Investment Strategy – July 2018
The recent leading indicators carried some important signals for policymakers. Accelerating growth in the US was counterpoised by greater uncertainty about economic growth trajectories in the Eurozone, UK and Japan. Emerging markets meanwhile showed increased signs of stress as exports fell amid a downturn in global trade.
Forward-looking indicators showed especially worrying signs for future output in both the Eurozone and UK. In contrast, US firms were often unable to keep pace with strong demand, helping explain why price pressure gauges have risen in the US but cooled in Europe. These themes are explored in more detail in our notes below.
With this backdrop, recent surveys could prove instrumental in guiding near-term policy at the ECB, Bank of Japan and Bank of England, with all three central banks looking for signs that recent economic weakness may prove temporary.
Direct and indirect refute
Trump has fundamentally adopted the Schopenhauer philosophy and principles who actually thrives at the art of controversy. He basically uses two principles. First, the direct refute, which aims at splitting the opposition defence by 1) either repudiating its bedrock and premises, or 2) by negating the logical steps that leads to conclusions. Second, the indirect refute, which concentrates on providing multiple and adverse examples / exceptions.
Trump excels in the art of abruptly changing tack, when engaging in talks and negotiations. He uses this tactic to destabilise the opposite camp. He is a Schopenhauer disciple when he leads by dividing and by using corrosive stratagems. Trump does not care at all about truth, when he stigmatises fake news. He definitely focuses on being right, by all possible means, be it by enforcing “the law of survival of the fittest”.
Beyond Canada and trade disputes, Trudeau is the perfect enemy for Trump. A measured, clever, well-educated playboy, perfectly symbolising the elite and establishment. Macron probably belongs to the same category. Though being more vindictive than Canadian Prime Minister, Macron may ultimately prove prisoner of the D. de Villepin syndrome: being right, applauded, but unable to change (bad) things.
Western policy-makers motivated by Reason and Logic are ill equipped and barely prepared to confront proponents of rhetorical eristic.
Still, serious challenges lie ahead for US cabinet
China and other societies, based on Confucius and Sun-Tzu teachings, have radically different relations with Time, Sacrifice and their quest for Prosperity. They excel at dodging, manoeuvring and bringing opponents to their field. Xi strategy of coaching North Korea and of creating multiple walkways with Russia are visible examples of it. China 2025 and Silk Road plans are incommensurable with US cabinet absence of vision. China will prove much less permeable to destabilisation gimmicks of US President. China is the key geopolitical player to look carefully at in coming weeks / months.
In order to benefit most of its new “doctrine”, US imposes bilateral talks / negotiation. It actually comes down to putting itself in a favourable position of power, by attacking different countries in a very focused way. But comes a time when the opening-up of multiple adverse fronts results in building improbable, but strong coalitions of opponents. In the future, G7 and G20 will probably prove much more insightful in this respect…
Geopolitics will stay in the spotlight.
Investment regime transition
H2 2017 was all about global reflation, liquidity and a weak USD. It took investors a surprisingly long time to acknowledge for the change in the liquidity landscape. Indeed, in January 2018, the extension of 2017 in vogue “search for yield /carry trades”, coupled with extremely low volatility levels continued. This was an accident waiting to happen. The sudden spike of equity volatility spelled a forced unwinding of large synthetic (short) positions on the VIX. This sharp consolidation of equities actually allowed for a long overdue repricing, based on a different set of US inflation perspectives and interest rates. Intense sector and country rotations favoured the healthy dissipation of exuberance. Risks are lower now than they were then.
The steady and relentless rise of US interest rates, coupled to the resurgence of Europe political risks, finally triggered volatility / spread widening in the fixed income sphere. As discussed earlier, we are still afraid of this sort of volatility transmission. This sensitive process is a pre-condition to healthier / less complacent markets pricing. The serious correction of emerging currencies and of local bonds symbolises this. The big question is to understand whether this normalisation process will be slow and corrections “contained” or whether a big and quick unwinding would rather fuel a global fixed income crisis… At this stage, we do not expect an Armageddon scenario.
Just like for equities a few months ago, we keep observing significant capital outflows in different segments of the fixed income markets. Indeed, the sum of capital invested by conservative investors, in “complacent” strategies, is of a larger size than in equities… For now, the investment transition regime is taking place rather quietly. We cross fingers. Unfortunately, there is no guarantee that it will continue likewise.
The disinflationary regime goes on
In our base scenario, we do not consider a serious trade war between US and China to erupt soon, despite rising tariffs’ tensions. Similarly, we do not expect oil prices to further spike and fuel a global shock. Both would have the potential to thrive an exogenous inflationary shock. In the US, the risks of an inflation slippage, fuelled by an overheating economy have somewhat abated. First, the traction from world growth is diminishing. Second, financial conditions are gradually tightening, courtesy of a stronger USD and of a partial reconstruction of risk premiums / spreads.
Global financial conditions will remain supportive, but…
The latest deterioration in financial conditions essentially reflects equity volatility spike and some corrective phase of risky assets. This is the prelude to a wider and long-lasting normalisation process. Restoration of higher macro volatility actually started in 2017 and was reinforced with the implementation of a significant / late cycle fiscal stimulus. US is gradually exiting the famous “New Normal” phase featuring subdued growth and tame inflation. US is entering the late stage of its economic cycle: the odds of a significant slowdown / recession over next two years are rising.
The protectionist agenda of Trump tightens ahead of US midterm elections. For now, the size and scope of US tariffs and of foreign retaliation have remained “contained”. For sure, China reaction (hardly hurt directly yet) will be key, when US gears up on Intellectual Property and on technology transfers. Such a delicate confrontation is probably in the making over next couple of quarters latest.
The latest tightening of the FC Index is of limited diffusion. It essentially results from 3 factors (out of 10) i.e. Interbank spreads, equity price’s growth, and term spread.
Towards a global quantitative tightening by 2019?
Japan and Europe are getting closer to tapering, like the Fed did from 2016. Only domestic political situation is delaying this process. These two large manufacturers of excess liquidity have reached the politically acceptable limits of unorthodox monetary policies: balance sheets’ size compared to GDP have become huge.
Addiction to negative real rates spells speculation and leverage, which ultimately threaten financial stability. China will maintain a balanced, if not accommodative stance, to support economic soft landing.
Over the next 12 months, we expect:
- The end of the concomitant rise of oil and of the USD. Both are due for a consolidation
- US to remain the engine of world growth
- US inflation to stay in the tolerance range of the Fed (i.e. it will stay below 2,5%)
- Europe, China and Japan to remain in a disinflationary boom regime
- Emerging economies to deliver good growth and benign inflation. A severe crisis is not in the making
- Alternative investments
Trade war back on the table
Trump’s decision to reinstate steel and aluminium tariffs on the EU, Canada and Mexico increases the risk of a bigger trade war. The initial market reaction was USD-negative (at least in March, when the prospects of the tariffs were introduced).
If the trade-tariffs work as intended, it should decrease the amount of imports and, hence, leave fewer USD floating around in the financial system. This is eventually USD-positive.
A more broad-based trade-war will likely lead to a significant downturn in the global growth. That usually coincides with a stronger USD. Obviously one-sided tariffs imposed on US imports will lead to structurally higher prices in the US, which should weaken the USD fair value.
If trade-tariffs were to structurally weaken the USD, then it would THE twin-deficit solution.
ECB caught between a rock and a hard place
Political risks, the relative economic weakness and the yield disadvantage are likely to continue to weigh on the EUR. It would stay a funding currency. The ECB is unlikely to quickly respond to higher April inflation data, given weak economic growth prospects and subdued underlying inflation.
Carry has become increasingly important as US interest rates have become the highest in developed markets. Holding a long EUR/USD position currently costs more than 3% p.a. and is likely to become more punitive if Fed tightening continue, the positioning seems unlikely to impede further EUR depreciation.
CHF in a tiny range for long
The CHF remains a structurally robust currency, backed by a near record basic balance surplus (12% of GDP) and a neutral long-term valuation.
We upgraded the CHF in April once our 1.20 vs EUR target was reached. Quite a lot has changed in the intervening period. We are taking the CHF forecast back down again. The CHF has once again played its traditional anti-EUR safe-haven role.
The SNB has not taken over action to halt the CHF rally. This looks reasonable given that it has more limited firepower and may need to be more discriminating in choosing when and how to deploy this. The SNB balance sheet stands at 125% of GDP compared to only 35% on the eve of the Euro area debt crisis in 2010. The acute phase of the European debt stress may be over, but we nevertheless expect recent events to have a durable and positive impact on the CHF.
Can the JPY weaken without Abe?
The upcoming leadership election in the ruling Liberal Democratic Party, scheduled to be held no later than September, is crucial for Abe leadership and Abenomics and by extension the JPY.
Until recently, there was little doubt about Abe’s prospect of winning the election, but his political standing is weakened by scandals. If the market starts to speculate that Abe will lose office, it will thus not be a surprise to see a stronger JPY. If Abe steps down, the USD/JPY could be headed back below 100.
- USD, EUR, CHF, GBP
- JPY, AUD, CAD, EMFX
How far can the Fed raise rates?
The answer will ultimately depend on 2 key variables: 1) to what extent output expands above potential, and 2) where the neutral rate is. Merely, the neutral rate is the one at which monetary policy is neither accommodative, nor restrictive. It cannot be observed, it can only be estimated. What is almost certain is that it has fallen considerably since the GFC. Various Fed estimates suggest that it has fallen between -0.5 & 0.5% post-crisis from 2-3%. So, in nominal terms to 1.5-2.5% from 3-4%. Based on past economic cycles, it is unlikely to move by more than 1pp over the coming years. The Fed Funds (FF) peaked at +1.5pp above the neutral rate in 2007 (cf. Del Negro estimates). It seems unlikely that Fed would adopt a restrictive stance. The FF would settle at 2.75-3.00%, i.e. 0.5-1.5pp above the neutral rate estimates.
There is a remarkably tight relationship between the yield curve, and the gap between FF and neutral rate estimates. The yield curve is expecting a slowdown scenario over the next year. The US 2y yield could reach a peak c. 2.90% in Q4 considering quarterly FF rate hikes. The US 10y yields could eventually reach 3.20% this year. We therefore expect a continued flattening of the yield curve.
Credit market is finally experiencing the kiss cool effect
This is the first time since the great financial crisis that we have both synchronised wider credit spreads and higher US government yields. The tighter monetary policy conditions are hammering high-quality bonds.
This is not due to deteriorating financials, as earnings trajectory looks healthy, but much more to the duration extension of the corporate bond market. The level of US non-financial debt is at its highest-ever level relative to GDP.
This is consistent with levels seen just before the past 3 recessions and associated default cycles. Concerns are growing & could drive us into the next downturn. On a relative basis though, corporate debt to GDP remains stable when compared to households or financial corporations. Moreover, underlying fundamentals are robust. The ratio of corporate debt to profits at 4% is well below the level in the past 3 crisis periods (over 6%):
- Corporate profits, as a percentage of GDP, are also at the higher end of their historical range, and
- Interest coverage is at the highest level in 50 years.
Finally, the highest USD investment grade yields in almost 5 years are likely to discourage massive new bond supply. The demand from pensions funds and overseas investors for long-dated bonds should resurface.
Rating agencies are warning of large wave of HY defaults ahead
With corporate debt hitting its highest levels, Moody’s is warning that substantial trouble is ahead for HY when the next downturn happens. Low interest rates and appetite for yield have pushed companies into issuing mounts of debt that offer low levels of protection for investors.
While the near-term outlook for credit is benign, that will not be the case when economic conditions worsen.
The prolonged environment of low growth and low interest rates has been a catalyst for striking changes in non-financial corporate credit quality. The record number of highly leveraged companies has set the stage for a particularly large wave of defaults when the next period of economic stress eventually arrives. However, the current default rate is just 3% for HY, i.e. its lowest level in the current economic cycle.
The Fed balance sheet reduction and USD rebound lead to the weaker hands deleveraging
The benefits of a weak USD and rising commodity prices, on EM growth in 2017, are now fading. This will leave EM issuers facing more challenging conditions. After the explosion of the short-volatility strategies, the next one has been EM assets and mainly currencies. The global tightening of financial conditions has pressured the weakest part of the global capital structure, namely leveraged EM economies. The trio of higher US yields, USD strengthening, and rising oil prices has led to some market repricing of BoP risk i.e. larger current account deficit, higher short-term external debt, limited buffer of FX reserves, all leading to foreign capital outflows.
For the time being, policy responses have moved globally in the right direction. We are not expecting a 2013 taper tantrum redux, as most of EM economies current account positions have improved relative since then. They are healthier than in 2013 & EM debt level is only modestly higher.
EM bonds, like the credit space, are experiencing a higher dispersion. Investors are becoming more discerning when it comes to reassessing credit risk and issuer profiles on the back of a lower strike central banks put. Not everything will rise anymore in synchronised fashion thanks to massive liquidity injections.
In that environment, the average EM local currency spread over US Treasury yield has widened and those currencies have experienced a sharp correction since their recent pick. Those assets stay appealing.
- Investment Grade,
- High Yield, Hybrid/Sub,
- Emerging hard currency
- US Treasury, Inflation
- Emerging local currency
- German Bund
Liquidity supports equity indexes
The 2 engines of the equity indices:
- The exceptional rise in US profits partly.
- Cash generated by this tax reform, used for share buyback programs, dividends and acquisitions, is estimated at $2,500 billion in 2018.
A powerful counterweight to a trade war. Approximatively US companies have $ 2,500 billion in cash in the United States and $ 3,500 billion abroad. Liquidity should continue to play a major role in 2019.
Share buybacks are estimated at $ 800 billion in 2018 compared to $ 560 billion in 2017. The US Technology sector is expected to account for 65% of these buyback programs, followed by Health (20%) and Consumer Staples (15%). Apple has announced $ 160 billion of share buybacks in 2018.
The bar has been placed very high in 2018
With such impressive figures in 2018, the base effect should be negative in 2019. But to remain pragmatic, in a disturbing environment and a nationalist and protectionist American policy, the situation has to be evaluated this autumn. The midterm elections in the United States, in November, could change a lot of things according to on the political colour of the Senate and the House of Representatives.
If the growth of US profits is expected to be +20% in 2018, the disappearance of the tax effect will result in a profits increase of “only” +10% in 2019. The Energy, Technology, Materials and Discretionary sectors will continue to be the main contributors to profit growth.
The technology sector is structurally attractive with steadily improving margins. See chart below. Investors also view this sector as insulated from the risks of a trade war.
Equities compare favourably with bonds
Dividend yields remain attractive relative to bond yields. According to our calculations, we have to get closer to 3.5% over the US to year yield before investors think seriously about the great rotation from stocks towards bonds.
The dollar and emerging markets are inseparable
The recent USD strengthening, coupled with a (modest) rise in interest rates, weighed on emerging markets. As usual. Stronger confidence in macroeconomics and better credit fundamentals have supported the “this time is different”.
But once again, we observe that the dollar remains the dominant factor, which affects emerging countries negatively when it appreciates:
- impact on USD-denominated debt,
- inverted correlation between the dollar and the price of raw materials; with the exception of China, India and Turkey, emerging countries are generally net exporters of raw materials,
- a decline in emerging currencies reduces in the medium-term foreign inflows, necessary for their positive demography and the growth of the labour force.
After a rally 7%, the dollar has stabilised, paving the way for a gradual return to emerging equities.
- Europe, Switzerland, Japan
- Discretionary, Energy, Financials, Health Care
- Emerging, China
- Large Caps
- Staples, Industrials, IT, Materials
- Telecommunications, Utilities
Industrial metals, lack of investment will support prices
The drop in oil and industrial metals prices between 2014 and 2015 proved ultimately positive for the industry. Oil companies in exploration and production, as well as mining companies, reacted rationally during the price recovery by favouring to strengthen their balance sheets and distribute dividends to shareholders rather than to reinvest in production capacity.
Today, we are probably in a new bull cycle, which started in early 2016, and there will be constraints in supply in the next few years as demand continues to grow. The Investment/Production ratio is expected to remain low within 12 months as production progresses to meet demand.
A recent survey for mining companies shows that investments will increase moderately, with companies cautious on certain commodities such as coal.
So, we are very far from the euphoria of 2011-2012. According to the same survey, half of the investment in exploration will be dedicated to gold.
Gold sensitivity to real interest rates
As a financial asset without remuneration, the gold price change is obviously negatively correlated with the evolution of real interest rates.
The rise in real interest rates since September 2017 has not been as negative for gold, because the geopolitical component came into play with extreme tension between the United States and North Korea at the end of 2017.
For the last ten years, the central banks of China and Russia have been important buyers of gold. If the Russian share of gold in its foreign reserves increased from 2% in 2007 to 18% today, it has remained close to 2% in China. Turkey’s central bank is also a major player. Recently, private demand for gold rose by 34% in Turkey as a protection against the fall of the Turkish lira and skyrocketing inflation.
OPEC and Russia will increase oil production, but less than expected
OPEC and Russia have reached an agreement to increase oil output by 1 million barrels a day to prevent the price of Brent from rising above $80, under the pressure from the United States and two important customers, China and India, despite the opposition of Iran, Iraq, Venezuela and Algeria. In practice, this could be 700-800 b/d, as most members are unable to increase production. Saudi Arabia is the only member that can act quickly.
Beside the increase in demand, some risks are pointing to supply: the problems in Libya and Venezuela, the next US sanctions in Iran and a possible increase of Chinese import taxes by 25% on US oil, in the context of the trade war, which would make US oil uncompetitive in China and force Chinese buyers to turn to OPEC.
On the announcement of the agreement, the oil companies and the oil price have soared, because Russia wanted an increase of 1.5 million b/d and Saudi Arabia 1.2 million b/d, while the deal proposes a lower output increase than expected. Brent rose 3.4% to $75.6, WTI was up 4.6% to 68.6%, and individual oil prices were up between 3% and 5%.
The record gap of more than $11 a barrel between Brent and WTI observed in early June should be reduced with 1) OPEC production increase, 2) in the US, slowdown in production and significant inventories decline in Cushing. We maintain our conviction that Saudi Arabia wants to prevent a rise in Brent above $80, but wants to maintain a price around $70-75, a price that balances its budget, that supports its Vision 2030’s main objectives and will allow to float Saudi Aramco on the stock market in good conditions.
- Industrial metals
- Precious metals
- Real Estate
- Hedge Funds
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