Investment review – May 2019
Strategy and Macro
- Disoriented investors barely participate in rising risky assets
- Rapid shift from recession to reflation mode
- Monetary loosening supports markets… but will not exert traction on economies
We continue to navigate the current global landscape with a full investment mode, though we pay attention to tail risks and remain focused on quality of underlying assets. Geopolitics (North Korea) is no longer interfering and could remain benign, provided Trump and Xi reach a deal. Brexit and Europe elections next May are definitely a source of tail risks and largely discounted. Macro fundamentals are benign. Risks of a monetary policy mistake have receded, with the ongoing Fed pause. Currency volatility is low. The extremely low investors participation to the recent rebound of risky assets is a source of comfort, featuring very little exuberance.
We stay tuned… and invested
Reflation bis repetita
After PBoC (Central Bank of China) in Q418, other major central banks sequentially started to pivot, from Q1 2019, towards a more accommodative stance. Financial conditions improved markedly. Investors have now re-positioned for a redux to the 2017 reflation process. While we actually acknowledge for a concrete stimulus process having started, we consider that it will be of much lower magnitude. Its success will anyway be contingent to a trade truce between China and the US. In its absence, gloom would re-emerge and impact corporate investment and ultimately consumption.
2018 deflation scare is probably over, for now
Markets switch to Reflation mode is significant
US economy is falling back to its potential. Benign, really?
According to experts, the latest change in a) Fed forward guidance (say lower dots) and b) management of its Balance Sheet correspond to … a fall of 0,5% in policy rates. This preventive move raises the odds of an extension of the business cycle. Indeed, in 2020, the US economy will no longer benefit from fiscal stimulus, nor from firms’ capital / profits repatriation.
If a recession happens in 2020, the Fed would only have little room to maneuver with Fed funds at their current nominal 2,5% (real 0,75%). If history is any guide, it normally takes about 3% negative real yields to heal from recession (translating into 4% negative Fed funds) … Not to mention the concrete impotence that ECB and BoJ would face under similar – dire – circumstances.
World and the US have been experiencing continuous disinflation over past decades. Up to a point where inflation, now, is getting – structurally – too low. Deflation may not be so far away, and this is the most dangerous development indebted countries should avoid entering into. Governments like high inflation, as it helps to hide their profligacy.
Therefore, as mentioned above with the MMT (Modern Monetary Theory), policymakers will look forward to engineer higher inflation. This is probably also why the Fed is contemplating a new – different calibration of its inflation target. This is a medium-term project, which should come to fruition in 2020. One of the prevailing ideas is to no longer consider the 2% inflation as a spot target, but rather to average its observation over several years. In practice, the long-lasting undershoot of US inflation below 2% would legitimate a durable overshoot.
Policy makers should imagine different solutions to address subpar economic growth and insufficient inflation
Chinese economy is stabilizing
Chinese growth seems to have bottomed out, according to leading indicators, to soft data (PMI) and to current economic indicators. The official target of around 6% should be reached (if not exceeded) in 2019. This is not surprising, considering the many levers that Beijing has been pulling back to restore a decent level of activity over last quarters. Among them, the furtive QE was notable, as well as the official will to ¨guide financial institutions in increasing credit supply and bringing down the cost of borrowing¨. A new positive inflexion towards the private sector also seems emerging, which contrasts with the skeptical posture that President Xi has had, up to now. Premier Li actually defined a new philosophy ¨the principle of neutrality¨ featuring that private and public enterprises should from now be treated on an equal footing. If realized, this would actually represent a long overdue shift, helping to improve innovation, hence Chinese productivity and capital allocation. He even alluded to the possibility of these new principles to be applied to foreign companies, provided a positive outcome emerges from ongoing negotiations.
For sure, China would like to exit trade tensions with the US and avoid tentative contagion to Europe (i.e. competition 5G, dual Internet standards, etc.). Let’s see if this charm offensive actually spells something concrete…
Europe and Japan have entered stall speed mode
The latest macro data have proved very disappointing over past months, triggering fears of recession. The room to maneuver in terms of conventional monetary policy is nil. Unorthodox measures might be contemplated, but it is difficult to imagine European / Japanese policy rates to fall further in negative territory, without pushing respective banks and financial institutions in dangerous situations. Balance sheets expansion might be risky after so many years of financial repression / asset price inflation. The fiscal stimulus could come to the rescue, namely in Germany. Long term expenditures in green / clean energy, infrastructure and defense might ultimately reach consensus. But, considering the early stage of growth (benign) deceleration, it seems much premature to expect some effective impact in 2019.
Growth will most probably be subpar in 2019. No inflation pressure is in sight. Politics will continue to restrain entrepreneur’s appetite for investment. A removal of Brexit uncertainty, and non-dramatic shift to political extremes in European elections would definitely pave the way for a much better second half of 2019 and 2020. Japan also needs a positive outcome for China/US trade discussions to restore confidence and momentum. This ¨rosy¨ scenario would make current slowdown just look like a soft patch retrospectively. On a flip-side, if any of these tail risks were to materialize, fears of deflation would rapidly re-emerge
Cyclical deceleration will continue
The fate of Europe and Japan economic prosperity lies in majority in the hands of domestic and foreign policy makers
Central bankers backpedaling
In 2018, the USD was propelled higher by 3 factors – 1) a strong US economy and perspectives ; 2) higher spot and forward interest rates; and 3) lower present and future risk appetite. They have boosted the USD demand as a safe-haven currency. These 3 factors are likely to offer less support going forward.
Even if the US data have remained stronger than outside, its outrageous outperformance has peaked. The FOMC has just confirmed that the Fed is on hold for the remaining part of the year, that only one rate hike should be expected in 2020, and that it will stop scaling back its balance sheet as of September. Given the recent market stress, speculative accounts have been net USD buyers, extending their net long positioning to its highest level since mid-2017. The fact that US rates are expected to remain higher than its peers could provide some support for the USD, but it won’t be enough to propel it higher. A lower risk appetite, due to US-China trade tensions, boosted the USD. So, an agreement between both should reverse the dynamic.
The EUR looks like the JPY… again
The ECB and German yields remain a drag for the EUR, as the BoJ is for the JPY. The EUR/USD has been under pressure, as the ECB turned more dovish, lowered its rate hike expectations and cut its GDP forecasts. No rate hikes are expected before 2020/2021. Intuitively, slower growth and still loose monetary policy imply less upside pressure. So, why do we expect an EUR rebound? The EUR/USD has found a support at the lower end of the 1.12-1.16 range as a lot of bad news (like German manufacturing PMI below 45) have already been discounted. The positioning is very defiant towards the EUR. The yield spreads dynamic vs. the USD is supportive.
SNB has tied hands
The CHF should weaken but it should struggle to achieve it. The monetary policy is very loose. This should remain the case for a while as the ECB is putting downside pressure on the EUR/CHF. The SNB made no change to its policy stance. It has little room to loosen its policy further. Moreover, any suggestion that it might be willing to edge away from its ultra-loose strategy is likely to have an oversized impact on the CHF, pulling it uncomfortably higher.
The GBP is the prisoner of uncertainty
The situation that the GBP faces regarding Brexit may become clearer soon. Given these ambiguous situations, investors have adopted a neutral stance on the GBP. This implies that the currency remains very exposed to big movements in both directions.
The JPY remains risk sensitive
The support that the JPY has received via low global risk appetite is fading but has not disappeared. The BoJ monetary policy will remain very loose, and very JPY-unfriendly, as growth and inflation are both below targets. The JPY movements continue to be largely a function of global risk appetite. The FX market remains focused on global growth concerns and US-China trade tensions. If they vanish, the JPY should deflate further.
A declining CNY volatility
The CNY has been more stable against the USD during March. China appears willing to keep the CNY at basically stable levels, even if this prevents the currency from being used as a tool to support the economy. The market had started expecting PBoC rate cut to further shore up the economy. However, like the CNY’s stability, China 10Y yields have also stabilized, well above 3.0%. The PBoC still preferred way to support growth is targeted measures to help private firms and reduce banks’ reserve requirements. Such fiscal and monetary stimulus should imply downside pressure on the USD/CNY.
Is it different this time?
The financial press has been filled with stories about the US yield curve inversion. It has just happened following a string of disappointing data and central banks shifting towards a more dovish direction. The ECB has become increasingly worried about its regional economic slowdown and the side effects of a prolonged period of negative rates. It has opened the door for further easing like extending its forward guidance and announcing new liquidity operations to spur lending growth. The ECB rates will stay on hold for at least the next 12 months. Similarly, the Fed sharply back-pedaled, by signaling no rate hikes this year, eventually one hike in 2020 and stopping its balance sheet run-off as of September. We have never experienced a prolonged pausing Fed and then resuming its hiking cycle yet.
Historically, the curve inversion has been a reliable recession leading indicator. Is a recession around the corner? Let’s put it into perspective. The yield curve inverted in July 2006, 17 months before the Great Recession start. The 3-month/10-year spread fell to -60 bps in early 2007. During the previous cycle, the curve inverted 8 months before the recession begun in March 2001, and the curve fell to nearly – 100 bps in late 2000. So, the degree of yield curve inversion is still insignificant relative to previous cycles.
The slope between the 2 and the 10 years yields remains positive. The curve would probably need to invert further and for weeks, if not months, before becoming a reliable recession signal.
Even so, there is now some question about its reliability as a recession predictor. The Fed QE program has collapsed the term premium on longer-dated bonds. Fed officials estimate that the $1.5 trn program has reduced the term premium by 60 bps. Even if the Fed has rolled off its balance sheet, the 10-year yield is still arguably lower than it would otherwise be. Without the QE purchases, the slope between the 3-month and the 10-year would probably be positive.
Furthermore, the yield curve is really the only indicator that is flagging any sense of trouble. The US conference board leading indicator continues to point out that the US economy is still expanding. Financial conditions are not restrictive. The stock market and credit spreads remain well oriented and growth in bank lending remains positive.
The recent yield curve inversion is not very significant in a historical context, and previous Fed purchases of Treasuries for its QE program mean that the curve is probably flatter than it would be otherwise.
Credit market is still chased
Investors will continue to buy more BBB-rated bonds. The segment already represents around 50% of investment-grade universe. The sector provides a lot of bang for the buck – a higher yield for lower risk. The net corporate leverage continues to decline. Corporate bond spread curves should flatten. The spread of BBBs to BB debt has significantly tightened since T3 2018. Given the central bank doubled down on the dovish guidance, the search for yield has resumed and should continue.
At the end of February, according to Fitch, the US high yield bond default rate reached its lowest level in 5 years, declining to 1.4% from 2.5%. However, financial leverage continues to increase for the riskiest part of the high yield universe, while the best part continues to deleverage.
The environment remains supportive
After the worst month of December in 2018 and the best month of January in 2019 never observed, the 1st quarter of 2019 rates among the best quarterly performances. Despite reduced visibility in economics, politics and geopolitics, stock markets remain in a bull market.
The main positive factors are:
- A 180 ° shift in the Fed’s monetary policy.
- A probable trade agreement between the United States and China.
- The end of downward revisions for earnings growth.
- Equities that are always more attractive than bonds in terms of multiples.
- Since March, some soft leading indicators are improving in both China and Europe, removing the risk of a global recession.
Stock indices delivered one of their best starts of year, but outflows continued
The good news is a) the rise in indexes without investor participation, and b) the absence of euphoria when looking at investors’ sentiment indicators which remained in the neutral zone. The rally is also explained by closures of short positions, in a relatively low volume. If results of the first quarter of 2019 were to prove better than expected, we could fuel entry of investors in equities.
Analysts appear to have come to the end of downward revisions in US profits for 2019, with growth rates that have been roughly divided by 3 since October 2018. For 2019, Factset estimates a 3.7% rise in US profits, and Refinitiv 3.3% in the US and 4% in Europe, far from the 10%-14% estimated in September 2018. In the immediate future, we will focus on profits of the first quarter 2019, which should decline in the United States by 3.9% according to Factset and by 1.9% according to Refinitiv.
In Europe, they should fall by 1.6% according to Refinitiv. Margins are expected to be under pressure mainly due to higher wages and logistics / transport costs (higher oil prices). A less pronounced decline in profits would encourage investors, who did not take part in this 1st quarter rally, to buy stocks.
The drop in interest rates is a favorable factor for stocks, unless we enter into a recession, which is not our scenario. The comparison between US 10-year and dividend/profit yields is still positive for equities.
The reflation theme
We are fully supporting the reflation theme thanks to:
- The Fed’s change of tone towards an accommodative monetary policy due to a risk of recession.
- A likely trade agreement between the United States and China.
- Significant liquidity injections from the Chinese authorities to support the domestic economy.
- Advanced economic indicators are rebounding.
In this context, we overweight the cyclical and value segments, to the detriment of the defensive and growth segments. The concerned sectors are Metals, Energy, Industry, Financial and Consumer Discretionary. In geographical terms, Europe is better armed than the United States with a larger cyclical / value component.
In a reflationary approach, we should also overweight the emerging zone. PMI Manufacturing in China, Indonesia, Vietnam, Thailand and South Korea have begun to recover. See chart below. We are overweight China, which is reflating its economy with large cash injections.
The Chinese equity indices have risen sharply since the beginning of the year. But domestic A-shares (+34% increase), listed in Shanghai and Shenzhen, have outperformed H-shares (+17% increase), listed in Hong Kong. Domestic equities benefited from the quadrupling of the inclusion factor, announced in mid -February, in the MSCI global indices.
The increase in the weighting of A-shares will be done in three stages, in May, August and November, and Chinese equities will account for 42% of the MSCI Emerging index compared to 31% today, split in 26% for H-shares and 16% for A-shares. Chinese equities still have a strong upside potential, but we are now favoring H-shares, which offer a significant discount in terms of valuations compared to A-shares, with respectively PE ratios of 8.9x 2019 and 12.8x 2019.
“OPEC or NOPEC ? ”
The price of Brent rose 27% in 2019, flirting with $75 a barrel. The objective of the Saudis is a stabilization between $70 and $80. The United States continues to increase its oil production, while Saudi Arabia and Russia have continued to reduce output, according to the OPEC+ agreement. The Venezuelan crisis, US sanctions against Iran, and optimism about a trade deal between the US and China have been other positive factors.
NOPEC could be a trigger for lower prices. What is NOPEC? NOPEC, the Oil Production and Exporting Cartels Act, is a bipartisan bill that may soon come into effect. It’s been 20 years since the Congress tried to get this legislation through, but with the risk of a presidential veto, the bill never went through. But times are different today with Trump frequently attacking OPEC for price manipulation. NOPEC is an amendment to the Sherman Antitrust Act of 1890, a law used 100 years ago to break John Rockefeller’s empire, Standard Oil. NOPEC was approved by a House Judiciary Committee on February 7th 2019 and the Administration is studying the subject. The US Petroleum Institute and the US Chamber of Commerce obviously oppose it.
NOPEC would serve to punish the OPEC cartel that manipulates prices by changing its production. It is also about sanctioning companies that work with OPEC. Once again, it is the extraterritoriality of American law.
According to some experts, the short-term impact could be a rise in prices due to OPEC retaliation, but in the long run a fall in prices. Saudi Arabia has given a clear message to Wall Street: if Washington passes the NOPEC law, the first victims would be the US shale gas. OPEC could no longer operate and each member would increase production to full capacity, causing prices to fall. OPEC is trying to convince the US shale gas industry and its bankers to put pressure on the Congress and the Administration. If the US Secretary of State for Energy opposes this law, Donald Trump remains silent.
Saudi Arabia threatens to sell its oil in a currency other than the dollar if NOPEC were to pass. In a US protectionist context, the European Union, China and Russia would well receive this monetary diversification to weaken American influence in the world. Nevertheless, experts do not think that NOPEC will pass; there are too many economic and political interests between Washington and Ryad.
And if China would join the party …
With the rally of stock markets and the strong resilience of the dollar, gold has lost some of its strength, but it still resists well.
Our positioning on gold is:
- A long-term vision.
- Diversification in a multipolar and highly indebted world.
- Participation in the gradual process of de-dollarization.
- Protection in times of high volatility.
- An interesting tool in portfolio construction.
Central banks of emerging countries have understood this well. Indeed, in 2018 they have bought the largest amount of gold for 50 years, especially Russia, Turkey, Kazakhstan, Poland and Hungary.
But the highlight is certainly gold purchases by China, after two years of abstinence. China joined the party by increasing its gold reserves in March 2019, for the fourth month in a row. If China starts to buy gold, the impact would be significant, knowing that gold accounts for only 2.5% of its foreign reserves. Gold accounts for over 60% of foreign reserves in developed countries. Yet, China is the largest gold producer in the world.
China has bought 43 tons of gold in the last four months. If it continues this pace, it will overtake Russia and Kazakhstan, the leading buyers in 2018.
The good vector to play reflation
Industrial metals prices performed well despite poor economic data. In recent months, the price of copper has resisted the deterioration of Chinese and German manufacturing PMIs. Today, copper is benefiting from the recovery of the Chinese manufacturing activity, falling inventories in London and production problems in Chile, the world’s largest producer, and Peru, weighing on supply. Glencore has also decided to reduce its production in the Democratic Republic of Congo. On the demand side, the latest manufacturing polls suggest that Chinese measures to support the economy are starting to work.
Mining specialists and major investment banks anticipate a rise in industrial metals prices in 2019 due to supply deficits. These are mainly copper, nickel and zinc. These metals will be needed in the development of the electric cars.
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