Outlook for the capital markets:
“A considered approach is needed”
Interview with Dr. Frank Engels
Head of Portfolio Management
and Chairman of the Union Investment Committee
Dr Engels, the capital markets have rallied strongly since their slump in mid-March. Have the stock markets already drawn a line under the coronavirus crisis?
No, I don’t think so. But we are probably over the worst of it. The course of the pandemic will continue to determine what happens in the capital markets going forward. Only if the virus is contained can the lockdown be eased, and economic activity depends on this. Ultimately, this is what drives the capital markets.
How would you assess the latest developments?
There has been clear progress in many regions. That is important because, in a global pandemic, improvements in individual regions never last. The situation has brightened significantly in Asia, and in Europe too. This is a very good sign. As a result, we are seeing a strong pick-up in economic activity in countries such as China, where the number of new car registrations has increased. However, other countries and regions still face huge challenges, for example India, Russia and Brazil. It is therefore too early to sound the all-clear. This will not be truly possible until we have found effective medication or a vaccine.
What impact will the pandemic have on economic growth?
There is no doubt that the slowdown will be dramatic. We anticipate that the slump in gross domestic product (GDP) will be twice as big as during the financial crisis, and over a much shorter period. The second quarter of 2020 will be particularly difficult for the economy. It should improve after that, although initially at only a slow pace. This is because unemployment has risen, short-time working is being scaled back only slowly, consumers and companies are taking precautions by building up their savings, while sectors such as tourism will suffer for a longer period as a result of the rules and restrictions that still apply. Growth should really pick up again from the middle of next year, in part because a vaccine will hopefully be available by then.
So should we expect to see a severe recession in 2020?
Unfortunately, yes. Roughly speaking, each week of lockdown comes at a cost of between 0.7 and 1.0 per cent for economic growth. So the impact over the past two months is significant. The damage will be bigger or smaller depending on how badly a country is affected. But no economy will emerge unscathed.
In the US, for example, GDP is expected to fall by 7.0 per cent. Moreover, the country’s presidential election campaign will properly get going in the summer. There is a risk that the coronavirus pandemic will lead to a heightening of tensions between the US and China. After all, President Trump is unlikely to win an election on the strength of his competence in stopping the spread of the virus during the crisis. By contrast, taking a harder line against China – where the virus originated – would likely earn him points with his core voters.
What is the situation like in Europe?
Very similar, both economically and politically. Our economists anticipate that economic output will decline by 8.5 per cent in the eurozone. The rate of decline will be even higher in Italy and Spain, which are predicted to see contraction of 11.7 per cent and 11.5 per cent respectively.
In Germany, we expect GDP to shrink by 6.7 per cent, with a sustained uptrend from mid-2021 onwards. Germany is likely to bounce back more strongly than countries that have been hit particularly hard by the crisis, such as Italy, France and Spain. They are also more reliant on tourism than Germany.
On the political front, the EU and UK must agree by the end of the year on how Brexit is to be implemented. It is looking increasingly unlikely that such an agreement will be reached. Moreover, the heated debate about how to fund efforts to tackle the coronavirus crisis shows that political tensions will probably increase in the eurozone. Overall, the geopolitical risks remain high.
You referred earlier to the extensive support that central banks and governments have provided in response to the coronavirus crisis in recent months. What is your assessment of these measures?
Very positive overall. Following a few teething problems, the central banks implemented very substantial support packages very quickly. The expansionary monetary policy measures introduced worldwide have been huge. This stopped the crisis in the real economy from spilling over into the financial sector and greatly helped the capital markets too. The recovery seen in recent weeks is thanks in no small part to the central banks. Governments have also contributed to mitigating the effects of the crisis. Whether in Europe, the US or, more recently, emerging markets such as India, economic stimulus packages and central bank intervention have prevented the worst-case scenarios from materialising and are helping to overcome the crisis. But irrespective of monetary and fiscal policy, the key factor will be containment of the virus.
“The prices of some goods may temporarily increase as a result of the crisis, but this will be outweighed by dampening effects such as the lower oil price.”
Dr Frank Engels, Head of Portfolio Management
Inflation is an issue in view of the easing of monetary policy. Is it likely to increase in the wake of the crisis?
No, I don’t think so. No war or similar event has ever had a lasting adverse effect on our potential output or our capital stock. So there is no danger of a shortage of goods at the same time as rising demand. Such a scenario would result in higher inflation for a longer period. In fact, the current situation is quite the opposite: The capital stock is intact and demand has actually fallen. We are therefore more likely to see reduced price pressure, i.e. disinflation. The prices of some goods may temporarily increase as a result of the crisis, but this will be outweighed by dampening effects such as the lower oil price.
What will happen in the medium to long term?
Fears about inflation triggered by the supply of money have always proved unfounded in the past decade. There are bound to be lasting price rises for some services, such as in aviation or the travel industry. However, we will not see higher prices for goods and services across the board after the current crisis. Instead, the slower growth should keep inflationary pressure in check, for example because substantial wage increases will be unlikely. Consumers and companies alike will be reluctant to spend. This will remain the case for as long as there is significant uncertainty about domestic and global economic conditions and about job security.
We therefore anticipate annual price rises of 0.6 per cent for 2020 and 2021 in the eurozone. Our forecasts for Germany are slightly higher at 0.7 and 1.4 per cent in view of the better economic situation. But overall, these inflation figures would not give central bankers sleepless nights. In other words, a change in monetary policy prompted by inflation is not on the cards for the foreseeable future.
Against this backdrop, how would you rate the outlook for the capital markets?
The capital markets will remain precarious in the short term. Firstly, this is because much of the gradual recovery of economic activity, which we expect to see in the second half of the year, has already been factored into asset prices following the rally of recent weeks. A further sharp rise is unlikely until coronavirus has been contained on a sustained basis or a vaccine has become available. People with a sufficiently long-term investment horizon may therefore be able to benefit by investing at current prices. But careful security selection is more important than ever.
Why is that?
Because the crisis is affecting everything, but not always to the same extent. Dispersion is increasing overall. This is clearly illustrated by the DAX 30 index. Some stocks have fallen by as much as 50 per cent in the year to date, while the gains of others have been in double figures. So the crisis does indeed present opportunities for active management.
Where do you believe the biggest opportunities lie at the moment?
As before, equities and investment-grade corporate bonds. Equity investments should have a good mix of companies that are benefiting from the effects of the coronavirus pandemic. The e-commerce, digital technology, software and healthcare sectors should feature in every portfolio in the medium term, along with large corporations from other industries that are well managed and consistently profitable. It is not yet the time to focus on cyclical shares. For this to be the case, we will need clearer signs that the economy is rapidly gathering momentum.
And what about bonds?
In the fixed-income asset class, our focus is on investment-grade corporate bonds. But we also recommend selectively picking hard-currency bonds from sound issuers in emerging markets. In terms of currencies, we anticipate that the US dollar will depreciate slightly in the coming months.
What are your personal conclusions with regard to investment?
A considered approach is needed at the moment, not a knee-jerk reaction. We will be grappling with the coronavirus crisis for some time yet, including on the economic front. However, opportunities are increasing in the stock markets, especially if you can play the long game. It is therefore not a bad time to gradually move into, or build up, risk assets as part of asset structuring.
As at 19 May 2020