Investment Strategy – August 2018
US knock-on effect
The US capex cycle has experienced a low magnitude and a slow-motion recovery, considering a) the unprecedented monetary and b) latest fiscal stimulations. The US cabinet counted on a significant acceleration from 2018, following new tax incentives. But, so far, companies have rather announced intentions to increase capex spending than actually done it! An unusual disconnect is therefore building between (very) optimistic surveys, and macro data. Large companies have favored, once again, financial engineering up to know. Trade tensions may also explain for this postponement. But one should not (yet) be discouraged, as the latest data on private non-residential fixed investment marginally improved, both in terms of diffusion and of momentum.
Europe soft patch, really?
H1 was all about US activity outperforming most developed countries. Europe disappointed significantly with a broad loss of momentum across the region in Q2. This deterioration process seems to be over. Indeed, economic surprise index significantly rebounded over past weeks after its dramatic collapse. Similarly, high frequency data (monthly figures) confirm the improvement, under the leadership of Germany and Northern Europe countries. The annualized rate of growth, which culminated over 3% in Q1 and collapsed to 1% in Q2, is regaining steam with a tentative 2% pace. A more competitive EUR will certainly be welcome. This pick-up might prove elusive if a broader trade conflict develops with the US, as Europe is fundamentally a more open economic zone.
China ahead of a 2015 redux?
Economic activity is decelerating. Quite rapidly in certain segments / industries. Market indicators are pessimistic, very much so. Equity prices entered a bear market, credit spreads are rising (high yield) and the Yuan engaged a significant phase of weakness recently. What should investors make of it? At first, this could resemble the dire 2015 phase, which featured crisis management and global markets / commodities routs. Chinese policy-makers have started to manoeuvre via liquidity injections (banks’ reserve ratios) and some targeted fiscal stimulus. The PBoC has been reassuring on the currency front. The – defensive – capital out- flows of 2015 were related to fears of uncontrolled devaluation and of new capital barriers. Foreign capital also stopped inflowing. This turned into a dramatic contraction of net flows. In the recent months, – offensive – capital outflows re-accelerated. But in practice, they have been linked to acquisitions abroad by Chinese companies. As a confirmation of this difference, inflows kept on increasing to reach unprecedented levels (courtesy of foreigners buying lots of Chinese bonds). For sure, portfolio flows are volatile by nature. But still, net flows are solidly in positive territory! When it comes to foreign exchange reserves held at the PBoC, they actually experienced their fastest growth since 2014, in spite of the USD rise. This is also reassuring. And it could (ultimately) be used to support the Yuan if needed. Beijing is deliberately helping its export sectors to absorb the impact of US tariffs, by weakening the Yuan. Actually, the Yuan gave-up all its 2018 appreciation vs. USD and also lost more than 2% in terms of RMB basket. China is also passing a message on to the US cabinet. Further significant devaluation would bear the risks of triggering defensive out- flows (again).
China is actively fine-tuning macro responses to address the ongoing soft patch
Market fears (of a 2015 redux) are exaggerated compared to fundamental data
A calm summer break requires further USD and long-term rates consolidations
Geopolitical risk seems on a decline, at least temporarily, following Singapore flirt between Trump and Kim last month. But things can eventually change (very rapidly). We have neither been impressed by the nature of the reciprocal engagements, nor by the elusive follow-up by both parties. Japan would be in a very tricky position anyway, were a tri-lateral agreement to set-in… Political risks (trade and currency wars) are stable to higher compared to last months. Both the US and China are broadening the means of pressure, while Europe may ultimately play the chicken and lower tariffs to save Deutsche Bank and German car manufacturers? Nothing brighter in sight for now. According to latest polls, Trump may avoid a cohabitation with Democrats over next mid-term elections. This may reduce US political risks substantially… Markets’ repricing is underway and the gradual resurgence of volatility too. The ongoing consolidation of equities coupled with rising earnings is positive: forward PERs are moving down and valuation may, globally, become more affordable finally. Inflation expectations seem reasonable at this juncture, considering short-term macro perspectives. A possible inversion of the yield curve, by Q4 2018, may add to investors’ hesitations. Cash in USD is back as an investable asset class of reference.
Quantitative tightening is not everything
US economy delivered an excellent first half and will continue on a good footing for the remainder of the year. But for good reasons, consensus now expects growth to peak in 2018. Monetary policy is becoming gradually less loose. Investors have actually acknowledged for the normalization of monetary policy, hence for the announced – gradual – downsizing of the Fed Balance Sheet. The market focus remains on the future course and destination of Fed funds rates. The undergoing improvement of inflation momentum is largely discounted, as considered of short-term duration. Interestingly, M2 velocity is giving signs of improvement, just like it – temporarily – did in 2010. The resurgence of inflation from 2011 shacked fixed income markets. For sure, M2 velocity is not the only indicator to look at. But its recent pickup deserves careful monitoring, as a confirmation of the buoyancy of US economy. A sustained resurgence in velocity would spell better economic activity – above potential – for longer i.e. in 2019. Such a late cycle upsurge would potentially restore stronger – late cycle – inflation expectations…
Watch for confirmation of M2 velocity pick-up
- Alternative investments
Back to basics
Despite the trade war escalation, the USD remains relatively strong, especially against commodity related currencies. Recent periods of risk-off have coincided with a re-steepening of the USD curve vs. the EUR one, and a lower EUR/USD. The reasons are obvious. The USD is coincidently the carry currency of choice and a safe haven. After raising Fed Funds 2 times this year, Powell described the Fed’s stance as still accommodative. The Fed will hike rates 4 times for this year. As the US yields are the highest in the developed world, why should investors decide to “park” their money elsewhere? The USD is simply now the highest carry currency in the liquid markets.
Global USD positioning flipped overweight in one of the sharpest shifts in the IMM speculative data set ever seen. This move reflects some short positions covering after the recent Fed and ECB meetings as well as the latest round of US-China trade escalation. The USD materially undershot this shift. The positioning shift scale was not uniformly broad and reflects more an overall ongoing FX risk reduction than a shift into the USD.
German political risk returns to the front stage
As a credible EU-wide solution to the asylum crisis appears out of reach in the near term, there is a growing tail risk of a German government breakup resulting in new elections later this year. The market would likely price out the prospect of meaningful structural and quick reforms in the Eurozone. Resurgence of political risks would weigh on the EUR. ECB decision to halt asset purchasing program by December would still leave significant monetary stimulus.
With inflation persistently undershooting in Japan, the timing of the policy pivot has been postponed. The JPY forecasts have not shifted significantly. Its strengthening drivers have shifted towards deleveraging risks from US trade war, as well as (domestic) political risks. The JPY remains the cheapest developed currency and to a lesser extent a safe haven asset too.
Towards policy error
The BoE is institutionally more hawkish than its peers. The question is around its ability to deliver further tightening given its economy and inflation underperformance. So, while the BoE is moving in an incrementally hawkish direction, the decision and timing of a hike are still very data dependent. The GBP ability to rebound is heavily constrained by the inescapable Brexit process.
The market is expecting slightly more tightening from the SNB than the ECB. Given the SNB structurally dovish tone, and avoidance of any discussion of its exit strategy, this looks inconsistent. Less SNB FX interventions and a still sizeable current account surplus should equate to more upside for CHF over time. So, the SNB cannot adopt a too early hawkish tone, except if it wishes to annihilate its past years costly efforts.
A more positive stance on EMFX
Since Q3 2017, we had a structurally bearish outlook on EM currencies. This was as EM markets experienced sizeable inflows to unsustainable levels, as well as expected US rising yields. We shift to a more constructive stance given that the more challenging factors are now well discounted. Non-residents have sold local bonds at a pace like the Fed Taper Tantrum episode. So, the risk is behind us.
- EUR, CHF
AUD, CAD, EMFX
Don’t declare the end of easy money just yet…
Major central banks took significant steps toward dismantling the emergency stimulus. However, most are clear, they are not ready to get out of supporting measures. Net asset purchases for the 3 main central banks are set to turn negative in 2019, but the loose-money era will persist. The combined balance sheet of the G3 central banks is still more than $10.0 trn higher than post-Lehman collapse, i.e. more than a third of their GDPs.
…even if the easy money peak is behind us
That does not mean we are going straight to tight money. The trade war risks and the rising populism are already denting confidence. Powell confirmed a gradual normalization policy, even if inflation rises above the 2.0% target. He does not seem eager to accelerate the tightening. The ECB announced that its QE will be slowed then stopped in Q4 but with a dovish guidance. The proceeds of maturing bonds will still be reinvested. The tapering has begun but not the tantrum. The ECB is still more than a year away from raising rates if it can reach the exit door. The BoJ slipped further behind its peers by leaving its stimulus program unchanged. Kuroda will maintain its powerful monetary easing persistently. The PBoC decided to soften its monetary stance to fight the economic downturn.
The risk for many developed central banks, except the Fed, is that their rates will still be close to zero when the next downturn happens.
Higher inflation only reflected in economic indicators… not market pricing
The NY Fed’s Underlying Inflation Gauge moved up to 3.3% in May, up from 2.5% a year ago. However, market expectations remain muted as inflation gauge points to muted response to labor market conditions. The risks continue to drag them down. The ECB mentioned growing confidence in inflation outlook. To gauge if the path is sustainable, the ECB looks at 3 factors: convergence, confidence and resilience. There is unambiguous evidence of convergence, as HICP has picked up. It seems more confident in the inflation outlook. However, it has persistently overestimated it. We remain skeptical on its resilience, as inflation pick-up is mainly due to energy prices which positive contribution will abate later in the year. And, measures of the underlying inflation pressures still paint a somewhat mixed picture.
So, is the yield curve flattening a concern?
Historically, the yield curve has inverted heading into previous recessions in the US, on average about one year ahead. The current economic cycle is already the 2nd longest on record. If it continues for another year, it will become the longest since WWII. So, the pricing in of a recession at some point seems very reasonable. Shorter term measures of the yield curve (2 years – 3 months) have steepened over the past months and therefore do not suggest any pricing in of a recession over the next 2 years.
Global debt balloon
High-yield spread versus Investment-Grade spread ratio has plummeted during the first half of 2018. Is credit cheap? Or is HY too expensive?
In a year that has proved challenging for credit market returns, the HY market has proved relatively resilient. It has been a standout performer compared to other parts of the credit market. In its defense, still firm US growth has helped. Based on historical relationships, it is hard to find a metric that does not suggest HY is expensive. HY spreads will continue to broadly track the volatility. The corporate debt, as a % of GDP, remains close to the record elevated level only visited at the top of the 3 previous cycles. However, it is not as alarming as it could seem.
- US Treasury
- High Yield, Hybrid/Sub, Emerging hard currency
- Investment Grade Underweight
- German Bund, Inflation
- Peripheral, Emerging local currency
Donald Trump hardens his positions in the trade war, the others fight back
◆ A shock to earnings growth may arise earlier than expected.
◆ Share buyback programs, dividends and acquisitions support US indices in the short-term.
◆ Overall, the outperformance of the small and mid cap market segment still signals confidence in the domestic economy.
◆ Large technology and “new economy” companies offer a defensive profile, but their stock market valuations could be challenged.
◆ The risk of a global economic slowdown encourages us to overweight the Consumer Staples and Utilities sectors.
◆ Gradually, we invest into emerging markets.
Profit growth is one of the driving forces of stock markets. In 2018, growth rates should be exceptional: FactSet expects US profits to rise by 19.8% in 2018 (+25% in Q1 and +19% in Q2) and the Bloomberg consensus expects a 16% increase. The impact of tax reform accounts for half of the increase. In 2019, the estimates are around +10%, but there is a serious risk of a downward revision of these growth rates if the trade war were to worsen adjustments in growth that could even happen in the 4th quarter 2018.
China, Europe and Canada respond to Donald Trump with import tax increases on US products. We enter into a tit for tat war. Japan, Mexico and India will follow. Only Germany would like to comply with the requirements of Donald Trump, fearing for its industrial exports, especially automobiles. Concerns are emerging with companies, some of which are delaying investment and staffing decisions. According to a CNBC survey, 65% of CFOs of large global corporations believe that Donald Trump’s policy will have a negative impact on their business within 6 months.
The automotive sector will be one of the most negatively affected sectors by a trade war. Daimler has already announced a profit warning. Motorcycle manufacturer Harley Davidson has announced a relocation of its production outside the United States to avoid the new European import tax (in retaliation for Donald Trump’s tax increases). Another motorcycle manufacturer, Polaris Industries, is also considering relocating to Poland to circumvent the rise in European taxes.
However, the stock market valuation of the US Value segment, represented by the Russell 1000 Value Index, continues to plummet and provides an attractive dividend yield. The main sectors are Financials, Healthcare, and Discretionary.
Generous valuations, but justified if the actual environment in interest rates and profits stay the same
PERs based on estimated profits over the next 12 months are above historical averages, but not exaggerated. Low interest rates and economic growth justify such levels.
On the other hand, the Shiller PE ratio (CAPE ratio), calculated by dividing the market capitalization by the average of the 10-year earnings, adjusted for inflation, indicates an excessive valuation of the US stock market. The room for manoeuvre is narrowing: we must not have a rise in interest rates or a sharp decline in profits. We believe that the question of profits will arise this autumn with the negative base effect in 2019 and the impact of the trade war.
More than a month ago, we gradually returned to emerging markets with the stabilization of the US dollar. The dollar and the emerging stock markets remain inseparable.
- Europe, Switzerland, Japan, Emerging
- Small/Mid Caps, Value
- Discretionary, Financials, Health Care
- China Large Caps Growth
- Staples, Industrials, IT, Materials, Energy
- Telecommunications, Utilities
Oil price will remain supported
OPEC and Russia have decided to increase their production by 1 million b/d. This decision was motivated for several reasons:
◆ Prevent the barrel from going on above $80 (risk on global growth).
◆ Donald Trump’s anger considering the price of the gallon too high in the run-up to the US midterm elections.
◆ Concerns of 2 major customers, China and India, which are net importers.
◆ Iran will not be able to export its oil from November because of US sanctions ordered by the United States.
◆ Venezuela and Libya have production problems.
◆ Oil inventories in the United States are falling faster than expected.
◆ Saudi Arabia can’t afford to see the price of crude falling because of its budget and Saudi Aramco’s next listing.
◆ New operational problem at the oil sands production site at Syncrude, Canada, owned by Suncor and Imperial Oil, which exports 350,000 bpd.
Industrial metals prices under pressure
Investors fear a slowdown in economic growth caused by the trade war. The Chinese economy weakens: in June, the FTCR China Export Index fell from 54.5 points to 52.1; Chinese exporters are seeing a drop in volumes, before the imposition of new US customs duties. The trade war is weakening prospects and many companies are putting off their investments. China’s new orders index fell below 50 to 49.7 points, signaling a contraction.
The price of copper, the metal that is the most correlated with overall economic growth, declined from $330 to $281 in 3 weeks. China consumes 50% of the world’s copper production. The good performance of the dollar is also an unfavorable factor for copper prices.
But the copper price could be supported by strike risks in Chile, country accounting for 35% of world copper production. The Chilean state has a problem with 2 of its mines, Codelco and Chuquicamata, while BHP Billiton is also in difficult wage negotiations in Escondida (Chile), the largest mine in the world.
Gold price slips
Neither the trade tensions between the United States and the rest of the world, nor the tense geopolitical situation in the Middle East have raised the price of gold upwards. Its reputation as a safe haven does not play. The rising dollar is for the moment the prominent factor influencing the price of gold. Despite rising oil prices, inflation is not materializing.
But gold remains an interesting diversification asset in a portfolio. Macroeconomic and geopolitical risks are present, and gold could regain its safe haven status, especially if this trade war turns into a currency war. And the decline/ stabilization in real interest rates could support gold prices.
- Industrial metals
- Precious metals
- Energy Real Estate
- Hedge Funds
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