each month
4 and end by mid-2022. Visibility is limited on the future level
of interest rates. Although, according to Jerome Powell, the
%

2 end of asset purchases does not indicate a rise in interest

rates, half the members of the FOMC anticipate a first rate
0
hike in 2022. Given the very gradual pace of the monetary
-2
policy normalisation process, it does not look as if the period
of negative real interest rates will end anytime soon.
-4

-6
1971 1976 1981 1986 1991 1996 2001 2006 2011 2016 2021

Federal funds rate - inflation rate

Source: Bloomberg

E C B H O L D I N G S O F E U R O Z O N E O U T S TA N D I N G G O V E R N M E N T The ECB has so far made only a marginal adjustment to its

SECURITIES ultra-accommodative monetary policy. At the last meeting of
the Governing Council of the ECB, the monetary authorities
45
announced a slight readjustment of asset purchases under
40 the pandemic emergency purchase programme to a level a
little below that of the previous two quarters. That said, the
35 ECB is continuing to accumulate sovereign debt and now
30
holds almost 40% of the total of all outstanding eurozone
government bonds. So far, the monetary authorities have not
25 yet given any indication as to the exit route from the current
monetary policy. To avoid a widening of yield spreads between
%

20
core and peripheral countries, it seems unlikely that the ECB
15
will be prepared to abandon asset purchases altogether,
despite the economic recovery and rise in inflation. At the
10 December meeting, the monetary authorities expect to give
more details on the monetary policy outlook for 2022.
5

0
5

15

16

1
01

01

01

01

01

01

01

01

01

01

01

01

02

02

02

02

02
20

20
/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2

/2
/

/
01

03

09

01

09

01

05

09

01

05

09

01

05

09

01

05

09

01

05

Eurozone government bonds held by the ECB as a percentage of total outstanding sovereign debt
Source: Jefferies, ECB
N ° 16 9 — 4 th q u a r t e r 2 0 2 1 FINANCIAL MARKETS 9

Financial markets

G L O B A L E Q U I T Y I N D E X I N E U RO S After continuing to advance in July and August, equity

markets suffered a more difficult end to the third quarter. The
420 publication of economic figures that were below expectations
in terms of growth and above expectations in terms of inflation
410
has raised the spectre of stagflation – an economy with
400 little growth and high inflation. The fear of seeing inflation
390 take hold drove bond yields higher and shook the market's
380 confidence as to when the Federal Reserve will start to tighten
370
its monetary policy. Financial problems at the Chinese property
development group Evergrande, uncertainties surrounding
360
the Covid-19 Delta variant as well as the US debt ceiling hike
350 were other factors weighing on the markets in September.
340

330

320

310

300

290
October November December January February March April May June July August September October
2020 2021

Source: Bloomberg

F O R WA R D P/ E R AT I O S Over the year as a whole, equity markets have nevertheless

risen strongly, all the more so as the indices rebounded in
24 24
early October. By mid-October, the MSCI World Index had
reached a new all-time high in euros and was up by around
22 22 23% year-to-date. It was also over 20% above its pre-
pandemic level. However, in contrast to 2019 and 2020,
20 20
valuation multiples fell in 2021 as corporate earnings growth
18 18 outpaced share price rises. In terms of regions, emerging
markets have significantly underperformed industrialised
16 16 countries, and within the latter, the US market has again
outperformed its European and Japanese counterparts.
14 14

12 12

10 10

8 8

6 6

4 4
2007 2009 2011 2013 2015 2017 2019 2021 2023 2025
Emerging markets Developed markets ex US S&P500
Source: MSCI, IBES/Datastream, NBER; Minack Advisors
10 Perspectives Financial markets analysis

U S I N F L AT I O N R AT E The most important question for the financial markets at

the moment is whether or not inflation is here to stay. The
7
leading central banks have repeatedly announced their
intention not to tighten monetary policy and the consensus
6 expectation is that the Federal Reserve will not raise its
headline rate before the end of 2022. However, economic
5
reality may force the monetary authorities to make a choice
4 between fighting inflationary pressures and supporting the
financial markets. Premature tightening of monetary policy
3
could be badly received by the equity markets at a time
2 when valuation multiples are running high. Financial history
%

shows that monetary tightening has always led to a fall

1 in multiples when these multiples have been elevated.
0

-1

-2

-3
1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022

Source: Bloomberg

W O R L D G D P, S A L E S A N D P R O F I T S G R O W T H Another point is that these multiples are applied to earnings

that are themselves very high as they are based on profit
margins that are well above the historical average. In recent
500
400 years, share prices have risen faster than earnings (hence
300 the increase in valuation multiples), and earnings faster than
sales (hence the increase in profit margins). A very negative
200
scenario would see a reversal of these trends, with falling
valuation multiples accompanied by falling profit margins
100 and earnings. This would be all the more likely in a context
90
80 of rising inflation. However, the main conclusion to be drawn
70
60 from the current high valuation multiples is that future
50 returns on the leading equity indices are likely to be low.
40
30

20

10
9
1980 1985 1990 1995 2000 2005 2010 2015 2020 2025

GDP Sales Profit

Source: BCA Research 2021

M I C RO S O F T (6 % O F S & P 5 0 0 , 3 % O F M S C I W O R L D, A A A E S G It follows from the above that the current environment is clearly
R AT I N G) S H A R E P R I C E O V E R 10 Y E A R S not conducive to index-based investing. The irony of passive
350
management is that it often appears most attractive at times
when it makes the least sense. Moreover, the popularity of
index-tracking combined with a growing interest in socially
300
responsible investment means that many portfolios are
invested in the same stocks, notably the US technology majors
250 since these have a high weighting in the indices and often a
good ESG rating (for Environmental, Social and Governance
200 criteria). While the markets are rising, this is not a problem,
but the question is, who will be the buyers for these stocks
if the portfolios that currently hold them had to sell them?
150

100

50

0
2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021

Source: Bloomberg
N ° 16 9 — 4 th q u a r t e r 2 0 2 1 FINANCIAL MARKETS 11

U S 10 -Y E A R T R E A S U RY B O N D Y I E L D Bond yields rose slightly in September after falling between

April and July. But the general message coming from the bond
3.5
market is that it still sees the rise in inflation as temporary.
Otherwise it would be difficult to reconcile a 10-year yield of
1.6% in the United States with inflation exceeding 5%. Logically,
3.0 if holders of long-term debt (as rational investors) feared that
inflation was here to stay, they would sell their bonds and
that would drive up bond yields. If they don’t sell them, or
2.5
only do so minimally, it would imply that they don’t expect the
acceleration of growth and return of inflation to last and that the
2.0 structural economic environment will remain one of moderate
%

growth, low inflation and expansionary monetary policies.

1.5

1.0

0.5
2016 2017 2018 2019 2020 2021

Source: Bloomberg

P E R C E N TAG E O F G O V E R N M E N T D E B T H E L D BY T H E F E D E R A L Whether the bond market is still functioning normally is

RESERVE an important question, however. Government debt seems
increasingly to be in the hands of investors for whom profitability
23
is only a secondary requirement or even totally unimportant.
21 Central banks are, of course, the ultimate exponents of
this type of investor, and they have been among the largest
19 purchasers of debt in recent times. In Japan, almost 50%
of government bonds are now held by the Bank of Japan. In
17
the eurozone and the US, the respective figures are around
15 40% and 25%. In addition, institutional investors are obliged
to hold this type of asset for regulatory reasons. Such a
13 situation is not helpful for the price discovery mechanism,
which is essential for the proper functioning of an economy.
11

5
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

2016

2017

2018

2019

2020

2021

Source: Federal Reserve

P R O F I T M A RG I N S I N J A PA N The Japanese market held up well during the market correction

in September, with the Topix index even adding around 4%. For
10 the year as a whole, however, it continues to lag other markets,
as it has done for several years. Japan's underperformance is
9
surprising as there are plenty of positive considerations in its
8 favour and the factors behind the disappointing performance
since its peak 30 years ago have gradually dissipated. Japanese
7
companies have also undergone a transformation in their
6 behaviour. Although the principle of shareholder value is not
as extreme as in the US, companies have been working to
5
structurally improve their profitability. Their profit margins are
%

4 approaching the levels seen in other industrialised regions.

AVERAGE
3 OVER
The resulting increase in cash flow has been purposefully
DECADE used to deleverage (such that debt levels are now well below
2 those in the US and Europe) and to increase shareholder
1 returns in the form of share buybacks and dividends.

-1
1980 1985 1990 1995 2000 2005 2010 2015 2020 2025
Japan World ex Japan

Source: Minack Advisors

12 Perspectives Financial markets analysis

U S D/J P Y E XC H A N G E R AT E The Japanese market’s underperformance in 2021 is primarily

due to domestic factors. Corporate earnings were more
120.0 affected by the pandemic and have rebounded less strongly
than elsewhere. The Japanese economy also suffered from
a fresh wave of the pandemic and the purchasing managers'
117.5
index fell below 50 in the second quarter. This situation
should gradually improve as the vaccination rate improves.
115.0 In the meantime, the Japanese market offers an attractive
valuation in relation both to its own history and to other
112.5 markets. Although the case for Japan is primarily structural
in nature, the improving global economy and the weak yen
110.0
are two cyclical elements that will also be beneficial.

107.5

105.0

102.5
2016 2017 2018 2019 2020 2021

Source: Bloomberg

C H I N A’S S T O C K M A R K E T P E R F O R M A N C E Markets throughout the Asian region are having a difficult

year. The MSCI Far East ex. Japan index is down nearly 7% (in
6000
dollars) year-to-date. This weakness is partly explained by a less
marked economic rebound than in the West, but is mainly due
to the poor performance of the Chinese stock market, which
5500 has been dented by the Chinese authorities’ announcement
of new measures against certain sectors and companies, the
financial problems of the property developer Evergrande, and
5000
power shortages in some provinces. This has all increased
the Chinese market’s risk premium and led to lower valuation
4500
multiples. However, the crackdown on ‘for-profit’ education
and companies such as Alibaba should not be interpreted
as the authorities' intention to destroy the private sector. On
4000 the contrary, the private sector will continue to play a very
important role in the modernisation of the Chinese economy
and the achievement of the Party's goals. Changing economic
3500 fundamentals and much more reasonable valuation multiples
continue to point towards a gradual shift from West to East.
3000
2016 2017 2018 2019 2020 2021
CSI 300 Index
Source: Bloomberg

C H I N A' S 10 -Y E A R B O N D Y I E L D One of China's objectives is to offer an alternative to the current

US- and dollar-based financial system. In an environment
4.00 marked by the gradual abandonment of fiscal and monetary
policy rigour in the US and Europe, China has opted to maintain
an orthodox approach, while trying to counter speculative
3.75
excesses. Like many other countries in the region, it is
maintaining positive real (i.e. inflation-adjusted) interest rates.
3.50 In so doing, it offers a reliable store of value to savers, who are
increasingly being hurt by policies in the West. China will also do
3.25 its utmost to avoid a balance of payments crisis, which means
that it will continue to aim for a current account surplus allowing
%

for the accumulation of foreign exchange reserves. All this

3.00
means that, in the medium term, Chinese government bonds
could replace US government bonds as the ultimate safe haven.
2.75

2.50

2.25
2016 2017 2018 2019 2020 2021

Source: Bloomberg
 N ° 16 9 — 4 th q u a r t e r 2 0 2 1 FINANCIAL MARKETS 13

GOLD PRICE So far, 2021 has not been a particularly good year for
gold. Since the start of the year, the gold price has fallen
2100 by nearly 7%. This decline may come as a surprise in a
context of rising inflation and a further fall in interest rates
2000 in real (inflation-adjusted) terms. As a general rule, the gold
price is negatively correlated with real interest rates (a rise/
1900
fall in real rates leads to a fall/rise in the gold price). This
1800 is logical for an asset that does not offer a recurring return.
The relative lack of interest from investors can be explained
1700
by various factors: doubts about the permanence of the rise
in inflation, the strength of the dollar, and preference for
USD

1600
other commodities, particularly oil. Gold's weakness in 2021
1500 should also be seen in perspective, given that the price of
the yellow metal rose by 18% in 2019 and 25% in 2020.
1400

1300

1200

1100
2016 2017 2018 2019 2020 2021

Source: Bloomberg

D O W J O N E S /G O L D The case for gold is stronger than ever. The economic

environment continues to be marked by hyperactive central
64
Equities expensive banks. The objective of price stability no longer seems to
be their priority. Added to this is the gradual abandonment
of fiscal discipline, with governments (re)discovering their
32 appetite for major fiscal spending programmes. All this
comes at a time when the very high level of debt (at all
levels) would seem to preclude a strong and sustainable rise
16
in real interest rates. Although central banks had reduced
Logarithmic scale

their gold reserves at the beginning of the century, they

8
have been replenishing them since the financial crisis. The
Median
pandemic has also led to a strong increase in demand for
physical gold. Time and again, history has shown that gold can
4 provide a hedge against equity risk in a balanced portfolio.

Gold expensive
1
1920 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020

Source: Bloomberg

G O L D A N D G O L D - M I N I N G C O M PA N I E S Disaffection with gold has impacted gold-mining companies,

which have fallen by an average of around 10% in 2021
500
and by almost 20% from their year’s peak in May. This lack
of enthusiasm for gold-mining companies comes at a time
when their financial position is very good. Unlike in the past,
400 they have generally been very disciplined in their capital
allocation. Previously, they tended to act pro-cyclically –
increasing exploration spending or making acquisitions at high
300
multiples when the gold price was high. When the gold price
subsequently fell, it was extremely difficult for them to make
200
these expenditures and acquisitions profitable. This has not
%

been the case in this cycle. As a result, at the current gold

price, gold-mining companies are generating a lot of free cash
100 flow for shareholders, which they are using to reduce their debt,
buy back their shares or increase their dividend. The valuation of
gold-mining companies is very low both in absolute and relative
0
terms, i.e. in relation to the gold price and the stock market.

-100
1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 2022
Gold Gold-mining companies index
Source: Bloomberg
Summary

To sum up, the authorities’ constant intervention in the markets

since the financial crisis (and even before) has rendered the
financial system very fragile. This fragility is likely to become
more visible if the rise in inflation sets in for the long haul,
forcing the authorities to make a choice between tightening their
monetary policy to combat inflation or continuing with current
policies to boost growth and support the financial markets.
The rise in bond yields is partly a reaction to the emergence of
internal disagreement within the central banks. However, it's
important to note that the current resurgence in inflation is linked
to a shortage of supply rather than excess demand. Premature
tightening of monetary policy is not likely to do anything to restore
supply chains or increase the supply of labour and raw materials.

Although the debate on whether inflation is here to stay rages

on, there seems little doubt that higher prices for products
and commodities (particularly oil) and rising labour costs will
have a negative impact on profit margins for many companies
at a time when high valuation multiples leave little room for
potential disappointments. Another risk for equity markets is
that higher inflation or simply greater inflation volatility could lead
to a change in the correlation between equities and bonds and
a reduction in the weighting of equities in portfolios managed
according to the ‘risk parity’ approach, a strategy of diversifying
a portfolio according to the risk contribution of each asset class.
The experience of the last few years has also shown that any
sharp rise in interest rates has caused an accident in the financial
sphere.

For investors, a more inflationary environment also raises the

question of how to protect their purchasing power over time.
High quality bond investments seem particularly ill-suited to this
need. So the solution will have to come from equities. In what is
likely to be a more difficult environment for equity markets, the
priority will be to confine investment to quality companies, with
a strong emphasis on those paying steadily growing dividends,
and avoiding overpriced ones. Such companies should continue
to benefit from a low cost of capital. Often, they also have
competitive advantages allowing them to pass on higher costs to
their customers by raising prices. However, favouring equities to
protect purchasing power also implicitly means accepting higher
volatility, as share prices fluctuate much more than bond prices.

Every decade has its big winners who are rarely the winners in
the following decade. In recent years, the US market, driven by
a rapidly-growing technology sector, has strongly outperformed
other markets. In the future, the pendulum might well swing East.

Gold continues to have a place in a balanced portfolio. Gold-

mining companies are a cheap option on the gold price but
investors will need to be prepared to accept their volatility.
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No.169 – 4th quarter 2021
Perspectives

Economic data and market information

contained in this issue are the latest
available up to 15/10/2021

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