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Investment Strategy – March 2019

Strategy and Macro

Asset allocation

We consider the global investment landscape as complex and potentially volatile. The ongoing change in liquidity regime is not over yet. Last year markets’ corrections proved valuable in a) addressing growing signs of speculation b) modifying investors’ complacent mood, namely retail ones. The central banks’ pause in its normalization process is providing some near-term markets’ relief. But further tightening of financial conditions is inevitable at this late stage of the cycle.

We recommend being fully invested, but navigate markets with caution and adequate risk monitoring

 

The worst wasn’t ineluctable

“Wall Street predicted nine out of five recessions”

P. Samuelson (Nobel Laureate)

Multiple risks / vibrations emerged in 2018 and shook markets. In 2019, we are entering times of recognition, as most issues will be coming to fruition in the coming weeks.

Growth deceleration is getting for real, globally. It may get dangerously closer to stall speed by Q2/3, namely in Europe and Japan. At this particular juncture, even a small policy mistake could induce dramatic consequences. In this context, Fed seems to have blinked, helping to evaporate some short-term concerns (of a growth overkill). And China is accelerating reflation.

Brexit and US-China trade war issues are still there, but tentative positive epilogues should emerge. European elections are coming soon, but Macron is gradually taking over control.

Year-end volatility made way for the January rally. After other inflated asset class segments, the dangerous high yield ¨mini-bubble¨ has also deflated ¨smoothly¨. Indeed, the whole credit moved from a December liquidity air-pocket fall to a January short-squeeze…

After a complacent summer, investors suddenly panicked in Q4 2018

Now, (excessive) recession fears are fading, dissipating markets’ tumult

  • Growth scare less prevalent
  • China accelerates reflation
  • Fiscal and trade policies under the radar
  • When central banks seriously blink…
  • A controlled normalization of credit spreads

 

Forget about a 2016 reflation Redux

When it comes to similarities, J. Powell seems to be following the J. Yellen script. At least he blinked. Practically he might well be undertaking a comparable U-Turn, based on a similar observation of a significant deterioration of China economic momentum, weak Yuan and commodities. In 2016, the Fed implemented only one policy rate (of 25bps) rather than 4 planned.

Incidentally it stopped tightening at that time, when Chinese manufacturing fell to the level of 48, exactly the latest print of December 2018… As a ¨counterpart¨, in the context of the Shanghai accord, Beijing stopped the Yuan competitive devaluation.

When it comes to differences with 2016, China has a brand-new policy playbook. Last months, it has rolled-out tax cuts and incentives to gradually boost consumption. Incidentally, the March plenum may give birth to additional, but gradual fiscal measures.

It also injected massive liquidity into the banking system, opening discreetly the door to a Chinese-style (progressive and focused) QE and engineering by the way the bailout / recapitalization of ailing domestic banks. Beijing takes further steps to open its capital markets. It will however continue its regulatory efforts to limit the adverse side effects of past and present easing (say uncontrolled shadow banking having fueled excess leverage). Let’s face it, China faces a classic dilemma: ensuring external stability (steady currency), while boosting domestic growth (private sector).

In 2016, inflation expectations were shifting towards deflation risks (US 5y5y inflation swaps fell below 1,4% and Eurozone below 0,5% in Q116). Situation is different now, spelling lower alarm / risks for central banks. Wages are much more resilient than then, namely in the US where they may ultimately tie the hands of the Fed. Deceleration / political pressure on world trade was absent in 2016.

The new Chinese policy mix spells a more arduous– less readable – reflation process

Deflation risks are lower than in 2016, and a new US fiscal easing is unlikely

 

US macro cyclical resilience

US banks are gradually tightening their lending standards. Except for a brief period around 2016, US banks have proved very willing to lend. This is the classical symptom of a maturing cycle, particularly when it climbs to much higher levels than now (above 40 in early and late 2000s). This actually features the tightening of financial conditions, as engineered by the Fed, when it drained liquidity and raised policy rates. This is much too early to be wary about it. US ISM, employment and other latest prints have been surprisingly good. It seems that, finally, the whole shutdown sideshow has not had a material impact. We reiterate our forecast that a US growth slowdown is likely in 2019, featuring a pace of about 2%+, not more, but probably not much less.
 

A new Bad Boy?

Eurozone economy is experiencing a troubling slowdown, in spite of a firm domestic demand, buoyant labor market and rising real income. Business confidence has weakened, and foreign trade developments have proved growingly adverse. Italy actually entered technical recession, while France is stagnating in the wake of Yellow Vests.

But Germany only avoided downturn at the margin. Granted, it normally suffers more than its European peers from a Chinese slowdown. But there is more than that playing a role.

Important industrial sectors suffered one-off shocks, like motor vehicles (slow implementation of new regulatory checks on auto emissions), and chemicals (water shortage on the Rhine).

The good news is that this resembles idiosyncratic risks more than structural deficiencies. Unless Trump specifically targets German cars next summer (while providing trade concessions to China), a recovery seems likely pretty soon.

  • Risks of a severe global economic contraction in Spring / Summer 2019 have receded
  • But macroeconomic policy is less-well positioned to fight downturn than in 2016

 

Overweight

Neutral

  • Cash
  • Equities
  • Fixed Income
  • Alternative investments

Underweight

 

Bonds

The Fed is not in a hurry mood

The Fed unanimously left its rates unchanged and confirmed that it is on pause for some time. The effects of financial market volatility, trade uncertainty and the shutdown give good reasons to adopt a wait-and-see stance. The Fed can be patient as the core PCE is running at its 2% target level. It had indicated, in December, that it would slow its tightening pace. It looks unlikely to see an interest rate rise in S1, but there is a decent chance of a move in S2.

The Fed has other available tools. Governor Brainard suggested to raise the countercyclical buffers. This is unlikely. The best alternative is a balance sheet tweaking. The Fed could decelerate (or interrupt) its Treasury sales and/or adjust its composition. A potential inverted US yield curve is a banking system problem as they have long-dated assets and short-term liabilities. Selling longer-dated US Treasuries would re-steepen the curve, thereby putting up borrowing costs but taking off some of the financial system pressures. The sudden weakness in US consumer confidence, exacerbated by the shutdown, needs to be closely monitored. Typically, when the Fed tightening cycle reached its end, the US curve starts to steepen.

The Q4 & January Treasury rally has already led to a significant positioning adjustment. After reaching an historically short level, investors have scaled down their exposure. The positioning is back into its long-term range. Investors remain short Bonds as the Fed is still selling them. If it announces a QT amendment, short covering would become a risk.
 

Credit market quality is not a source of stress

The significant rise in volume of BBB-rated bonds may not translate into a multiplication of downgrades. Some of this rise is due to M&A activities and some to upgrades from HY. According to Bloomberg, 70% of IG issuers since 2012 have increased their indebtedness, but only 45% by more than 0.25x Ebitda. Over the past 5 years, the BBBs total debt-to-Ebitda increased by only 0.40x. In 2018, 20% of BBB and BBB- rated issuers had leverage above their downgrade thresholds. It should decline to 15% in 2019 and 5% in 2020 as they should deleverage post-acquisition. Many low IG companies have used low funding costs to finance M&A and dividends. So, they will be able to reduce cash spending and to redirect it to balance sheet preservation, if needed.

In January, Moody’s projected that in 2019, the High-Yield default rates will climb. The US 12-month default rate is expected to rise to 3.4% by year-end. Given the last year huge credit spread widening, this is already well discounted. If spreads remain at least stable, High Yield bonds will deliver positive returns.

 

EM debt should attract capital, despite volatility

The global economy is not really at risk of another recession. Like in 2015 – EM stress period – yields widened, currencies depreciated, and corporate spreads increased. The world was fearful that recession was looming. And, we did not have it. This was, and is today, a kind of cyclical adjustment. The cycle is not at risk given the Chinese significant ease, the US fiscal stimuli and Japanese and the Europeans lack of wishes to tighten monetary policies.

The situation has started to fix itself. Spreads are at levels that have historically been considered as attractive. After having widened in 2018, sovereign bond spreads compressed in Q4, driven by Brazil and China. But, on an issuer-weighted basis, spreads have increased and are still offering attractive entry levels. This is also true for corporates.

Medium-term EM inflation expectations remain close to their past decade lows. As they remain stable, EM central banks have sharply hiked rates to head off further financial instability. Monetary policies are expected to stay tight to support their currencies. The EM-DM real yields spread remains near the past decade wide. It is the most attractive part of the fixed income universe.

Overweight

Neutral

  • Investment Grade, Inflation
  • High Yield, Hybrid/Sub,
  • Emerging hard currency,
  • Emerging local currency

Underweight

  • US Treasury, German Bund, CH Bond
  • Peripheral

 

 

Currencies

The USD is set to stabilize…

It has been decades since the US has been denounced / considered as imperialistic. The vectors of this supremacy have shifted from hard power (defence, economy, finance, politics) to soft power (culture, ideology, value, exemplarity). The novelty with Trump administration is that it a) constantly recurses to the law of the strongest and b) practically ignores soft power. US President crushed all inhibitions to transcend the law of the strongest.

Like preceding Administrations, Trump’s is weaponizing the USD against ¨non-compliant¨ foreign countries. The roots of this mechanism comes from the aftermath of Bretton-Woods. The US is the only country which prints money and runs deficits with little – if any – direct impact on its exchange rate. The world interbank payment system (SWIFT) is run by the US and based on the USD. Now, Russia and Iran are under Trump radar, but Europe and Germany are not very far from it…

China is taking gradual steps to make the Yuan fully convertible. This is a medium to long-term goal. Its share among other currency reserves is still minimal. Beijing also entered into long-term oil supply contracts settled in Yuan. This was done with Russia and, in 2018, with Saudi Arabia! Gold and Oil markets have been organized in Shanghai. Their developments are rapid and they may soon become more than just confidential. Over time, the Yuan will definitely challenge the USD, as the unique currency of pricing for these strategic raw materials.

For obvious political reasons, Russia central bank not only ceased buying, but also sold all its US Treasuries. Turkey and Kazakhstan are potentially moving along the same line. Europe is attempting to circumvent the Iran embargo through a system of barter trading. US assertiveness has become a serious concern for a growing number of countries. Trump policy is fostering the early emergence of a contender to the USD

The ECB will probably allow its balance sheet to shrink. Some bridge solution to the coming maturing TLTROs will be offered, but on less attractive terms. TLTROs still represent 15% of the ECB balance sheet. That should push some of the TLTRO banks back into the regular money market – and the ECB balance sheet to shrink. The EUR/USD has bottomed out.

It is still very hard to see a breakthrough in the Brexit talks. Investors seem to position for a much more benign Brexit outcome than months ago. According to polls, investors put a higher chance for a second referendum (40%) compared to a no-deal (10%). Brexit risks are well discounted.

The JPY is a victim of the Powell tone shift. The 110-hurdle will hold. The low global rates environment has allowed for further slowing of the monthly purchase pace from the BoJ. A dovish Fed implicitly leads to a more hawkish BoJ due to its Yield Curve control policy.

The slowing purchase pace should keep the downside risks alive in the USD/JPY. The Yuan has appreciated since last November. At that point, it was testing the 7.00 level vs. USD. It strengthened by over 4% since then. The CNY gains came even as Chinese economic data deteriorated. Policymakers appear keen to prevent further weakness, at least ahead of the US-China trade talks.

The latest PBoC measures are having some success, rates have weakened, and latest credit data surprised to the upside. However, a reduction in official interest rates is not there yet, but it should imply a slower pace of USD/CNY depreciation over the coming months. The Fed change in its rhetoric is good news for the sentiment and coupled with a large undervaluation, it should benefit to all EM currencies.

Overweight

  • EUR

Neutral

  • USD, CHF, GBP, JPY, EMFX

Underweight

  • AUD, CAD

 

Equities

Stock indexes can’t rise if corporate profits retreat

December 2018 was one of the worst December ever and January 2019 was one of the best January ever ! January 2019 recovered a large portion of December 2018 losses. On December 24th, adjustments to 2019 profit growth estimates were divided by 2 (from 10-12% to 6-8%) and stock market valuations contracted to interesting levels.

Exceptional stock market performance in January was the recovery of the exaggeration in correction in December due to investors’ massive capitulation, but also thanks to a rise in profits of the S&P 500 in 4Q18 higher than estimates, +12.4% currently compared to +10.5% at the beginning of January. But corporate guidance have been lowered for 2019, prompting analysts to revise their estimates for 1Q19. See chart below.

Today, profit growth estimates continue to decline. Factset Research estimates a 0.8% decline in profits for the S&P 500 in Q1 2019 and +5.6% for 2019. Refinitiv estimates an increase of 0.4% in 1Q19 and +4.6% in 2019. For Europe, Refinitiv estimates profit increases for the Stoxx 600 at +2.7% in 1Q19, +2.9% in 2Q19 and +1.8% in 3Q 19. In September 2018, profit growth estimates for 2019 were between 10% and 14%.

In the United States, in 1Q19, the expected sectors which will rise in profits are Healthcare (+7%) and Utilities (+5.2%) and those which will decline, Technology (-8.9%), Energy (-5.9%), Materials (-5.1%) and Consumer Discretionary (-2.7%). The chart below shows that stock market indices can’t rise if earnings fall. We therefore have to expect a consolidation of the stock market indices.

“The good news” is that the decline in profits in 1Q19 is due to accounting effects related to the tax reform (coming into force in Q1 18) and tax benefits, effects that will also be observed in Q2 19 and Q3 19, rather due to an economic slowdown.

A negative base effect that will be seen in particular on the technology and energy companies. Ex-technology and energy, quarterly profit growth will be closer to the 2011-2017 average.

 

Low correction risk: PER are fairly valued

PE ratios are at fair levels and, as we often said, the inflationary regime influences the level of stock valuations. We remain in a low inflation regime that favors higher stock valuations.

In the United States, the PER should have contracted by 2015 with the rise in inflation. The contraction of the PER was sharp in 2018. The recent decline in retail prices should support stock valuations. In Europe, the deceleration in retail prices calls for a stabilization / extension of stock market valuations.

 

Towards a temporary end of the US outperformance vis-à-vis the rest od the world? Possible

Over the long term, US equities outperform the rest of the world through technology, growth sectors and disruptive companies. The United States has a strong financial capacity to support emerging industrial and service sectors. The new economy. The 5G could still allow US indices to outperform.

However, the technological war between the United States and China could curb the expansion of American companies and create 2 separate internet and 5G environments. Not necessarily good news for US technology.

The FAANG will no longer be such a powerful support for the US stock market. The Apple, Google, Facebook, Amazon will have to deal with 1) a more restrictive regulation on private data, 2) the maturity of some of their activities, 3) the difficulty of entering into the Chinese and Indian market and 4) the attacks from countries on their tax model.

In the short term, a probable trade agreement between the United States and China would favor the Chinese and European stock markets. China, because its visibility would be better, allowing the PBoC to decrease its key rates and accelerate its reflation policy, and Europe, because its economy is more export-oriented.

Overweight the emerging zone. After a fourth bear market in 11 years, the Chinese stock market has a potential for a significant rebound thanks to the acceleration of reflation policy and advantageous stock market valuations. In the run-up to the legislative elections, the Indian central bank came to support the government by easing its monetary policy and by lowering its inflation target. Brazil is attractive thanks to a pro-business government; inflation at 3.75% at the end of 2018 allows the central bank to have a more accommodating speech.

Bolsonaro’s health problems and a failing industry (Vale’s accident) are not integrated by investors. The main point of the government will be the reform of the pension system. And more generally, our optimism about the emerging zone is also based on a positive outlook on emerging currencies.

  • January rally caught up losses from December’s massive capitulation
  • In this environment of low inflation, stock market valuations seem fair
  • In 2019, US equities should no longer outperform the rest of the world as easily as in the last years
  • Emerging and china stocks should outperform
  • In the short term, a pause would be justified

 

Overweight

  • Emerging, China
  • Value
  • Staples, Discretionary, Energy
  • Communication services

Neutral

  • US, Europe, Switzerland, Japan, UK
  • Growth
  • Financials, Health care, Industrials,
  • Technology, Utilities, Real Estate

Underweight

  • Materials

 

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