Investment strategy – November 2018
STRATEGY AND MACRO
Trigger, what trigger?
Trump accused the Fed for having triggered Wall Street correction. This is destabilizing for professional investors. He did it a couple of times already, to preemptively appoint a culprit, ahead of an inevitable economic slowdown or of a possible market correction. This is just a new episode of his very typical communication with his political base. No more, no less.
Amazon just boosted minimum hourly wages for all US workers to USD 15. This is an important symbol, as coming from a leading disrupting firm, being often blamed by economists and politicians for the pauperization of low skilled workers. Is it a U-turn for wages? Anecdotally, Wall-Mart increased its starting wage rate as of early January 2018, just a few days before equity correction of Q118…
(Geo)politics: Not so simple
As mentioned by National Security Advisor Bolton, US is officially attempting to provoke a behavioral change in Iran. But it actually looks for a regime change in Teheran. Recent developments represent serious geopolitical challenges.
Embargo on Iranian oil will be enforced next month, set-ting the stage for a full collapse of Iranian oil exports. While Europe still supports the so-called nuclear deal and gesticulates (with its initiative of an alternative commercial / barter circuit), it is ultimately expected to comply with the US embargo. However, it seems unlikely that India and China will do the same. Both will be keen on finding appropriate means to buy Teheran oil.
Down the road, US neo-imperialism will forge a rejection front. Among risk scenarios, this may ultimately result in an active quotation of oil in Asia, practically in China and in Yuan. Needless to say, that it would infuriate Washington, because of the collateral damage on the status of the USD, as the reserve and commercial currency of reference.
Turkey is an additional and serious source of regional concern. A shift from the Occidental block and a con-sequential exit from NATO would be highly explosive.
US mid-term elections are rapidly approaching. On November 6th, Americans will head to the poll to elect for all 435 House seats and for 35 of the 100 Senate ones. Voters’ turnout, on both sides, seems key. A change in House majority is pretty likely and probably discounted, while a climb in the House is unlikely. Any other outcome would surprise markets… Stakes are very high for Trump, namely since a Democratic victory would pave the way to investigations.
During the two latest serious crises (2008/9 and 2012) 10y Italian bonds yielded between 5% and 7% and the country CDS moved from 100 to 500 bps. Now long bond yield is approaching 4%, while CDS climbed to 250 bps. In short, one could say that markets are not discounting (yet) a disruptive European crisis with an epicenter in Roma. Italy is definitely not Greece. It is healthier and more resilient, but at the same time much more material, dangerous, and hard to tame politically…
Very strong ego and characters of Trump, Putin, Xi, and Erdogan are not a source of comfort
US and Iran seem irremediably moving ahead to a confrontation
Mid-term elections represent a referendum on Trump and the Republican majority
Italy and Europe are not in crisis mode, but still half-way through
Global growth will decelerate in 2019
The magnitude of world growth deceleration will be reasonable i.e. from about 4%+ this year to around 3,25-3,5% in 2019.
The current US boost, essentially due to one-off mega-fiscal stimulation, is going to fade and, coincidentally, monetary policy will gradually shift to restrictive from neutral. US yield curve has stopped flattening lately, probably because of a series of technical and political factors. Nevertheless, its recent trend advocates for a continuation of US expansion in 2019, to be confirmed. But beware, as distortions of bond yields in the context of QEs in advanced economies have reduced the explanatory power of yield curve…
China is already decelerating markedly and Japan nowcasts have proved disappointing lately. Europe is facing important challenges with Brexit and Italy, which will impact on entrepreneurs’ spirit. The rising cost of capital (larger spreads) will not help the refinancing of European SMEs. The long overdue pick-up in capex cycle will not take place in this context.
First question is, to what extent!? And, more importantly, is it a precursor of a more serious slowdown (if not a recession) by 2019 year-end?
Towards, finally, the end of low wage inflation?
Last January, the sudden rise of wages took investors by surprise and probably contributed to the correction of equities. For sure, wage inflation was lethargic, i.e. much lower than price inflation, for years now in advanced economies, in contradiction with economic textbooks. The recent trend is clearly up. US wage inflation, which is nearing 3%, now stand only about 50 basis points of former cycle tops…
Overheating of labor market indicators in Japan did not manage to boost wages, still rising at a moderate pace of 1,5%. Interestingly, wage inflation has also started to rise in Europe, in spite of resilient unemployment.
Wage inflation was one of the missing links in the current cycle
Since 2017, wage inflation has responded more normally to tightening labor markets. If recent resurgence is confirmed, this could impact monetary policy, interest rates and markets
Global landscape is complex and polarized with good developments on the macro and earnings’ side, as well as the resolution of US, Mexico and Canada trade deal.
Volatility spike has caught off-guard many investors which have lately been forced to dismantle leverage/carry strategies and move temporarily to the sidelines.
China is also preparing for a second devaluation, if not to a broader set of retaliating measures against the US. The emergence of protectionist tariffs will ultimately represent a burden to be shared between corporate margins (probably a minor share) and end consumers (probably the lion share).
Ingredients have piled-up for a consolidation / correction. Lately, volatility and correlation have actually started to pick-up. We consider it healthy, in order to evaporate complacency and exuberance.
Short-term visibility is low, as several tentative developments will actually occur in coming weeks
We raise our bond exposure to neutral
- Alternative investments
The USD is still the global reserve currency of choice…
A reserve currency is a stable and liquid currency, widely used in international trade, trusted and held in large quantities by central banks as part of their reserves.
Factors such as the size of the domestic economy, the depth and openness of its financial markets, its convertibility and use as a peg, help determine the demand. In the early 20th century, the USD took over from the GBP as the dominant global currency and reserve currency of choice. So, this status is not a lifetime warranty.
… but it loses ground…
The latest IMF data suggest that USD-denominated re-serves continue to decline. The Q2 2018 data show that 62.3% of the allocated FX reserves are in USD, down from over 65% a couple of years ago. However, the USD continues to dominate the other currencies. The liquidity of the USD makes it unrivalled, with persistent trade deficits al-lowing investors to accumulate an abundance of USD.
Quarterly FDI data confirmed this dynamic. There are signs that foreign investments in the US are substantially slowing, if not starting to reverse. At the same time, Fed data confirmed that holdings of US Treasuries by foreigners continue to decline to 38% from its historical peak reached in 2011-2013 at 45%.
… in favor of the yuan
The size and speed of the Chinese economy growth suggests that the CNY will become a currency of choice. It is by far the most populated country and is likely to become the largest world economy. This should enable an increase in demand for renminbi. In fact, demand for the CNY as a reserve currency has already been rising in recent quarters. The biggest move in FX reserves in Q2 2018 was once again at the benefit of the CNY, with the total reserves held rising by $48bn to $193bn. This was a sizeable 33% quarterly increase, following robust 18% and 14% in-creases over the previous ones. If we adjust the move by the CNY 5% weakness, the increase reaches 40%. However, the CNY reserves still represent only a very small portion of total reserves. Indeed, CNY reserves still lag a long way behind the USD, EUR, JPY and GBP reserves, and even the CAD. However, it rose to 1.84%, overtaking the AUD to become the sixth most held reserve currency. In contrast to August, which was a volatile month, the USD/CNY traded within a narrow range of 6.80–6.88 in September. In the near future, the pair should remain stable.
Otherwise, trends are less clear
The ECB extraordinary policy settings will end in December. Trade tension has abated. The euro area cur-rent account surplus will exceed 3% of GDP this year and its budget deficit will be below -1.0%. These are not the conditions for a persistent EUR weakness. Internal pressures should wait on the EUR over the coming months.
The UK government’s proposals for resolving Brexit’s Northern Ireland border impasse and future EU trading relations have hit resistance domestically and from the EU. Without a breakthrough, GBP is vulnerable in the near term, but recent price action indicates that investors may be less pessimistic about a “no deal”.
At the beginning of the year, the EURCHF was positively correlated to risky assets and the short CHF was consensual. Therefore, the short positions reached multi-years high. Once political risks resurfaced in Europe, the CHF strengthened but the short positioning have stayed wide. In the meantime, German CPI in-creased to 2.3% while it remains at 1.0% in Switzer-land, making Swiss real yields more than 1.0% higher than German ones.
Overall, this nuanced environment leaves us focused on idiosyncratic stories. The October calendar is likely to be dominated by two events: 1) The coming US mid-term elections (in early November), and 2) Prime Minister May must, to keep Brexit negotiations moving, give Brussels a proposal before the EU Summit on mid-October. Both could be significant trend changer. On net, this leaves us in a cautious mood.
- EUR, CHF, JPY
- AUD, CAD, EMFX
The end of the Zero Interest Rate Era is coming
Recently, Fed tightening process and oil prices spikes have been the main drivers of higher US long-end yields. The Fed has confirmed that its normalization process is on autopilot until rates reaches a neutral stance around 3.25%-3.50%.
But the Fed is not the only one shifting its policy stance. In the developed world, other central banks sound ready to move away from easy policies. The BoE has already raised its rates twice over the past 12 months, the BoJ recently decided to allow long-term rates to move more flexibly around its target and the ECB pointed for a more robust inflation going forward and will discuss interest rates normalization in the coming months.
This has driven yields higher around the world. So, the amount of negative-yielding debt worldwide has shrunk and has been devided by 2 since mid-2016 peak. Sovereign yields are back to more realistic levels.
From a risk-reward perspective, investors should be more inclined to opt for risk-free assets with less underlying volatility rather than riskier credit. Furthermore, the US debt market may also benefit from domestic pension fund de-risking.
US bond market back in the domestic hands
Even if yields are on the rise and the speculative positioning has reached a new record short level, US fixed income assets remain demanded by domestic investors. US pension funds bought $40bn more of US Treasuries than corporates in each Q1 and Q2, showing the biggest preference for the government debt over credit since 2001. US domestic real money man-agers, banks and households are taking profit from the positive real yields to boost their US Treasuries holdings.
While foreign investors are net sellers due to high hedging costs. Given the sharp yield repricing and the elusive of credit spread widening, US Treasuries look more attractive than credit at this stage of the cycle.
September job report showed the lowest unemployment rate in 48 years. Average hourly earnings grew 2.8%, in line with forecasts. So, looking at wage growth with some historical context makes sense. Labor costs’ growth is significantly below where it was in the previous tightening cycle. We believe that inflationary pressures must be taken with an ample cushion. Nevertheless, markets may be sensitive to signs of growing inflation. Wage pressures remain at manage-able levels. Furthermore, as they are moving in line with inflation, so real wage growth is moderate.
Still the most plausible reason for the recent bond sell-off is the growing hedging costs for foreign investors who hedge the currency risk such as Japanese insurers. But whatever the catalysts are, the bond sell-off has an enormous significance as it breaks the key declining trend line in place since 1981. From a more near-term perspective the renewed steepening of the US yield curve also raises the potential for a greater number of Fed rate hikes than currently priced in.
The above-mentioned breakout could prove to be a false breakout and that the disinflationary trend will sooner or later reassert itself as the US cyclical momentum succumbs to prevailing high debt levels and higher interest rates. Still the near-term risk of having the US long-end yields remaining in the higher part of our in-house range [2.5%;3.5%] is on the rise. Longer-term wise, the disinflationary trend would support demand for US Treasuries.
Credit market is okay for now, but war-rants further monitoring
The US corporate sector was quick to shore up its financial health in the wake of the Great Recession. A decade later, however, the financial health of the non-financial sector has weakened. Companies have taken on record amounts of debt. While asset values make the debt load look benign, the financial health has started to erode.
To be sure, we are not saying that the financial health is now “bad”. But some metrics have declined to reach levels that are not truly worrisome, at least not yet. First, the 46% net debt to US GDP, has already exceeded the three previous recessions’ levels. According to different studies, 14% the S&P1500 firms have not enough earnings.
With short-term interest rising, this could represent a source of stress. However, at the same time, the leverage (net debt/Ebitda) on US large caps over the past 3 years has been stable. Some warning signals are popping up like a deteriorating market structure, with for the first time the BBB-rated bonds representing more than 40% of the market, and the loan protections deteriorating. Stay tune.
Emerging credit risk has lastingly been mispriced due to unprecedented monetary stimulus, record low yields and desperate search for yield. However, with US rates and USD rise claiming its first casualties, EM credit spreads have rapidly normalized in line with fundamentals. They are closely tied to economic activity indicators. EM bond segments (Sovereign, Corporate and Local currency) have all experienced persistent outflows since the be-ginning of Q2. On the bright side, after the lessons learned during the taper tantrum, EM economies have successfully reduced their fiscal and current account deficits. On aggregate, EM economies moved from a –2% overall current account deficit in 2013 to almost 0% in 2018.
But not all countries appear resilient in an environment of tightening financial conditions. On the corporate side, earnings results continued to show improving fundamentals, although at a slightly lower pace. Leverage and interest coverage ratios have also improved. However, not all is rosy in EM corporate fundamentals: higher borrowing costs and potentially slower earnings growth are likely to gradually build pressure on interest coverage ratios.
- Investment Grade
- US Treasury
- High Yield, Hybrid/Sub,
- Emerging hard currency
- German Bund, Inflation
- Peripheral, Emerging local currency
A change of regime
The US 10-year came out of a downtrend channel, which lasted 30 years from 10% to 1.3% (2008 financial crisis), to reach 3.25%. The Fed started to normalize its monetary policy in December 2016, with the Fed Funds rate going to 2.25% from 0.25% in September 2018. But US long-term rates, which influence stock market valuations, remained low due to a deflationary/disinflationary environment despite of a sustained economic growth in the United States and China. This interest rates normalization lead to a PE ratios contraction in 2018 until the end of September and then to a correction in share prices over the last 2 weeks.
The regime seems to be changing: inflation is resurging slowly and long interest rates are rising. A logical normalization. The level of interest rates obviously has an impact on stock market valuations: when they rise, stock market valuations (PE ratios) contract, and vice versa, since they are used to calculate the present value of a company future cash flows.
The upward pressure (still low in real terms) on wages in the United States, the sharp rise in oil prices and the trade war/protectionism (rising tariffs) are inflationary factors. We are entering into a new range of 3.0%-3.5% on the US 10-year. The stock markets are adjusting to this new environment of higher interest rates.
This current correction is a first warning
We have not reached yet breaking points on stocks. But there are risks that make us cautious:
- A risk would be that the US 10-year will install in a band 3.50%-4.0%, which is not our scenario.
- Another risk is a Brent oil price at $100, resulting in higher inflation expectations and interest rates, as well as a reduction in global economic growth expectations. An unfavorable environment for equities. But this scenario is in our opinion unlikely: not sure that Saudi Arabia let oil prices slip vis-à-vis its main Asian customers, namely China and India.
- We are monitoring the unwinding of short positions on volatility (VIX). The extent of the correction in January was partly due to this process and in recent weeks it was reported that the short positions were reconstituted on the VIX.
- In recent weeks, small and mid-caps (S&M caps) have corrected more than blue chips. See right graph below. Since August 31st, the Russell 2000 has lost 10% versus 4% for the S&P 500 and the MSCI Europe S&M Caps has lost 9% versus 4% for the MSCI Europe. A signal of a more severe correction coming or an adjustment after a strong outperformance? In the corrective phase, S&M caps fall more sharply due to lower market liquidity, which increases volatility. But the S&M caps are also more sensitive to the economic cycles and could herald an economic slow-down. We will continue to monitor the S&M caps closely to see if share price declines are buying opportunities or harbingers of more difficult times. Anyway, in a more defensive approach, we overweight the blue chips and underweight the S&M caps.
Some strategists are starting to point the risk on mar-gins due to: 1) rising oil prices, 2) tariffs, 3) pressure on wages and 4) higher (re)financing costs. However, it should be noted that the prices of the main industrial metals (copper, aluminum, iron ore, steel) are down in 2018. The companies’ comments/guidance on Q3 18 results will be analyzed closely. Strategists fear a total trade war in 2019 with China. In this case, there will likely be downward revisions in earnings per share. It should be noted that the pressure of Donald Trump works: Mexico, Canada, South Korea and partially Europe aligned with the US demands.
Substantial performance gap be-tween the United States and the rest of the world
Since the beginning of the bull market in March 2009, the US stock market has significantly outperformed the rest of the world. See above chart. In the World ex-US index, Europe accounts for 45%, Asia/Pacific 30%, Emerging 21% and Canada/Mexico 6%. Investors have chosen their camp in the trade war between the United States and China. And, the winner is … the United States.
In 2018, the S&P 500 outperformed the CSI 300. The US stock market is one of the most expensive in the world, while the Chinese stock market is the cheapest. If a trade agreement were to be settled, the Chinese stock market would have a significant catch-up potential.
European stock markets are also cheap. Earnings growth estimates for European companies are +6% in 2019.
Higher rates favor the Value segment
There has been a sector rotation for the last three months: investors are back on defensive companies offering high dividend yields, Pharma and Staples particularly, and they have taken their profits on high multiples stocks in Technology and Consumer Discretionary.
Utilities and Telecoms have defensive characteristics and behave rather well in the short term in a context of readjustment, but these two sectors outperform especially in times of economic recessions.
- Europe, Switzerland,
- Discretionary, Staples, Health Care
- US, Japan, UK
- Chine, Emergings
- Large & Small/Mid Caps
- Industrials, IT, Financials
- Telecommunications, Utilities
- Energy, Materials
Oil, an eminently (geo)political subject
The evolution of oil prices is (geo)-politically driven, be-cause Saudi Arabia can compensate at any time and quickly compensate for the deficit of worldwide markets. According to Saudi oil minister, Saudi output can be in-creased by 1.3 million barrels/day without additional investments. Russia could do it, but it is seeking compensation with its international sanctions.
Oil prices are rising because of: 1) the upcoming US sanctions, which begin on Nov. 4, on Iranian oil ex-ports which are wide, ranging from 500,000 barrels/day to 1,000,000 barrels/day less on worldwide market, 2) supply-side pressures due to increased demand and the agreement between OPEC and Russia, and 3) the Venezuelan crisis which removed 1.5 million barrels/day from worldwide markets.
Investors/traders/speculators are betting on a Brent price at $100; Brent has already increased by 27% in 2018 and WTI by 24%.
Russia and Saudi Arabia recognize that oil prices are high. It is not sure that the main customers of Saudi Arabia, China and India, still accept this situation for a long time. We have trouble believing in a sustainable brent price at $100 for. On the other hand, a sustainable price between $75 and $80 in 2019 seems reason-able. The delay in Saudi Aramco’s IPO in 2021 – still valued at $2 trillion – , and Aramco’s acquisition of Sabic for $70 billion are factors that will encourage Saudi Arabia to control prices more firmly than ever to guarantee its economic and societal transition.
Industrial metals, an eminently Chinese subject
China accounts for 50% of global industrial metals demand. The economic figures show a growth deceleration, which has a logical effect on the industrial metals’ prices. In 2018, the price of zinc lost 19%, cobalt -17%, copper -13.2%, aluminum -9%, iron ore -4% and steel -1%. The price of nickel rose by 2%. The Mining & Metals sector, represented by a Mining Producers ETF, followed closely the Chinese manufacturing index evolution.
As long as Chinese economic growth continues to slow, industrial metal prices will not rise. Copper has also been under pressure with the recent crisis in emerging countries. Emerging economies are dominating the list of the world’s leading copper producers, Chile, Peru, China, Congo, Zambia, Mexico and Indonesia. We can become a little more optimistic because recent Chinese copper and iron ore imports have increased. In response to the trade war, the Chinese authorities have taken measures to support the economy by easing banks’ capital ratios. But we would like to see a real improvement, or at least a stabilization, of the manufacturing indicators before coming back positive on industrial metals.
Gold hurt by rising real interest rates and falling emerging currencies
The inverse relationship between the price of gold and real interest rates is still valid, as gold does not pay a return. See graph.
The strength of the US dollar and the normalization of the Fed’s monetary policy are negative for gold. Investors prefer the Swiss franc and the yen as safe-haven assets.
The demand for gold has returned to 2009 level. Demand from investments (ETFs, coins, bars) has fallen considerably. The crash of emerging currencies has increased local gold prices, particularly in India and Turkey, countries that are important retail buyers.
Net purchases by central banks increased by 8% in S1 2018 compared to S1 2017, mainly supported by Russia, Turkey and Kazakhstan.
But we maintain gold in neutral, a safe-haven asset in a balanced portfolio in a very chaotic environment.
- Industrial metals
- Precious metals
- Real Estate
- Hedge Funds
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