Strategical Investment Review – Q2 2019
The Fed adopts a cautious approach given the recession risks
The Fed brutally changes its monetary policy stance, which goes from a restrictive mode – balance sheet shrinking, and 3 to 4 rates hikes expected in 2019 and 2020) – to a (very) dovish tone, including only one rate hike in 2020 and slowing down its balance sheet contraction. The market is already pricing rates cuts in 2019! The European Central Bank has confirmed that its monetary policy will remain very accommodative. The main reasons are the growing recession concern and financial market support, which was sharply shaken in Q4 2018 following significant growth downward revisions.
Despite the risk of a recession, financial markets posted very good performances in Q1 2019: the MSCI World equity index is up by +12% and the global bond index by +2.4%. The main currencies remained stable. Other risky asset classes such as the Emerging or High Yield segment delivered positive returns of between 5% and 8%.
Other factors have influenced financial markets
The Brexit process is ridiculous. The European Union, which is losing patience, has accepted a deadline report from March 29th to April 12th, 2019, only if the signed agreement between Theresa May and the European Commission is approved by the UK Parliament. A tricky exercise given that neither the Tories nor the Labor are agreeing. A Brexit with no-deal will be much more detrimental for UK in the short term than for the European Union.
The IMF has lowered its growth forecasts, especially in Europe, on the brink of trade tensions, Brexit, undermining multilateralism, rising tariffs, and protectionism. Germany is particularly affected by the Chinese slowdown and Trump’s attacks on the auto sector.
No trade agreement has been reached yet between China and the US. After the release of the Mueller Report, Trump wishes to add victories by presenting a favorable trade deal. We are entering the pre-presidential campaign. The technological war will be a long process given its bipartisan support.
Trump failed to get funding from Congress to build the Mexican border wall. He used his veto and declared a national emergency. Following the Mueller report release, the Pentagon allowed one billion to start the wall.
The Hanoi summit between Kim Jong-un and Donald Trump on the North Korea denuclearization failed. Kim Jong -un called for the lifting of all sanctions, Trump refused. This is not a surprise. North Korea is a China ally, and we are amid a trade and technological war with the US.
The fall in auto sales reflects the current economic and political environment (tariff war, protectionism). However, there are also the impact of the Chinese subsidies’ abolition on small cars in the summer 2018, the technological transition towards electrification, the diesel gate and the progressive ban of diesel cars in major European cities. In China, February sales fell for the eighth month in a row by 14% and in Europe fell by 2.9% over the first two months of the year.
Strategy and Macro
During H218, geopolitics improved as, notably, Donald and Kim meeting in Seoul reduced fears of a conflict in the Korean peninsula. A second meeting in Hanoi strengthened the feel-good factor. The Middle East (Iran embargo, confrontation with Saudi Arabia), as well as Russia assertiveness waned lately. As well as Turkey instability. The perspective of a trade truce between China and the US also played a positive role recently.
Still, we consider that the Geopolitical landscape remains very unpredictable and potentially ¨explosive¨. Indeed, the layers of tensions between Washington and Beijing remain numerous.
European – far-right – populism has a chance to shake institutions in 2019. Recent showoff between India and Pakistan, two nuclear States, is also a source of concern for Asia, namely in the context of the prevailing G-Zero regime.
In a best-case scenario, it will take years to denuclearize the Korean peninsula
Current reading of Geopolitical Risks by medias and markets is complacent
Aborted Macro regime transition in the US
During H218, the US economy recorded, most probably, its current business cycle apogee. Indeed, growth was running at a much higher speed than potential and inflation gave early signs of a slippage above the 2% threshold. Today, the question of the sustainability of this take-off remains central and… open. Let’s review the main – opposite – arguments.
One school of thought (call it A) argues that the outperformance – probably of lower magnitude – of US growth is sustainable, because of a virtuous cycle formation. In short, lower taxes and better incentives to invest will ignite a significant pickup-up of the capex cycle, favoring improved productivity and higher wages. The main risk to this rosy picture was, ultimately, a tug of war between a Fed leaning towards further tightening and a profligate Administration. We consider that this scenario has a very low probability to unfold at this stage.
Another school of thoughts (call it B) calls for the imminent end of the business cycle. The rationale is that inflation is gradually resurging. The government is also crowding out the private sector, dis-incentivizing capex, and fueling the inevitable deterioration of financial conditions. Many impediments should be expected from the unbridled rise of debt (watch for car and student loans, credit cards, etc.). The inevitable endgame is a recession.
This (B) scenario has gained traction lately. The sudden pessimism pervasively provoked the rise of the cost of capital (say credit spreads and risk premiums) and the drying up of liquidity conditions (hence capacity to raise debt), etc. Fortunately, the growth scare seems to have proved temporary. A more benign perspective, whereby the business cycle may continue for another couple of years is emerging. It is favored by more accommodative Federal Reserve and financial conditions. It would spell further ¨Goldilocks¨: not too high nor too cold an economy…
Still, we acknowledge for a not too far end of the US business cycle. Let’s face it, a soft landing of the economy is rather the exception than the rule. But, admittedly, the absence of major ¨classical¨ imbalances raise the odds of this outcome in 2019 (if not in 2020). But one should stay alert, as high debt and little ammunition on the fiscal and monetary policy fronts significantly reduce the room to maneuver for policy-makers….
A benign Goldilocks macro environment is likely in 2019 in the US…
… as well as a significant slowdown / mild-recession in 2020
Bye-bye EM-DM convergence?
According to playbooks, the sustained rise of the USD, coupled to higher rates impaired emerging countries in recent years. Some emerging countries were painfully obliged to raise policy rates to defend their currencies and control inflation. A fiscally doped US economy also played a role in contracting EM-DM economic performance differential. Indeed, in 2018, emerging growth outpaced advanced countries expansion by a mere 2+%.
Over next years, this gap should gradually widen again to more than 3%, courtesy of the end of the US cycle and of a normalization of financial conditions in emerging countries. Still, the capacity of emerging countries to generate excess growth, like in the early 2000 (close to 5%) is not in sight because of residual trade tensions, tentative capital outflows and volatile oil prices.
Developed and emerging economies achieved a remarkable disinflation from more than 15% in the mid 70’s to about 3,5% in 2018. It is namely due the deflationary shock due to the financial crisis of 2008-9, but also to structural conquests, like the broad adoption of robust monetary, exchange rate and fiscal policy frameworks, as well as financial integration. But slowing globalization and rising protectionism represent a concrete (new) threat. Profligate governments may attempt to impose inflation prone frameworks to central banks, whose independence is already under growing threat, not least in the US. Populist politicians would indeed not refrain from inflating out of their rising debt obligations (like Italy) …
Total trade volume fell by a cumulative 3,5% by T418. This is the first notable contraction since the 2009 financial crisis … These (volume) figures are actually not distorted by lower oil prices. This decline is coming from lower trade activity of the usual suspects (US, China, Germany and Japan).
Further DM-EM convergence is unlikely
US trade policy is impacting world trade and … expansion
Towards “QE infinity”?
The Chinese Party is convinced that raging inflation represents its existential risk. Indeed, an implicit contract exists between the communist party and people, whereby the former ensures decent and improving standards of living (hence no corrosive inflation), while the latter supports the authoritarian political regime. As per the government perspective, the Tiananmen scare was indeed connected to a long-lasting and damageable spike in food inflation.
In this context, China strictly followed a German-like type of philosophy script in the past decades, by setting-up a German-like monetary policy i.e. very conservative. This has not prevented the country from creating imbalances and excesses. Indeed, targeted growth pace and inflation control have been achieved thanks to a significant rise of global indebtedness. From now, this burden will weigh on economic perspectives (i.e. through low marginal return of new debt issuance). Population is ageing rapidly, therefore labor productivity is on the decline. In addition, the confrontation with the US reduces the room to maneuver for policymakers. This explains why China has recently shifted gears. Indeed, it has given itself the monetary policy means to a) implement QE-like operations and b) organize a multi-participants bailout of the banking system.
The Fed is contemplating to end its QT in 2019. It also studies a recalibration of its inflation mandate. A change towards a ¨price-level targeting¨ mode would practically allow CPI to overshoot the 2.0% target to make up for time it spent below 2.0%… This would spell, short-term, a more inflationary / accommodative stance. The mechanics resembles that of the output gap. Politicians would of course opine, as higher inflation is good in times of government profligacy / high debt.
ECB is implementing a new life line liquidity support for its banks. This eventual follow-up of the former TLTROs is a likely prelude to other more structural measures. We anticipate that more ambitious will be inevitable by the end of 2019, be it a bail-out / recapitalization involving public authorities, or mutualization of risks (Eurobonds).
With its officious QE coupled to more active fiscal stimulation for private sector, China will maintain its growth around potential say 6% in next couple of years
A decent pause in QT, if not further (temporary?) liquidity injections lie ahead
Deflation scare in Europe is exaggerated
No paradigm shifts in investment regime, but…
For sure, volatility made a brutal comeback, fueling an overdue mode of repricing risk. The blend asset price reflation, liquidity driven, ended in early 2018. Lots of uncomfortable gyrations and corrective phases for investors ensued. This sort of landscape will prevail, despite recent return to calm. The breakout of long US interest real interest rates late Q3, above 1%, proved a false alert. It was based on the inexact assumption that US CPI was on a verge of a significant acceleration. This is a very important metric for assets’ price valuation, as a symptom of prevailing financial repression. Lots of quantitative model recourse on the monitoring of this level to assess the future correlation among asset classes. Risk parity funds belong to them. Their significant size in terms of AUM ultimately gives a significant – short-term – importance to developments of this indicator. The quick resumption of the macro ¨disinflationary boom¨ regime, early 2019, encouraged investors to reconsider this tentative investment regime shift.
We also monitor a few other long-term indicators, featuring inflation dependent factors. Like namely the ratios of Gold to bonds and to equities. Further recovery of gold to bonds ratio would precede a new round of global reflation, or of a weak USD cycle. At this stage it doesn’t call for a new inflationary regime.
The negative correlation regime between bond and equities will continue
No ¨severe¨ earnings recession, but rather a framework of decent companies’ profitability, should prevail
Towards a de-dollarization
The de-dollarization of the economy has been on the move for many years now, but it has sped up recently. According to the IMF, the USD share in the world FX reserves has slipped to 62% from a top of 72% reached in 2001. This has been done at the benefit of the other developed currencies, but not exclusively.
Recently key officials, even in the EU, urged to change the international payment standards. The world ’s most essential resources are denominated in USD. Juncker judged absurd that Europe pays 80% of its energy imports — EUR 300bn per year — in USD, when only 2% come from the US. China also senses the absurdity, as the USD penetrates the country economic norms. China is doing its best to ditch the USD in international transactions. It notably launched its own oil and gold futures, denominated in CNY.
History shows that when the USD replaced the GBP, the size of the US economy already outstripped the UK one. Chinese GDP is still less than the US one, which suggests it will take time for the CNY to overtake the USD. But in the current era, the reconstruction of the global currency system may be faster than expected. De-dollarization and diversification of international currencies reserves will inevitably continue.
Short term noises cannot hide structural trends
In the very short-term, the sentiment towards the CNY remains dictated by the progress of the US-China trade talks. Although March 1st deadline has been postponed, an agreement is not still settled. This optimism is already reflected in the recent CNY strengthening.
Structural changes are in place for months now and should remain there for a while. According to the IMF, over just one year, the CNY share in the official FX reserves has doubled. Even if the stock remains low at $192bn, it already represents c. 2% of the international reserves. On the valuation front, both the US Treasury and the IMF came to the same conclusion. While the latest Treasury report kept China on its monitoring list, it could not point to any evidence of a competitive currency manipulation. The IMF also concludes that CNY valuation is broadly in line with its fundamentals.
Furthermore, as its current account slips into deficit, is it sustainable to push for a CNY trengthening? Recently, the PBOC has used tools to guide a modest CNY appreciation. But beyond that, with a current account deficit, a stronger currency would require either sustained foreign inflows or USD selling interventions. China already did it to be included into MSCI and bond indices. The PBOC lost $1tn of reserves since 2014 to support the Yuan. So far this year, equity inflows have picked up on early signs of credit growth stabilization. But for continuous inflows, incoming data need to catch up with optimism. In bonds, we do not expect a significant increase in inflows. Passive inflows from China’s bond index inclusion should continue at an average pace of USD 5.5bn per month.
Hopes for a monetary policy normalization, driven last year by Fed language , are now completely dashed. Now further rate hikes will be data-dependent. The sluggish economy, central banks dovish shift, and the lack of momentum in inflation across main economies have supported the purchase of long-dated Treasuries. The main consequence is that the term premium has compressed and that even if nominal yields have been volatile, the long -term expected yields have remained quite stable around 3.30%.
What has become clear is that Powell, Clarida and Williams are willing to let inflation measures tell them whether the policy rates are too low or high. The consequence is likely to lead to a Fed admitting a 2% inflation target overshooting to anchor higher long-term inflation expectations. The Fed has also talked about policies employed elsewhere and found them as credible alternatives. This illustrates well its dovish twist. As commercial banks demand for reserves is higher, the Fed is no longer pretending that it will be able to reduce its balance sheet to pre -financial crisis levels.
The buzzword is: ¨patient¨
If the above elements represent a re-assertion of dovish tone at the Fed, it is also true that inflation has continued to surprise to the downside despite a tight labor market. The PCE deflator only rose by 1.8% in November. This has pushed the Fed members to re-assert their positions. The reality is that the disinflationary trend is primarily due to high global debt levels, declining money velocity and real economy factors such as demography and technology.
Markets continue to respond positively to dovish monetary policy signals
The Fed has succeeded in – partly – normalizing rates and reducing its balance sheet by $490bn or 11% since September 2017. So, most of the monetary tightening looks behind us. According to Powell, the balance sheet could drop to 16-17% of the GDP. The balance sheet shrinking will stop around $3.5trn, if not before, vs. $3.9trn today. Powell confirmed that the QT end is approaching. At 19%, the balance sheet is already a lot lower, in % of GDP, than any other main central banks (BoJ 102%, ECB 41% and BoE 29%), and its policy rates are also much higher. The timing of this announcement is interesting, as the fiscal deficit will grow from $779bn or 3.8% of GDP in 2018 to $1.13tn or 4.7% in 2022. So, it raises the issue of whether foreigners will be willing to keep funding US deficit spending by buying Treasury bonds. So far, only Russia sold whole its Treasury bonds. By contrast, China holdings fell by only $67bn or 6%. The supply is not a major concern. The long-end yields remain primarily driven by the nominal GDP growth trend.
All eyes turned towards profits. Growth, stagnation or recession?
Two major parameters influence the stock market indices:
- The interest rate/inflation regime, which justifies the level of stock market valuations, high in periods of low inflation and low in periods of high inflation. Today, generous PE ratios do not shock us.
- The evolution of profits. In general, stock indexes decline when profits fall. This parameter will be decisive in the coming months.
In Q1 2019, S&P 500 profits are expected to fall by 3.6% according to Factset and to increase by 0.4% according to Refinitiv. As we are approaching Q1 2019 results, investors will certainly be cautious. In Q4 18, the positive surprise rate was below the average of the last 5 years. For 2019, Factset estimates a rise in profits of 4.1% (+20% in 2018) in the United States, and Refinitiv of 4.6% in the United States and +5.6% in Europe.
We are clearly in a period of slowdown. Since September 2018, downward revisions in earnings growth in the US for 2019 have been impressive, declining from +12% to +6%. In Europe, estimates have also been divided by 2.
But there are factors supporting equities:
- Dividends. 2018 was a record-year in terms of overall dividend payments: $1370 billion, or +9.3%, with the United States accounting for $510 billion. The amount of dividends is expected to rise by 3% in 2019 to $1,410 billion.
- Share buybacks. Stock repurchases also contributed to the attractiveness of the shares: in the United States, they amounted to $800 billion in 2018 ($550 billion each year in 2016 and 2017) and to $61 billion in Japan. They are expected to remain high in 2019, with companies enjoying a still favorable environment, as the bipartisan US Congress would like to limit share buybacks in favor of wages and the real economy; this could be a theme of the next American presidential campaign, supported by the Democrats Schumer and Sanders, but also by the Republican Rubio. In the United States, dividends and share buybacks amounted to $8’000 billion since 2009!
- Mergers & Acquisitions. In the past four years, mergers and acquisitions have accelerated. The reasons are: 1) low interest rates facilitating financing, 2) the plethora of liquidity in balance sheets and 3) the difficulty of growing organically. However, in 4Q18, there was a deceleration with the correction of stock market indices, and trade and political uncertainties. In 2018, the number of transactions decreased by 10%, but megaacquisitions (> $ 5 billion) increased. Chinese transactions in the United States slowed considerably in 2018 with the trade war and the blocking in the technology sector in the name of the US national security, but also due to less aggressive Chinese companies heavily indebted like HNA, Dalian Wanda or Anbang. National security issues, justifying to stop Chinese acquisitions, have also been observed in Canada, Germany and Australia.
The US stock market, the big winner in the long run?
The US stock market outperformed the rest of the world during the IT bubble and the expansion of FAANG. This is due to the US capacity for innovation, its disruptive companies and its ability to finance emerging companies/new economy.
Outside these two periods (IT bubble and FAANG), the outperformance of US equities is not obvious. The questioning of the business models of the FAANG, with the regulation of flows on private data and the pressureson their tax models, could stop the strong outperformance of the US stock market.
Senator Elizabeth Warren, a Democratic nominee for the upcoming US presidential election, has announced a plan to break up big tech companies like Amazon, Facebook and Google, which, she says, pose a major risk to competition, economy, society and democracy. They make profits thanks to private data, they squeeze small companies and stifle innovation.
Contrarians will appreciate the strong underperformance of Europe
Debt crisis, euro crisis, banking crisis, political crisis, Europe has not been spared. And the difficulties persist. This has resulted in a huge underperformance since 2009 (see chart) and weak stock market valuations. A more sectoral than geographical approach is needed in Europe, because we are still in a mess : European elections this spring, rise of nationalism and populism, Brexit.
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