Weekly investment update – 2 September 2020

Tenative signs that
European countries may be learning to manage COVID-19. Last week US Federal Reserve Chair Jerome Powell announced a revised
framework for US monetary policy. We see it as ringing in a new, potentially
inflationary, era. August was a bumper month for stock markets, the latest in a
strong run since April.

Covid-19 – encouraging signs

As of the start of September there have been almost 26
million cases of COVID-19 and 850,000 recorded fatalities.

The US has recorded 6 million cases – around a quarter of
the total according to Johns Hopkins University – and the administration’s
handling of the virus remains a key issue in the election. The focus has
actually been on the evolution of the virus in Europe in recent weeks given a
worrying rise in cases, but according to the World
Health Organization, there are “encouraging signs” that countries in Europe
are learning how to manage the virus:

“Europe has learned how to identify, isolate, quarantine …
It’s also identified how to put in place the individual measures so we’ve already
seen in some areas of Europe a very rapid reversal in what were some rapidly
increasing curves”

Economic data

Over the last week, the flash release of data on consumer
prices in the Eurozone in August was the most significant piece of data,
with the eurozone falling back into deflation territory as inflation fell by
-0.2%, down from 0.4% in July.

In terms of the numbers, the pace of deflation in energy
prices moderated from -8.4% to -7.8% in August, with energy prices flat on the
month. Meanwhile, the pace of food inflation slowed from 2% to 1.7% and
services inflation slowed from 0.9% to 0.7%. However, the major development was
in core goods inflation, which stood at 0.2% in June, 1.6% in July and -0.1% in
August – a rollercoaster ride driven by a delay in the timing of summer sales
this year.

The recent cut in the rate of VAT in Germany has no doubt
contributed to the weakness of core inflation. However, given the recent
appreciation of the euro, the large margin of spare capacity in the economy and
the risks of inflation expectations becoming detached there are good reasons to
suppose that it will remain weak in the medium-term.

Policy news

On the policy front, last week marked the beginning on a new
era in US monetary policy and the end of an era in Japanese politics.

Chair
Powell used his presentation at the virtual Jackson Hole conference to
unveil the key conclusions of the Federal Reserve’s strategy review. The bottom
line for investors is that the Federal Reserve will adopt a flexible average
inflation targeting framework which in Chair Powell’s words means that:

“following periods when inflation has been running below 2
%, appropriate monetary policy will likely aim to achieve inflation moderately
above 2 % for some time.”

This change was widely anticipated and the implications
are broadly understood by the market: interest rates will likely stay low for a
number of years as exit from the lower bound will be delayed to facilitate that
period of moderately above target inflation. However, a couple of key points
are worth emphasising.

• Firstly, an important change has been made to
  the employment dimension of the Fed’s dual mandate. Policymakers will now focus
  on “shortfalls of employment
  from its maximum level” as opposed to “deviations from its maximum level”. In other words,
  unemployment can never be too low from a monetary policy perspective unless it
  is contributing to too much inflation, but you can have too little. As a
  result, the Federal Reserve would be unlikely to repeat the strategy pursued
  during the last hiking cycle of raising rates because unemployment appeared to
  have fallen too low and it was expected that inflation would soon rise. This
  change was arguably necessary because otherwise concerns about positive
  deviations of employment from its maximum level would have acted as a brake on
  efforts to push inflation above the target in order to re-anchor the average
  rate at 2%.
• Secondly, the new framework is flexible: Members
  of the Federal
  Open Market Committee will not constrain themselves to use a particular
  formula (time period) to calculate the average. Had they done otherwise then at
  any moment in time, the published formula would have produced a precise target
  for the cumulative increase in the price level that the Federal Reserve would
  have had to achieve over the future in order to hit the required average, given
  the observed behaviour of the price level over the past. As a result, it will
  be harder to demonstrate whether policy is too tight or too loose ex ante, or whether it has been a
  success or failure ex post. However,
  that flexibility comes at a cost. Households, companies and investors should be
  less confident that the Federal Reserve will deliver 2% on average without the
  commitment device of a mathematical formula.

Meanwhile, in Japan Prime Minister Shinzo Abe has announced
that he will be stepping down as both President of the Liberal Democratic Party
and as Prime Minister on grounds of ill health.

It is no secret that Abe has suffered from an incurable
inflammatory bowel condition (ulcerative
colitis) throughout his adult life. Indeed, the medical condition was the
cause of his resignation in 2007. However, his health had become an
increasingly frequent topic of conversation in the Japanese media in recent
weeks, and in particular the claim that Abe had visited hospital several times
in recent weeks.

It is hard to over-play Shinzo Abe’s importance. He has
just surpassed the record set by Eisaku Satō as the
longest serving Japanese Prime Minister. He has become so personally associated
with Japan’s economic strategy for managing demographic change and escaping
deflation that everyone refers to the plan as Abenomics. But it is not just
economics. Abe has also shaped Japan’s role on the world stage and its
relationships with the two global super-powers, China and the United States.

Abe’s successor will be chosen by the Liberal Democratic
Party, which is the dominant force in Japanese politics. That process will take
place over the next couple of weeks with the chosen candidate being elected
prime minister by the lower house of parliament on 16 September. At this stage,
Yoshihide Suga is the politician most likely to succeed Abe.

We suspect that the succession will lead to less change in
macroeconomic policy than investors
may have initially feared. In the short run there is little alternative to the
current strategy of the Bank of Japan, unless policymakers are willing to
accept a significant correction in the exchange rate and equity prices. Indeed,
if anything, the stance of fiscal policy may be eased further. The direction of
the domestic reform agenda or Japan’s approach to foreign policy is a little
less clear.

Markets – stocks extend positive run

In August stock indices performed very well. The MSCI World
Index of stocks in developed nations rose 6.6% in August, the strongest August
rally since 1986. The broader MSCI All-Country World index that includes
emerging market stocks rose 6.3% in August, its best month of August since
1988.

The S&P 500 index rose 7.01% (its strongest August
since 1986 when it rose 7.1%) having, over the course of the month of August,
erased the last of its pandemic losses and struck an all-time high. For the
S&P, August was the fifth consecutive monthly rise. This represents the
longest period of positive consecutive monthly performance for the S&P
since 1938.

Stock markets in Germany, France, Italy and Spain rose by
between 4 and 7% in August on a euro basis. In Asia, Japan’s Topix rose 8.2% on
the month, and China’s CSI 300 returned 2.6% in local currency terms (source of
all data is BNP Paribas Asset Management as of 31/08/2020).

This strong run for stocks again raises concerns about a
potential discrepancy between market valuations and the still fragile state of
the global economy.

Any views expressed
here are those of the author as of the date of publication, are based on available
information, and are subject to change without notice. Individual portfolio
management teams may hold different views and may take different investment
decisions for different clients. This document does not constitute investment
advice.

The value of investments
and the income they generate may go down as well as up and it is possible that
investors will not recover their initial outlay. Past performance is no
guarantee for future returns.

Investing in
emerging markets, or specialised or restricted sectors is likely to be subject
to a higher-than-average volatility due to a high degree of concentration,
greater uncertainty because less information is available, there is less
liquidity or due to greater sensitivity to changes in market conditions (social,
political and economic conditions).

Some emerging
markets offer less security than the majority of international developed
markets. For this reason, services for portfolio transactions, liquidation and
conservation on behalf of funds invested in emerging markets may carry greater
risk.

Writen by Marina Chernyak. The post Weekly investment update – 2 September 2020 appeared first on Investors’ Corner – The official blog of BNP Paribas Asset Management.