Yves Bonzon, Group Chief Investment Officer of Bank Julius Baer, shares his views on the effects of the Coronavirus epidemic to financial markets. Plus, he explains why large US tech stocks are not in a bubble and why markets could see a melt-up before this bull run is over.
Fear is back to equity markets. Within three trading days, the S&P 500 has corrected by roughly 7%, while bond yields in the US have plunged to all-time lows.
Now what? According to Yves Bonzon, Group Chief Investment Officer of Swiss bank Julius Baer, markets are in the process of a reassessment of the risks to economic activity caused by the global Coronavirus outbreak. Hence the correction might last a while longer.
But apart from the Coronavirus shock, Bonzon is rather optimistic about the economy and financial markets. In an in-depth interview, he explains why tech giants like Google and Microsoft are not in a bubble, when it will be time to buy stocks in Europe and Japan – and what he thinks about the prospects of a Bernie Sanders presidency.
Mr. Bonzon, the spread of the Coronavirus epidemic to Italy and Korea has provoked a selloff in financial markets. What’s your take on how long it will last?
Investors just found out that the pandemic is spreading outside China in a completely unpredictable way. Furthermore, quarantine measures are unlikely to be as effective in a place like Italy as they are in China. This is triggering an abrupt reassessment of the risks to economic activity. Demand shall probably suffer more and supply chains be even further disrupted. This is an external shock whose duration is very difficult to estimate, hence investors are adjusting their required risk premium very quickly. I would say, hopefully, that in a couple of months fears should have receded.
For several weeks, equity markets saw the epidemic as a temporary setback that would only affect the first quarter of this year. What has changed?
The new piece of information is that the virus is spreading in remotely connected places. Furthermore, fiscal policy can hardly help in the very short term and monetary policy, which is quite exhausted to start with, can only help stabilize asset prices preventing a negative wealth shock that would further damage confidence and the economy.
So for the time being, the epidemic is an external shock to markets, whose effect and duration remains to be seen?
Yes. We had actually expected a longer and somewhat deeper correction in late January already. The S&P 500 only lost about 3% back then. Starting February, the market just looked through the effects of the epidemic. Now the market goes through a reassessment of the risks. For the Coronavirus to trigger a real crisis, we would need a massive spread in the US and in Europe, which would provoke a recession. That’s a tail risk.
Apart from the Coronavirus issues, what is your view on world financial markets today?
I generally distinguish between four different market regimes. Regime number one, which holds pretty much 90% of the time, is an economic expansion. There’s volatility in this regime, driven by sentiment, but in general equity markets go up. Regime number two happens every once in a while, when there is an external shock, something like the Brexit vote in 2016. This causes a temporary change of valuation in your portfolio, but not a change in value. You suffer a drawdown, but when the dust settles, everything is back to expansion mode. Regime three is a systemic crisis, like the housing crisis in the US in 2008 or the Euro crisis in 2011, that transpires into credit markets. Regime four is a recession, when corporate profits collapse, the economy contracts and equities are in a bear market.
And in your view we are still in regime number one?
Yes. The macro condition in the US and in Europe is what I would call boring and benign. When you look through the noise of the daily headlines, the economies in North America and in Europe are the most stable they have been in a very long time. Which means, absent a policy mistake such as fiscal tightening or an external shock big enough to derail the economy, we will continue to expand at a modest rate.
You see no risk for regime three, a systemic shock?
No. Our message in the past five years has constantly been that systemic risk is dormant. Well, there’s a tail risk that the Brexit syndrome could spread and other wealthy European countries want to leave the Union too. Then we could have a return of systemic risk in Europe. But that’s not very likely.
Why is gold performing so well? Isn’t that an indicator of rising systemic risk?
You’re right that gold is a systemic risk hedge. In physical form, gold is the only financial asset that is not a claim to anyone else. This unique characteristic makes gold a very good hedge against systemic risk. But as there is no systemic risk today, gold is primarily a trading instrument. To me, the recent rise in gold is simply a consequence of falling interest rates.
You call the macro condition in the US and Europe boring and benign. Why are these economies so stable?
The private sector in both these areas has spent the entire last decade deleveraging. There are no debt excesses in the European and American private sector – not in the household and not in the corporate sector. There is no excess investment today, unlike in 1999. The deployment of capital by corporates is the most prudent it’s ever been.
Many companies in the US lever up their balance sheet to buy back stocks. Wouldn’t you call that a debt excess?
There is the perception that leverage has increased in the US corporate sector. But that is not true. I see real excesses in private markets, in the field of venture capital-backed startups. But in public markets, leverage in aggregate has not increased. Corporates are not borrowing to buy back shares, they buy back shares with their cashflow. To be honest, as a shareholder I’d prefer to have a large US bank like Citigroup buying back shares rather than extending bad loans.
In late 2019, there were signs of a global cyclical upswing, which caused cyclical stocks to outperform.
Yes, that bounce was driven by the realization that the global manufacturing cycle had bottomed. The virus epidemic has stopped that upswing. Macro data will be blurred for quite a while now. What has been driving equity markets higher until last week was the expectation of more central bank liquidity and a big economic stimulus in China.
Do you expect that?
Absolutely. The epidemic is a major challenge for the central government in Beijing. There is no way Xi Jinping can lose face to the world by not being able to a) contain the outbreak and b) manage the economy. Ever since Xi became president, China engaged in a rebalancing of its economy and a deleveraging of sectors with capital misallocations. Now they will take no chances: They will err on the side of too much stimulus after the epidemic. They have ample leeway for stimulus. There is no way China will want to find itself a year from now in an economy that has ground to a halt. No way. So they will stimulate.
What will that mean for equity markets going forward?
First, markets will sniff that more liquidity will be hitting the system. The prime beneficiaries of this wave will be high quality growth stocks, what we call the FAANMGs: Stocks like Facebook, Apple, Amazon, Netflix, Microsoft and Google. Once it gets clearer that the stimulus hits the real economy, value stocks and cyclicals will start to perform again. That’s when European cyclicals, emerging markets and the Nikkei will turn up. But they need the stimulus to hit the real economy first.
So it’s too early to buy Europe and Japan again?
Yes. Well, Japan has a structural issue, too. It has become a derivative of the global economic cycle. The Japanese economy has been on a flat nominal GDP path forever – which in itself is an achievement, given the demographics. But even in this environment, Japanese corporations continue to reinvest capital in their businesses. If they started to return capital to shareholders like their peers in the US do, the Nikkei would take off. Just an example: Japanese banks produce an 8% return on equity, they pay 3% dividend and reinvest 5%. Why do they reinvest 5% in a mature, flat economy? That doesn’t make any sense.
You said the primary beneficiaries of central bank liquidity are the FAANMGs, the high quality growth stocks. What’s so special about them?
They are the leaders of the current bull market. Facebook, Apple, Amazon, Netflix, Microsoft and Google have become a $5,6 trillion asset class on their own; these six names are 20% of the S&P 500. Apple is bigger than the entire energy sector of the S&P.
That to me sounds like a great contrarian opportunity in energy stocks.
Yes, at some point it will be. But not yet. You see, the FAANMGs are the epicenter of a global group of about 100 companies that are able to grow their revenues by 15 to 20% annually, every year. Of these 100, about 80 are in the US, 15 in China and 5 in Europe. Companies like Adobe, Visa, Mastercard and so on.
Are these growth stocks in a bubble?
They are quite extended right now, but not yet in a bubble. Look back ten years: In 2010, nobody was interested in Google and Facebook. Investors were interested in Petrobras, commodities, Glencore had just gone public back then. At turning points of the secular outlook, people are always focused on the leadership of the old bull market. The FAANMGs have spent the entire decade undervalued. They are not undervalued anymore, but they are certainly not overpriced given their enormous free cashflow.
Apple, Microsoft, Amazon and Google recently all crossed the $1 trillion mark in terms of market capitalization. Doesn’t that have an eerie 1999 feeling to you?
Yes and no. Yes, they are clearly the leaders of this bull market. But for the first time in history, the leadership of the bull market is not only growing very fast, but also producing an incredibly large free cash flow. In previous cycles, the market leaders were building capacity like hell. Think Japanese corporations in the Eighties, US tech giants like Intel and Cisco in the Nineties, or commodity producers in the last decade. They all had to raise capital on a large scale. The FAANMGs don’t have to do that. They return capital to shareholders. So again, they are not overpriced given their free cash flow.
What is their Achilles' heel, then?
The bubble in venture capital-backed private markets I mentioned earlier. This VC bubble is the remake of the Dotcom bubble, but worse and much more extreme. The historical illiquidity premium has been turned upside down: Companies in the private market get a higher valuation than in the public market. That’s why their IPOs all fail miserably. Every investor that has invested in private financing rounds of Uber after 2012 is at today’s market price under water.
And why will that affect the FAANMGs?
Between 15 and 20% of the revenues of Facebook, Amazon or Google is produced by VC funded private companies. All these loss-making internet companies buy cloud computing and marketing services from the large tech companies. Their top line is inflated by revenues from VC-funded companies. So when the music stops in the VC sector, it will impact the FAANMGs.
Do you expect a melt-up in equity prices before this bull market ends?
Yes, that’s quite possible. Private clients have completely missed the stellar returns of 2019. They are sitting on piles of cash. Because of all the headlines about the trade war, there was always a lot of perceived uncertainty. There is no enthusiasm in the stock market yet. All in all, equity risk premia – even accounting for the fact that bonds are overvalued – are still very generous. In the US, the market is fully valued, but Europe is very cheap relative to bonds. This is the last risk premium that is still available to the investor. I’d much rather be in public equity markets, where companies buy back shares and pay dividends, than in private markets, where too much money is chasing too few opportunities.
You said earlier that absent a policy mistake, the economy in the US and in Europe will continue to expand at a modest rate. Would a monetary tightening be such a policy mistake?
Yes, but I don’t see that. The monetary tightening that culminated in December 2018 by the Fed was the last time a major developed market central bank was trying to tighten preemptively, before any tangible evidence of reaching or exceeding the inflation target. Back in 2018, Fed Chairman Jerome Powell was not on top of things. But now I think they have fully shifted from inflation targeting to asset price targeting.
They know that the wealth effect has become so large that a severe drop in the S&P 500 would hit the real economy. The US equity market is worth $30 trillion. If we had a drop of 30% or more, that would wipe out $10 trillion of wealth – and that wealth effect would have a deep recessionary impact on the American economy. Remember the housing crisis of 2008: That was a nationwide negative wealth shock of $7 trillion. The quantitative easing policies introduced by the Fed were all about reflating financial assets and correcting that wealth shock. It was successful. The Fed knows they won’t have a choice. If they did not step in, there would be an Austrian debt deflation cycle – and we know from history that democracies usually don’t survive such a cycle.
In other words, the Fed simply won’t permit too large a drop in equity markets?
Exactly. The Fed won’t cut rates when the S&P 500 sits at an all time high. They’ll save the bullet for a nasty correction episode. We’ll see it in the next bear market associated with a mild recession in the US, which will probably happen some time after the presidential election. The S&P 500 will decline 20%, but not much more. By that time, the Fed will be in full easing mode, Trump will be in full fiscal stimulus mode, and the cycle will bottom. The Fed cannot afford a 50% drawdown in the S&P 500 anymore, because the political system would be at risk. They have become hostage to asset prices, that’s the message.
So when push comes to shove and the US enters a recession in 2021, the Fed will even resort to buying equities outright?
Yes, absolutely. It’s always a political choice at the end of the day.
Bernie Sanders is strengthening his lead in the primaries of the Democrats. Why is the market not worried about the possibility of a Sanders presidency?
That’s indeed a big risk. After Super Tuesday on March 3 we might have some visibility on the situation. If it will look like Sanders will be the Democratic nominee, I think we will see an increase in risk premia. But at the same time, in a race Trump against Sanders, I’d say Trump will win. Everyone has always underestimated Trump. We’d need something really really bad to come out about Trump for him to lose such a race. But if for some reason we’ll end up with Bernie Sanders as president, there is one advice I’d give to an investor: Reduce your US exposure, and increase your China exposure. By a lot.