Investment Strategy – January 2019
T4 2018 was marked by an equity market correction, particularly painful in December. The 2018 full year saw major part of asset classes delivering negative returns. Unlike other complicated years, the US Treasury Bonds and gold have played a limited role as a hedge or diversifier.
With the Sino-US trade war continuing, investors began to anticipate a risk of recession in 2019. The G20 Summit in Argentina was disappointing between the advocates of globalization and nationalism/protectionism, and the supporters of the COP 21 and climate sceptics. All this wrapped up military tensions between Russia and Ukraine. Donald Trump conceded a relative pause in the trade war against China by accepting not to raise tariffs for a 3 months period. This did not prevent Canada, by order of the United States authorities, to arrest the Huawei CFO, a large Chinese company in telecommunications equipment. This arrest questioned the semblance of truce in the trade war with China and negatively affected the financial markets. The technological war, launched by the United States against China, is still in its infancy and is bipartisan (Republicans and Democrats). In August, the US enacted a law banning China from acquiring US technology and being active in the US market, under the guise of national security.
The mid-term elections in the United States allowed Democrats to win the House of Representatives. The Senate remains in Republican hands. This balanced political situation in Congress removes the risk of further fiscal slippage. Donald Trump blames the Fed Chairman, Jay Powell, for the equity markets fall because of the Fed Funds hikes.
Europe is embroiled in the rise of populism, the Brexit, the Italian budget and the movement of “Yellow Jerseys” in France. An agreement was reached between the UK Prime Minister Theresa May and the European Union on the Brexit, but largely denied to Parliament; the English crisis is getting worse. The Italian budget of the 5-star populist /nationalist coalition and La Ligua does not meet the European criteria. But engaged in a standoff with the European Commission, the Italian government has dropped the ballast by proposing to present a new budget in line with the rules European. In France, fiscal sluggishness and loss of purchasing power has spawned the social movement of Yellow Jerseys. The government has dropped the ball by increasing the SMIC and taking other measures, but an impending resolution of the crisis seems unlikely. The France 2019 budget deficit should exceed the rules of the Stability and Growth Pact.
The United States is becoming the world’s largest oil producer, a major change that has upset the absolute dominating position of OPEC in recent decades. The OPEC meeting on December 6th confirmed the rapprochement between Saudi Arabia and Russia. Even though the United States can not let go of Saudi Arabia, the first buyer of US military equipment, the assassination of Khashoggi has cooled ties. And for Russia, this assassination is an “opportunity” to reinforce its geopolitical reconquest.
As expected, the ECB kept its policy rates unchanged as well as its forward guidance on interest rates, and continues to expect rates to remain at their present levels at least through the summer of 2019. The central bank will end its net asset purchases in December and intended to continue reinvesting, in full, the principal payments from maturing securities purchased under the APP for an extended period past the date when it start raising rates. The December meeting made it clear that rate hikes are not imminent.
The Fed delivered in December its 4th 25 bps hike for 2018. But with growth headwinds intensifying and market tensions rising the Fed will tread a more cautious path in 2019. This is its 9th Fed Funds hike since December 2015. The big news is that Fed projections signal only 2 quarter-point rate increases in 2019 compared to 3 to 4 rates rate hikes previously. 2018 has been a great year for the economy with output expanding at its fastest rate for 13 years and unemployment hitting a 49-year low. But 2019 will undoubtedly see more economic headwinds. The lagged effects of higher borrowing costs – 30-year fixed rate mortgage is averaging 5% – and a strong dollar will act as a source of risk. However, there are also some upside economic factors from a strong labor market, which is finally feeding into higher worker pay. At the same time, business surveys, like ISMs, remain at very strong levels.
Strategy and Macro
US in very good shape, for now…
The steroid-like fiscal stimulus adopted by US Congress in 2018 delivered a strong impulse. Actually, US growth significantly exceeded its potential and inflation accelerated to range around long-term Fed target of comfort, i.e. 2%+. Most economists doubted that a) such a strong rebound (3,5% like) was possible and b) that it is sustainable. The outperformance of US in 2018 was essentially based on a very strong domestic consumption, but much less on a significant revival of the capex cycle. The virtuous circle of stronger investment, better productivity, and therefore higher potential growth did not happen. Corporate America gave priority to financial engineering. In this context, the odds of stronger growth for longer i.e. an exit from the Great Moderation regime remains very unlikely. Even more so if, according to most leading indicators, a cyclical deceleration is in the offing for 2019. A likely chaotic domestic political landscape, with its epicenter in Washington, will for sure dissuade firms from committing significant capital to long-term investment. When it comes to US inflation, the 2018 strong cyclical upswing provoked legitimate fears of a (late cycle)resurrection of inflation.
Oil spike, as well as rising wages, added to the uncertainties. But here also, the short-term tailwinds will not be sufficient to evaporate the long-term disinflation drivers. The up-move of long-term inflation expectations above 2%, as derived from capital markets, was short-lived. Excluding goods concerned by tariffs, import prices have proved very tame and will remain so in the context of calm commodity prices, and of a strong USD / weak Yuan. A 25% taxation of all Chinese imports would, at worst, fuel a one-shot spike in CPI goods (like say a change in VAT), but will neither result in sustainable distortions between supply and demand, nor impact onUS salaries…
US will not shift out of Great Moderation over next couple of years
China more fragile…
The momentum of the Chinese economy is losing steam, as expected. In addition to the pace reduction due to economic transition, China is also facing several additional headwinds. US pressure on trade is a serious mediumterm imperilment. The take-off of the Belt and Silk Road large infrastructure plan is also experiencing growing resistances from beneficiaries, as the looming imperialist after-thoughts of Beijing create problems. The deliberate deleveraging of the economy and of SOEs subtracts means of re-stimulating investment. Still, the Party has started to use the country deep pockets to engineer a gradual fiscal response. We expect this process to accelerate in 2019 and 2020, when important political anniversary of the communist party will occur.
China will not deeply fall into corrosive deflation / depression
But risks of a deeper visit into ¨bad territory¨ are gradually rising
US midterm results
From a pure economic standpoint, the forced cohabitation is positive, as it – partly – removes risks of unbridled deterioration in US deficit. Nevertheless, Trump administration remains in charge, and its disruptive policy and corrosive attacks on free trade too. The rivalry with China goes beyond the trade dispute and is here to stay, for long. Actually, there is a bi-partisan consensus in the US to stem the hegemon (China) rise, as considered threatening for US financial, IT, and defense supremacy. Trade truce with China is fragile. Profound disagreements with Democrats will resurface from 2019, namely on social security, taxes and deregulation, etc. This will probably pave the way for spectacular show-downs, like government shutting or debt ceiling. The cherry on the cake might be Mueller investigation, which, finally, should make the news pretty soon.
Developments of US politics in 2019 will remain hectic
A cleaner investment landscape in 2019
The burst of bubbly / speculative pockets of financial markets accelerated in Q3 and Q4. Short-VIX, Emerging debt, Bitcoin, Anglo-Saxon real estate, long-short equities, high yield debt and high flyer / disrupting firms have been sequentially battered down. This sequential process is healthy, as it features the eventual deleveraging that financial markets needed, after several years of liquidity over-abundance.
Exuberant valuations have been revised down. Long-term irrational expectations (IBES consensus for next 5 years earnings >16%) needed to deflate markedly. This is a work in progress. Finally, credit spreads are starting to gradually widen. This remains a source of potential concern, namely as the huge inflows of last years, namely through passive investment vehicles, may find insufficient liquid counterparts in case of further deterioration of mood…
The painful end of investors’ complacency – herd mentality – is underway
- Global growth and inflation will remain supportive, though less so
- Policy-makers will miss means of reflating economy
- No shift into an inflationary regime
- Negative correlation between bonds and equities will continue
- USD cash and gold remain shock absorbers for risky assets
- Markets volatility will continue, in a context of residual risk premiums’ adjustments
- Alternative investments
A stronger USD in 2019…
While the Fed no longer views monetary policy as accommodative it certainly cannot be described as restrictive. The Fed Chair, and other members, have highlighted headwinds that the US economy may face in 2019: 1) slower global demand; 2) the lagged effect of past rate hikes; 3) fading fiscal stimulus; and 4) rising debt. The USD has gained across the board in 2018 and whilst a still strong economy should support sentiment, a more modest set of interest rate hikes in 2019 than in 2018 .will support the USD in a still volatile environment.
Admittedly, near-term downside risks will remain. In broad fundamental terms, the EUR may remain vulnerable in early 2019. Business surveys are slipping, and German GDP recently contracted. However, the decline in sentiment has been seen in many economies, as recently highlighted by the IMF. The Eurozone economy is expected to underperform the US, although this gap should narrow as the year advances. The ECB will try to raise rates in 2019 but will maintain an accommodative stance.
Global trade tensions, political uncertainties and volatile equity markets have encouraged investors to seek sanctuary in the JPY. Japan’s growth and inflation outlook continue to point for a looser monetary policy. The big picture should continue into 2019.
The SNB will maintain its loose monetary policy throughout the year and will not consider altering its stance before the ECB hikes rates. The economy has fared very well in H1, but growth is already slowing, and inflation remains low. Eurozone risks have supported a safe-haven demand for the CHF. The deposit rate at -0.75% will stay the lowest
key rate amongst developed markets. As other central banks are adopting less dovish stances, the FX market is likely to view the SNB’s policy as vulnerable to change. The sizeable balance sheet (127% GDP) remains a source of concern, largely due to its huge exposure to risky assets (almost 20% in equities whose half in the US) and outside the CHF market (94%).
The Brexit situation remains very unclear, and, as a result, the near-term outlook for the GBP too. In addition, the UK economy will underperform its peers and the BoE should keep rates on hold until we have a deal around mid-next year. Both factors should weight on the GBP.
The PBoC is expected to support private firms. We do not expect another major CNY depreciation, in the current context of a trade war truce . The 2018 USD/CNY direction was largely determined by the USD strengthening, as it outperformed all the currencies. Its 2019 direction will depend more on domestic factors and how policymakers deal with slower Chinese growth.
The Chinese central bank target in 2019 will be to help small private companies and thereby avoid a too material increase in unemployment. To achieve that, the PBoC will cut required reserve ratios (RRR) on all banks. The central bank could potentially favor a very gradual depreciation of the Yuan only if trade war resumes.
- EUR, CHF, JPY, AUD, EMFX
- GBP, CAD
The Fed, and its Chair Jay Powell, are fudging the facts while its monetary policy is approaching a neutral stance. It is almost impossible that the BoJ amends its monetary policy stance before the October 2019 VAT hike has taken effects. So, all eyes will turn to the ECB. 2019 will be the year, at least attempted, of the next ECB Policy normalization step. It will also be the latest one of Draghi as President.
Until Fed QT and ECB QE tapering started, money supply growth was steady above +5%. The subsequent deceleration to nearer +4%, since the tightening began has been disappointing. Monetary aggregates indicate further slowdown in 2019. Real M1 growth, a good leading indicator of economic activity, has now been on a downward path since July 2015. The ECB has failed to restore positive yields across the board.
Broad money growth runs at a low cruising speed, but comfortable enough for the ECB to stop its net asset purchases in January. The focus will then turn on the first rate hike timing. However, given doubts about the strength of the Eurozone recovery and underlying inflation, the ECB will keep a dovish tone to push the timing of a first hike towards year-end. Some ECB members had doubts regarding the growth outlook. So, any slowdownmight put TLTROs back on the agenda.
Euro corporate market has been hit harder and faster than government bonds by the ECB QE term announcement.The big unwind has already started as monthly purchases has dropped by half in October. So, the end of QE comes with a bigger bump for corporates than governments. When the ECB was still buying EUR 15bn per month, 2.5 were dedicated to corporate bonds. But next year, when purchases will be limited to reinvestment of maturing debt into government bonds, corporate debt’s demand will shrink.
ECB data shows a monthly average of EUR 0.5bn of corporate debt maturing over the next 12 months and 12bn for government debts. And there is still uncertainty over the reinvestment policy, which the ECB has to spell out yet.
Reinvestments in corporate debt in 2019 will be, at best, limited. Credit spreads have significantly widened for the first time in years. The repricing has largely reversed last year trend which sent yields to record lows. Credit spreads no longer reflect quantitative easing.
The segment the most at risk is the EUR high yield. It has benefited from ECB purchases because some of those bonds still have an investment grade rating from one ratings agency. EUR 19bn appear on the ECB’s purchase list. And, it has also benefited to some investors transfer down in the credit universe. Ultimately, there will finally be more focus on fundamentals. The segment is already experiencing large outflows, this is only a beginning. The second corrective leg is looming and should coincide with the ECB balance sheet reshuffling.
- Some reconstitution of risk (term) premium will continue, in the context of central banks’ gradual normalization
of their Balance sheets
- Credit markets, especially the most risky segments, still need to adjust to this less supportive environment
- US Treasury
- Investment Grade,
- Emerging hard currency
- German Bund, Swiss Confederation
- Inflation, High Yield
- Peripheral, Emerging local currency
The year 2018 has been a phase of corrective adjustment with 2 coinciding factors:
- The decline in the Fed’s balance sheet, reducing liquidity for risky assets
- The maturity of the US business cycle, resulting in upward pressure on wages and logistics affecting the
operating margin of companies
Twice, the beginning of the corrections, in January and October, was the inflationary fears in the United States, coming from the rise in wages, translating into interest rates. Each time, it was exaggerated fears, but sufficient for a downward adjustment for stock market valuations. Growth companies with high PE ratios – high flyers – have obviously been the most penalized.
Then, more recently, the downward revisions of corporate profits’ progression for 2019 multiplied : US-China trade war, maturity of the US economic cycle and contraction of GDP in Europe in the 3rd quarter, confirmed by leading indicators in October and November. Third quarter results also confirmed margin pressures, prompting analysts to revise their estimates downward.
Stock indexes correct each time when interest rates rise and/or earnings per share contract. However, it seems to us that the market exaggerates risks : a jump of interest rates is unlikely and we are expecting a slowdown in profit growth, not a contraction.
Over the last 40 years, 2018 was the year with the 3rd largest contraction of the PE ratios of the S&P 500. Since two months, US 2019 profit growth has been reduced from +11% to +9% on average, with low points at +7%. According to Factset, the S&P 500’s profit growth will be 20.4% in 2018 and +8.8% in 2019, and according to Lipper Alpha +24% in 2018 and +9% in 2019. The US tax reform contributed 40% to the increase in profits in 2018; ex-tax reform, the increase is +14%. For Europe, the profit increase of the STOXX 600 in 2019 is estimated at +9.4% compared to +9.9% in 2018. So, we are still far away from a contraction in profits.
The trade war initiated by the United States and the volatility of the oil price are holding back investments. Nationalism and escalating protectionism will result in a costly overall effect for businesses with the need to relocate production capabilities and revise the supply chains through a local approach and a less global approach that has prevailed over the last 20 years. The extraterritoriality of US law and, for national security purpose, the ban of US technology to China could be detrimental to global economic growth and investment.
In conclusion, the corrective phase of stock market valuations and stock market indices begins to incorporate the regime change (end of abundant liquidity injections by central banks), hence the rise / normalization of risk premiums. The stock markets seem to us today correctly valued. But we will remain in a volatile environment where the search for quality will be at the heart of investments and stock market valuations should be in line with the next-three years profit growth.
Is the end of the outperformance of the US stock market coming?
In recent years and until October 2018, the US stock market has outperformed the other developed markets thanks to the extraordinary stock performances of Facebook, Apple, Amazon, Alphabet and Netflix, disrupting companies that have evolved in a perfect regulatory and fiscal context for them. Today, their environment will be greatlycomplicated: the governments will put in place a binding regulation on the management of private data after theFacebook scandals and force them to pay adequate taxes.
The trade war is one thing, the technological war is another. And this one will last. A war with more heavy consequences. The United States and China are the only two nations to compete in technology for the battle of artificial intelligence and 5G, among others. The United States’ request to its allies not to invest in Chinese telecommunications equipment for the development of 5G, the arrest in Canada of Huawei’s CFO and the US refusal of Qualcomm’s acquisition by Broadcom are events that show that the war for technology is going to be ruthless. The China 2025 plan is a program that defines the priority in technology sectors in which China wants tobe the world’s leading power, especially in artificial intelligence. In the spring, the Americans almost bankrupted
ZTE, making Xi Jinping realize that China should become autonomous in technology. It is likely that the technology index NASDAQ will experience more volatile years in this war.
Europe and Japan have a more value profile . We think that the large outperformance of US equities is over.
- Switzerland, Value
- Staples, Health Care, Communication
- US, Europe, Japan
- China, Emerging
- Large & Small/Mid Caps, Growth
- Discretionary, Industrials, IT, Financials,
- Telecommunications, Utilities, Energy
- UK, Materials
Saudi Arabia’s strategy of dropping oil prices in 2014-2015 to halt the expansion of US gas/oil shale has been a failure. The Saudis have underestimated the ability of US domestic oil companies to adapt very quickly and find technical solutions to lower the breakeven .
Between 2014 and 2016, the number of rigs had been divided by 5 in the United States, from 2,000 to 400. The impact had been limited, since the US production had lost only 1 million barrels/day. Today, with half of the rigs compared to peak in 2014, the United States has become the largest oil producer ahead of Russia and Saudi Arabia.
In October 2018, the price of Brent reached $87 a barrel and investors began to phantasm on a $100 price because of US sanctions on Iranian oil exports. Our conviction remains : the price of oil is political and will stabilize around a reasonable level .
The arrival of US shale is disrupting global markets and the Saudis do not know how to handle this new situation. It will be recalled that after 40 years of embargo, US can be exported since 2016; a revolution in American energy policy linked to the explosion of shale gas. Lowering prices did not disrupt US oil production and the reduced OPEC and Russian production to support prices prevents Saudi Arabia and Russia from gaining market shares.
We believe that a Brent price of around $70-75 “suits” everyone: consumers, non-OPEC producers with economic breakeven around $40-50 (Norway, UK or US) and producing-countries whose budgets are based on the price of oil (Saudi Arabia, Russia in the lead). But it is true that 1) the end of OPEC’s price-fixing monopoly, 2) the arrival of US oil and US LNG on world markets, as well as 3) the new energy relations between Russia and China, could announce the end of OPEC, a scenario of “every man for himself”, announcing a bearish chaos on prices. By the way, Qatar has just announced its exit from OPEC.
- Precious metals
- Industrial metals
- Real Estate
- Hedge Funds
- Soft commodities
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