Having finally seen the back of 2020, 2021 had barely started when we witnessed significant historical events, such as the onset of Brexit, demonstrators storming the US Congress and a US president impeached for the second time. But will any of this impact investors with a 3-5 year investment horizon?
2020 returns and fundamentals
Now that 2020 is over, it is time to review the fundamental events that took place during the year, most of which were closely related to the COVID-19 pandemic: the lockdown in the second quarter; the worst drop in quarterly GDP for decades; huge fiscal emergency spending; a monetary policy of “endless buying” and ad libitum liquidity - all contributing factors to the most volatile financial markets in living memory.
In a year when we learned to live online, what was the outcome for euro-based investors? Many focused on the big internet stocks, where an equal-weighted portfolio of FAANG stocks (Facebook, Apple, Netflix, Google, Microsoft and Amazon) had a return of more than 50% in US dollar terms.
Figure 1 Return for 2020 in EUR - different asset classes.
While the S&P 500 had a return of more than 16% in USD terms, in EUR terms the result was less than 7% due to the appreciation of Euro. Although FAANG stock had an excellent year, the rest of the S&P 500 returned roughly the same as an investment in the STOXX 600 (the stock index for the largest 600 companies in Europe), which lost just over 4%.
European fixed income investments had a positive result in 2020, with the Barclays High Yield Index returning almost 2%, while the broader Euro Aggregated Total Return Index gained just over 4%, results driven mainly by the ECB’s large-scale purchases of government and corporate bonds. In comparison, an alternative investment in Quantrom P2P Lending gave investors a respectable return of more than 6% - without a single month of negative returns.
All in all, 2020 was a challenging year for investors, but what will happen over the next 3-5 years when COVID-19, thanks to effective vaccines, will hopefully be a thing of the past?
An outlook with perspective
Governments and central banks have opened all the economic floodgates to battle the impact of COVID-19. While central banks are overtly announcing their purchase programs and conditions for obtaining liquidity, governments have introduced compensation and support packages without disclosing the total amounts they are spending.
No government has so far indicated that it will start to roll back fiscal support for the economy, but with lockdowns tightening at the beginning of 2021, this support will probably continue until summer.
Although there is a lot that we currently do not know about the ultimate economic impact of COVID-19, we nevertheless do know a great deal about the impact so far, due to available statistics and communication from the various EU governments.
In a normal economic environment, total general government expenditure rises by approximately 3.5% year-on-year. In the quarters of 2020 for which we have data, government spending rose more than 10% over the same period for the previous year.
Figure 2 Direct effect on EU27 GDP of increased government spending in 2020
Had governments continued their normal spending behaviour, it would have directly resulted in significantly greater negative growth rates and a EU27 GDP that would have been approximately 3.5% lower than it actually was in the second and third quarters of 2020. The indirect effect on GDP is, of course, much bigger, since governments have transferred funds to companies and individuals in order to avoid large-scale bankruptcies and soaring unemployment.
As far as Q4 2020 and the current quarter are concerned, there is some information available. Much of the EU has been in lockdown during most of November and December We also know that the majority of EU states will likely continue to be in some sort of lockdown at least until March, and perhaps longer. It is almost certain that this will lead to a double dip in the economy. A conservative estimate would be that a month of lockdown will lower nominal GDP by approximately 2% per month, which is less of an impact than in the initial lockdown in the first quarter of 2020. Without additional government spending, or at least continued government spending at the same level, the fall in nominal GDP would be much higher.
Governments can currently finance all their spending at negative or close to zero interest rates, and this will probably continue as long as the ECB buys most of the bonds that are issued.
These buying programs have led to the fact that, in mid-January 2021, the entire German yield curve up to 30 years is in negative territory, which naturally has a significant effect on credit spreads and equity markets, as investors seek alternatives.
A dilemma for investors
For investors, this presents quite a dilemma. Currently, economies in general, not just in Europe, are being propped up by government spending and a very expansive monetary policy. This has been driving yields down, as mentioned previously, and equity indices back up to or above pre-COVID19 levels.
Meanwhile, economies are 3-5% smaller in nominal terms than before COVID-19 and heading into a double-dip recession, as Q4 2020 and Q1 2021 will most likely have negative growth rates. While economies themselves are much smaller, certain sectors within them, such as travel and tourism, will take years to rebuild. Many companies in such sectors are currently being kept alive by state support; when this support ends, the impact will be noticeably severe. As an example, rail services operator Eurostar reported in the Guardian issue of 17 January that it had seen a drop of 95% in passenger numbers.
Investors should look out for early signs of changes in economic policies, in particular concerning how long governments can continue to support the economy as they are currently doing, and when central banks might stop increasing their purchase programs. Any indications that these stimulus measures might end could be the straw that break the camel’s back in the financial markets.
There are alternatives
The real economy still offers alternatives to the exchange-traded financial markets.
In alternative lending, which is not affected by the purchase programs of central banks, interest rates have stayed high despite low yields on government and corporate bonds.
Investments in real, unlisted assets that have not been mis-priced because of the excess liquidity provided by the central banks, could also be attractive. In fact, there are a number of solid, attractively priced assets that present interesting investment opportunities, sharing the common characteristics of being fairly priced and part of the “real” economy.