Monthly investment review – August
Strategy and Macro
- Unstable equilibrium for long-term interest rates
- Risky assets have become expensive
- Currency volatility may resume
- Impotent monetary policy
- Fiscal panic?
Granted, the worst did not happen in Osaka and trade talks have not ended yet. Central banks have shifted for some accommodation. Currency volatility and global rates are stubbornly low. Liquidity flows are coming back, and desperate search for yield mentality resumed.
Too good to be true probably… Long lasting unorthodox monetary policies have not only impacted macro drivers, but also distorted fixed income markets. The size of debt market with negative yield, which exploded since last summer, is a symptom of it. This is also a harbinger of embedded fragility. Developed economies, plagued with huge debt load, are no longer able to contemplate normalization. As soon as real yields re-enter positive territory, markets cry and tank…
Negative yields support hedging assets
Valuation of risky assets benefitted from lower long-term interest rates. Granted this is a ¨mechanical¨ phenomenon. But still, at current very low levels, long-term yields actually discount a recession… We consider having reached a turning point. From now on, either our base case scenario unfolds, triggering a rebound of yields. Or a recession develops, favoring the widening of credit spreads and the downfall of corporate earnings. In the first case, a consolidation, if not a short-term correction should take place. In the second case, long duration government bonds would thrive, but risky assets as a whole would dramatically suffer.
Monetary policy has become impotent
Whatever policymakers hope, there is a limit to zero or negative interest rates policies (ZIRP/NIRP) beyond which it produces more harm than good. It disincentives productive investment, it reduces savers’ revenues (retirees and pension funds) and it transforms ailing banks into zombies. Even the best in class economy, i.e. the US, did not manage to restore a decent pace of nominal growth in the aftermath of the Great Financial Crisis.
In practice, oversized and infected banking systems, like that in Japan and Europe, have been hoarding cash and buying government bonds rather than lending. In practice, the transmission process of the monetary policy to the private sector is impaired.
A virtuous cyclical convergence is underway, but…
The good news is the latest macro re-synchronization, namely between US, China and Europe. But the bad news is that we are getting closer to stall speed. Worse, there are still numerous headwinds haunting major economies: a trade war, tentative currency devaluations and still an explosive Middle East framework…
The orientation of leading indicators remains concerning
The silver lining may come from a ¨fiscal panic¨. The political pre-conditions for major initiatives, be it a Green New Deal / Mega-infrastructure plans are emerging. The broad discontent of electors and the ¨creativity¨ of populist leaders raise the odds of monetary experimentations. The US should in principle be the first laboratory for such initiatives. But for once, US may be second to other G7 countries. Indeed, the relatively healthy stance of the economy so far, the recent kick-off of its electoral cycle, as well as last years’ fiscal profligacy of Trump administration will delay such initiatives to 2021.
Conversely, Europe is already considering it with its all-new cast of leaders. The dire straits of its banking system and the higher risks of falling into a corrosive deflation would legitimate it. The first statements of Ms. von der Leyen, regarding a major green new deal in the next 100 days, seem to go in the right direction at first. But talk is cheap. And frustrated European ecologist lawmakers have not yet endorsed it. And for now, the European budget is actually microscopic. At some EUR 137 bn in 2017, it is smaller than the budgets of Austria or Belgium…
China stabilization has been achieved lately. The stimulus measures implemented from Q4 18 are helping. Beijing has not yet used more bazooka-like measures, like lower policy rates or proper asset purchasing program (QE). This may well come in H2, provided a genuine and durable truce unfolds on the trade front with Washington. Elsewhere in large Asian countries, namely India and Indonesia, there is a significant room to lower policy rates from a relatively high level, provided US dollar remains stable to weak. Populist leaders in Latin America may use deficit spending to revive domestic activity.
Convergence is underway, for sure
But towards subpar activity level…
- The USD remains expensive
- The EUR, and especially the JPY, should catch up
- The Yuan must strengthen
Insurance cuts welcome and sufficient
There are some signs that the USD is topping out. Trump would certainly expect a weaker USD to stimulate the economy. However, the USD is not giving up its gains that easily and it may take time. The past month has seen a weaker USD but primarily against the defensive currencies. The USD remains the most overvalued one in the G-10. What would drive the USD substantially lower?
Last time we experienced such front-end yields slide; the USD followed. But this time, the link seems to be broken.
Some elements can prevent from a higher EUR like European Central Bank easing stance, the threat of US auto tariffs on the EU, Italy and Brexit. But all of them are already well discounted.
The GBP and the UK more broadly remain an interesting quandary. The path to a deal resolution is expected to be long and fraught, particularly as both Prime Ministerial candidates refuse to rule out a no-deal Brexit . Bank of England has been hawkish on rates most of the year. Some dissident voices are emerging to back the market dovish call. The GBP is cheap against the USD. But as expressed earlier, the USD is the most expensive developed currency. The GBP looks fairly valued vs. the EUR.
Currency manipulators countries have a limited room of maneuver
The USD/JPY sits at the low end of its 2019 range. The Bank of Japan (BoJ) has re-entered the monetary policy fray. Kuroda opened the possibility of lowering short-term rates, increasing asset purchases, expanding the monetary base and/or lowering the long-end yield target. While the Governor is willing, others BoJ members are less keen. Given the size of its balance sheet, the BoJ has a limited room of maneuver to weaken its currency. Any action would trigger Trump’s retaliation. The EUR/CHF has slided. This is not a surprise given the ECB remarks about new easing measures and the risk of no-deal Brexit. Recall that it was the impending threat of the ECB asset purchasing program (QE) that prompted the Swiss National Bank to abandon the 1.20 floor in January 2015. QE, Brexit and Italian politics all suggests the EUR/CHF stays under pressure in H2 2019. FX intervention may upset Washington too.
The only good solution is a stronger yuan
China could devalue and give itself a breath of fresh air. But if it does so, the credibility of its own currency and, down the road, its dependence to the USD should increase. In order to become a reserve currency, Chinese authorities should intervene less and less on the FX market. To cut its dependence to the USD, Chinese authorities have only one way to do it: that is by having a strong currency.
- Market expectations are too aggressive about the Fed Funds path
- Risk reduction on high yield bonds
The Fed has already accomplished more than you think
The last time the Fed cut rates was in September 2007. It first cut by 50 bps and then many times until the end of 2008. By October 2008, Fed Funds were at 1.0% while the US 10-year yield was still around 4.0%. In late 2008, after Lehman collapsed, Fed Funds were near 0.0%. Briefly, the US 10-year yield dropped from 4.0% to 2.0% and then snapped back. A few months later, by June 2009, it was back into its 3.5% to 4.0% range – despite ZIRP and QE policies. It took years and trillions to bring long-term yields down, but it had trouble keeping them down.
Today, short-term Treasury yields have already plunged, ahead of rate cuts. Yields are already lower than most of the time during the ZIRP and QE periods, even if the Fed is still shrinking its balance sheet. This has stimulated the economy. Last time the Fed cut rates, and launched its QE, it took years to get those results. The Fed is already stimulating more with its verbiage than it did by cutting rates multiple times and doing trillions of QE.
US Inflation, a thorn in the foot
The Fed explained its dovish shift because of falling inflation. However, its preferred measure of inflation, the core Personal Consumption Expenditure, has been below 2.0% for most of this cycle. The main source is China. Its headline inflation came unchanged in June at 2.7% only thanks to higher food prices, which were up 8.3%. China is also battling with lowflation. Core inflation is at 1.6%, non-food inflation at 1.4% and producer price inflation back to 0%. So, the country is exporting low inflation, where it used to export higher prices, complicating the work of central banks in reaching their inflation targets.
In its latest Global Fund Manager Survey, Bank of America showed that just 1% of global fund managers believe inflation will rise in the next 12 months, despite the main central banks willingness to cut rates. Perhaps investors are doubting whether more stimulus will ultimately lead to higher inflation as demography, digitalization and uberization are the main headwinds.
Core PCE inflation is far enough – from the Fed’s 2.0% target – to allow it to cut rates.
High yield fundamentals remain largely supportive
Technical have improved more recently. The prospect of renewed ECB purchase is a supportive factor. This has led to an increase in new issuance over the last several weeks which have been well demanded. Despite these positive trends, we continue to monitor earnings growth . High yield is still offering an attractive carry. Risks are on the rise, we come back to neutral.
- End of multiple expansion
- Low profit growth
- Equity risk premium is in a neutral zone
- Neutral positioning on emerging due to a tougher environment
Higher stock market thanks to multiples expansion seems limited
The sharp rise in stock market indices in 2019 is largely due to the expansion of multiples due to falling interest rates. The US 10-year declined from 3.20% in November 2018 to 1.60% in august 2019. There is a mechanical effect between PER and interest rates.
The yields fall reflected the expectations of a slowdown in economic growth, even a recession, and a persistently low inflation rate.
Low (negative) profit growth
According to two main sources, FactSet and Refinitiv, the S&P 500 profits growth will be around 13%/+1% in Q2 19. Net margin should compress, but not significantly, to 11.8% in Q2 19 from 12.5% in Q2 18 and 11.7% in Q11 9. It is rather good news, as we will not be clearly in a recession of profits. But profits will also not be a massive argument for a rise in indexes over the next few months.
A prolonged trade war between the United States and China will delay the recovery of profits. Profits are also affected by the tax reform. A negative base effect will unfold in 2019 compared to 2018.
According to Refinitiv, the profit growth of the STOXX 600 is expected at +0.2% in Q2 19, while it was at +3.6% at the beginning of May. Profits fell by 2% in Q1 19.
The equity risk premium is neutral
The global equity risk premium (earnings yield – bonds yield), based on the 12-month forward PER, is below its 10-year average. It is in a neutral zone.
This equity risk premium is also below its average for the S&P 500, whereas the MSCI Emerging is on its average. On the other hand, the equity risk premium is above one standard deviation for Europe and Japan.
The MSCI World All Countries 12-month forward PE ratio is above its past 17-year average. This is the same with the United States, Europe and Emerging. Japan’s PER is below its historical average.
Overall conclusion on equities: stock market indices rose significantly in 2019, pushed by the expansion of multiples. Their progression may be more limited in the coming months.
On the other hand, a sudden agreement between the Americans and the Chinese on trade and technology issues would obviously be good news for the stock markets.
Search for quality
Since early 2018, investors have turned to quality stocks. In 2019, we have seen an acceleration in the outperformance of the MSCI World Quality. The three main fundamental variables for the integration of companies in the MSCI World Quality are: 1) return on equity, 2) steady and sustainable profit growth and 3) low financial leverage.
Gold plays its role
The de-dollarization is running, even if this process is slow. Once again, the dollar will remain for a long time the main currency of the world trade, but if a trade currency emerges at the margin, and we are talking about the renminbi, gold will find a new status with the central banks of emerging countries.
Economic reforms in India and the process of monetary diversification of China’s central bank are major structural supports to gold. After a two-year pause, the central bank of China has started buying gold on a monthly basis since December 2018.
It held 1’916 tons of gold, or $87 billion, which represents 2.5% of its monetary reserves. We don’t know what is China’s objective of holding gold in its foreign reserves, but it is certain that if China wants to increase its gold share, the impact in volume and on gold price will be significant.
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