Investment strategy – February 2018
Preconditions for an eventual debt shock / crisis are multiplying. It will definitely happen in coming years. But predicting its timing is, unfortunately, impossible.
Before that, short to medium-term, the odds of a ¨normal¨ fixed income correction are rising.
It could well coincide with a phase of ¨irrational exuberance¨ i.e. a melt-up phase for equities, nurtured by growing public enthusiasm
Repeated gains spell addiction
The last decade imposed a fundamental examination / introspection to professional economists and investors, who based their forecasts and shape their portfolios on solid and largely agreed theories. Indeed, textbooks did not guide them to navigate a very special ¨cycle¨. Policy-makers took unprecedented decisions that neither fuelled hyperinflation, nor restored decent growth. Snowballing debt level no longer appears to be a problem. In short, conservative investors capitulated and ¨markets¨ have finally got used to central bankers playing sorcerers’ apprentice, to negative interest rates, to moral hazard, to volatility (technical) evaporation, etc.
After several years of gains, the never-ending story of asset price reflation suspended vigilance of markets participants
H. Minsky (1919-1996) rolled over – many times – in his grave
Often described as a post-Keynesian economist, HM is one of the most famous reference, when it comes to understanding financial crisis. He actually emphasized the macroeconomic dangers of speculative bubbles in asset prices. He has notably been adamant on the malfeasance of debt accumulation and on the risks of ¨excess calm¨. According to HM, economic stability is not only followed by instability, it inevitably creates it. For the record: HM disciples predicted the subprime crisis. Now they are vocal again because of collapsing volatility and of frantic debt accumulation.
Two significant changes are coming: liquidity peak, inflation through
The Fed engaged a very slow normalization of its monetary policy a few quarters ago yet. Other Anglo-Saxon central banks are emulating it. The ECB and the BoJ are shifting rhetoric at the margin. Both expect to take a progressive similar sort of action during the year, the later the better. But adverse market forces are building, in the wake of a strengthening global expansion and of a cyclical re-bound of inflation. They may be forced to comply earlier…
A planets’ alignment for stronger cyclical inflation has set-up. Bond markets are sniffing it al-ready. If future productivity data improves further, it could become a concern. Indeed, the thesis of entrenched disinflation and moribund productivity is now – dangerously – dominant among economists.
Very skeptical markets have disregarded the odds of such changes and downplayed their consequences. A surprisingly flat yield curve is a symptom of it
Watch for the unraveling of short-volatility strategies
Yield-hungry investors – namely institutions – have been obliged either to gravitate towards lower quality credit or to sell option premiums (namely on equity / bond volatility). The size of the capital flows concerned is huge, not to say alarmingly so. This large pool of assets is not protected by a solid dyke: lots of short positions would unwind if the rates were to exceed levels considered as ¨impassable¨ by complacent structuring bankers (around 2,6% on the US 10y government bonds).
A breakout would fuel higher volatility, then margin calls and unwinding of large positions, hence ultimately considerable negative flows for fixed in-come markets. For once, we don’t expect central banks to repress this consequential volatility renaissance and higher rates. They would rather welcome it, as it would feature a) confirmation of the normalizing cycle, and b) a welcome trigger to investors’ deleveraging. Indeed, G3 central bankers have lately become warier of financial stability than of deflation.
Markets are not discounting – at all – ECB and BoJ exiting financial repression soon. This scenario could spark a fixed income markets’ correction
Good macro, yeah!</h2)
But lower odds of a long cycle
A few years ago, Pimco and then L. Summers pioneered the concept of New Normal / Secular Stagnation, upon which potential growth was experiencing a relent-less decline because of structural headwinds (ageing population, tame productivity). The accumulation of debt, courtesy of financial repression in most advanced economies, reinforced this trend. In short, they actually proved right, as for instance US nominal growth under-performed that of previous cycles by over 100bps in the past 10 years. It is therefore no surprise that this thesis has become mainstream. Global investment – capex – definitely collapsed in 2008-9. It remained moribund since, in a painful legacy of the Great Financial Crisis, with about zero contribution to expansion in 2012-3 and 2015-6!
There are few economists to bet on US growth exceeding 2% over the medium term. Now, let’s take an agnostic look at what is going on in front of our eyes. Indeed, the latest estimate for world growth now stands close to 5%, roughly 1% above trend. Indeed, since 2017, capital investment turned upwards. More interestingly, it is coming from the non-real estate sector. In H217, investment in G3 countries recorded a quarterly annualised rise between 8 to 10%. In 2018, world spare capacity will be gradually absorbed. Is this cyclical upturn the prelude of a more fundamental change? If confirmed, this would actually raise the odds of a classical multiplier effect (with ¨down the road¨ a better productivity growth and wages).
China safe landing
China momentum has probably topped in 2017. The demand-side stimulus of early 2017 is fading, leaving room for the impact of more recent supply-side constraints. The party’s focus on financial stability was a top – legitimate – priority. Lower credit momentum will logically penalise expansion, but good quality growth is definitely better than credit-fuelled growth. The very solid construction cycle is markedly decelerating. Imbalances in the investment cycle continue, with the clear prominence of the public sector. This does not bode well for the long-term capital / investment efficiency. This will ultimately prove problematic, if XI continues to favour control on the economy, via grater centralisation forces. This must be closely monitored.
Some cyclical inflation is coming
So far, so good for US inflation. Except for two parameters. A) The country doesn’t need the sort of fiscal stimulus it voted late 2017. Considering the very mature stage of its cycle, risks are building that a buoyant capex cycle would turn into overheating, hence ultimately provoke the collide between fiscal and monetary policies (i.e. a much more hawkish Fed). This is even more true that the funding of the rising US deficits remains a clear enigma B) The oil factor… As mentioned in earlier publications, a too sharp rise in oil prices is dangerous (say if the Brent barrel was to exceed and stabilize around $80 in H118). It would first exacerbate short-term inflation pressure and then act as a tax on consumers, finally resulting in a severe slowdown.
Eurozone unemployment rate has steadily fallen, even below 9% now. This is the lowest level since late 2008. In principle, with a usual lag, salaries should follow through. For sure comparison to former cycles is tricky, considering the rapid skills’ obsolescence in the labour markets, due to automation, digitalization, etc. The high level of slack in certain economies may also reduce the elasticity of wages. Nevertheless, Eurozone labour markets are less efficient than Anglo-Saxon ones. M. Draghi may soon confront unexpected pressure to normalise more rapidly monetary policy.
A significant rise in producer price inflation occurred in China, which favoured the resurrection of corporate earnings. It is not translating into consumer price slippages and will not, considering the measured pace of growth expected in 2018, i.e. high 5 to low 6%.
No doubt, the global solid cyclical upturn will further unfold, including some cyclical inflation resurrection
Major macro risks (China recession, euro breakup) are off the table for now. But a new era of ¨secular ex-pansion¨ is far off
If the US capex cycle was to considerably acceler-ate, this would seriously challenge the thesis of a long / goldilocks cycle
All about central banks… again
The USD fell against most major currencies in 2017. There was nothing wrong with the US economic growth in 2017. It was just unexceptional in a global synchronized expansion, as the USD typically weakens when the rest of the world is outperforming. Tax reform could support the USD in Q1 through the repatriation channel, even if it would be limited. We are still expecting 4 Fed hikes in 2018, but we remain cautious against those expectations to translate to a broadly stronger USD. In the wave of the tax reform approval, the USD index drifted. If the market rapidly migrates to the Fed dots, the USD discount could be eliminated. The USD is currently undervalued by 7 to 10% compared to 2Y and 5Y yield spreads.
The European macro momentum explained a large part of the 2017 rally. The EUR/USD upward trend can resume only if the Euro area growth outpaces the US ones. The end of QE distorts currency-rate relationships and capital flows the same way as the implementation of QE did. Another source of concern, even if it is no longer what it was, is the political risk namely Germany and Italy. The EUR main risk is the current extreme positioning. A complete unwind of record speculative longs, over Q1, could weaken the EUR/USD by 5%.
The BoJ announced to cut purchases of super-long bonds with maturity of 10 to 25 years by ¥10bn to ¥190bn per operation. The JPY immediately positively reacted to this announcement. This decision, however, was not a particularly noteworthy development as the purchase amount has already trended lower over time and does not signal any significant shift in the BoJ monetary policy. Given that, the JPY appreciation is likely attributable to short positioning unwind, as the JPY re-mains the cheapest developed currency. According to IMM data, the JPY short positions appear large; they are as stretched as the peak reached in June 2007
The GBP remains undervalued as political un-certainties are still high. The structural risk premium is large. The GBP is the second largest undervalued developed currency after the JPY. The GBP’s NEER is 15% weaker than its long-term average. The recent BoE tightening was mainly motivated by high inflation rather than a booming economy. The slide in GBP since the Brexit vote has made slight difference to the current account deficit. Meanwhile, inflows have slumped, which are explaining the low currency valuation.
The CHF is now closer to its fairly value. Some signs of a potential liquidity reduction through SNB FX operations are emerging. SNB sight deposits have declined for 8 of the last 9 weeks. The cumulative decline represents CHF 7bn, so 1% of GDP and 1% of the total SNB reserves. The SNB has recycled the en-tire Switzerland current account surplus though FX intervention since 2008. Safe haven assets demand is a secondary driver for CHF. But that is not to deny that there continued outflows from this quarter could drive additional modest weakness in CHF. Fi-nally, global rate spreads will need to widen more for Swiss investors to embrace global markets and sink the CHF.
The Chinese authorities have removed the im-pact of the counter cyclical factor (CCF) in determining the CNY fixing. The PBoC statement suggests that the beta of the CCF could be adjusted over time. It has been designed in 2017 with an asymmetric bias to mitigate CNY depreciation pressures. The motivations are likely to reflect several factors: 1) recent domestic commentary warned about the downside risks to exports due to a rapid CNY appreciation; 2) drive more two-way volatility in the FX market; and 3) finally, elevated domestic yields have encouraged offshore inflows, and while these flows have helped the capital account the authorities may be mindful of the speculative nature of such flows. Whilst these factors are likely to temper CNH sentiment in the short term, the outlook for China’s BoP position re-mains positive, as does the growth backdrop, which should ultimately cap weakness.
USD, EUR, CHF, JPY, AUD, CAD, EMFX
The new Fed is amongst the yield curve flattening drivers
A yield curve flattening historically has been a reliable forecasting tool. Current flat yield curve could be considered as a flashing orange light. In 2006, when the slope was close to today’s levels, the curve foreshad-owed the crisis that began in July 2007. But that was the yield curve’s finest hour as a forecaster.
During a prior flattening period in the mid-1990s, the markets roared ahead for another 5 years before trouble began. One also can argue that the actual curve is qualitatively very different. Central banks formerly controlled the short-end of the curves while leaving the long-end to market participants. The shape of the curve, therefore, was the illustration of 2 different views. The reaction to the financial crisis changed the curve’s players. Through all their non-conventional measures, central banks took the control of the long-end too. Fed studies conclude that its QE is still suppressing c. 50bps to the US 10-year Treasury yield. This is confirmed by the abnormally low term premium. Adopted regulations and low inflationary pressures have also favored a massive purchase of long-dated bonds by institutional investors.
Since mid-80s, the yield curve was not the only key indicator to monitor, the level of long-end yield was also essential. The yield curve was flat to inverted when happened the Savings & loans crisis in 1990, the Great bond massacre in 1994, the Dot-com bubble bust in 2000, the GFC in 2006. However, at the same time, the US 10-year yield reached coincidently its long-term downward trend line. So, both are not sending the same message as in the past.
For us, the yield curve is not a source of concern yet. The real question is by how much the yield curve is distorted. Whatever the answer is, it is likely enough to de-emphasize the yield curve slope as a warning signal.
In 2018, investors will have to start dealing with a new and less experienced FOMC. First, the new Fed Chair Powell, a non-economist will take the lead in February. Second, the Board of Governors will be strongly reshuffled, with experienced members like Yellen, Fischer and Tarullo leaving while Quarles and probably Good-friend may join. Finally, the NY Fed president Dudley is set to step down next summer. The market should start from a blank sheet, including ways of communicating it. Second, until more vacant seats on the board have been filled, the balance of power within the FOMC will look unclear. The FOMC has a tradition of working by consensus and it should be slightly more hawkish.
However, all those changes will complicate forecasts.
While the White House Federal debt-to-GDP ratio was at 77% when Trump took office, the highest level since Truman in 1945, the debt is still expected to rise. It would reach 85% by the end of a hypothetical 8-year term. Despite the current high debt, the end of the year brought a flurry of deficit-increasing legislation and there may be others coming soon. Policies under consideration would cause trillion-dollar deficits to return for the first time since 2012. This would push the US government to issue more Treasury bonds in the near future, just when the Fed is starting to reduce its Treasury holdings. Supply/demand imbalances will soon resurface.
Coming into 2017 after the US presidential elections, expectations for the return of inflation were very high. Investors anticipated that fiscal stimulus would be substantial and boost inflation. Then, TIPS underperformed as core CPI unexpected-ly softened as stimulus reforms waned. The still elevated level of China PPI growth should continue to put upward pressure on US import prices. The continued decline in resource slack should put upward pressure on flexible prices. The falling unemployment rate should continue to bias wage inflation higher, which in turn should bias core goods inflation higher.
Credit the last alternative
High yield spreads tightened sharply since last November in the wave of strong global economic data and tax optimism which fueled a firm demand for risky assets. HY spreads look expensive as they are back at 2007 and 2014 lows. Each time the market reached those levels, we experienced a sharp reversal as valuations were disconnected from fundamentals. There will be a crossover point in the coming months where global quantitative easing turns to global tightening. At that time, there may be a shock. The past year-end HY rally looks like a capitulation, suggesting investors are waiting for the just the right moment to leave the segment.
High Yield, Hybrid/Sub,
US Treasury, Inflation
Emerging local currency
2018: early signs of regime change
2018 should be more volatile. The good health of the global economy will push central banks to reduce liquidity injections that used to benefit to risky assets. The Fed has already started.
Investors are beginning to anticipate a pickup in inflation, which will not be without impact on stock mar-ket valuations (PE ratios) if inflation starts to rise significantly. We have already explained that current and past valuations were/are justified by the disinflationary environment. After years of very accommodative monetary policies, the economic cycle is accelerating, in a global and synchronized way. The prices of industrial metals and oil are blazing. And the protectionist/anti-globalization measures of the new US administration are rather inflationary. Recently, business feedback has indicated that the fundamentals for a pickup in inflation are taking hold: both in the industry and in retail sales, companies are working at full capacity and facing pressures on their production capacity. To fulfil rising demand, 1) they either hire people, what did department stores in the US and in Europe in December, and/or invest more in their production/service tools, or 2) they raise prices to cool down demand. In conclusion, the delays ob-served at the end of 2017 on the supply chain could signal that the pricing power could move from the buyer to the seller, potentially resulting in a gradual upward pres-sure on retail prices.
In the very short term, the S&P 500 is overbought, investor optimism is high and US households participation in equity market is at its highest since 1996, according to data from Ned Davis Research, which could signal a consolidation phase. But we are not expecting a significant correction in the first half of 2018, as revenues (economic growth and higher prices) and profits (even if there is peak margin in 2018, see our monthly report The Compass monthly in December 2017) will remain well oriented.
One of the biggest risks in 2018 is an inflationary slippage with slowing profit growth, a scenario that is difficult to envisage in the first half of 2018.
In addition, investors are waiting for the next stim-ulus package, such as the US infrastructure spending program and the possible easing of US banking regulation. The impact of the US tax reform will be positive and the repatriation of cash ($400 billion expected) from US companies strapped abroad could be used for share buy-backs, acquisitions or investments in the real economy. Surveys of economists show strong confidence in Emmanuel Macron’s ability to revive the European economy; companies are optimistic about the future. Mergers and acquisitions involving French companies have never been so numerous since 2007.
The dollar’s indecisiveness is good for US and emerging equities, as well as for metals and oil. We have therefore increased our exposure to the US and emerging markets to the detriment of Europe. In the US, we favor domestic stocks that benefit from Donald Trump’s pro-business and protectionist measures – America first. The Swiss stock market remains attractive vis-à-vis the euro zone thanks to the decline of the Swiss franc against the euro, to its central position in Europe, taking full advantage of the European recovery and to its opening on global markets thanks to competitive companies. We are overweight Japan: the yen has managed to contain its appreciation against the dollar and the prospects for reflation of the economy are real.
In this environment, there is little doubt that we should overweight Value and underweight Growth sectors. Overweight: Discretionary, Finance, Energy and Health care. Underweight: Utilities and Telecom.
Pharma (Growth segment) is a special case because of attractive valuations.
Discretionary, Energy, Financials, Health Care
Staples, Industrials, IT, Materials
Metals are a key theme
Despite the exit from the Fed’s accommodating monetary policy, the dollar lost more than 10% in one year in terms of index and interest rates remained low. This trend is favorable for gold. Regarded as a pure financial asset, gold also benefits from the bubble on cryptocurrencies, investors protecting themselves against the collateral risks of a possible explosion of this bubble. With the emergence of cryptocurrencies, which are intangible and digital, many investors buy gold, a tangible and storable asset. The central bank of China, the PBoC, could be tempted to reduce its purchases of US Treasury in favor of gold.
Industrial metal prices are expected to remain firm. Economic growth is accelerating in a global and synchronized pattern. Chinese demand will remain strong, while the rest of the world will catch up. By 2018, Asia should no longer be the only driver of demand for industrial metals. Infrastructure spending will accelerate globally. Reducing overcapacity in China to reduce pollution will benefit to aluminum and steel, and offset the effects of a more restrictive monetary policy on the real estate sector. In steel, the establishment of cleaner plants will require the use of superior quality of iron ore, favorable to BHP Billiton, Vale and Rio Tinto. Regarding copper, the supply-demand is well balanced, but Chile and Peru, the two largest copper producers (38% of world production), will face significant wage negotiations in the next 2 years which could lead to strikes. Lithium and cobalt will benefit from the rising demand for batter-ies used in electric cars.
The United States produced 9.7 million barrels/day in October 2017, the highest level since 1971. De-spite the return of the US to world markets, the price of crude continues to rise. The reasons: demand is growing and the OPEC-Russia agreement is working. The United Arab Emirates is anticipating a strong 2018 year with confirmation of supply-demand rebalancing. The price of oil will remain strong in 2018. Saudi Arabia, the world’s largest exporter and the world’s second largest produc-er, behind Russia, needs a stable price of around $70 for Brent to succeed in its economic and societal transition and the Aramco IPO, scheduled for 2018 and probably launched on the Saudi domestic stock market according to the latest information. Iran’s internal political and economic situation and tensions between Saudi Arabia and Iran are other factors that will maintain oil prices high. Like metals, oil has also benefited from the decline in the dollar.
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