by Chief Economist & Strategist Finn Øystein Bergh

FINANCIAL MARKETS AND THE ECONOMY IN 2020

Heaven to hell, roundtrip

A year of unprecedented declines and record rises provided some very useful lessons in investing.

What a year this was! Going into 2020, financial markets Stock Exchange benchmark index fell by exactly 33 percent. were characterised by restrained optimism, as rate cuts in The bottom was reached on March 23. the preceding year had triggered a bull market in stocks and tightening credit spreads. Then came a turn of events that Now, be as honest as you can be with the benefit of hindsight: must be very close to the economic definition of an external At that point, where would you expect the markets to be on shock. New Year’s Eve?

At the end of January, the World Health Organization (WHO) THE ANATOMY OF PANIC declared a global health crisis due to a new virus that had One may certainly be excused for describing the March appeared in China. A few weeks later it became clear that the 2020 market situation as a state of panic. Not only did stock fight against this virus would require drastic, comprehensive markets plunge; all risk assets fell in value, from corporate measures in all affected countries – which soon turned out to bonds to commodities. be more or less the entire world. In late March, Nordic high-yield corporate bonds were quoted On March 12, the Norwegian government introduced the some 25-30 per cent below their value at the end of February. strictest measures ever in peacetime, banning a number of From a midwinter peak of $59/bbl, the Brent Blend crude events, introducing limited quarantines, partial travel bans oil price hit $19/bbl towards the end of April. And currency and much more. And Norway was by no means alone. Within markets experienced wild swings, with the somewhat typical a few weeks, more than half of the world’s population was risk-off movement out of small currencies. In less than two subject to some kind of lockdown. weeks, US dollars shot up by more than 23 per cent versus Norwegian kroner. You would be excused for thinking that the As investors quickly realized that this would have significant magnitude of fall was not fully unrelated to the plunging oil economic consequences, stock markets plummeted. In little price; versus Swedish kroner, the dollar appreciation was less more than a month, both the MSCI World Index and the Oslo than half.

Oil hit real bottom this millennium Uneven toll

160 GDP growth Total deaths of COVID-19 per 10 000 Nominal oil price Real oil price

140 Total deaths of COVID-19 per 10 000 UK

120 Italy 100

US 80

60

40 Norway 20

Japan 0 1989 1994 1999 2004 2009 2014 2019 -15-10 -5 0510 15 20

Oil price (Brent Blend), current quotes and adjusted for American CPI. Souce: IMF, OECD, OurWorldInData.org, Statistics Norway and Norges Bank Source: FactSet, US Bureau of Labor Statistics, Pareto Asset Management

Pareto 1 Deeper than 1932 Stagnating world trade

8 70

6

60 4

2

50 0

-2 40

-4

-6 30

-8

GDP growth Average 1980-2019 2019 est. difference -10 20 1930 1940 1950 1960 1970 1980 1990 2000 2010 2020 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

Annual real global GDP growth in per cent. World trade to GDP ratio in per cent. Source: IMF, World Bank, IEA Source: World Bank, IMF, own estimates (2020)

Backpedalling economies Unprecedented fear

106 90

104 80

70 102

60 100

50 98 40 Adj CAPE 10 96 30 CAPE 10 as reported 25 yr avg adj 94 20 50 year avg

92 10

GDP growth Average 1980-2019 2019 est. difference 90 0 United Norway Nordic Sweden Germany Euro France United 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 17 18 19 20 States region area Kingdom

Estimated 2021 GDP in per cent of 2018 GDP. VIX - the CBOE Market Volatility Index - a.k.a. the Fear Index. Source: IMF WEO January 2021 update, Pareto Asset Management Source: FactSet

Market fears had a logical rationale: the global economy would Here’s the quirk: it depends. Our psychological discount rate come to a halt. In fact, estimates of dramatically negative is not a given. It fluctuates, depending on e.g. your mood. GDP growth soon appeared, only to be fully confirmed – and When you are depressed, it may increase dramatically. The more – as the year progressed. The United Kingdom, being clinically depressed have a hard time imagining the day after one of the worst affected countries, is now believed to have tomorrow or perhaps next year. experienced a contraction of as much as 10 per cent in 2020. For the Norwegian mainland economy, it was the worst drop Back to 2020: The coronavirus was (and is) scary. We became since 1944. insecure, discouraged by the torrent of bad news. The psychological discount rate increased. And we all know the THE LOGIC OF PANIC implication: falling prices on stocks and other risk assets. We And then we had a classical knee-jerk reaction, exacerbating don’t specify any particular rate, but collectively, we act as if the fall. Please allow me a bit of a detour through behavioural we did. economics. We all have different psychological discount rates, meaning that we have different time preferences for capital. This time, the VIX index, popularly known as the fear index, A dollar tomorrow is worth less than a dollar today, but how spiked to record levels. One might surmise that the ensuing, much less? swift recovery would go some way towards inoculating the

2 Pareto Currency movements for the history books Fiscal profligacy?

12.00 0

2 11.50

4 11.00 6

10.50 8

10.00 10

12 9.50

14 9.00 16

8.50 10 years 5 years 3 years 18

GDP growth Average 1980-2019 2019 est. difference 8.0 20 2019-12-31 2020-03-30 2020-07-03 2020-09-30 2020-12-30 US UK Brazil Japan China India Italy France Germany Norway

Norwegian kroner per US dollar. Source: FactSet Total fiscal deficit in per cent of GDP. Source: IMF, Norges Bank

The almighty ... euro? demonstrating the advantages of unhedged diversification in foreign currency. For Norwegian investors in bond funds, 1,0 however, there was an unusual side effect.

Many funds hedge bonds quoted in a foreign currency to Norwegian kroner, in order to eliminate the currency risk for 0,9 their unitholders. The funds then have to put up a margin as collateral for the counterparty bank. With the precipitous fall in Norwegian kroner, these funds had to increase their 0,8 collateral at a time when, collectively, redemptions dwarfed subscriptions. Their only source of liquidity was thus selling bonds, which of course aggravated the falls.

0,7 In Sweden, which did not suffer similar margin call problems, there was nevertheless a liquidity crunch in the market for 10 years 5 years 3 years corporate bonds, forcing a number of funds to suspend

0,6 trading. It is a fair conjecture that many of their unitholders 01.11 06.12 11.13 04.15 09.16 02.18 07.19 12.20 were surprised by the actual risk of their investments. Euro per US dollar. Source: FactSet During the worst market panic in March, many Nordic high- market from similar declines in the future. Given the role of yield corporate bond funds fell by some 25-30 per cent, human psychology, I strongly doubt it. There will be more although it must be noted that this development was not market panics like 2020 – only to be succeeded, of course, by sustained by a matching increase in defaults. new price climbs. And it didn’t last long. A prompt and fairly concerted global In the short run, though, the rapid recovery may certainly government response to the crisis ensured that confidence have boosted confidence, reinforcing the magnitude of the soon began picking up. recovery. FISCAL CAUTION TO THE WIND A PARTICULAR FOREX SIDE EFFECT There was little hesitation. In a matter of days, key rates were The sharp currency appreciation in March was not limited cut in most of the developed world. Quantitative measures to the dollar. The euro rose almost as quickly and, in a were expanded or reinstated, as was the case in Norway, longer-term perspective, the euro has in fact been stronger, where the Government Bond Fund was rekindled with a having appreciated through the presidency of the former US starting capital of NOK 50 billion. president Donald J. Trump. Market rates of course responded immediately to the crisis, For Nordic investors in foreign securities, the sharp fall in the with short-term rates falling deeper – producing a distinctly value of the local currencies certainly cushioned the blow, more positive yield curve. Long-term rates fell too, though.

Pareto 3 Growing mountain of public debt Worst value year ever

140 30

120 20

100 10

80 0

60 -10

40 -20

20 -30

GDP growth Average 1980-2019 2019 est. difference 0 -40 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020 1975 1980 1985 1990 1995 2000 2005 2010 2015 2020

Public debt as a share of GDP in per cent, advanced economies, actual and estimates Difference in annual total return, MSCI Value less MSCI Growth, percentage points. (2020 and 2021). Source: IMF, Norges Bank Source: MSCI

The yield on 10-year US government bonds, having ended the stocks. The low interest rates imply that future earnings have previous year at more than 1.9%, briefly dipped to 0.5%. In the a higher present value. euro area, the corresponding rate almost went down to -0.9%. If you ever wondered whether this was merely a theoretical As for fiscal policy, the last decade’s call for more restraint construct, 2020 delivered an unmistakably clear useful and better balanced budgets was noticeably absent. The lesson. The MSCI World Growth Index rose an impressive government deficit in the US, with no lack of vocal fiscal 34.2 per cent in dollar terms. The MSCI World Value index, hawks, is now estimated at a record-high 17.5 per cent of on the other hand, actually fell by 0.4 per cent. Put differently, GDP – and that’s before president Joe Biden’s $1.9 trillion relative to growth stocks, 2020 was the worst value year ever stimulus plan has been put before the vote. Given the size of since the inception of these indices in 1975. the US economy, and of US imports, this provides a powerful stimulus to the entire world economy. Even in Germany, Of course, there may be other possible explanations. With a normally a model economy for the prudent-minded, the deficit limited number of large-cap stocks looming large in the return probably reached 6.3 per cent of GDP – more than 12 times calculations of even the world index, company-specific factors the limit in the European fiscal compact. cannot be discounted. Still … a difference of this magnitude? One would be hard-pressed to state that interest rates don’t In terms of economic policies, then, 2020 was a powerful enter into the equation. reminder that authorities were indeed not out of policy tools. To some extent, the very manifestation of a forceful reaction may have been just as important as the details of the measures taken. In Norway, the news of the re-establishment Looks expensive?

of the Government Bond Fund was probably more important 50

than the fund itself. At the beginning of July, only NOK 3.6 Adj CAPE 10 billion had been invested. Confidence is a central, if nebulous 45 CAPE 10 as reported factor in financial markets. 25 yr avg adj 40 50 year avg Of course, the highly expansionary fiscal policies are not without side effects. After deep concern in the years following 35 the global financial crisis, public debt is again shooting up most 30 everywhere. At some point, this will reappear in the worry

spotlight. For now, with the extremely low government bond 25 yields – long euro bonds are still in negative territory – it is not that difficult to finance. 20

FUELLING THE STOCK MARKET 15 Low interest rates also affect the structure of stock prices. In 10 particular, so-called growth stocks – with high expected future 1990 1995 2000 2005 2010 2015 2020 earnings growth and similarly high pricing in the stock market CAPE adjusted for changing dividend payout ratios. – appreciate in value relative to more moderately priced value Source: Robert Shiller / S&P Dow Jones Indices / Pareto Asset Management

4 Pareto Mega-cap stocks getting more expensive is also part of the FUNDAMENTAL FUEL explanation for the apparently higher pricing of the wider As the year progressed, positive news on vaccines bolstered stock market. In December 2020, the cyclically adjusted P/E optimism, while a seemingly calm US presidential election ratio (CAPE) in the US stock market almost reached 34, only calmed nerves. Markets had been expecting the worst and kept surpassed by the years leading up to the dot-com bubble getting good news, as evidenced by the surprisingly bullish Citi bursting. Economic Surprise Index.

This, too, can be easily explained by the behaviour of interest Whereas monetary stimuli may produce immediate results, rates – or at least be made to look more sensible. During 2020, fiscal stimuli take a bit more time to work their way through the yield spread on US equities (the CAPE earnings yield the economy. Hence, despite the disastrous GDP estimates for relative to the yield on 10-year government bonds) increased, 2020, it seemed obvious that 2021 would be far better. which many would take to represent an increased margin of safety. The same holds for other stock markets, although long- A similar argument can be made for private consumption; term interest rates have climbed a bit after the end of 2020. there is more to come. With a lot of goods and services suspended or practically unavailable, the savings rate increased substantially in economies under some degree of lockdown. In Norway, the savings rate has tended to oscillate Relatively inexpensive between 6 and 8 per cent. Now, Statistics Norway estimates 6 last year’s savings rate at almost 15 per cent. That’s a lot of consumption waiting to happen. 5 Good news in the pipeline is generally appreciated right away 4 by financial markets. So too in 2020. Towards the end of the year, we had a string of all-time highs in a number of stock 3 markets around the world. With the possible exception of

2 typical value stocks, and disregarding the extreme turbulence en route, 2020 can be summarised as a good year for stocks. 1 FOOLED BY THE GDP GROWTH? 0 Upon entering 2021, the outlook is decidedly upbeat. The copper price, a traditional business cycle indicator, has reached -1 levels not seen for eight years. The oil price has risen further. 10 years 5 years 3 years

-2 The IMF has raised its 2021 global GDP growth forecast. 10.03 06.05 02.07 10.08 06.10 02.12 10.13 05.15 02.17 10.18 06.20

Yield spread: Earnings yield as defined by the adjusted CAPE 10 less the current yield on 10 yr Treasuries. Source: Robert Shiller, Pareto Asset Management

Surprisingly bullish Positive pandemic returns

300 140 Never before has the index MSCI World Index Norway OSE Benchmark S&P 500 (Rebased) seen such a spike! OMX Copenhagen 20 OMX Nordic 40 250 130 OMX Stockholm 30 S&P 500 OMX Nordic 40 (Rebased) 200 ... and we're still way above 120 the long-term average 150 Norway OSE Benchmark (Rebased) 110

100 100 OMX Stockholm 30 (Rebased) 50

90 OMX Copenhagen 20 (Rebased) 0

80 -50 MSCI World Index (Rebased)

-100 70 10 years 5 years 3 years

-150 60 2003 2005 2007 2009 2011 2013 2015 2017 2019 nov des jan feb mar apr mai jun jul aug sep okt nov des 19 19 20 20 20 20 20 20 20 20 20 20 20 20

The Citi Economic Surprise Index. Source: FactSet Total return indices, rebased 31 December 2019 = 100. Source: FactSet

Pareto 5 Dr. Copper in a festive mood That being said, we are still in a phase with steadily improving fundamentals and more to come from further stimuli and 8500 suspended consumption, while key interest rates are expected

8000 to remain low for some time to come. That’s usually a good environment for risk assets. 7500 And remember: Risk is all about your time perspective. If you 7000 have the solvency and the patience to hold on, well diversified 6500 investments in risk assets pay off. Sometimes, as in the months following the 2020 March plunge, you don’t even have to wait 6000 for long. You just need to have the confidence that comes from

5500 understanding financial markets.

5000

4500 10 years 5 years 3 years

4000 01.16 06.18 12.20

Copper cash official LME, $/t. Source: FactSet

Risk assets, from stocks to corporate bonds, have appreciated further. The pandemic is far from over, but there seems to be a more credible timeline for vaccines in most countries.

A caveat is in place, though. Among the lessons learnt in 2020, this one seems indisputable: There is no clear contemporaneous relationship between economic growth and the stock market. After all, the market ended up doing pretty well in a year that was disastrous to the real economy. And, in case you have forgotten, the very same development took place in 2009.

2020 in a nutshell OSEBX 4.6% S&P 500 return 18.4% MSCI World net (USD) 15.9% 3-month NIBOR from 1.84 to 0.49% 3-month STIBOR from 0.149 to -0.046% 10-year Norwegian Treasury from 1.55 to 0.96% 10-year Swedish Treasury from 0.15 to 0.03% 10-year US Treasury from 1.92 to 0.92% Brent Blend from USD 66.00 to USD 51.80 USD/NOK from 8.78 to 8.53 EUR/NOK from 9.86 to 10.47 GDP growth, global -3.5% GDP growth, Norway -0.8% GDP growth, Sweden -2.8% GDP growth, Mainland Norway -2.5%

Sources: Oslo Børs, S&P Dow Jones Indices, MSCI, Norges Bank, FactSet, IMF, SSB, SCB, Riksbanken, Pareto.

6 Pareto