Monthly investment review – June 2019
Strategy and Macro
- China, as the determining macro factor
- Come-back of (geo)politics
- Expect further hesitations ahead
Certainly, US-China trade negotiations are crucial. Both countries need a truce – say a minimum agreement – to avoid significant negative side effects on the global economy. This has attracted the attention of the media. Nevertheless, we should nevertheless not forget that the rivalry between the two countries is much broader. For instance, on the geopolitical front, contention is still going on with naval manoeuvres in the China Sea, North Korea’s missile test, not to mention the Iranian oil embargo. Trade talks are only a small part of the more holistic and complex discussions between the two giants. We remain of the opinion that a truce on trade negotiations will be reached, possibly during the summer. The threat of US tariffs is clearly oversized and, if implemented, the US would de facto become one of the most protectionist countries in the G-20. This would undoubtedly lead to widespread retaliation, which would be a major setback for free trade…
- Rivalry between China and the US is a long-term issue
The macroeconomic outlook has deteriorated in recent weeks and, while market assessments are tense, they are not alarming. Thanks to cautious central banks, financial and liquidity conditions have become more favourable. Increased market volatility and more volatile bond to equity correlations are the new regime.
We maintain a significant portion of our asset allocation in real assets (such as gold) and cash. These tend to outperform or offer interesting decorrelation in this particular phase of the cycle.
- At the end of the cycle, we avoid leveraging. We carefully select long positions in each asset class and favour uncorrelated vehicles
An old, but resilient, US economic expansion
The end of the cycle does not mean the death of the cycle. Recessions result from a trigger/shock (inflation, oil crisis, war, etc.) or speculative spill overs (financial/banking/geopolitical crisis, over-investment). None seem likely in the short-term, with the exception of a “trade war”. Even so, we must remain vigilant. The scenario of sustained global expansion in the coming years is unlikely, particularly given the excessive size of global debt, low inflation and the limited impact of the major central banks.
- Risks of a recession in H2 2019 have recently decreased significantly
- They have been postponed to mid-2020
Soft deceleration of the US economy
Precautionary purchases before the tariffs of Q4 2018 and the government shut-down / psychodrama in Q1 2019 were temporary – non-recurring – factors that reduced visibility and contributed to fear. Things are clearer now. The slowdown in US activity towards its long-term potential – about 2% – is ongoing. The chances of a severe slowdown / recession in 2019 have declined significantly, thanks to a more accommodating Fed and a significant improvement in financial conditions.
Fear of wage inflation had emerged last summer and was reinforced by the decisions of two large US employers, Wal-Mart and Amazon, to become more generous with their employees. In practice, these symbolic measures were not followed on a larger scale.
Pressure on labour costs remained moderate, despite a rise in recruitment and low unemployment. Indeed, the increase in the employment cost index slowed slightly in Q1 compared to Q4 2018. This gradual increase, combined with the improvement in labour productivity, led to a slowdown in labour cost growth per unit in the first quarter.
- The US economy is booming for the moment
- Labour costs and wage inflation remain under control
China is the determining factor in the global cycle
The trade confrontation forces China to forget the rebalancing / deleveraging of its economy. More than ever before, China is one of the main drivers of the global cycle. According to supranational calculations, it is expected to close in on 30% by 2023 (India 16%, US 9%). The debt reduction process initiated a few years ago is on hold for now. Indeed, Beijing is speeding up the pace of its fiscal and monetary easing. Time will tell us whether the private sector and households will spend more, or save as a precaution. Over the past few months, a healthy soft-landing process has unfolded, and some leading indicators have improved.
- Growth in 2019/20 may surprise positively, but at the expense of higher risks in the medium term
A recession, combined with deflation, is unlikely in the near future. Fiscal policy is increasingly becoming more expansive in the three largest economies. Despite its official medium-term balanced budget target, Germany is preparing a discretionary/counter-cyclical fiscal stimulus package of around 0.8% (comprising both tax cuts and capital expenditure). France is reducing taxation and will postpone any cuts in public expenditure. A temporary shift towards “preserving purchasing power”, i.e. a more Keynesian recovery phase, is likely. The Italian populist coalition is likely to inject at least 0.5% of its GDP into the fiscal stimulus measures. Depending on the outcome of the European elections, a new coalition might again face Brussels and try to strengthen its stimulus measures.
Increased activity in China will be a driving force, particularly for Germany. The latest stimulus plan will not have the same impact as the 2016 one, as it focuses this time on infrastructure and consumer spending.
- The recent pessimism about the outlook for the euro zone is exaggerated
- New measures will stimulate growth by more than one percent by the end of the year
Increased interest from European voters were this year
After decades of declining voter turnout, Europeans are a little more interested about the upcoming elections. A participation rate of just over 50% is the best since 1994. The three main Eurosceptic political groups hold just over 22% of the votes – a small gain compared to the current 20%, but below expectations. However, do not forget that the Brexit Party took a significant number of these anti-EU votes. Assuming that Brexit will still happen, these seats should disappear. The often-feared rise of Eurosceptic parties has not fully materialised. Full cooperation will be undermined by their disagreements on how to manage the migration crisis, Russia or China. Eurosceptic parties are here to stay, but the only potentially significant impact will be at the local level.
Political fragmentation continues. The European Parliament is following the trend observed in many national parliaments, i.e. the end of a two-party majority. This won’t make decision-making easier. The majority of the new parliament remains pro-European, but there will probably be more different coalitions on different issues. This is not necessarily a bad thing, but perhaps a chance for more colour and diversity. While the European People’s Party remains the largest party, it does not seem that the case for Manfred Weber as President of the Commission has become any clearer. It will now depend on the formation of a coalition. The Greens, for example, are strong supporters of the Spitzenkandidaten concept (a party’s main candidate), while Macron has frequently suggested that this concept should disappear. The Spitzenkandidaten concept is not enshrined in any laws and, in the end, government leaders give the green light. However, moving away from this concept would be a major blow for the European Parliament and could lead to a long approval process.
No volatility in foreign exchange markets
We are currently experiencing a period of particularly low currency volatility. Implied currency volatility has fallen sharply to its lowest level since 2014. A low volatility period indicates consolidation, as investors are not convinced of the direction to take. However, volatility levels cannot remain low indefinitely. The apparent calm in FX markets in recent months has led some international investors to increase their protection against exchange rate fluctuations. They remain vulnerable if volatility rebounds from its lowest levels in 5 years. This represents an extreme risk, as this pattern is also present on the bond market.
The weak Yuan (CNY) explains the recent strengthening of the USD. The US-China trade negotiations remain a threat to the Yuan and global growth prospects.
After a downward revision of its growth forecasts, the lack of details on the ECB’s new lending cycle weighs on the EUR. Abundant liquidity should support growth and demand. Usually, lower liquidity coincides with tighter monetary conditions and an increase in the EUR. Given the growth concerns, this could weigh on psychology and be negative for the EUR. The tiered process could also be ambiguous. It should protect banks with surplus reserves from the effects of the loose monetary policy and be positive for the EUR. However, this could be negative for the EUR, if it is perceived as a rate cut. The EUR may soon rebound. The Italy-Germany spread, a Eurozone risk proxy, shows that the EUR/USD is cheap.
The CHF is expected to weaken gradually. The Swiss National Bank (SNB) should stick to its very accommodating monetary policy, with inflation remaining moderate.
The GBP seems to have reached a low price. Political and Brexit-related uncertainties will remain a key focus. The Bank of England (BoE) confirmed that key rates would remain unchanged, although it would still be appropriate to tighten the monetary policy in the coming years. The announcement of Theresa May’s upcoming resignation reduces downward pressure on the GBP.
The support that the JPY received last year, via a low risk appetite, is fading. Despite a moderate economic recovery, low and below-target inflation, the Bank of Japan (BoJ) will remain very accommodative and unsustainable for the JPY, at least until spring 2020.
The IMF publishes the global distribution of FX reserves on a quarterly basis and the latest findings may seem uninteresting at first glance with minimal changes in major currencies. The domination of the USD as a global reserve currency is determined by the amounts of USD-denominated financial assets (US Treasury securities, corporate bonds, etc.) that central banks, other than the Fed, hold in their FX reserves. The role of the USD as a global reserve currency decreases as central banks reduce their holdings of USD and replace them with assets denominated in other currencies. In 2002, when the EUR was inducted, the USD share represented 71.5% of FX reserves. Today, its share has fallen to 61.7%. The share of the EUR in FX reserves is now 20.7%, its highest level since Q4 2014. The remaining currencies represent 17.6% of the allocations. On 1st October 2016, the IMF added the Chinese renminbi to its basket of currencies. Gradually, the renminbi is gaining ground. In Q4 2018, with a share of 1.9%, it was ahead of the CAD for the first time and ranked fifth behind the JPY and GBP. All reserves are benchmarked against the USD and recent adjustments may appear marginal. However, if we take into account exchange rate fluctuations, the changes are much more significant. The reserve managers aggressively reduced their USD holdings in favour of other currencies. As the US continues to isolate themselves while the rest of the world wants to reduce its influence, this may only be the beginning of a long-term cycle.
- The main carry trade continues
- The FX volatility still too low… but for how long?
- Too much bad news is expected in the EUR and some commodity related currencies
Earlier this year, great pessimism emerged following the closure of the government, fears of a slowdown and an inverted yield curve. However, stronger macroeconomic data and better corporate performance were relieving. Over the past 4 months, after the Fed announced a prolonged break, central banks in developed and emerging countries have become nervous about tightening their policies.
The unexpected slowdown in the Eurozone and lower-than-target inflation prospects motivated its accommodative bias. Although Draghi tried to convince that the ECB was ready to act, the options available are rather limited. The SNB has reduced its inflation forecasts. As a result, it has become more accommodating than ever. No rate increases will occur until the beginning of the next economic cycle.
Negative rates will remain the norm in Switzerland. The governor of the BoJ admitted his frustration at being unable to reach the 2% inflation target. Low rates will remain until spring 2020, at least. Although the BoE has left the door open for further tightening, the chances of this happening this year are reduced. This discussion will only re-emerge in October, the Brexit deadline. After the surprisingly strong credit growth in Q1, the Central Bank of China adopted more flexible liquidity management tools to supplement the Required Reserve Ratio (RRR).
World interest rate markets are looking for drivers
The Fed remains the most obvious driver unless significant progress (or lack of it) is made in the US-China tariff negotiations, or in the Brexit schedule, and the recent surge in oil prices has not affected long-term inflation expectations. After its turn in Q1 (an accommodating tone, end of the reduction in the balance sheet and tolerance for inflation slippage), it is difficult to believe that higher inflation figures would matter. They could be much more important if they did not meet expectations. The Fed did not reach its 2.0% target convincingly. Since the Fed unveiled its official inflation target in 2012, inflation has averaged only 1.4%. If this persists, it could anchor inflation expectations. In addition, the cyclical components of inflation have not increased since 2017. Even if market-based inflation expectations are rising, investors are abandoning the theme.
Large spread in flows in the bond universe
There is some evidence that demand for risky assets in bonds is not temporary.
ETFs invested in government bonds have experienced significant capital inflows this year, while inflation-indexed products have recently experienced outflows. In the credit sector however, ETFs invested in high-yield bonds benefited from the highest capital inflows, while emerging segments in hard and local currencies failed to attract interest from investors. The USD does not need to be very low for emerging local currency bonds to be a good investment. Even in a context of moderate USD strengthening, local emerging bonds can generate interesting returns and outperform US bonds.
- The current range of government rate fluctuations will remain the norm in the coming weeks
- Inflation forecasts remain moderate
- Risky assets remain popular
- The emerging segment is lagging behind
A strong start to the year
These first months of 2019 were characterised by:
- Low investor participation, rather in risk-aversion mode, with a fear of a global recession and a sharp decline in corporate profits; and
- Low volatility, explained by the calmness of investors, and observed in many asset classes.
Net short volatility positions reached high levels again, raising fears of a return of a Vixmageddon, as in January 2018. However, some analysts point out that the situation is different because of very weak long positions. Short volatility positions are lower than in 2018. The current situation is also different from January 2018: at that time, the Fed reported that it would raise interest rates faster than expected, while today the Fed should not move until the end of 2019.
Turnaround for profits in the United States
At the beginning of the US reporting period, Factset and Lipper Refinitiv anticipated a decline between 5% and 3% in US profits for Q1 2019. Today, the situation is quite different: Factset now estimates a decline of only 0.5%, and Refinitiv an increase of 1.5%! We could therefore see an increase in US profits for Q1 2019.
This unexpected trend is due to the strength of the US economy. However, international companies are suffering. Those who generate less than 50% of their income in the US saw their profits fall by 12.8%, while profits rose by 6.2% for those who generate above 50% of their income in the US.
European societies are more open to the global economy, and therefore more sensitive to US trade wars, tariffs and geopolitics. American protectionism and the extra-territoriality of American law are elements that penalise European companies. In Q1 2019, earnings per share are expected to fall by 3% and then recover over the rest of the year. Profit growth is estimated at 6% in 2019.
Switzerland retains its advantages
The Swiss economy accelerated in Q1 2019 with a 0.6% increase in its GDP. According to the economic forecasting institutes, growth is expected to slow down, given the recent, less buoyant, economic figures. The Swiss stock exchange recorded surprising performances this year. While most stock market indices fell in May, the Swiss Performance Index is at its highest level ever, and is even among the best in class, behind the Chinese stock market. Corporate results are good and the Swiss franc (CHF) remains a currency appreciated by investors. In May, the large-cap index, the SMI, outperformed the small and mid-cap segment, reflecting the more defensive bias taken by investors.
Share buyback programs: always a support for stock markets
Share buybacks continue to grow. According to Bank of America, they have increased by 20% since the beginning of the year. Goldman Sachs also expects larger share buybacks in 2019. By 2018, US companies had returned USD 1,250 billion to their shareholders, including USD 800 billion in share buybacks and USD 450 billion in dividends.
Stock market valuations are at fair levels
Our analysis supports current levels of market valuations. The low interest rate environment compensates for the moderate outlook for growth in the global economy. Stock market valuations have contracted since the beginning of 2018 in the US and since 2015 in Europe. The market therefore takes into account the risks of slowdown and European difficulties (nationalism, Brexit).
In our opinion, since interest rates are expected to remain low, the evolution of stock market indices will depend on the global economy and its prospects.
In the short-term, consolidation is normal and desirable
In a multipolar world, economic, political and geopolitical risks are increasing. After 4 months of rising stock market indices and low volatility, consolidation seems normal and desirable. An economic (e.g. trade disagreement between the US and China) and/or geopolitical (Iran) incident could accelerate profit-taking. However, central banks have been assuming their role as financial markets stabilisers since 2009. In the event of an economic downturn, the Chinese central bank could pull out the bazooka by injecting liquidity and lowering interest rates, while the Fed could lower its key rate to the advantage of risky assets.
The stock markets began to retreat in early May as a US-China trade agreement approached, and pressure – tweets – from Donald Trump in the final phase of negotiations.
Renewed interest in the Value segment
The performance gap between the Growth and Value segments has rarely been so wide. At the end of the cycle, the Value segment tends to outperform the Growth segment. This is a positioning that should not be neglected.
Emerging equities struggle due to the strength of the dollar
Emerging equities did not deliver the expected performance due to the strength of the dollar. The return of volatility on the Turkish Lira and the Argentine Peso also contributed to more caution. In 2019, the MSCI Emerging Market Index still progressed well thanks to the strong growth of Chinese indices, with Greater China accounting for 45% of the index.
- US companies’ results are better than expected
- Economic outlook will be the dominant factor for stock markets
- In 2019, share buybacks are expected to be higher than in 2018
- Stock market valuations are fair
- The failure of a US-China trade agreement will not put the bull market at risk, but we have to temper our exposure
Oil prices have recently declined due to fears of recession and failure of US-China trade negotiations, in addition to Donald Trump’s intervention urging OPEC to stop manipulating prices. On the consumer side, the US and China are obstacles to a further increase in oil prices. The US embargo on Venezuelan oil and the tightening of US sanctions on Iranian oil exports are contributing to higher crude oil prices. However, the impact is more limited than a few years ago, as exports from these two countries have declined significantly over the years. The civil war in Libya is another factor destabilising oil markets. A military crisis between the US and Iran, with a blockade of the Straits of Hormuz, would be a more worrying event, which would certainly cause a rapid surge in oil prices.
Gulf countries, and Saudi Arabia in the lead, need high oil prices – estimated at around USD 75-80 per barrel of Brent – to make a successful economic transition. Saudi Arabia will list part of Aramco’s capital (in 2020?), but Aramco must first integrate the USD 69 billion acquisition of SABIC (petrochemicals/chemicals).
- The rise of the Yuan as a commercial and lending currency; and
- The loss of confidence in the US, which adopts a nationalist and protectionist vision.
In Q1 2019, global demand for gold increased by 7%, driven by purchases from emerging central banks and the wedding period in India. Central banks bought 145.5 tons of gold in Q1 2019, the highest amount for a first quarter since 2013. Russia was once again the largest buyer, with 55.3 tons, followed by Turkey, Kazakhstan, Ecuador, Qatar and Colombia. In March 2019, China bought gold for the fourth consecutive month, after 2 years of abstinence.
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