Investment strategy – May 2018
Macro OK, but with more heterogeneity
Global growth will remain solid over coming couple of quarters. Synchronization is still ok, but with declining homogeneity. In spite of early signs of deceleration, the pace of global expansion will stay superior to long-term trend rates.
Consumer sectors have not markedly decelerated, though the latest rise in oil prices, as well as the deterioration in geopolitics and in financial markets development may change the tack in T2. But for now, disposable income – hence consumption – remains well orientated, namely thanks to more resilient wages. Service sectors remain buoyant. The very gradual tightening of financial conditions, due to both central banks and to higher risk premiums required by markets, is playing some dampening role, gradually. The economic slack continues to be absorbed. A reduction of excess capacity – a legacy of the Great Financial crisis – is good news per se, except possibly for the US.
A sharp acceleration of the US Capex cycle seems less likely than expected, as US companies continue to be rather prone to financial engineering, than to modernizing their production tools. The most important inflexions are coming from Japan and Eurozone, which have both decelerated sharply. Manufacturing loss of steam and currency moves – i.e. higher EUR and JPY – seem to essentially ex-plain for this. Germany has given early signs of breathless-ness, probably also due to political uncertainties surrounding tax policy (corporate and household). China maintains a steady pace of expansion around 6%. We expect this regime to continue in H2.
Trade war, a – crucial – swing factor ?
Needless to say, countless trade invectives between US and China are already playing a softening role on sentiment… Asian trade growth would be particularly at risk of an ex-tension of trade controls. Most experts expect a ¨global trade war¨ – based on tariffs’ rise inferior to 20% – to result in a negative shock of about 1 to 3% to world growth, potentially smoothed over few years. Global trade volume would diminish by more than 5%. At first, this seems ¨manageable¨. But impact would be very different among regions…
Inflation. Gradualism spells no harbinger of a regime change
The flattening of the Philips curve is the conundrum most economist is still discussing of. Indeed, never before over former economic cycles did we observe such a disconnect between (un)employment and trend in global prices. This is not just a semantic quarrel among economists. This macro relation has actually been at the root of the tool box used by the Fed. Re-cent white papers by the Fed staff still argue that ¨inflation could suddenly respond non-linearly to falling unemployment, as spare capacity is further eroded¨. That may ultimately resemble to sort of a capitulation. The arrival of a new Chair, Powell, who doesn’t belong to the Gotha of Academic pundits may actually change the approach. Contrarily to expectations there seems to be little appetite either for raising the Central bank 2% target, or for expressing it as a range (say 1,5% to 2,5%). A price level regime, under which the Fed would compensate for past years’ deviations un-der 2%, is not in the agenda.
- The cyclical surge is slowing down, but not dra-matically
- It reduces the odds of undesired inflation slip-page
- A full-fledged trade war would definitely put in question this benign scenario and amplify the emerging divergences among regions and coun-tries
Geopolitics is taking over (again)
Watch-out for two important short-term deadlines:
- First, from May, the clear focus will be Asia with tentative talks between Trump and KJ-II, as well as with an inevitable confrontation with China on trade. A policy mistake might well occur, due to the high degree of unpreparedness of the US Cabinet.
- Second, next Fall with US mid-term elections. Stakes are very high for Trump. Were Democrats to gain majority in both chambers, one could indeed expect a destitution procedure to rapidly unfold… If Trump loses political ground with his electoral base during the summer, one could also fear dramatic initiative to foster ¨Holy Union¨.
These short-term deadlines should not distract from monitoring several fundamental long-term developments / is-sues:
I) Trump is attempting to impose major changes to the US society :
- Neo-Imperialism / Nationalism
- Regulatory crusade
II) The ineluctable rise of China is both an opportunity and a threat to ¨Western interests¨.
China mercantilist model is actually not ¨fair¨. A grand bar-gain might ultimately take place, where the US may tolerate some – further – technology transfers, in exchange for a genuine opening of the Chinese consumer markets and for a respect of intellectual property.
The odds of Trump fundamentally changing US society are pretty low. Still, the country will not remain unscathed from a very atypical – Trump – presidency.
Trump is under high short-term pressure to deliver. Oppo-sitely, China is more than ever the Lord of Time, therefore owns an advantage in the context of upcoming bilateral talks.
The liquidity driven phase is over…
There are many ways of tracking liquidity, from macro-driven aggregates to composite indices based on market indicators (spreads) and to capital in/out-flows into mutual funds. None is perfect. When it comes to macro, for sure the economic recovery, as well as the rise in commodity prices (namely oil) feature a reduction of the excess – investable – liquidity as economic agents have a larger use of it. A rise in bank loans – which we namely observe in the US and more lately in Europe – is actually a symptom of it. A spike in economic growth / inflation would be a paradoxical threat for financial markets.
When it comes to QE related liquidity, things are slowly and marginally changing. While the Fed cautiously and predictably removes some, other major central banks keep the suspense up. Globally, courtesy of a sensitive overleveraged landscape (with both private and public debt levels still very high), policy makers will advocate / opt for a measured pace of central banks’ balance sheets reduction.
The unwinding of short-equity volatility strategies seems well underway. Investors seem to have reverse course up to having built precautionary hedges through long VIX positions… Therefore, an aftershock from this source is unlikely. That’s good news. But still, a contagion to other asset classes is not impossible.
Liquidity remains ample, but less so. Central banks’ repression of volatility is over and repricing of risks / premium reconstitution is underway.
- Alternative investments
A more careful approach prevails
Q1 was more of a continual noise on the FX market than a clear melody. The worst-performing major currencies were the usual suspects during risk aversion episodes i.e. SEK, CAD and AUD. While the top-performers currencies came as a surprise. Indeed, the MXN, COP and ZAR even beat the JPY. The EUR/USD rose in Q1.
The latest published $ 57.6bn trade deficit is not going to ease the US-China trade tensions and is another reason to expect a pretty soft Q1 GDP growth. The deficit is running at 3.0% of GDP on an annual basis, which is in line with the 2010’s average level, and the current account deficit is stable at 2.4% of GDP. So, there is no reason to panic. The US trade data will remain a key market driver going forward. The US fiscal/monetary policy mix is designed to get the deficit up and by consequences not USD-friendly. That may be offset by the fact that underlying sentiment is USD-bearish since last September, by positive economic surprises, favorable relative bond yields and USD liquidity reduction (cf. Libor-OIS spread). At this stage, those factors are slowing the USD weakness rather than preventing it.
The divergence between EUR/USD and relative yields (nominal or real, short- or long-dated) goes on and on. The fact that markets have discounted an ECB purchasing bond program end so far in advance means that progress towards the EUR/USD 1.28 hurdle seems unlikely. The re-cent macro data weakening seems to be related to the EUR strengthening. This would push the ECB to backpedal if it wishes to reach its inflation target over its forecast horizon. The speculative positioning remains “long”. Official demand from central banks reserves (IMF data) for EUR re-mains low.
The official demand for the JPY, on the opposite, is heavy. Central banks like it from a long-term valuation standpoint. They purchased the JPY as it is significantly undervalued on all PPP, REER and NEER measures. Central banks have a 2 to 5-year investment horizon. While the JPY offers negative rates, there is a decent chance that a mean reversion pro-cess happened over their investment horizon, which would generate a solid return.
The GBP has been surprisingly resilient to UK soft indicators weakening. The UK composite PMI dropped 2 points in just one month to 52.5. Historically, the Bank of England never hiked rates when the composite PMI was below 55. While the money market curve is amongst the steepest in the developed world over the next 12-18 months, we stay sceptical towards further GBP strengthening. Moreover, speculators remain extremely overweight GBP.
Switzerland has long enjoyed persistent current account surpluses. The balance of payments recycling process broke down after the global financial crisis. This contributed to a CHF strengthening and a significant accumulation of foreign exchange reserves. We are seeing encouraging signs that financial account outflows are resuming. If the global growth outlook does not sour, financial outflows should contribute to keep the CHF at current levels.
Beijing has many retaliation tools at its disposal be-sides its currency or Treasury holdings, especially in terms of trade and direct investment. Devaluating the currency might infuriate the US, but it also gives Trump a valid excuse to brand China a currency ma-nipulator. This is not in line with Xi’s self-image of a rational and responsible statesman. Hence, devalua-tion will not be used unless all other alternatives have been exhausted. We also find it unlikely that China will try to “dump” US Treasuries on a large scale.
Commodity related currencies remain exposed to trade war escalation and global slowdown risks.
- USD, EUR, CHF, GBP
- JPY, AUD, CAD, EMFX
2018 started with a fixed income sell-off, which pushed the 10Y Bund yield up to 0.80% in February and by close to 50 bps since mid-December. However, over the past weeks, yields have edged lower and the German yield is now back to 0.50%. US 10Y Treasury yields have tested the 3.0% level.
As expected, the Fed raised rates by 25 bps. More interestingly, it kept its 3 rate hikes scenario for this year. This is important given that some of the most audible doves [Bullard, Evans and Kashkari] are no longer voting this year. This supports our view that risk is tilted towards 4 hikes. The 2019 dots were raised and the target range too to 2.75%-3.00% by year-end. This move up is mainly due to the more expansionary US fiscal policy. Powell confirmed that the Fed is not about to alter its plan to shrink its balance sheet and has not decided what the appropriate target is.
Over the past weeks, European growth momentum lost some ground. We still do not expect the first rate hike be-fore H2 2019, as inflation pressures remain subdued. That said, the ECB remains increasingly confident that inflation will eventually meet the inflation target. But it does not mean that the first rate hike has moved closer. The ECB is keen to communicate that a taper tantrum episode in the Eurobond market is unlikely. The ‘free float’ of government bonds is very limited, as largely owned by the ECB, other central banks and banks. This is very different from the US market in 2013. The impact of the ECB ending its QE pro-gram should be small due to sizeable reinvestment flows of coupons and matured bonds for the foreseeable future. The most consensual and crowded trade is “short duration”. Speculative positioning reached the same extreme short exposure as in Q1 2017 in the wake of the Trump election. The Libor-OIS spread rise is not a symptom of a banking stress. However, it is a source of trouble for leverage accounts, which are amongst the most aggressive bond sellers. Due to higher funding costs, keeping those positions becomes even more costly and unattractive.
High quality credit market remains rich and well demanded
The credit markets start Q2 on the same mood as they ended Q1 i.e. stuck in a range but under several fires. Issuance is not a problem anymore as markets have digested huge deals, although it remains a worry. However, the trade war between the US and China and technology sec-tor concerns are weighing more heavily on sentiment. Fundamentally, there are no major changes to credit quality, but the environment clearly remains fragile. It is now difficult to see a significant rally any time soon. The best we can hope for is that the markets calm down and see a period of stabilization, letting credit find a sure footing. Spreads could rally if the above-mentioned issues do ease. But will they?
High yield under pressure
High Yield spreads are holding extremely well in a context of elevated equity volatility, which usually is more a source of pressure. This has been the 1st time in 10 years that the VIX has averaged more than 20% over a 5-day period and that HY spreads were below the 500-bps hurdle. At least thus far, the remarkable resilience of HY spreads in the face of rising equity volatility can likely be attributed to the lack
of primary market activity. The US high-yield default rate increased to 2.21% and is now 0.31% higher than a year ago. Total Q1 defaults represented $28.3bn i.e. the 6th largest quarterly total since 2005. For context, we had $59.4bn defaulted in 2017 and $34.2bn in 2016. Historically, higher default rate ultimately leads to wider spreads. Lastly, global high yield bond funds are experiencing persistent and regular outflows for the past 6 months.
Emerging local bond markets (out)performance was exceptional and unlikely to persist.
Despite a less supportive global risk environment since early February, EM local currency bond markets have delivered a positive return, contrasting with hard currency sovereign and corporate ones which printed both negative performances, making an exceptional period of local outperformance. This resilience in the face of multiple shocks has been a surprise given the increasing number of tail-risks which included disappointing global growth momentum, a FOMC meeting, increasing trade tensions, and already elevated EM FX positioning. End-March, EM local markets had seen a 10% 3-month outperformance versus hard currency, which has not been seen since 2004. We feel this level of outperformance is unlikely to persist.
The yield spread tightening between EM local curren-cy and hard currency bonds needs to be highlighted. While EM local yields are still 2%+ higher than hard currency counterparts, they look overpriced. Each time, the spread was that tight since the global finan-cial crisis, a mean-reverting process happened. EM credit has not yet “bounced” from the recent lows, raising concerns that EM spreads are an early signal for other EM asset classes. However, the current spread trajectory is in line with previous EM credit corrections.
- Investment Grade,
- High Yield, Hybrid/Sub,
- Emerging hard currency
- US Treasury, Inflation
- German Bund
- Emerging local currency
Readjustment in stock valuations
The corrective phase in place since January 23, 2018 helps to clean up complacency among investors. The S&P 500 has had a negative first quarter performance since 2015.
In recent years, the rise in stock market indices was explained by the combination of three factors: a low inflation regime, which has justified high stock valuations, profit growth and abundant liquidity. In 2015/early 2016, one of these three factors were missing: corporate profits were falling, and stock market indices fell, with the MSCI World falling 19% between May 2015 and February 2016.
Today, one factor is losing steam: central banks will inject less cash. Another is at risk: profit growth. In the immediate future, investors should not be disappointed by the results of the first quarter, whose profit growth is expected in the United States at +18%, including +7% from the impact of the tax reform, and +7% for revenues. But it could be different in a few months if a trade war were to materialize. In addition, leading economic indicators in Europe and Japan are slowing down.
A trade war between the United States and China would also affect some European companies that produce in the United States to export to China like Daimler and BMW.
Supportive factors remain in place.
Nevertheless, the climate of confidence from companies is not yet deteriorating if we observe the level of mergers and acquisitions that reach record levels compared to the same period in previous years and the announced share buyback programs that should reach the $850 billion in 2018 compared to $560 billion in 2017 according to Gold-man Sachs. Exceptional increases in dividends are also expected. Tax reform in the United States has clearly brought a wave of optimism to business leaders. Easing banking regulation and spending on infrastructure are Donald Trump’s next priorities in 2018.
In the short term, technical elements could favor a stock market consolidation: the support of the S&P 500 on the 200-day moving average is strengthening, the “short” speculative positions on the S&P 500 reached high levels, the “long” speculative positions on VIX are also at historically high levels and investors’ sentiment indicators are in areas of extreme pessimism. Easing in fears on trade war and less stressful geopolitics could push speculators/investors to close their speculative positions.
- Switzerland, Japan
- Large Caps
- Discretionary, Energy, Financials, Health Care
- US, Europe
- Emerging, China
- Small/Mid Caps
- Staples, Industrials, IT, Materials
- Telecommunications, Utilities
Geopolitical tensions accelerate the rise in oil prices
Attacks on Saudi interests (civilian areas, tankers) by the Houthis, backed by Iran, and the threat of an American missiles attack in Syria have pushed up oil prices. If the Saudi tankers become a target of the Houthis, there are 5 million barrels/day that are at risk. Saudi Arabia is clearly committed to the conflict in the Middle East, pointing to the Iranian threat.
The Israeli army makes some incursions into Syria. In any case, strikes or not strikes in Syria, the United States will probably denounce the Iran nuclear deal in May, unless France, Great Britain and Germany agree to change it. Iranian oil exports account for nearly 2.5 mil-lion barrels/day. While there is a balance today between supply and demand, a major military conflict in the Middle East would obviously result in a (very) sharp rise in crude oil.
Brent returns above $70 level. Long speculative positions returned to historically high levels. If tensions ease, it is likely that the price of crude oil will stabilize.
But the fundamentals also explain the rise in oil. There is a balance between supply and demand despite a record production – 10 million barrels/day – for the United States, which returns to 1970-peak levels. Global demand is strong and OPEC, with Russia, controls production through an agreement that should go beyond 2018. Saudi Arabia would like an oil stabilization around $80 to strengthen the valuation of Aramco, before listing it on the stock market.
Gold, an “ideal” protection in this chaotic environment
Geopolitical risks and commercial and monetary wars in-crease interest in gold. With the exception of a short period at the end of 2016, gold holdings in financial products have steadily increased. Recently, Chinese investors have massively bought shares of the Bosera Gold ETF listed in Shenzhen, the largest gold-invested ETF, behind the iShares Gold Trust and the SPDR Gold Shares, as a protection in case of trade war.
Industrial metals favored by the sanctions against Russia
Over the past 16 months, industrial metal prices have been rising, thanks to rising global demand and reduced global production capacity between 2015-2016.
Sanctions against Russia affect Russian production capacity and obviously impact prices in an already tight market be-tween supply and demand. The price of aluminium immediately reacted to the rise; the other metals concerned are nickel and palladium. The Russian aluminium producer Rusal collapsed on the stock market, while the main winner was Alcoa.
Copper is consolidating, whereas producers were worried 2 years ago on a possible return of excess supply. The sector has remained very disciplined on investments and projects launched in recent years have not reached a sufficient level of profitability. Despite rhetoric, producers note that the real economy is strong in both developed and developing countries, and the industrial metals remain in a bullish cycle. The expansion of the electric car and the renewable energy grid will result in increased demand.
- Precious metals
- Industrial metals
- Real Estate
- Hedge Funds
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