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Weekly – Investment Adviser 12 September


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USDJPY -1.8%
EM FX -1.9%

Chinese way

Moral Hazard variations

Moral hazard exists when a party to a transaction has an incentive to take unusual business risks, because he is unlikely to suffer potential consequences.

Source: Investopedia

In the late 2000s, the recession brought to the light the risky behaviours of US giant corporations like Bear Stearns, AIG, Chrysler and General Motors. Their inept strategies, excess leverage and accounting ¨tricks¨ eventually put at risks the $ billions of contributions to the economy, as well as thousands of jobs. US taxpayers money was injected to save these firms, considered as too big to fail. Top executives of these firms have actually been shouldered by public money.

In Europe, the cult of austerity and the Maastricht treaty leave, in principle, no place for Moral Hazard. In practice, Greece bailout and the multiple financial engineering activities of the ECB have allowed for a confidential / officious version of it. Italian and Spanish banks have been practically given life support over last years via – sometimes indirect – public funding. German banks, if not car manufacturers will eventually come next.

UK / Ireland also intervened to bail out major banks.

A couple of decades before, Japan did it too with life insurers, which risked bankruptcy because of too generous fixed income liabilities payable to policyholders. The government just broke the private contracts and their changed conditions.

The Moral Hazard is also at the heart of China’s banking system. Policymakers hate to bail out banks, but have been doing it for years. Bank of Jinzhou, a small northern lender, is one of the latest example of such an operation last August. Before that, the money market panicked last June, when Baoshang Bank (Ineer Mongolia) was taken over by authorities, but without all its liabilities being covered. Indeed, while all household depositors were fully guaranteed, corporate depositors and interbank creditors with over Rmb50 million (US$7.2 million) exposure were only paid out up to 70-90%… This laudable attempt to impose discipline in the banking system could easily have triggered mass panic in what was the first bank takeover by the authorities since the early 2000s. Ultimately, the bank achieved to close short-term refinancing, through negotiable certificates of deposits (NCDs). The domestic credit market calmed rapidly.

Différentiel entre NCD et obligations du gouvernement à 3 mois

Source: Grizzle

The Baoshang takeover confirms the government’s will to advance in its long structural reform process, i.e. in the fight against moral hazard. This is surprising (courageous?) in the context of last year‘s painful deleveraging squeeze on shadow banking. Relevant authorities seem indeed committed to reducing risk in the financial sector, whatever the price / cost.

High-level political support for structural reforms continues in spite of growth deceleration.

  • China is playing a symbolic redux of “the long March” (military retreat undertaken by the Red Army in October 1934 – 1935)
  • We should neither expect a major fiscal easing (à la 2016), nor quantitative easing in the short-term. Economy and markets will probably muddle through
  • But it may emerge in H1 2020, just when the US economy and President will face critical deadlines


Currencies. Neutral is the new hawkish

According to the BIS, we count 17 central banks which have already cut rates 32 times for cumulative 13,85% so far this year. However, the Bank of Canada has decided to skip its turn, like the Norwegian one some weeks ago.

The Bank of Canada policy statement was less dovish than expected by many markets commentators. The BoC held rate unchanged at 1.75% as universally expected but there was very little in the way of an obvious concession to thoughts of an October rate cut. Rather, the BoC played it relatively neutral, driving a short covering in the CAD.

Bank of Canada Deputy Governor Lawrence Schembri confirmed than the Canadian economy is at potential, inflation at target and current policy rate provides sufficient stimulus to offset trade headwinds and is consistent with inflation reaching its 2% target over the two-year horizon.

Market expectations for an October rate cut have receded to less than 50% probability, well down from the 70% just before the meeting. By consequence, the 2-year yield gap between the US and Canada edged below 10bps, the narrowest spread in 2 years.

US-Canada 2-year yield spread & USD/CAD

Source : Bloomberg

  • The last time the spread was that tight, the USD/CAD was trading near 1.26


Fixed income. Are Fed models outdated?

The Cleveland Federal Reserve just released its quarterly update. It aggregates the traditional models which are predicting the Fed Funds. The Fed uses the 7 most popular monetary policy models (Taylor Rule, r*, output gap, etc.) and a range of economic inputs (CBO, Survey of Professional Forecasters, their own estimates) to produce an array of Fed Funds forecasts from which it calculates a median.

Historically, the Fed Funds futures in the next quarter have been close to the model outputs, until now.

If Fed Funds futures are correct, the Q4 average will be 79 bps below the median model estimate.

Difference between Fed Funds Futures and Fed models (bps)

  • Are the Fed models outpaced or the market too pessimistic about Fed futures decisions?
  • Whatever the answer, market volatility is here to stay


Thematic. Take profit from rising volatility

Ulta Beauty is an American chain of beauty stores. It carries cosmetics and skincare brands, men’s and women’s fragrances, nail products, bath and body products, beauty tools and haircare products. Ulta Beauty currently has 1196 stores across all 50 states.

Ulta Beauty share price

Ulta is still gaining market share, even though sales growth has cooled in recent quarters amid rising competition. Ulta may struggle to lift sales in the 2nd semester as industry makeup sales is softening due to an absence of innovation. Still, Q2 transactions rose by 5.4% and gross margin by 0.4%, highlighting the power behind its business model.

Ulta is drawing customers by enhancing multichannel retail offerings, expanding product mix and promoting its loyalty program, initiatives which continue to boost sales that have grown more than 200% since 2008. Along with supply-chain optimization, the strategy may eventually drive single-digit store sales gains and high-teens margin expansion.

  • Favor a barrier reverse convertible to take profit from the recent stock weakness and higher volatility



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