Mr. Gallo, where are you during these extraordinary times?
I am still working from home. I had a lot of time to read during the lockdown. The best book I read was «Monetary Regime and Inflation» from economist Peter Bernholz.
What did you like about it? It was published almost twenty years ago.
The topic is highly relevant. Bernholz visited countries with high inflation and concluded: inflation is not a purely monetary phenomenon like Milton Friedman said, it is also a political and social phenomenon. All through history, governments in a crisis – be it a war or a pandemic – have used money as a tool for survival not as a store of value.
And why is this relevant today?
The US has been using respectively abusing the fact that the dollar is the global reserve currency. This abuse will continue at a faster pace. In a broken society, when faced with social unrest and high inequality, inflation becomes the least of all the problems. There is a strong incentive to keep rates low, maybe buy high-yield-bonds, give loans and grants to SME and even create a digital currency to give money directly to the people. We are getting closer to helicopter money.
What are the consequences?
Higher inflation. A sudden rise in consumer price inflation is the biggest risk in the market right now. Not this year but maybe next. This may cause a shift in the system. Especially in the bond market where the majority of investors is positioned for lower rates for longer. Out of 80 trillion $ of outstanding bonds, 95% are yielding less than 3%. I do not expect a massive increase of inflation with strong wage inflation. But the market is not positioned for somewhat higher inflation and a small rise in yields, while inflation will easily go to 2 to 2,5% in the US.
But consumer prices are still falling, at least in Europe.
There are strong deflationary forces such as demographics and disruptive technologies. However, all this liquidity combined with fiscal policies can first inflate asset bubbles and then lead to a currency depreciation.
Central banks have been purchasing securities without causing inflation to rise. Why should it be different this time?
We are at a turning point. After ten years of asset QE, with central banks buying bonds and even equity-ETF like in Japan, it is clear that it has not worked for everyone. In the US, the top 10% of the population own 90% of all the assets. If asset prices are inflated, inequality increases. Initially, QE helped to reduce unemployment but there are huge collateral effects, including lower social mobility and more corporate inequality. Large companies end up with a big advantage. Companies like Apple (AAPL 130.46 -1.01%) can buy competitors and create monopolies. It also favours weak business models. Now, policy makers are realising that this sort of QE does not work and we are moving towards QE for the people.
What exactly do you mean by «QE for the people»?
Instead of helping the economy indirectly by inflating asset prices, QE for the people supports consumers and companies more directly through a combination of monetary and fiscal policy. It involves the central bank printing money and monetizing debt. Is is based on ideas of Modern Monetary Theory and universal basic income.
Does it only apply to the US or is it a global phenomenon?
China has exactly been doing this already. It supports the economy more directly. In the Eurozone, policies are less aggressive, which explains the recent strength of the Euro. But there is also a shift from monetary dominance to a combination of fiscal and monetary policy, which was something the ECB has been pushing towards for a long time.
What does this scenario mean for financial markets?
If the next QE becomes helicopter money, it could be good for the recovery of the real economy but also mean more pain for the markets. Everything that is linked to low interest rates would suffer. Within equities, banks and energy stocks would fare better relative to utilities and growth stocks. This is a major risk but not our baseline scenario. Our base case is a general depreciation of currencies and moderately more inflation with yields more or less stable.
But how do you earn money with a fixed income portfolio if rates are below inflation?
With normal, nominal government bonds, this is indeed almost impossible. More attractive are corporates, where we look at hybrid and convertible bonds, too. Long-term government bonds are the most dangerous thing you can have in a portfolio. Even if rates remain low but inflation goes up to 2%, you are losing 1% in real terms. We therefore shifted into inflation linked bonds.
The scenario you described with negative real yields sounds like the perfect environment for gold.
Yes, that is why in our funds, we have been buying gold since last year. With gold we replace the duration we used to have in long-term government bonds because we think that real rates will be negative.
But who is buying all those newly issued government bonds if not central banks?
Ask the big pension funds and insurance companies. There are still a lot of investors that can only do investment grade.
You have mentioned corporate bonds. What about the credit risk?
Credit risk essentially disappears with central banks’ unlimited stimulus for most of the market. There is still credit risk for the lowest end of the spectrum, issuers with rating B and CCC. Of course, there are many SME going bankrupt. But essentially, the tail risk of a big increase in default rates is low. Even companies with weak business models like TUI are getting government help. Generally, this is a transfer of risk from the private to the public sector. That is also why it makes more sense to own debt from the private sector than government bonds.
Rating agencies forecast a rise in default rates to above 10%. Do you think that is too pessimistic?
In Europe, speculative grade default rates are between 2 and 3% and won’t rise significantly. In the US, they might go up to 6%, but not up to double digits. What’s more, bonds from issuer that default have a very high recovery rate of 50 to 60%. There is a lot of financing available to restructure.
What corporate bonds are you buying?
We find names in sectors that are not structurally weak, for example in the automotive sector. The traditional retail sector is less interesting as it is in a structural decline.
Can you give an example of an attractive new issuance?
The Finnish airline Finnair has recently issued a hybrid-bond with a coupon of 10,25%. Finnair is one of the more stable airlines with less leverage than Lufthansa (LHA 10.33 -0.86%). The government holds the majority share.
In Spain and France, daily new Covid-19-infections have reached the levels we’ve seen in spring. Do you expect another hard lockdown and how would financial markets react?
Governments will try to avoid a total lockdown but rather take specific measures such as mask requirements. The second round of the pandemic is less deadly. And the authorities and the medical staff have more experience dealing with it. Even if such drastic measures had to be taken for a second time, markets would not panic because central banks are now the weapon of first resort and very active in countering volatility.
The European Union has agreed on a Recovery Fund. Is this a game-changer for Europe?
Europe has really turned the corner. We now have a fiscal union. The risk of a break-up of the Euro Area is close to zero. I think the European model of a social market economy with all its flaws can work. But it is now time to not only defend the Euro but to play more offense by funding good debt. That means to invest in education, research and technology. From a market perspective, Europe has been a huge underweight from investors globally. There is room for more upside and we could see the Euro getting stronger.