Investment strategy – April 2018
A major change occurred in the past months following the Trump fiscal package.
Indeed, the US economy will receive a shot in the arm through the recent massive tax and spending. The magnitude and the duration of this reform is significant. It will derail the trajectory of the US economy from its ¨secular stagnation¨ course from the last decade. Indeed, it hap-pens very late in the business cycle, when the output gap just closed and when signs of full employment / wage pressure emerge. For sure, US economy will shift from its former growth / inflation centre of gravity in 2018, 2019. Nominal growth will accelerate by probably 1 to 1,5%. It is nevertheless premature to figure out whether growth or inflation will accelerate more. Lowering corporate-tax rate actually makes sense and may ultimately contribute to a long overdue – and healthy – revival of the investment cy-cle. Tax breaks to households, on the opposite, should have a lower economic impact. They would neither reduce – growing – inequalities between haves and not haves, nor raise the share of labor relative to capital.
One important consequence of this US reflation is that the duration of the cycle may ultimately prove shorter than expected. The best recession indicator models (Fed or Guggenheim) consider very low risks (below 10%) of a US recession in the next 12 months. But the odds are shooting up – to 80% – of a recession occurring from 2020…
US economy is shifting its economic gravity centre. It is premature to conclude on the trajectory of this shift.
Japan and Europe are also experiencing a significant cyclical rebound. But their future momentum will be much less pronounced than the US, missing a major similar fiscal impulse. A significant / durable acceleration of inflation is unlikely because of structural headwinds (demography) and of cyclical factors (output gap). Both economies moved somewhat on the right of the diagram but remain entrenched in the very favourable – Great Moderation – regime. China transition remains in place. Growth deceleration compared to former cycles, as well as relatively low inflation keep the country close to the crossroads of global regimes.
This soft-landing process spells risks of falling into the ice / debt deflation regime (bottom left) if policy mix proved inappropriate. For sure, the country must continue to address the issue of excess leverage and pro-vide adequate stimulus to avoid stall speed. Up to now, the Party proved effective in setting up the key priorities, like reducing over-capacities, internationalising the Yuan and opening up the capital account. A clear focus on financial stability is now required to pre-vent from possibly falling into a debt trap /¨crisis¨. Emerging countries ex-China engage in a pretty virtuous trajectory, which should be reinforced by the bottoming-out of commodity prices. Inflation is not a major threat. Globally, their economic momentum should no longer lag that of developed countries over next couple of years.
The pace of current expansion should reach its top by summer (fall?) 2018. A global and synchronised expansion phase will likely continue into 2019, with limited risks of an inflation slippage.
Globalisation and consequential adoption of free trade have been two relentless processes over recent decades. When put into the historical perspective, Trump latest attempt to restore tariffs may seem, at first, like an epiphenomenon.
Still, the extended periods of tariffs proved very unstable and featured extreme variations of growth and inflation, hence hectic business cycles developments… The Great Crisis / Depression of the 1930’s is the most insightful example of it.
Watch for outright trade protectionism, featured by an explosion of tariffs, which could change trajectories of countries in terms of inflation dynamic…
Monetary policy transmission into financial markets takes several channels, particularly since developed countries major central banks largely relied on unconventional policies and tools.
When it comes to regime, one could argue that the Anglo-Saxon central banks, under the Fed leadership, are attempting to exit financial repression. Very gradually so… This actually spells restoring positive real rates over time, downsising balance sheets and no longer re-pressing financial market’s volatility. This process is now well underway.
The recent crash-landing of short-volatility products is a symptom of investors’ late acknowledgment of this… The unwinding of their positions has recently begun, the acknowledgment of a new regime is still far from being con-sensual. In any case it will take time to unfold in a best / gradual / rosy scenario. New markets’ corrections are possible, if sensitive thresholds are too rapidly by passed (like 3,5% on US long rates, 2,5% on CPI, etc.).
The current pick-up in global growth is far from trivial in terms of liquidity. As well as the rise in commodity price (namely oil) when it comes to funding inventories. Both tend to absorb the remaining excess / investable liquidity.
Such a transitory regime from central banks is going to continue, whereby the so-called Fed -put possibly still exists, but with a lower strike price! We expect financial market’s volatility to keep rising from past years level, across all asset classes.
When in doubt…
Equity bull market is not invalidated (see equity analysis below). Macro is supportive, but the ongoing regime change creates potential vulnerabilities, which may have significant short-term impact on markets. Higher macro volatility will translate into growing uncertainty and a deli-cate transition phase for markets.
Sharp slowdowns / recessions impact very differently on asset classes. Bond markets tend to anticipate it earlier, and some segments of it benefit dramatically. It is very premature to consider asset allocation changes in this respect for now! But still, it reminds us that lengthening gradually du-ration and maintaining a sizable portion of bonds will prove appropriate over next quarters, despite rising yields risks…
- Fixed Income
- Alternative Investments
Still unloved USD
US growth expectations have been recently revised up because of the tax bill and the state budget. This implies a $300bn federal spending increase by 2019 as well as emergency funds release. As a result, as pointed out by the new Fed Chairman, the Fed should re-vise up its forecasts.
However, the USD remains under pressure for several reasons:
- The dangerous public deficit rise happens in an above-potential growth. It will lead to higher deficits in 2018 and more markedly in 2019. At the same time, the twin deficits (public deficit + current account deficit) worsen and endanger the sustainability of public finances in the long term. Investors wonder about the government’ leeway ahead of a new crisis.
- Fears of a trade war in an increasingly protectionist rhetoric environment and a willingness to weaken the USD.
- The Trump Administration’s stance on the USD seems clear. Such as previous Republican governments, Trump seeks to support manufacturing activity by weakening the USD.
- The Yuan is being increasingly integrated into the foreign exchange reserves whose world trade share is expected to gradually increase over the coming years. This move will happen at the expense of the USD.
- The US bonds favorable interest rate differential, once the currency hedging costs are considered, offers a limited additional value over German yields. Thus, flows to US assets remain contained.
The currency market positioning clearly confirms this analysis and seems too consensual. Indeed, the market consensus remains in favor of a gradual USD decline to 1.28 by year-end. The speculative positioning confirms this view with an USD underweight close to its past 5 years highest level.
Reducing trade and geopolitical tensions, as well as easing banking regulation expectations could also support the USD.
Political headwinds across Europe are ignored
The ECB has just amended its forward guidance, as expected, given the solid macro momentum. Therefore, it no longer entails the QE flexibility. President Draghi adopted a softish tone. The main reason is that the victory on the deflation front cannot be declared yet and seems very difficult to achieve over a reasonable time horizon. The updated staff projections confirmed that pattern, the near-term growth outlook has been strengthened – which is logical – however the ECB’s core inflation forecast remains too optimistic. Given the political risks across the area – namely Italian government, German coalition, banking union and infrastructure/budget spending misalignment – all represent major risks to the Eurocurrency.
Japanese reflation is softening
According to latest reports, wages in Japan rose modestly but are decelerating since the December pick. Despite the tight job market, political support and incentives for companies to raise wages at a faster pace, the wage inflation remains modest. Will it remain indefinitely low in Japan? One of the key drivers would be the acceleration in part-time wage inflation. Part-time workers’ hourly wage inflation remains on the rise at a pace close to 3.0%. The tightening in the demand/supply of labor is affecting the wage inflation of part-time workers.
However, it is still a long process and, for the time being, not spilling over to full time wages. A wage inflation has been a road-mirage in Japan for the last few years. However, the linkage between the tightening in the labor market and wage growth does exist. Still, clearer signs of a broad base wage inflation are elusive.
EMFX at risk
The emerging market complex has been well supported recently in a USD weakness context. However, EM currencies are now at cross-roads after Trump decided to exclude Canada and Mexico from the steel and aluminum tariffs as the 3 countries would succeed in reaching a new NAFTA agreement. Other countries will still be subject to it.
Therefore, it maintains the pressure on other commodity exporting countries, which casts a shadow on their growth outlook. Secondly, the continuous in-crease in US Treasury rates is adding pressure on higher-yielding currencies as it reduces the attractive-ness of carry trades.
As example, the 2-year interest rate differential be-tween the US and Brazil currently stands at around 6%, compared to more than 16% in September 2015. The monetary tightening that is underway in the US could only reduce the attractiveness of those currencies.
- USD, EUR, CHF, GBP
- JPY, AUD, CAD
Yields are facing opposite forces
Bond markets have reached a delicate point as yields are rising at one of the fastest pace over the past decade. The Fed is on track to gradually normalise rates whilst the ECB is slowly, but surely, coming towards its QE end. We are experiencing the inevitable consequences of the unwind of those accommodative policies, namely volatility shocks . Several opposite structural and cyclical forces have dropped into place.
- Bond market correction began in mid-16 after the QE announcement peak. Since then, the Fed subsequently removed stimulus and yields increased. The global liquidity should decrease as the Fed is shrinking its balance sheet by $10bn a month up to $50bn later this year.
- Higher inflation is expected since mid-2017 due to strong global & synchronised growth. US inflation expectations have sharply risen since mid-December. The triggers have been the US tax reform bill, the spending deal in February and wages pressures . On their side, Euro realised data have disappointed. So, specific US factors are at play.
- The government bond supply is also back with the expanding US budget deficit. US debt sales are set to more than double this year.
- China, Japan and other nations, which have recycled their USD through Treasuries, could decide to whit-tle them down in the current “currency” confrontation context. It looks unlikely that they do it altogether. However, there is a risk.
- The low core CPI can be explained by the 18-months lag with growth. Inflation should pick up as output gaps are closing. However, this is an obvious relation – not a market surprise – and market-based indica-tors are already discounting 75% of this scenario. See chart below
- Other QE program in Japan and Europe are still alive. This will help to maintain supportive financial conditions which, despite higher yields and volatility, are close to their past 5 years average.
- The US Treasury department has been able, in just 2 months, to already fund 30% of its $1.3trn expected net supply. Amongst the re-entering buyers, US banks should increase their Treasury holdings after cutting them in 2016-2017. As Fed tapering will reduce bank reserves, firms would buy more of high-quality liquid assets. In the same vein, speculators and households have strongly reduced their Treasury exposure to unprecedented levels.
- Over the past 2 years, China has moved from a big reflationary force, driven by a recovery in the housing market and a significant reduction in capacity. Those reflation forces are easing due to the monetary tightening functioning, lower China export prices and PPIs and a stronger Yuan.
The biggest risk is that a very leveraged financial sys-tem may prove very rate-sensitive. Therefore, rising rates/yields/inflation may provoke financial condi-tions’ tightening, which feeds back into much weaker growth. This may cause central banks to pause tight-ening, which would become bond supportive.
Historical correlation between credit spreads and yields is changing
Relationship between yields and spreads is complicated and has changed over the time. Spreads tend to be highly cyclical.
Over the long-term, both have had a negative correlation which has an economic sense as higher (lower) yields reflected a stronger (weaker) economy which in turn generally led to tighter (wider) spreads. However, this correlation has gradually weakened due to a continuous increase in corporate leverage and unconventional monetary policies pushing down yields and spreads. Spreads are more exposed to a reversal.
If higher yields are the result of central banks’ balance sheets shrinking, spreads could widen more than the long-term data suggests. So, the correlation could spike into positive territory. This is particularly true in Europe where the ECB has purchased corporate bonds. This could mean higher yields and higher spreads.
Realigning premium across EM
The global economy is entering another stage of its long normalisation cycle, namely the liquidity conditions tightening. QEs are still alive but financial conditions have started to tighten. This time would be different as output gaps are shrinking and fiscal policy takes the baton from easy money.
Such headwinds would weigh differently on developed and emerging markets. EM spreads and local currency bond markets which have been supported by persistent USD weakness and low yields could suffer a repricing. Inflows have been resilient for the time being. However, when compared with 2002-06, many important EM economies are more leveraged and show no reform impetus.
- Investment Grade,
- High Yield, Hybrid/Sub,
- Emerging hard currencies
- US Treasury, Inflation
- German Bond
- Emerging local currencies
The “mature” bull market remains alive, but volatility is back
The normalisation of monetary policies and the gradual withdrawal of liquidity are factors that are as important as profit growth and stock market valuations.
As promised during his election campaign, Donald Trump will put his trading partners under pressure with a protectionist policy. If it increases tariffs on steel and aluminum, certain sectors and stock indexes will underperform: in the United States, Industry, Real Estate and Energy, as well as exporting countries like Germany and Japan. Half of the DAX achieved a significant share of its sales outside Europe.
In late January, the stock markets fell with the return of inflationary risk and at the end of February with fears of global economic slowdown, fearing that Trump adopts anti-smeasures.
For the first time in a long run, we see some risks for equity markets. The markets are approaching important technical levels. We therefore prefer to adopt a more defensive tactical positioning.
Inflationary pressures coming from a demand shock – increased investment, household consumption, fiscal stimulus – are positive for equities, especially for cyclical sectors such as banks, industrial or materials companies. But that can change and become a supply shock in a tight labor market, causing a rise in wages. A rise in wages in an environment of rising interest rates is unfavorable for equities, as it leads to a reduction in margins. Higher wages, lower margins and higher interest rates are the typical end-of-cycle scenarios. But the signs of recovery of wages and inflation are not very visible.
We do not believe in a slippage in inflation and stock market valuations are not expected to contract in 2018. Growth in profits and revenues is a support for the stock markets: +11% and +6% in 2017 for the S&P 500, and expected at +18% (impact of the tax reform) and +7% in 2018 and +10 % and +5% in 2019. A re-cession may come only towards the end of 2019-2020. Interest rates will gradually normalise, but long US rates should not exceed 3.5%.
There is therefore no negative change for equities compared to other asset classes. The bull market regime is still valid, but volatility will return and sector rotation accelerate. Historically, the S&P 500 is advancing during a phase of rising Fed Funds by the US Federal Reserve.
The valuation of the European stock market is 30% lower than that of the US stock market, but adjusted by sectors it becomes comparable. On the Euro Stoxx, the low PER sectors dominate – finance, energy, materials, while technology is important in the S&P 500.
Emerging markets are still doing well
Factors like a weak dollar and stable US interest rates are the main reasons. But if the Fed continues its normalisation monetary, with 3 to 4 increases of Fed Funds in 2018, the question of the stock of debts will arise.
An expected dollar rebound and the normalisation of the Fed’s monetary policy are now a risk for emerging stock markets. China has recently benefit from Indian Stock Ex-change outflows – high stock valuations and elections in 2019 – as it is offering attractive stock valuations.
In recent years, investors have not captured the economic growth of the emerging zone through the stock markets due to large capital increases and IPOs, while developed country stock markets have undertaken significant shares-buyback programs. The dilution factor was higher in emerging markets. Over the last 10 years, market capitalisations have increased much more than price indices.
Between 2007 and 2010, China floated Bank of China, ICBC, PetroChina, China Shenhua Energy and Agriculture Bank of China. The attractiveness of emerging countries’ growth did not translate into EPS growth, and volatility re-mains higher in emerging markets.
- Switzerland, Japan
- Large Caps
- Discretionary, Energy, Financials, Health Care
- US, Europe
- Emerging, China
- Small/Mid Caps
- Staples, Industrials, IT, Materials
- Telecommunications, Utilities
Investment deficits should support oil prices
Oil prices are stabilising above $60 a barrel, supported by robust global demand and a freeze on OPEC and Russian production. Saudi Arabia would like the agreement in OPEC and Russia to be a permanent one. The United States has increased production to more than 10 million barrels per day, surpassing the peak production in 1970. The International Energy Agency forecasts additional US production of 3.7 mil-lion bpd by 2023, accounting for half of global growth. The United States will overtake Saudi Arabia in terms of production and get closer to Russia. China and India will account for 50% of global demand growth.
By 2023, the IEA forecasts world oil demand of 104.7 million bpd, up 6.9 million bpd from 2018. The United States, Brazil, Canada and Norway will account for 60 % of world production. The IEA reports that exploration/production investments remain low and that the risk of a supply deficit is real in 4-5 years; investments had fallen a lot in 2014 and 2015 when the price of Brent crashed to $27 in early 2016 and since then they have only slightly increased.
Investments are no longer sufficient to meet rising demand by 2023. The other major factor supporting the price of oil is Saudi Arabia’s changing economic and societal model, reducing its dependence on oil. The listing of Aramco’s capital is part of this new direction and will fund major projects.
Starting with steel and aluminum, Trump paves the way for a trade war
This could be negative for global growth and industrial metals prices.
The bullish cycle of industrial metals may be under pressure due to the slowdown in China’s real estate sector and US protectionist policy. Rising US tariffs on steel and aluminum imports have had an impact on industrial metal prices, anticipating a reduction in imports. If this protectionist pol-icy were to continue, and the probability is quite high, with higher taxes on other products, overall economic growth would probably be affected.
We do not expect prices to collapse, thanks to other supportive factors. Historically, industrial metal prices tend to rise in a cycle of rising interest rates. In addition, the Chinese government remains in a process of reducing overcapacity, and therefore supply; China accounts for 50% of global demand for industrial metals.
Decline in gold demand in 2017 is due to lower demand from investment products… But demand in jewelry has progressed for the first time since 2013. India and China account for 41% of total gold demand. Mining production continues to slow down.
Gold should benefit from the erratic policy from the US government. US debt and rising deficits are also supporting gold. A sudden rise of real interest rates would impair gold prices.
With the collapse of cryptocurrencies and the questioning of multilateral agreements by Trump, gold has regained its role of capital preservation and risk management tool.
- Precious metals
- Industrial metals
- Real Estate
- Hedge Funds
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