Monthly investment review
Strategy and Macro
- Embedded political chaos
- Macro fatigue
- A transitory of window low volatility
- Currency developments as a swing factor
- Bonds essentially expensive, but scarce
- Equities relatively attractive, but fragile
Fundamentals remain about adequate, not more. Liquidity provision and forward guidance by central banks remain the key supportive factor. The disconnect between (repressed) sovereign bond yields and (resilient) equity markets is still alive but probably not durable. Keep in mind return to the mean forces, which occurred already this year in a similar context. Realized volatility remains too low, considering the lack of visibility.
Risky assets are still hoping kind of a long-lastly cease-fire between China and Washington. In this positive scenario, a currency pact – sort of a redux of the 2016 G-20 meeting in Shanghai – would definitely help, at least temporarily. Indeed, currency dumping was at the epicenter of the financial markets’ destabilization, raising the odds of renewed deflation. It not only impacted a large specter of emerging (commodities producers), but also developed countries. Such a welcome outcome – to be confirmed and, more importantly, durably respected – would help investors’ sentiment short-term, no doubt. It may not be enough for global growth and inflation to resurge to a more comfortable – healthy – level over next quarters. It would clearly benefit to emerging countries and markets.
We see no major reason to increase the risk profile our allocation
We maintain extensive diversification and a focus on quality
Fortunately, manufacturing gloom is not spilling-over
Manufacturing recession is spreading to the US. But world services sectors and consumption have been, so far, pretty resilient. Who’s going to give next months?
At first, the contagion scenario is possible. Latest growth slowdowns, i.e. early 2000’s, 2012 and 2013, started with a significant deceleration of manufacturing. In most cases, it gradually morphed into consumption through the transmission channel of lower capital spending, employment, then disposable income, etc. For now, early signs of layoffs have indeed appeared in banking, retail and certain segments of manufacturing. But definitely not on a large scale. In most cases, a severe contraction of investment (usually from an excessive level), triggered it. Like, namely, the collapse of US shale spending in 2016.
Still, contrarily to these former episodes, the usual imbalances (over-investment, inflation) are absent. Quite the opposite: global capex is already weak, as well as capacity utilization. So the downside risks, from a depressed level, are lower than in former cycles.
Source : Board of Governors of the Federal Reserve System (US)
More, the recent collapse of interest rates is providing a significant support to real estate capex, giving early signs of picking-up in the US. China is also providing credit support to targeted sectors, not to mention Technology / security related ones… Under growing pressure, Europe may finally surge. It may not only contemplate, but launch sort of Green Deal / Infrastructure initiative under a new political framework transcended by C. Lagarde, a new Commission leadership and a growingly federalist Macron!?
The Jury is out, but the odds of a global recession in 2020 remain significant
But a lengthy (soft)-landing, with world growth staying below 3%, remains our base scenario
- End of the USD strengthening
- Gradual higher EUR
- Stable CNY
The USD has been strong …
The main recent driver of the FX market has been the ongoing US-China trade war. The USD resiliency is due to the lack of attractive alternatives. Recent trade developments have been volatile. However, both sides still appear willing to negotiate. So, the USD has been helped by worries over trade tensions and boosting demand for safe-haven assets. But trade tensions could be viewed as a threat to the US economic growth, which might require more Fed rate cuts and should be USD negative. US yields have been falling but remain higher than all their peers. The USD is still offering an attractive mix of safety and yield.
…but should not move even higher
And in a world of secular stagnation, no one wants a strong currency. US growth worries seem to be increasing. The US should grow by 1.8% in 2020 after 2.5% in 2019. Even if it is higher than peers, the US growth premium is tightening. The Fed will cut rates at least 2 more times over the coming months, while other central banks have already mentioned they are running out of ammunitions. Whilst US rates will remain above its peers; rate differentials will tighten and become more USD negative.
The Fed balance sheet grows again
The Fed has further increased its permanent open market operations (POMO) to stabilize overnight funding markets and keep its target borrowing rate in check. The Fed will likely purchase $250-300bn bills over the next 6 months. This will bring back the Fed balance sheet up to $4.2trn. Such a move would be bad news for the USD. Even with a QE restart, the ECB cannot compete with the Fed to weaken the EUR.
Some policies are compensated by dovish ones elsewhere
Like the SNB, another rate cut is unlikely to weaken the JPY. With their balance sheets standing at more than 100% of GDP, they have less room to boost asset purchases. Deeper negative rates could impact the financial sector, general economic confidence and demand.
A Chinese cautious approach
The CNY remains soft against the USD but off its lows. An apparent easing of trade tensions between the US and China has helped alleviate some of the pressure. However, concern about the pace of Chinese economic growth remains, suggesting that policymakers will adopt further easing measures. Industrial production grew at its slowest rate since 2002. Chinese CPI remained relatively high, but PPI fell further into deflationary territory. However, the impact on USD/CNY may be countered by further US rate cuts.
- Lack of ammunition
- Long-end yields on key supports
- Favor EM over High yield
The race to bottom
Global bond yields slide as another easing round kicks in. The US 10-year yield is back on its lows. This level seems consistent with the current weakness in soft data. Since the GFC, each time the Fed has printed USD, it has helped PMIs to recover. So, long-end yields should stabilize there.
The current rebound in economic surprise, i.e. a halt in economic disappointments, is pointing at least for stable long-end yields. When economic data are in line with expectations, long-end yields over the next 6 months should be at least unchanged. If Fed stimuli fuels PMIs rebound, then yields should increase
Inflation expectations are falling again
While US core inflation was the highest since 2008, inflation expectations have fallen rapidly. The US 5Y5Y rate has dropped back to late august lows or its lowest level since the 2016 economic slowdown. German ones are at their all-time lows. It can be explained by the recent fall in oil prices and manufacturing PMIs. Given that the US economy is growing in line with its potential, inflation linked bonds look attractive.
Emerging bonds, a haven of peace
According to S&P, high yield default rate is expected to rise by mid-next year. It would be 0.5% higher than the current rate, representing a reversal in the downward trend experienced since mid-2017. This remain below the long-term average default rate of 3.1%. Under an optimistic scenario, the default rate would be 2.0%, while in a pessimistic one the default rate would be 3.5%.
EM bonds have exhibited a surprising stability over the past coupe of months even when HY suffered volatility. EM debt rally cooled in Q3, local currency lost a little ground, while external debt produced small gains. The US bond rally has left valuations for many countries looking rich, while risks to global growth have risen. Some higher-yielding countries continue to look cheap. They will continue to be supported by dovish monetary policy while fundamentals in many countries are improving. For EM corporates, steady fundamental improvements continue. The external environment, like commodity prices, should continue to be a source of stress.
Country-specific problems in Argentina and Lebanon drove aggregate sovereign spreads wider, but half of spreads have tightened. Sovereign spreads continue to show significant differentiation among countries. Even after the 2019 rally, Fed and ECB dovishness along with improving fundamentals will support the asset class. However, risks to this outlook remain elevated, specifically around trade and geopolitical stability.
- Prolonged transitioning period in a bull market
- Risk on margins
- Supportive factors: sector rotation, low downside participation, underweight investors in equities, alternatives in a low interest rate environment, active central banks
As the risk of entering into recession in 2020 increases, the evolution of earnings is important, since it determines the direction of the stock indices.
Q3 profits are expected to slightly decline in the United States and in Europe. Analysts expect a rebound in the fourth quarter of 2019. Profits are holding up well thanks to the resilience of domestic economies (household consumption and real estate), but non-manufacturing indicators are beginning to weaken. In contrast, if the soft indicators (ISM, Markit) continue to deteriorate, the S&P 500 should continue its lateral annual variations.
Profit quality has decreased since 2016: S&P 500 earnings per share are strongly driven by share buybacks and the procyclicality of GAAP, while National Income and Product Accounts (NIPA) profits coming from national accounts only slightly increased. NIPA data are certainly more reliable on the earnings state of US companies because they include private companies that play a big role in the economy and they separate domestic profits from foreign profits, while the S&P 500 does it only at the revenue level. If there is an economic shock, there is a chance that the S&P 500’s profits will fall sharply. The S&P 500’s operating margin is also at risk: Historically, it tracks the ISMs and it follows, with a delay of 3 quarters on average over the last 30 years NIPA margins that have already contracted.
Today, investors are afraid of the recession; the reversal of the yield curve during the summer has made investors nervous about a classic recessionary signal. They want good news. More accommodating central banks do not change their perception, whereas a few months ago they wanted bad news (they did not believe in a recession) for interest rates to fall, justifying higher multiples.
Over the course of history, there are only a few examples of “mid-cycle adjustments” – in the phrase used by Powell earlier this year – in which the Fed has cut rates two or three times and has succeeded in prolonging an economic expansion. But there is no precedent for the Fed to reduce by one percentage point or more without a recession shortly thereafter. And there is no precedent for a recession not followed by a bear market for equities. We must hope, then, that we find ourselves in the few past examples of a successful mid-cycle adjustment.
The probability of having a more difficult period for profits and margins increases. The extent will depend on whether we enter a recession or whether it will be a soft landing. A trade deal between Americans and Chinese will not change much because it should be targeted and distrust will remain. However, equities are an alternative to low interest rates and equity holdings with institutional investors have rarely been so low. We therefore remain in a bull market with buying opportunities on lower prices.
Emerging equities, still some patience
Our analysis argues that emerging currencies are cheap and that bonds in local currencies are interesting. The MSCI Emerging equity index significantly underperformed the MSCI World Index and stock market valuations of local indices are low. So we have a combination of positive factors. But we still maintain our relatively cautious bias because of the trade war between the United States and China and the strength of the dollar.
On the other hand, a trade agreement, even partial, combined with a monetary pact, between the United States and China, could result in a depreciation of the dollar and a yuan returning below 7 against the dollar. This scenario would be positive for emerging countries and other risky assets. There would be a double effect for emerging countries thanks to the rise of commodities prices. In this case, we would overweight to emerging markets.
China continues buying gold
Since December 2018, the central bank of China has bought gold every month, after 2 years of abstinence. In September, it still bought 5.4 tons of gold, bringing the total to 100 tons since December 2018. And it is not finished, because gold counts for only 3% of the foreign reserves of China, far from 20% of Russia and 60-70% for developed countries (except the UK and Switzerland). Faced with the emergence of a multipolar world, the ongoing dedollarization and the loss of confidence in the US trading partner, all central banks in emerging countries are buying gold. It is a strong and durable structural process. In a diversified long-term allocation, gold holdings are obvious.
But in the short-medium term, the price of gold rises in a visible way with the interest of investors, by strong demand or speculation, through ETFs/funds invested in physical gold. What is surprising today is the continuation of net purchases of gold in ETFs/funds in recent weeks, as the price of gold is consolidating. The answer seems clear: investors are continuing their purchases of physical gold, while long speculative positions are decreasing.
Oil price caught between economic slowdown and abundance of supply
The sudden rise in the geopolitical risk premium during the drone attack on Saudi Aramco’s oil installations will have been short-lived, due to plenty of supply taking over. On September 15th, the price of Brent rose from $59 to $69 in 2 days, to return to the price before the attacks, and despite stopping 6% of world oil production! The Middle East region is by no means stable and clashes/attacks/sabotage could justify large sporadic price increases.
The agreement between OPEC and Russia on a production freeze did not keep the price of Brent between $ 70 and $ 80, a goal for Saudi Arabia. The United States, the world’s largest producer, is increasing production to more than 12 million barrels a day, and demand estimates are (slightly) revised downward. The EIA estimates US production at 13.2 million barrels / day in 2020. OPEC has announced a possible reduction in production in December.
The US Energy Information Administration (EIA) forecasts stable to declining crude oil prices until the 2nd quarter of 2020 due to rising inventories and warmer winters. The National Oceanic and Atmospheric Administration (NOAA) forecasts in the United States a 2019-2020 winter less cold of 4% on average compared to the 2018-2019 winter and less cold of 1% compared to the last 10 winters. In conclusion, on a fundamental basis, oil prices should remain around current levels.
Dr. Copper is not good yet
The evolution of the price of copper depends on global manufacturing indicators which are deteriorating. World trade is slowing down. Copper is considered the best barometer of the health of the world economy because it is used in a wide range of industrial products. For nearly 2 years, its price has been falling steadily; since the intensification of the trade war between the US and China. Copper demand is expected to increase only slightly in 2019 due to lower investment in power grids and falling car sales.
Analysts are nevertheless positive on copper over the long term: the supply will not succeed in filling the demand for the coming years and copper will be an important player for a shift towards a decarbonized economy. Copper is needed in wind, solar, electric motors, renewable energies. Electricity generation by wind and solar will require 3 to 15 times more copper than production by fossil fuels. Climate change has a positive impact on sales of air conditioners, especially in Europe
In the short term, copper prices will remain depreciated, but a more positive outlook on the global economy, as well as the emergence of investment projects in the green economy, will be favorable.
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