Quarterly Investment Review
Resilient financial markets
The global macroeconomic and political context deteriorated further over summer. Some of the downside risks have materialised, especially the decision by the Trump administration to intensify the trade war with China, after announcing its intention to hit the remaining USD 300 billion of imports from China with 10% tariffs. After this announcement at the end of July, risk appetite plunged further and bond yields reached new lows.
Major central banks have some ammunition left. They have used some to stimulate the economy. The Fed cut its rates by 0.25%, the ECB by 0.10% and restarted its asset-purchasing program. The SNB, which has the lowest developed world, has decided not to act. No progress on Brexit with both sides standing their ground.
The World Trade Organisation has lowered its global trade growth forecast (in volume) to +1.2% in 2019 and +2.7% in 2020, after +3% in 2018 – compared to the forecasts the organisation announced in April (+2.6% for 2019 and +3% for 2020). The World Bank has revised its global GDP growth forecasts to +2.6% in 2019 (+2.9% previously) and +2.7% in 2020. The IMF has also slightly reviewed its forecasts downwards to 3.2% in 2019, the lowest global growth rate since the 2009 crisis.
Financial markets have many reasons to be more volatile due to tensions between the US and China, attacks on Saudi oil infrastructure and the endless Brexit story. September saw stock market indices offsetting August losses. The fluctuations over the summer period are in line with all the adjustments we have experienced since the beginning of 2017. Global equity markets are more or less at the same level as in January 2018 while yields have reversed their trend. This summer, the US 10-year rates fluctuated between 1.45% and 1.90%. The price of gold consolidated after a significant strengthening between May and the end of August. On the currency market side, low volatility prevailed with the strengthening of the USD. The euro remained weak against all major currencies.
Strategy and Macro
Asymmetric risk-reward framework
The structural economic landscape will remain stable: weak expansion and disinflation. The fundamental factors of this “secular stagnation” (to quote L. Summers) remain valid: gloomy demographics, poor productivity, as well as digitisation / “uberization”.
Major central banks have started to improve the global economic liquidity provision. More generally, financial conditions remain favourable.
From a more cyclical perspective, the global expansion shows serious signs of weakness. We are raising the probability of a recession in the next 12 months to about 40%.
Geopolitics remain highly volatile and unreadable.
Investors’ psychology has recently deteriorated with the increase in volatility. Equities suffered major outflows, which largely benefited bonds. Safe-haven assets are in high demand and are likely to remain so.
Further significant market increases seem unlikely
A generally cautious approach is justified, in terms of both allocation and selection of underlying investments
Stall speed ahead
“Stall speed is the airspeed at which an aircraft stops producing lift. Unless immediate corrective action is taken, such as reducing the wing’s angle of attack or the weight of the aircraft, the results are not likely to be good. An economy can hit “stall speed” when it becomes burdened with too much dead-weight loss.” Quote from Richard W. Rahn, The Washington Times.
When it comes to the world economy, stall speed approaches when the rate of expansion falls below 3%. According to Nowcasts calculations (by Fulcrum), global economy experienced a similar slow expansion, for a short period, during the summer of 2016. China’s subsequent credit-fuelled stimulus package prevented a dramatic slowdown.
Since then, growth has continuously exceeded long-term potential (about 3.5%). Until last June, before a sudden relapse below 3%… Nine major economies are currently in or about to enter recession: Argentina, Brazil, Germany, Italy, Mexico, Russia, Singapore, South Korea and the United Kingdom. Japan is quickly losing strength as well, and China’s slowdown is affecting more than just manufacturing sectors – contrarily to a few months ago.
This is a source of concern, namely in the context of disproportionate global debt levels and persistent disinflation. A decade of hyper-accommodating monetary policy has led to a decline in consumer price inflation, but has fuelled asset price inflation… and greater inequalities. Interestingly, a handful of US high-profile CEOs recently called for an end to the “shareholder primacy”.
Their roundtable advocated nothing less than to a new model of profit sharing. It is certain that the US is not about to adopt the German participatory capitalist model, but reflects the need for the American society / economy to rethink the foundations of its expansion model.
The slow pace of expansion – close to the stall speed – is unstable. Over past cycles, it regularly preceded recessions
Economic policies are on the verge of major changes
Monetary policy is entering a deadlock
Global inflation targets, as set by the major central banks, have not been reached in years. Most of them acknowledge that they only have a limited stock of ammunition. Buying more bonds / assets and cutting rates remain a possibility. However, it will prove increasingly ineffective and controversial. European banking systems will not tolerate a recession without major damage. Such a scenario could well force C. Lagarde to launch Season II of the famous movie “Whatever it takes”. Financial repression is also a poison to pension funds. Their future commitments – including in the US – could ultimately compromise global financial stability.
The private sector is far from immune. A few big names (Deutsche Bank, General Electric) are also in the spotlight! The US simply cannot afford zero interest rates …
It is not clear yet whether: a) central banks will lose their independence and become governments’ puppets. Such a scenario is reminiscent of the dreadful links between R. Nixon and A. Burns in the early 1970s, which led to excessive stimulus and inflation from 7.4% in 1970 to 13.4% in 1971 and 11.7% in 1972… or b) major – oversized – fiscal stimulus packages will emerge with a focus on vibrant political themes such as infrastructure and climate change. For instance, the ECB and Germany could conclude an agreement on economic stimulus measures while the Maastricht treaty framework (deficit, debt) could be revisited.
Major central banks have to change track in next years
Time has come for major tax / public initiatives
Into the unknown
The currency market is evolving. It still wonders how to integrate uncertainty and the evolution of geopolitical risk. The fact that the market is concurrently seeking to integrate an unprecedented change in central bank behaviour adds to the challenge. This creates a wider than normal distribution of outcomes in the markets that leave markets in a difficult situation. It remains very difficult to predict the daily twists and turns (and tweets) of world politics.
We therefore focus on the main FX drivers such as a) relative growth outlooks, b) policy direction, and c) yields on hedged and unhedged bonds.
- The resilience of US consumers and employment give the US economy a clear advantage. With a preventive easing of the Fed and a sharp drop in mortgage rates, a sharp gap is protecting the American economy. In contrast, Japan, Europe and China are caught between low consumption and greater exposure to trade war impact. The US economy is expected to outperform.
- However, politics should be more active and rapid outside the US. We are entering an election year in the US, Trump will be blocked by the Congress. In other countries, such as China and even Germany, fiscal stimuli are already being discussed.
- Higher rates in the United States and the faster transition to non-conventional policies outside the US have supported the USD so far. US rates could fall further given their current levels. US flows to the rest of the world will remain hedged, while flows entering the US market may not be.
The Yuan enters a new world
The CNY will now be managed with more flexibility. Now that the PBoC has allowed its currency to cross the historical or psychological 7.0 mark against the USD, Chinese authorities seem happy to allow the Renminbi to float as US-China relations stretch. This is weighing on emerging currencies and, combined with a weakening of Europe, will help China restore its competitiveness, even in a context of rising US tariffs. The CNY will not be used as a weapon by the authorities to avoid an exclusion of the yuan as a reserve currency.
A cornered SNB
Unsurprisingly, the SNB kept its policy rate unchanged at -0.75%. The ECB’s decision to lower its key interest rate did not influenced the SNB, although officials stressed the importance of the interest rate differential with the Eurozone. The spread with the ECB’s key rate is now 25 bps, which seems sufficient given that market spreads have moved only slightly. For 2021, expected inflation is 0.6% compared to 1.1% previously. This rate is very low and indicates that positive policy rates are unlikely in the coming years.
The SNB has been more proactive than usual. Negative policy rates have been eased. Given better fundamentals, the CHF will remain on an upward trend.
Towards a global “Japanification”
The US 30-year rate has just seen its biggest monthly decline since the European debt crisis. Sustained low inflation and an almost permanent easing from central banks – i.e. Japanification or Japanisation – will be the key factors keeping interest rates low.
Two commonly used measures to evaluate the attractiveness of the bond market are real rates and the slope of the yield curve. The first is a valuation measure, while the second is a carry metric. The valuation according to real rates is certainly low, and the curve is also extremely flat. Below 0.0%, US real rates and, consequently, government bonds are unattractive. However, outside the US, the outlook is worse. US Treasury bills remain the most appropriate hedging tool in the bond market.
Long-term correlations are under pressure
US break-even seems fundamentally cheap relative to its three main factors: core Consumer Price Index, credit spreads and oil prices. With the latest core CPI at 2.2% and US 10-year break-even trading at 1.5% in August, US inflation-linked bonds look attractive. Moreover, accommodating financial conditions and a healthy US consumer should support higher prices. Budget spending could also boost inflation.
Calls for fiscal stimulus measures, both within and outside the euro area, are becoming more and more frequent. Germany could use its financial room for manoeuvre to spend EUR 55 billion a year. South Korea has just announced that its 2020 budget foresees an increase in public spending of 9.3%, or a net increase of 2.2% of GDP.
Negative rates are not limited to sovereign debt
Investors were bombarded by various statistics showing the stock of negatively rated debt. Most of them are in the Eurozone and Japan. Other markets are approaching negative rates. The longest-lasting government bond yields in more than 20 developed countries – more than half of them in the Eurozone – reached new historical lows, particularly in the US, the United Kingdom, Canada, Germany and France.
There are already more than 1 trillion negative corporate debts. Investment Grade credit spreads narrowed despite fears of a trade war and geopolitical tensions. Weak supply and persistent capital inflows, combined with accommodating monetary policies, remain key performance factors. The offer is still insufficient.
Last year’s concerns about over-indebted companies have disappeared. Most of the big names in M&A – Comcast, AT&T, etc. – achieved their debt reduction objectives. The carrying and spread compression is low. Except for emerging sovereign bonds, all segments are trading at levels close to their lowest levels in the past decade. A cautious tone prevails.
Reducing exposure to equities
Stocks seem attractive to bonds – risk premium, profit and dividend returns – but historical valuation models are critical – and criticised – because of central banks’ non-conventional monetary policies.
The main question is profit recession or not? Reversing the yield curve would signal a recession in the near future, but again, if interest rates are distorted by central banks, is the yield curve a reliable signal of a recession in the future?
The evolution of profits is important because stock market indices do not rise during periods of declining profits. The difficulty in 2019 is that we do not expect a sharp contraction of profits, but neither do we expect a strong expansion. We are between two waters that do not provide a real trend. In the first half of 2019, US profits increased by +1% and 2019 will be a soft year with an estimated increase of between +1% and +2%. However, if profits are in a downward trend in terms of estimates, they turn out to be better than expected.
Nor can we ignore an unfavourable environment:
- The expansion of the US economic cycle is the longest in history with 121 months, beating the previous record of 120 months in 1991-2001.
- Reversal of the interest rate curve, even if there is controversy.
- The sharp contraction in manufacturing indicators, because of the US trade war and a process of de-globalisation.
- The US-China technology war that is weighing on the entire IT sector and supply chains.
Despite a turbulent global environment, there are positive points that reduce visibility on profit growth:
- Domestic consumption remains strong and real estate is not weakening.
- Wage growth is contained despite a decline in the unemployment rate, which is rather good for margins.
Share buybacks are slowing down
Share buybacks are slowing in the United States, which could increase volatility. S&P 500 companies repurchased $166 billion of shares in 2Q19 (the lowest amount since 4Q17) compared to $205.8 billion in 1Q19 and $190 billion in 2Q18. Share buybacks amounted to $806 billion in 2018 and are expected to reach $798 billion in 2019 according to S&P Global. Technology companies that have reduced their share buyback programs, particularly Apple, Cisco and Microsoft.
A sign that companies are getting nervous about the trade / technology war with China, the deceleration in profit growth, and uncertainties about the Fed’s monetary policy. They will again focus on liquidity.
Share buybacks have been a powerful driver of stock market index growth. Since 2013, according to Bank of America Merrill Lynch/EPFR Global Data, US companies have repurchased $4,200 billion of shares, but during the same period, investors have not been as enthusiastic, as outflows of funds/ETFs in US shares have been $84 billion. Share buybacks accelerated in 2018 because of the tax reform.
However, these share buyback programs also face strong opposition from Democratic candidates for the 2020 presidential election, wishing to restrict them to promote wages instead of shareholders. Republican Senator Marco Rubio has proposed less favourable taxation for investors when a company buys back its shares.
The perfect cocktail for gold
The price of an ounce of gold rose by nearly 15% in 2019. Several factors explain this fine performance:
- The decline in US real interest rates reduces the opportunity cost of holding gold. The price of gold rises when real interest rates fall.
- The de-dollarization process among central banks in emerging countries. The loss of confidence in the US, which is no longer a reliable partner, is pushing central banks to sell the dollar and buy gold.
- Gold is an excellent monetary asset for central banks and investors in the face of global debt risk.
- China and India, the 2 largest gold buyers (central banks, investors and households) accelerated gold purchases in 2019. The Indian central bank has just increased its gold holdings to 9.2% of its foreign reserves, the highest level in 10 years.
- Chinese newspapers, close to the government, frequently return to the need for a new world financial order and the re-emergence of the gold standard, since Washington has disrupted the current financial order.
- Investors find gold to be a defensive monetary asset in a protectionist, nationalist and multipolar world.
Short-term oil recovery possible
After reaching $75 per barrel in April, the Brent price now stands at $58. The optimistic phase on the resolution of a trade agreement has given way to pessimism, resulting in growing fears of a recession in 2020. Estimates of crude oil demand were reduced. On the supply side, the US has increased production. Saudi Arabia and Russia have failed to stabilise Brent prices despite an agreement to freeze output.
Geopolitical tensions in the Middle East, between the US and Iran, have not pushed prices up despite some clashes, while 25% of global production passes through this region (Strait of Ormuz and pipelines). Fears of recession are taking over. Even if the price becomes political when Saudi Arabia and Russia manipulate supply, it is clear that the price of crude oil is under pressure when demand weakens due to a global economic slowdown; which seems to be the case today.
This document is solely for your information and under no circumstances is it to be used or considered as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. All information and opinions contained herein has been compiled from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy or completeness. The analysis contained herein is based on numerous assumptions and different assumptions could result in materially different results. Past performance of an investment is no guarantee for its future performance. This document is provided solely for the information of professional investors who are expected to make their own investment decisions without undue reliance on its contents. This document may not be reproduced, distributed or published without prior authority of PLEION SA.