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Green light as long as the full recovery is not certain

Winter 2020/2021 in the northern hemisphere is proving to be more difficult than expected in the fight against the Covid-19 pandemic. The discovery of a new strain of the virus that seems even easier to spread, while no more dangerous, further complicates the task of governments in their efforts to manage healthcare systems. Several countries, particularly in Europe, have reintroduced lockdowns or curfews. Curiously, the markets have superbly ignored the Covid-19 infection curves.

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Investors are looking beyond the COVID-19 valley
Apparently, the prospect of reaching herd immunity as early as mid-2021 in the countries that are quickest to vaccinate their populations is prompting investors to look beyond the valley for economic normalisation. Admittedly, gross domestic product (GDP) will contract again in the short term, but the effect is relatively modest, as the sectors affected are already virtually at a standstill. By definition, when a sector is almost at a standstill, its potential negative contribution to GDP is also close to zero. On the other hand, governments see this as an opportunity to extend their budget support measures, and central banks, which are now supposed to wait for inflation to manifest before changing course, have even less reason to question their accommodating policies. The macroeconomic environment therefore remains favourable for risky assets, at least until a full economic recovery is definitively assured. A second consequence of the new measures to restrict mobility and enforce physical distancing is that households will further increase their involuntary savings, as they are unable to spend their income the way they normally would. We therefore observe that the private sector, particularly households but also companies in sectors that are little or not at all affected by the pandemic, has strengthened its balance sheets. In addition, there is a positive wealth effect thanks to the recovery of financial assets and strong residential real estate markets. As a result, services consumption should experience a mini boom when Covid-19 is finally reined in, i.e. from the second or, more likely, third quarter on.

Risks will actually increase when the recovery is complete
It is precisely at this point, when the economic recovery is complete, that the risk/reward ratio will be the least attractive for risky assets. First, investors’ optimism will be at its highest and their positioning will be in line with the feeling of confidence in a bright economic and financial future. This is rarely a great starting point. Second, the authorities’ response has been unprecedented in terms of speed and scope. This is particularly true for the monetary leg of the macroeconomic policy response. Monetary policy determines the amount of liquidity in circulation, which in turn determines the valuation multiples that investors pay for corporate profits. The resulting level of market equilibrium derives more precisely from the year-on-year change in excess liquidity in the financial system. By the time the economy returns to its pre-pandemic form, the year-on-year rate of change in the money supply will have subsided due to the base effect of central banks’ massive liquidity injections in spring 2020. When the economy fully recovers, asset valuations will have reached their peak. We have not reached that point yet.

This is an extract of the ’CIO Monthly’. If you want to learn more about our investment approach, get in touch with us.

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