Weekly – Investment Adviser– 06 November
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Be water !
“Empty your mind, be formless. Shapeless, like water…”
Bruce Lee (Hong Kong martial artist and actor)
Emerging countries experienced the Arab Spring a few years ago. Since then it precariously calmed down. Indeed, a second wave of protest started in 1H19, with the overthrow of the Sudanese dictator Al Bashir and, in Algeria, of Bouteflika. Maduro is on the watch list. Last summer, demonstrations reached Moscow, Cairo, and now Lebanon, Chile, Ecuador, Bolivia and Indonesia. Everywhere, young people missing hope and future confront dehumanized “dictatorial” regimes. In Hong Kong, it will eventually result in an organized fall of C. Lam. But the HK population supports the demonstrators, contrarily to former episodes (like 2014).
A new from Beijing will not feature a durable solution. In Bolivia, Evo Morales, the first Amerindian president elected in 2006 yet delivered sensible economic and social goodwill in the last 13 years. Still, his fourth – fraudulent? – mandate spells “caudillismo”. This is unacceptable, as reminiscent of times of military juntas (Pinochet, Stroessner).
Authoritarian regimes of Emerging countries experience solid distrust and rejection
Successful people revolt in Sudan and Algeria feed hope
Globalization of demonstrations
World has changed. The full control of information by governments is over. Demonstrations are primarily featuring young people. Our digitalized world favors instantaneous and cross-border emulation. Look at demonstrators in Hong Kong, Chile, Spain and France: they wear the same masks. In Barcelona, the Tsunami group uses the same principle / philosophy as in Hong Kong featuring the B. Lee quote: #be water (i.e. be unpredictable, elusive, slipping). Hong Kong ban of masks in demonstrations has backfired.
For sure, the economic situation plays a crucial role. Indeed, pauperization and rising inequality are key factors of demonstrations in the developed world. The so-called “Social fracture” severely hit the middle-classes over past decades fueling a severe social crisis. This is becoming a serious issue. Across history, it was the germ of “Revolutions”. In France, the Yellow jackets insurgency lost some steam only after significant concessions (financial gifts) from President Macron. For now, some initiative occurred in the US thanks to the private sector. Very large firms (Amazon, Walmart) increased minimum wages from 2018. But, according to the latest polls, it is no longer impossible that a shift to the far left takes place (Warren) in fall 2020…
The striking exception is mainland China, which has proved immune to protests so far. There are two main reasons. Firstly, government has delivered its share of the social pact: a relentless rise of the buying power of its citizens. Secondly, Beijing remains credible and performing on internal propaganda and in the building of a nationalistic sentiment.
Interestingly, these “modern” revolts totally miss, for now, charismatic leaders, like Che Guevara or May 68’s D. Cohn-Bendit. The “good news” for incumbent governments is that it provides “some” time to react. On the flip side, it prevents from negotiating, exfiltrating, or discrediting opponents.
Youth and middle-class engagement prefigure the entrenchment of revolts / demonstrations
In developed countries, the social peace might be restored if very different redistribution policies (minimal wage, minimum income schemes, etc.) are rapidly implemented
Western medias – and investors – are only gradually acknowledging for the growing wave of discontent. Investors are still – complacently? – expecting non-dramatic issue to it… See graph below.
- Let’s face it, the ongoing deterioration of global (geo)-politics remains serious
- It shouldn’t be underestimated when investing
- Emerging markets are attractively valued. But still, exposure to the asset class should remain selective
- “Systemic” political risks do not threaten developed markets. But still, the impeachment saga in the US and trade tensions are darkening the cyclical perspectives over next quarters
Fixed income. High yield stress is resurfacing
High-yield bonds have performed well in absolute and relative terms this year thanks to the major central banks U-turn. High-yield bonds have outperformed investment grade corporate debt. The spread paid over investment grade bonds is near the lows.
Despite this outperformance, things have occasionally gone wrong. Recent events have reminded high yield investors that it does not come without risk. Defaults have mainly been concentrated into the retail and energy sectors. Retailers have failed to adapt to the online competition and low margin environment. Big names like Debenhams, New Look or Rallye have bankrupted. The energy sector has been the dominant sector, accounting for more than half of defaults. The most notable defaulter was PG&E. The energy sector is the bottom performer. In contrast to the HY universe, energy sector spreads have widened, which might come as a surprise considering that the oil price is up and trading above breakeven levels for many oil players.
Having a single asset exposure, like energy companies, can be fatal. Bond investors need to remain careful. Thankfully, these default cases are the exception rather than the rule.
Overall, outside both sectors, HY defaults remain low. However, some pockets of stress are emerging. The Fitch 50 index provides a look at debt structures and credit profiles for 50 prominent US leveraged issuers. Its members have a total debt of $500bn. Their median leverage was mostly steady at 5.9x over the past year. However, median interest coverage sharply declined to 2.4x from 3.3x, reflecting higher rates and a lower cash flow generation. Furthermore, downgrades have recently spiked and surpassed upgrades by a ratio of 5 vs. 1.
In addition, the portion of bonds trading at distressed levels, i.e. with a spread higher than 1000bps, is on the rise. The number of those bonds has increased by 63% over the past 12 months. This tends to be a good leading indicator for future defaults.
S&P is expecting a rise of the 12-month trailing default rate for the HY issuers to roughly 2.8% by mid-next year. This level would be roughly half a percentage point higher than the current rate, representing a reversal in the gradual downward trend experienced since mid-2017.
Nonetheless, this forecast is still slightly below the long-term average default rate. According to S&P, in an optimistic scenario the HY default rate would be stable, while in a pessimistic one it would climb to 3.5%. The negative credit outlook for HY rated issuers is on the rise too. Bond investors are currently witnessing an increasingly two-tier market. Those that can borrow cheaply and benefit from the low interest rate environment, and those falling out of favor which are locked out of the market.
The recent ECB announcement to restart its purchasing program has already drained huge amount of cash into the asset class. So, a more cautious approach prevails.
- Default rate is already expected to increase somewhat
- High yield is not to ban, but investors have to be selective. Favor BB-rated bonds
Fixed income. Emerging bonds an oasis of calm
Recently the IMF trimmed its estimate for emerging countries economic growth in 2020 by 0.1% to 4.6%, that is still well higher than advanced economies. The IMF is projecting a stable growth in 2020 around 1.7%.
In Emerging countries, political risk has increased in recent months, with mass protests and populist parties coming into power. These days it is easy to name countries experiencing some sort of political crisis. The list includes, but is certainly not limited to, Hong Kong, Turkey, South Africa, Chile, Lebanon and Ecuador. Investors may only focus on political risks to assess emerging markets opportunities. Despite that, investors behavior is relatively calm. Capital flows are moderately negative, but FX holdings show investors are comfortable holding exposure into EM countries. Maybe politics matter less. Chile is probably one of the least vulnerable to political risk among EM. However, even though in Chile a lot of bad news are already priced in.
This year, hard currency bonds are still outperforming local ones. Institutional investors have not been net sellers of local currency bonds; most of the outflows have come from retail accounts. Most of the inflows gone into high yielders countries, like Brazil, Mexico, Russia and South Africa, at the expense of low yielding countries like China, Hong Kong, Turkey, Poland and Colombia.
- Demand for E will resume
- Favor the New Capital Wealthy Nations Bond fund
Equities. A year-end rally?
European and Japanese indices have broken their resistance upward. The S&P 500 is very close to doing it by closing Friday at 3,023, at 0.2% of its historic high at 3,030. US results are currently expected to decline in 3Q19, but less than expected at the beginning of the publication period. Some strategists even estimate a 1% rise in profits for the S&P 500.
Support from the three major central banks (US, Europe and Japan) is beginning to pay off positively on risky assets.
Today, investors prefer to see long rates rise, a sign that the economy is resilient. In previous Fed Funds declines in May and July, stock indexes had corrected, but the situation looks different today.
Investors are starting to position themselves for a revival of the economy if we observe that the Value segment, Europe and Japan have been outperforming since early September.
Investors are also incorporating the message from central banks: “Our accommodating monetary policies are no longer effective. It’s up to you, the governments, to implement fiscal stimulus and/or a Marshall Plan, like the Green New Deal, to revive the economy. “The psychology of investors seems to be changing with the idea that the Fed is in a mid-cycle adjustment. Social protests (Hong Kong, Chile, Bolivia, Ecuador, Iraq, France, Spain) could prompt states to finally implement ambitious plans for recovery.
In addition to a cyclical sector rotation, the market is showing a solid breadth with a majority of stocks moving into historical highs. In 2019, only 75 stocks in the S&P 500 declined, while 361 stocks rose more than 10%.
The strong performance of the shares in 2019 is a surprise, while there are concerns about the US-China trade war, the shape of the global economy and corporate profits.
- The psychology of the market has changed. Will it last?
- Will it translate into a year-end rally?
- If yes, the Value segment, Europe and Japan should continue to outperform
Equities. French luxury is doing very well
In the first 9 months of 2019, LVMH recorded a 16% increase in sales to € 38.4 billion (+11% organic growth), as well as Hermès at +16% to € 5 billion and Kering +17.2% to € 11.1 billion. French groups do not feel the global economic slowdown, nor the Brexit, nor the political situation in Hong Kong. They manage in an extraordinary way the complexity of the global environment.
LVMH: Fashion & Leather Goods sales rose by 22%, Perfumes & Cosmetics and Selective Retailing by 11%, Wines & Spirits by 10% and Watches & Jewelry by 8%. Hermes: Asia ex-Japan grows by 19%. Management confirms its medium-term forecasts. Kering: strong growth in 3Q19.
LVMH has announced its intention to launch a takeover bid on the American Tiffany for $ 14.5 billion, or $ 120 per share (+20% over last Friday’s price). Some analysts consider the Tiffany’s fair value at $160 per share. Tiffany would strengthen LVMH’s position in high-end jewelry, as well as in the US market. This would be the largest acquisition after Bulgari’s purchase in 2011 for $ 5.2 billion, the rest of Christian Dior in 2017 for $ 7 billion and the Belmond luxury hotel chain in 2018. LVMH has a market capitalization of $ 214 billion compared to $ 12 billion for Tiffany, sales of $ 52 billion (2018 figure) compared to $ 4.4 billion and a net profit of $ 6.4 billion compared to $ 586 million. The CEO of Tiffany is Alessandro Bogliolo, the former CEO of Bulgari who sold Bulgari to LVMH. The acquisition would not be dilutive, as the profitability of both groups is equivalent and by generating a free cash flow of € 5 billion a year, LVMH does not need to make a capital increase.
- LV H. Valuation at € 427 (upside potential of 11%)
- Hermes. Valuation at € 725 (upside potential of 11%)
- Kering. Valuation at € 595 (upside potential of 16%)
Equities. Amazon, delivery investments weigh on results
Profits fell by 26% in 3Q19 compared to 3Q18. On the other hand, revenues were higher than expected and growth accelerated with +17% in 1Q19, +19.9% in 2Q19 and +23.7% in 3Q19. Acceleration in online sales, while AWS (cloud services) recorded lower growth rates (AWS accounts for 13% of sales, but for 72% of operating income). AWS has just lost a Pentagon beauty contest in the cloud, to the benefit of Microsoft, a $ 10 billion deal.
Amazon invests heavily ($ 800 million in 3Q19) in delivery to customers, which weighs on profitability. The Amazon Prime subscription should offer customers delivery no later than the day after the order (one-day shipping). Amazon wants to multiply warehouses to be closer to the customer. In 4Q19, Amazon will spend $ 1.5 billion to speed up deliveries, which also means hiring new employees. These investments prompted management to warn that the profits of the 4Q19 will decline, despite a significant period with Black Friday, Cyber Monday and Christmas.
The growth rates are still strong for Amazon, in all activities. But the AWS milk cow is decelerating. The market must ask itself the question of what will be the appropriate growth rate for AWS. + 50% like in 2017-2018 or close to the currently + 30%? This is important because the answer makes it possible to value Amazon at best. The PE ratio 2019 is at 56x and 45x for 2020, which seems excessive to us, with all activities recording growth rates between 20% and 35%. Taking the current stock market valuation, Amazon would be valued at $ 2,185 per share; taking a more appropriate PER, or 40x, would value Amazon at $ 1’600.
- In the coming quarters, Amazon will invest heavily in one-day shipping to push customers to join Amazon Prime, which should result in the underperformance of the share
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