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Investment strategy – December 2018

Strategy and Macro

US Elections

In the US, this time, polls were good and reliable. We are due for cohabitation / gridlock over next two years. In principle it would spell low odds of significant changes in economic policy, which should remain supportive, but gradually less so. The good news is that overheating and a confidence crisis, linked to difficulties to refinance the budget, are less likely than if Republicans had won.

When it comes to foreign policy, it is hard to draw new conclusions from mid-term elections. Foreign policy re-mains in the realm of the President. It might well turn out that Trump could reduce pressure on China with tariffs and postpone the inevitable confrontation for a few quarters. Indeed, it would a) avoid US consumers / firms paying the brunt, hence protect growth b) reduce imported inflation, hence tame the Fed. Late 2019 / early 2020 would be more appropriate to galvanize electors ahead of the Presidential elections.

 

World economy decelerates

Expansion slowed from a peak of about 5.0% last year, to about 3.0% now. The decline essentially happened in the last couple of months. According to the latest nowcasts, the current cruise speed of China is of 5.0%+, Europe 1.0%+, US 3.5%, Japan 0.5%+. In Europe, idiosyncratic events, like change in carbon emission regulation (Germany) or populist government (Italy) dampened confidence.

 

US expansion: Peak Trump?

Over the last two years, the US economy experienced a sustained period of above trend growth (i.e. about 2.3 – 2.4% according to consensus). The fiscal reform played an important role, in 2018, to achieve this outstanding growth rate for such a very large and mature country. In the same vein, the latest data were very good indeed. Unsustainably so. Indeed, according to both agnostic (¨mechanical¨) and to factor-based models (including assumptions), the US expansion is expected to significantly decelerate in 2019. The future pace of growth for 2019 should probably decelerate to a range of 2.0 to 2.5%.

US economy can’t operate above its long-term potential ad infinitum. Even more so, with a federal budget deficit setting to rise from 4.5% in 2018 to above 7.0% in 2020. Courtesy of gridlock due to mid-term elections, fiscal changes will only be minor from that base, in spite of Trump’s opposite will.

For sure, US economy is in a late cycle phase. Hence, the odds of a very significant slowdown are by definition on the rise. Fortunately, we don’t observe the usual suspects – domestic imbalances – that precede recessions, like excessive wage growth (over 4.0%), housing bubble, over-investment, or over-consumption, etc. Risks are rather coming from potential exogenous shocks, say an outright trade war with China, or a sharp deterioration in financial conditions. Q4 and the aftermath of the mid-term elections will be key. A growth recession / mid-cycle slowdown would occur by mid-2019 if a) tariffs are imposed to all Chinese imports, b) a confidence crisis unfolds, linked to Fed independence or to uncontrollable deficit.

A US recession in H1 2019 is extremely unlikely, but a significant slowdown is in the cards.

Next year, growth will reach 2.0%+, assuming no new tax reduction and no major infrastructure plan.

 

China: painful now… But expect much more macro-easing (medium-term)

Domestic deleveraging and foreign trade war have significantly impacted on expansion pace. Equity bear market and Yuan devaluation added to fears of recession. We consider them misplaced. China initiated a moderate easing in monetary policy and a mild devaluation in Q2-Q3. PBoC reduced domestic rates significantly in past weeks. Beijing is also providing addition-al support to the private sector. A fiscal easing is underway in H2 2018. Tax reductions for households will take place in 2019. Some recovery in fixed investment is visible and broad-based credit has started to recover too. Contrarily to the 2015 crisis, deflationary forces are not taking control. No capital flight has taken place.

2019 is the 70th birthday of Communist Party taking over. 2020 will be the centenary birthday of the Communist par-ty… Beijing can’t afford a recession in coming years. Its reflation / re-stimulation will therefore be gradually more intensive to achieve solid growth for these symbolic dates.

China policy makers remain so far under control and still possess significant ammunition.

No doubt, a much more stimulating economic policy will gradually emerge for both domestic and international reasons.

 

Inflation. More than ever a controverted, intriguing, and decisive factor to assess…

For now, global inflation is tame, very much so. Inflation in the OECD was actually stable at 2.9% in September, for the third consecutive month. Excluding food and energy, OECD inflation climbed to 2.3%, compared to 2.1% in August.

The elephant in the room is the US inflation. Indeed, US economic cycle is by far the most advanced and the output gap undeniably closed (probably late 2017). Growth is firing up above trend and financial conditions remain supportive. Up to recently, these inflation prone conditions were largely compensated by a) benefits of globalization (essentially on imported goods) b) pressure on salaries (technology / robotics). Trade war and tariffs are challenging the a) point, very seriously, even if the actual impacts will only become visible progressively, from 2019.

A late cycle normalization in inflation cycle is underway.

This does not spell unbridled price developments.

 

Asset allocation

Carry-trades and speculative strategies / investments had a bad 2018 year. Damages impacted short-volatility, then crypto, emerging, negative cash-flow / exorbitant PER equities and long-short equities. High Yield, risk parity strategies and ¨pot stocks¨ remain an issue, but they are also in the process of deflating.

All in all, we consider that global risks have partly receded.

Leverage, speculation and exuberant expectations experienced an overdue correction. Recent markets’ jitters feature a healthy return to basics. Consequently, the risk re-turn profile of risky assets has slightly improved.

Overweight

  • Cash

Neutral

  • Alternative investments
  • Equities

Underweight

  • Bonds

 

Currencies

The USD remains a high-quality risk currency. The USD barometer is driven by 4 forces: core inflation and growth outlooks, monetary policy and politics. Earlier in the year, they have mostly been supportive. But, what about today?

Core inflation has tended to disappoint over the past 2 months, but this has been offset by the same pattern in European metrics. While unit labor costs are on the rise, the shelter component, i.e. c. 35% of the CPI, is sliding.

The leading macro indicators, ISMs mainly, remain at elevated levels but are losing some momentum. Euro-area weakness (PMIs, ZEW) suggests the same trend but from lower starting points.

The hawkish Fed tone remains supportive. While the quicker than expected pace of its balance sheet shrinking, driven by a sharp reduction in bank excess liquidity, is not supposed to be so. The debt ceiling talks on March 2019 should create some short-term shock. The US Treasury is not allowed to be overfunded, so it will need to drawdown its cash from the Fed. This will imply a short-term cash injection into the system.

Politics is an important factor, and even more complicated than economic factors. Russia, Turkey and Italy were not on the radar at the beginning of the year. Democrats may carry negative implications for the USD due to their smaller appetite for further fiscal easing. Some reliefs on trade talks at the next G-20 summit would support global growth, at the expense of the US. This would help to close the gap with US.

Leverage accounts are already well loaded in USD.

European growth disappointed and confidence is weakening. PMI data across the region and in neighbor countries are sliding close to less comfortable levels. Merkel/CDU future is more than challenging and German leadership in losing ground. This could create a fertile ground for further budgetary discussions across Europe. The EUR is fairly valued with a mixed bag of risks.

The EUR/CHF continues to be relatively agnostic to the EU/Italy developments. It looks less sensitive to the spread changes. The latest SNB FX reserve allocation release showed a modest increase in the share allocated to the USD, at the expense of the EUR and GBP. That makes sense given the extra-yield offer over European peers.

The USD/JPY correlation with US equities has been picking up recently. The BoJ just cut its GDP and CPI forecasts and looks unlikely to alter its monetary policy ahead of the October 2019 VAT hike. The JPY remains the cheapest developed currency and should remain, except in case of cri-sis.

Remarks that we will have a Brexit deal have helped, even if a deal for financial services is far from done. The GBP has now swung into the lower half of its recent range. The GBP remains under pression.

Overweight

  • USD

Neutral

  • EUR, CHF, JPY, AUD, EMFX

Underweight

  • GBP, CADs

 

Bonds

Since the US debt ceiling crisis in 2013, in the wake of its 2011 downgrade, the US Treasury has suddenly and sharply underperformed its German Bund peer. The correlation, which was at that time above 80% since early 2000, de-creased to 0% since 2013. This correlation regime change is also linked to other factors like the ECB decisions to adopt negative interest rates, to launch a large asset purchasing program and to the German government to scale down its indebtedness. So, the classical drivers have lost some ground i.e. growth, inflation and monetary policy divergences at the benefit of credit quality divergence and trade tensions. The lack of correlation has driven the US-Germany 10-year yield spread to an historical high level, even not experienced at the time of the Germany reunification, the dot com bubble burst or the 2008 financial crisis.

The regular monetary policy tightening by the Fed over the past 2 years has driven up the currency hedging costs, for Japanese and European investors, to level never experienced. The consequence is that not any of these investors have purchased any US Treasury for a while. And the most perverse effect is that, for the past 18 months, USD-based investors have achieved better return in purchasing German hedged bonds than being invested in their own market. This is amongst the main reasons for the historical large leverage accounts short positioning on the US Treasury.

 

The High Yield is catching up the In-vestment grade credit

Corporate leverage has been an increasing point of focus, as the credit Investment grade (IG) quality has shifted to the downside over the past couple of years. The BBB-rated segment represents now close to 50% of the market. In such a context, IG spreads have al-ready widened from their cyclical lows reached in February, by more than 35bps in the US and 50bps in Europe, or respectively 40% and 60% of widening. The High Yield segment, which has for a long time been immune in the US, has caught up sharply. In the US, the spread has widened by 60bps, or 20%, since its lows reached earlier in October. On the European side, the story is quite different. The market is suffering regional pressions, mainly Italy, since mid-2017. So, the spread has already widened since then by 150bps or 60%. However, both markets are still trading on the expensive side.

 

Emerging assets have already well discounted the risks

Financial conditions in China, which is at the center of an ongoing tariff fight with the US, have remained quite stable over the past year thanks to the central bank monetary policy easing. The PBoC has lowered 4 times this year the amount of reserves banks must hold, unlocking more cash to lend to businesses and households to cushion a slowdown. The central bank maintains that its monetary policy has stayed prudent and neutral, and not accommodative. Nevertheless, those actions by PBOC have helped to ease some pressure that was building up in the Chinese financial system due to its massive shadow banking industry and the high level of domestic corporate debt.

Financial conditions index (FCI) across emerging economies have continued to tighten due to higher corporate borrowing costs, stronger USD and higher US interest rates. FCI has already reached restrictive levels not seen since end of 2015. The markets have already discounted this factor as EM spreads and local currency bond yields are both trading near their highest levels in over 2 years.

Overweight Neutral

  • US Treasury
  • Investment Grade
  • Hybrid/Sub,
  • Emerging hard currency

Underweight

  • German Bund, Inflation
  • High Yield
  • Peripheral, Emerging local currency

 

Equities

Equity markets have adjusted

Equities have adjusted to this new environment: stock market valuations have contracted since the beginning of the year.

In the short term, stock market valuations should stabilize, allowing stock market indices to be better oriented, as corporate profits will continue to grow. But the equity markets will no longer advance thanks to the rise in PE ratios due to the normalization of interest rates. The favorable period for high-flyers seems behind us. According to a statistical study, the current S&P 500’s PE is in line with the US 10-year mark.

Compared to bond yields, earnings and dividend yields are returning to historical averages; then, equity markets are entering into neutral zone.

In the short-to-medium term, we enter into a statistically more favorable period after the US mid-term elections: according to the data compiled by Yardeni Research (see chart below), the S&P 500 recorded positive performances each time on the 12 months following these mid-term elections since 1951, be-tween 4% and 33%. The results of these mid-term elections are probably the most favorable scenario for equities.

 

Better times for the Value segment

The normalization of interest rates will drive investors to reduce their craze on high-PE growth stocks. Then, after years of expansion, these growth stocks begin to be mature in their major markets; they are trying to penetrate two gigantic markets, China and India, which are relatively well protected against foreign competition.

Value Segment: Generally attractive valuations and less risky because companies generate profits on proven business models.

Growth segment: generally high valuations, because investors pay for high future profits, and risky, be-cause we make a bet on the future.

 

Q3 results beyond expectations

The results of Q3 18 proved to be extremely solid. However, companies report the lack of visibility be-cause of the trade war between the United States and China, the Chinese economic slowdown, the strength of the dollar and pressure on margins from wages, industrial metals (custom tariffs increases), in particular steel and aluminum, and transport/logistic (rising oil prices).

Profits for the S&P 500 increased by more than 27% in the 3rd quarter and revenues by nearly 9%, while estimates predicted a 20% rise in profits. Obviously, the tax reform has had a significant impact, but the core growth still remains close to 13%. The tax reform contribution is 40%. Rising oil prices have enabled the energy sector to record a 123% increase in profits, a sector that accounts for 6% of the S&P 500. Tax re-form, that has encouraged the repatriation of huge amounts of cash held abroad, contributed to large share buy-back programs and dividend increases, estimated at $ 1,000 billion. For the 4th quarter, the consensus expects a 19% increase in profits.

In Europe, the profit growth of the Stoxx 600’s companies is even stronger than in the United States (excluding tax reform), as they are up more than 14%. As for the United States, the energy sector makes an important contribution; ex-energy, the profit progression is 11%.

 

What’s next …? 2018 will probably be the peak of margins and profit growth

Investors are beginning to view the 3rd quarter of 2018 as the peak of profit margins and growth. In the United States, companies across all sectors report the negative impact of Donald Trump’s trade war and pressure on margins due to higher tariffs, as well as the maturity of the business cycle. An impact that could be more visible in 2019. After the increase in US profits of 25% in 2018, analysts are only counting on 6%-8% for the first 2 quarters of 2019 compared to 9%-10% previously. But the trend will remain positive, with most economists predicting no recession until early 2020.

However, there is an important point: US and European companies are pushing the rising costs on consumers, in all sectors. This is a new trend. Nestle, Unilever, Mondelez, Procter & Gamble, Colgate-Palmolive, McDonald’s, Coca-Cola, Kellogg, Stanley Black & Decker, United Technologies, Whirlpool, Chiptole Mexican Grill, Caterpillar, among others, are announcing price increases now or from January 2019.

There are also two other impacts of Donald Trump’s trade war and his bilateral approach to international relations: companies have to revise their supply chain and for some of them, they have to relocate their production. This situation particularly affects the automotive sector.

 

No capex boom

US tax reform has not translated into an investment boom despite temporary incentives. The repatriation of cash held abroad by US companies mainly stimulated stock buyback programs, estimated at $ 770 billion in 2018. This trend also reflects good corporate management, as well as concerns about a turnaround in the global business cycle and China’s slowing economy. Is it time to overweight non-US stocks? The European stock market is attractive.

The US stock market is one of the only ones with a positive performance in 2018, accompanied by, for the main ones, India, Brazil and Russia in local currencies!

Overweight

  • Switzerland
  • Value
  • Staples, Health Care
  • Communication

Neutral

  • US, Europe, Japan, UK
  • China, Emerging
  • Large & Small/Mid Caps
  • Growth
  • Discretionary, Industrials, IT, Financials,
  • Telecommunications, Utilities, Energy

Underweight

  • Materials

 

Commodities

Oil. The United States, the world’s largest producer

US oil production jumped to 11.6 million b/d in early November, exceeding Russia (11.4 million b/d) and Saudi Arabia (10.7 million b/d). US production doubled in 7 years!

In early October, investors were positioned for a barrel at $100, with US sanctions on Iranian exports approaching. On November 4th, they came into force, but Donald Trump once again surprised by announcing that 8 countries could buy Iranian oil, China, Tai-wan, India, South Korea, Japan, Greece, Japan, Italy and Turkey. Since its highest at $87, the price of Brent has dropped 50% to $53 and future WTI prices have gone into contango, which means that traders consider that there is an oversupply in the market.

So, there is no problem of supply and therefore no fundamental reason that the price of crude skids up, despite a decline of 1 million b/d of Venezuelan production since early 2017 and 500,000 b/d of Iranian production in 2018, before US sanctions. US production is offsetting this miss, and Saudi Arabia, which is the global swing producer, can at any time rebalance the market, with its oil minister signaling that its leeway is 2 million b/d.

In the face of US expansion, Russia is reluctant to follow OPEC in its price controls through production adjustments. Russian oil companies would not like to be outdistanced by the Americans. So, we are in a new tripartite situation, and very clever those who can predict the price of a barrel in the coming months. OPEC will meet in Vienna on Dec. 6 and may decide to cut production to maintain a Brent price of between $75 and $80, but the leading consumer countries, the US, China and India will not accept higher prices. It is not sure that Russia will still follow OPEC, it must think of its own interests, in particular consolidate its energy relationship with China.

 

Industrial metals in a bear market. A Chinese story

Prices for industrial metals, such as copper, aluminum, zinc, nickel, follow China’s economic growth, as China consumes half of the world’s production of industrial metals and semi-finished metals, mainly steel and aluminum. The trade war and the strength of the dollar accentuate the downward trend in prices.

The crisis in emerging countries has been another destabilizing factor for industrial metal prices. The correlation co-efficient between the copper price and the MSCI Emergings is relatively high at 0.6.

Since May, China’s PMI Manufacturing has fallen and the price of copper also by 18%. Steel prices fell by only 10% thanks to a reduction in steel production overcapacity in China. There are always times when prices recover thanks to a Chinese restocking, but fundamentally, we can’t return positive on industrial metal prices as long as the Chinese economy slows down and as long as the depreciation of the renminbi continues. In the long term, bulls estimate that prices should be significantly higher than current prices. The main argument is the underinvestment of mining companies; they only spend a third of the amounts invested 5 years ago in new projects. Analysts say copper mines must invest an additional $50 billion in the next 10 years to balance the market, while they invest only $10 billion a year. Zinc is in the same situation.

Mining companies do not want to invest as long as uncertainties remain over the US-China trade war and China’s ability to maintain GDP growth around 6.5%. In the long term, industrial metals offer buying opportunities, but it is difficult to know the entry point. Analysts do not dare to be too assertive and recommend buying mining companies with a horizon of at least a year.

 

Normalization of interest rates weighs on gold

The rise in US real interest rates makes gold less at-tractive. Gold had recovered during the correction of the stock indexes in October, but little help is to be expected from real interest rates or from the USD.

Resilient US economic data and confirmation of the Chinese economic slowdown are unfavorable to gold. The central banks of Russia, Turkey and Kazakhstan have continued to buy a substantial amount of gold (148.4 tonnes in Q3), while those of Poland, India and Hungary started to buy gold.

Overweight

  • Energy

Neutral

  • Precious metals
  • Industrial metals
  • Real Estate
  • Hedge Funds

Underweight

  • Soft commodities

 

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