Monthly investment review
STRATEGY AND MACRO
- A tidal wave of global liquidity
- A trade truce, finally
- End of deflation scare
- Low odds of a global recession in H1 2020
- QE4 maybe. But not for sure…
The world has become growingly complex in the past couple of years. Therefore, mega-trends deserve particular scrutiny. They will, one day, takeover from the cyclical, benign developments. The most pessimistic forecasters announce the close arrival of a ¨Minsky moment¨, which would mark the dramatic end of the growth phase of the economic and credit cycles! For sure, the exuberant rise of global debt – rising at much quicker pace than nominal GDP – is worrisome. But, to put it bluntly, one must be humble: who can figure out when such a brutal outcome will occur. What would be the trigger?
In the practical daily world, things are, sometimes, much more straightforward, namely when it comes to financial markets. The old saying, ¨don’t fight the fed¨, has proved – once again – a smart and profitable tool of asset allocation over last months.
¨Markets can remain irrational much longer than I can remain solvent¨. Quote of John M. Keynes, 1930
While we do not adhere to the gloomy Minsky theory in our base scenario, we still consider that global investing requires a margin of caution. The factors behind the creation of the latest – unprecedented – wave of liquidity are concerning and will remain so. Practically, there are also decent reasons to believe that future liquidity injections may wane, notably if the US repo market confirms its stabilization.
Visibility is low and we may well be on the verge of the end of multi-years’ cycles
But for now, the tidal wave of central banks’ liquidity has taken over
On the way to QE4?
Markets expect recent Fed’s liquidity injections (through purchase of T-Bills) to morph into QE4, i.e. purchases of mid to longer term Treasury bonds in Q120. This may explain the relative calm of 10y government bonds yields, staying below the symbolic 2% mark. Indeed, a genuine upcoming recovery, coupled with the significant funding needs of US administration, should rather translate into the normalization of (higher) rates.
But the Fed has definitely not acknowledged for QE4 (yet). Powell has rather been adamant in advocating non-QE liquidity injections. If he’s right, part of the liquidity provision would reverse. Possibly after the end of Q120, when seasonal demand is important (banks window dressing).
The jury is still out on whether we are – or not – on our way to QE4
Unexpected tighter liquidity would provoke serious turbulences on markets
Let’s cross macro fingers
Governor Carney has repeatedly called for preemptive actions to address climate risks. There is a – new – con-sensus among prominent central bankers that growing climate risks fuel financial stability and must be addressed urgently. The dramatic fires of Australia are probably also playing a role in this change of mindset. Lagarde has also defined climate change policy, as a critical mission for her. She’s considering encompassing climate change in its new models featuring medium-term growth, inflation, productivity… and equilibrium policy rates. Investors are keen on such a kind of revolutionary change of approach.
Market indicators of economic contraction, like the shape of the yield curve (featuring Treasury spreads), have recently improved from ≈40% to <20% odds. Economists think that U.S. expansion, now in its 11th year, will continue through the 2020 presidential election with a healthy labor market backing it up.
Interestingly, the very latest measures of the PBoC confirm a shift to a more accommodative mood too. After several reductions of banks’ reserve ratio, it has finally resumed direct injections (from November 2019).
In short, the Fed played a leading role in flooding – extravagantly (?) – US economy. Central bank of china has just acted and massively injected liquidity. Under a new leader-ship, European Central Bank may also become more accommodative, even if possibly using much different means of action.
- All in all, hyperactive central banks managed to dissipate recession / deflation fears
- This macro-relief will continue short-term, fueling investors’ feel good sentiment
The link between central bank balance sheets and currencies is not a settled science. Over the past decade, their expansion and contraction have coincided with significant changes in currency levels. During periods of Fed balance sheet expansion, the USD generally weakened. While during periods of balance sheet slower growth or shrinkage, the USD strengthened.
Over the past 4 months, the balance sheet has grown by about $413bn. For the time being, investors are considering that the Fed interventions are transitory and that it will not twist its purchase form T-Bills into short-term Treasuries. Given the latest Fed comments, it remains unclear what these future purchases will be.
The EUR/USD looks tilted to the upside as US economic data, in relative terms, have disappointed and underperformed the European ones. The current speculative positioning remains long the USD. It has been slightly trimmed since Q4 following the Fed intervention on the Repo market. It has still room to adjust.
Amongst the disconnections, the most significant one is related to safe even currencies. Usually, the CHF and the JPY are very well correlated. However, since mid-November, the link is broken. The JPY has been stable in a risk-on environment. The CHF has surprisingly strengthened while the Brexit risk has eased. Any un-expected risk-off resurgence should support the JPY.
Monetary policies on pause
The Fed and the ECB have confirmed that they are taking a policy pause in 2020. The dovish central banks pivot that drove markets in 2019 is largely be-hind us. The Fed has already injected $413bn over the past 4 months, at a faster pace than what it did during its QE3 between 2012-2014. The current creation of new reserves is not about stimulating the economy as the Fed focuses on T-bills instead of bonds.
Both banks have indicated guarded optimism about the growth outlook, partly due to their accommodative policies stance. The Fed and the ECB still have an accommodative bias. The hurdle to cut again is high for the Fed while the ECB is concerned about the troublesome side effects of negative rates. Both central banks have also marginally raised their inflation forecasts. But the ECB remains further away from its price stability objective and – according to market pricing and consensus expectations – would still be short of its target even in the fourth quarter of 2022. Sluggish inflation makes another dose of easing more likely in the euro area than in the US where inflation is close to the Fed target. Yet markets have priced out any further easing by the ECB, while still maintaining a 50% probability of another Fed cut over the next year.
The notion that inflation is gone is a strong assumption
In its December minutes, the Fed signaled a willingness to keep rates steady until there is an inflation pick-up, even if it has remained below its 2% target de-spite several cuts in 2019. The Fed embraces the idea of letting CPI run above target to avoid the Euro/Japan sluggishness. It is also close to wrapping up its monetary policy toolkit review. It is considering introducing a make-up strategy, allowing a temporarily rise of the inflation target after periods of undershooting. While inflation is still below the target, expectations are lower than its favorite inflation gauge, the core PCE. It has dropped to 1.6% last month, after being closer to 1.8% the year before.
Break-even rates look low and have upside potential as fiscal measures become the preferred tool to shore up growth. Given the recent escalation in US-Iran tensions, a slightly positive trend on oil can push up prices. Last year, investors largely shunned TIPS. According to State Street, flows into ETFs that buy inflation-linked assets accounted for only 1% of a total $260bn fixed-income products in-flows. That could change not only because the Fed is encouraging prices to move higher but also because the growth outlook will stay positive.
Credit market cracks
Signs of fragility in the booming corporate debt market are materializing. Investors watch the leveraged-loan market because it is a barometer of credit conditions.
Tightening credit conditions could cause a slowdown in corporate or even consumer lending. The market for lever-aged loans has grown significantly in recent years, supported by the creation of CLOs and investors’ hunting for yield in a world where central banks’ easy-money policies have pushed capital into riskier assets. According to S&P, the ratio of downgrades to upgrades on US leveraged loans over the past 12 months rose to its highest reading since 2009. 282 issuers were downgraded in 2019, up from 244 in 2018 and 33 in 2017. Leveraged loans are junk-rated corporate loans.
This is corroborated by the auto loan (4.8%) and credit card (8.2%) delinquencies, which are rising since 2014. A recent report by the Financial Stability Board warned of risks to the global financial system posed by leveraged loans, citing the lower quality of corporate debt and changes in loan documentation. Finally, valuations across the credit spectrum seem expensive.
EM debts exhibit an attractive risk reward
Emerging debt continues to offer a stronger risk-adjusted return profile than most of its peers. This trend should persist even as sentiment improves. EM local and hard currency bonds exhibit the highest ratio post-GFC. Given the lack of demand last year, they should attract more inflows this year.
After an exceptional stock market year, in an adverse environment, supported in the second half of the year by Fed liquidity injections, we remain positive on equities. This 10-year-old bull market is the most unloved of all bull markets.
The reflationary bet
Since the fall of 2019, investors have been playing reflation, hoping for an overall growth acceleration in 2020 and higher profits. Soft manufacturing indicators have stopped deteriorating, or even improving, in China and the United States. Inflation seems to be picking up. Global liquidity indicators are signaling that the global business cycle is expected to recover.
In 2018 and 2019, the US equity market took ad-vantage of large share buyback programs (Apple accounting for 27%) and dividend payments, returning more than $ 1,000 billion to shareholders. 2020 will be less supportive for share buybacks.
Profit growth in 2020
Profits are expected to recover in 2020. The bottom-up approach by Factset, Lipper Alpha Refinitiv and Bloomberg Intelligence expects a 10% increase in profits, in both developed and developing countries. In 2019, US profits had zero-growth and fell by 2% in Europe, which is not that bad considering the world trade decline in the US/China trade war context, and American threats to its trading partners, European in particular.
The profits increase will come from world trade improvement, but also from base effects in the Energy, Materials, Industry and Technology sectors. Energy and Materials are expected to benefit from higher commodity prices. The average price of Brent was $64 per barrel in 2019 compared to $72 in 2018; we estimate a range between $70 and $80 due to higher demand, lower world inventories and a slower pace of US production. Technology, which accounts for 25% of the S&P 500 and 17% of the MSCI World, has raised its outlook for Q4 19 and 2020.
April 2020 (publication of Q1 20 results) will be important to validate or refute the optimistic (but not unrealistic) 2020 view, with an expected 6% increase in US profits. The largest contributors will be Energy and Communication Services. Europe is expected to see a 8% profits increase. In the near future, we will focus on the Q4 19 results, which should be a “non-event”, with investors focusing on 2020.
Expansion of multiples, but the situation is different from 2018: the Fed is back
The 2019 indices rise was obviously due to the expansion of multiples, since growth in earnings per share was zero or negative depending on the region. Virtually all indices are around 15% above their past 10 years average in terms of PE ratios. If we take other ratios, such as Enterprise Value, Book value, stock market valuations are rich. But the situation is different from 2018: PE ratios were increasing, while the Fed was more and more restrictive. Today, the revaluation does not look abnormal to us, while the Fed is clearly accommodative, inflation remains low and the macro outlook is improving.
Stock valuations and indices can still go up, if investor expectations are right, that is, a re-acceleration of profits in 2020.
A relative risk is that inflation and interest rates will rise if global economic acceleration takes place in 2020, which could affect multiples. In the very long term, the inflation regime is important, since it determines the regime of the level of valuations. In times of low inflation, PE ratios are high and vice versa. But in the short term and tactically, an inflation rebound is rather positive for equities: it improves the profits outlook, even if margins could be under pressure for specific sectors.
In these reflationary phases, investors tend to favor the Value/Cyclical segment with low PE ratios: Energy, Materials, Industry, Banks, Semiconductors.
We are therefore going to monitor closely global manufacturing data and inflation over the coming weeks.
The environment looks better for commodities
A better expectation for overall growth and emerging markets will be positive for commodities. We need an industrial recovery confirmation in China and rising car sales, a sector that is heavily using industrial metals. Even a partial trade agreement between the United States and China would normalize supply chains. Entering the fight for the presidential election, Donald Trump is expected to reduce pressure on his trading partners, China in particular, to promote a global economic recovery and secure his re-election in November.
Commodity prices suffered from the dollar strengthening and a deflationary / disinflationary environment. We believe the dollar will weaken and inflation is showing signs of recovery.
Copper will be the main beneficiary. In 2019, demand was weaker and Chinese producers cut production by 6%. Over the longer term, demand will grow with the development of electric vehicles, which use 4 times more copper than classical cars, and new technologies for the production of green electricity.
Brent prices are expected to be in the $70-$80 range in 2020. Demand is expected to improve and trade tensions between the United States and China will ease. On the supply side, the OPEC+ agreement seems solid and the United States, which is the world’s 1st producer, should not produce at the same pace as in the past 2 years. In 2018, oil prices were unresponsive to geopolitical tensions between the United States and Iran, with the market focusing on economic growth and the US-China trade war. If the reflationary bet were to be right , crude oil prices would strengthen.
Gold has been one of our convictions for over a year. The (very gradual) de-dollarization of trade in Asia and the large purchases by the EM central banks, which are structural factors, and the fall in real US interest rates, are favorable for a further rise in the price of gold.
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