Weekly – Investment Adviser– 12 November
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… of this dark and deserted castle where lie our dead illusions …
Jean Ferrat 1991
The rise of the industrial sector is a usual pattern of an economic take-off from countries at the middle stage of their development cycle. It happens at the expense of the primary sector (agriculture). It often features the strengthening of the military / defence sectors.
In Japan, the zaibatsu have been centerstage of the country take-off in the 20th centuries. These conglomerates also had great influence over national and foreign policies. These extremely powerful companies were first dismantled post WWII (by the Allies). Survivors (financial and industrial multinationals) were later brutally hit by the burst of the Japanese bubble. Today, none of the big four i.e. Mitsui, Mitsubishi, Sumitomo, Yasuda remains a significant multinational company.
In South Korea, flamboyant conglomerates are called Chaebol. By the 1990s, they helped the country reach the status of one the largest newly industrial-ized countries. A low (subsidized) funding cost allowed them to expand to Western markets. But mountains of debts, coupled with overcapacity, became fatal to most of them. In the aftermath of the 1997 Asian financial crisis 11 of the 30 largest ones collapsed (like Daewoo). The remaining chaebols have become more specialized in their focus (Samsung).
Over past decades, the US underwent its rapid deindustrialization, as it increasingly became a service-based economy. US manufacturing now makes up just 12 percent of US, while less than 10 percent in Canada. The decline of manufacturing is even more obvious when we look at employment rather than GDP. Goods-producing industries (manufacturing, mining, construction, agriculture, etc.) now employ only about 15 percent of America’s working population.
Former stock-exchange juggernauts like General Motors, General Electric, and U.S. Steel gave way to JPMorgan Chase, Walmart, UnitedHealth Group and the likes.
Looking ahead, new shocks may even accelerate this process. For instance, energy sectors may be growingly challenged by climate change.
The decline of Industrials is structural, when countries reach a mature economic stage
Repatriating jobs and restoring US industrials’ prominence is just another inept promise
Europe may be next casualty
Germany is the fire line. Beyond traditional economic forces, the 20th century fortress of manufacturing is also assaulted by political risks (Trump protectionism). Its car manufacturing sector risks obsolescence / decay, as it did not engage early enough into the technical disruption (electric, autonomous vehicles). The inability to forge transnational champions is obvious (in banking too). The failure of the merger between Alstom and Siemens is another symptom of short-sightedness of European policymakers. Brexit is another negative factor when it comes to setting common security, defence and other aerospace projects…
The corrosive peculiarities of the current business cycle
Over-capacities are resulting from China economic model, which directly subsidies certain heavy industries, like steel for example. But the global collapse of interest rates is also helping non-productive / non-profitable companies to survive everywhere.
By sustaining industrial zombies, developed countries’ financial repression and China prevent market forces to clear over-capacities
- Industrials would outperform with a growth/cyclical rebound
- But structural pressure will continue to weigh
- Avoid large namely indebted groups. Prefer companies a) with a clear business edge and focus b) niche and innovative players
Fixed income. Fed cut and pause
As widely expected, the Fed cut rates by 25bps at the third consecutive meeting, lowering the Fed Funds range to 1.50%-1.75% and downplaying expectations of further cuts in the near term. Once again, the decision was not unanimous, Fed members Esther George and Rosengren dissented again, preferring unchanged rates, while James Bullard opted for a 25bps cut instead of 50bps previously.
Now, the FOMC will monitor the incoming information to define the appropriate path of the Federal Funds rate. This suggests that the Fed wants to take stock after 3 consecutive rate cuts in July, September and October. In the press conference, Powell stuck to his usual mantra that the Fed stands ready to act. He also sought to show the Fed’s intention to navigate well the recent destabilization of the bank funding market. Powell tries to steer market expectations in a mildly uncertain future, hoping to maintain his policy options open. A pause in December is the most probable outcome.
The US GDP growth came in Q3 at 1.9% qoq annualized. That was a touch better than expected, but lower than the last couple of quarters. Private consumption was strong. Other elements were unexciting and in line with expectations. The US economy is experiencing weakness in manufacturing, the overall economy should slow further during the next couple of quarters. A recession, however, is very unlikely. The US growth is now more correlated to the service sector than the manufacturing.
Furthermore, Chinese manufacturing PMI has rebounded to its highest level in over two-and-a-half years. New orders were strong. It highlighted a sustained improve-ment in manufacturing conditions. Goods producers reported improved demand due to stimulus measures and rising hopes of easier trade tensions.
US jobs report shows some green shoots. Employ-ers added a better-than-expected 128’000 jobs in October despite ongoing trade concerns and a slowing global economy. The solid pace of hiring came from manufacturing sector even if it was penalized by GM strike. Additionally, employment gains for August and September were revised up. The labor force participation rate rose to its highest level since 2013 at 63.3%. Annual wage growth remained level at 3.0%.
- The key takeaway is that the Fed allows itself some more time to judge the economy on the incoming data before deciding on the next action. The Fed will be on hold in December
Currencies. Arrivederci Mario
A large change is taking place as Mario Draghi left, after 8 years at the top of the ECB, and Lagarde takes over as president. We do not know that much about Lagarde’s thoughts on monetary policy. She has never been a monetary policy decision maker. As IMF President she has supported ECB non-conventional policy decisions. She has already called for more fiscal and structural policy which is in line with ECB requests. So far, Lagarde has emphasized she will continue with ECB’s stimulating monetary policy stance. The bad news for Lagarde between when she accepted to take over the reins at the ECB and a week ago were that official headline inflation was still falling. Fortunately for her, the euro-area core inflation came at a higher-than-expected 1.1% yoy level in October.
The Fed capitulation this year includes much more than just reversing from rate hikes into insurance cuts. The QT pivot process has gone from slowing shrinkage, stopping and then expanding the balance sheet. The Fed is now running various repo operations and will continue into 2020 while committing to getting back to ample reserves for the banking system.
- Given the forward guidance in place any abrupt changes at the ECB are very unlikely. It would be confusing for markets
- Excess reserves remain jumpy and will grow rapidly into year-end, offering another catalyst for the USD bears
Equities. PSA-FCA, a merger that makes sense
It takes time for FCA to get married. Two years ago, it tried with GM (market share problem in the United States), then Renault (too political). The FCA-PSA merger makes sense, especially in terms of geographical complementarity. And no politics. The Peugeot family (14%) remains a reference shareholder. The new group will be headed by Carlos Tavares, the current CEO of Peugeot who has managed to integrate Opel and is recognized for its cost management. A manager who is unanimously considered and maybe the only one to achieve such a merger. The other shareholders are the French State (which arrived in 2009 with the rescue of the automobile sector) and Chinese Dongfeng with 12% each.
With € 184 billion in sales, PSA-FCA will be the world’s third largest automotive group, behind Toyota (€ 248 billion), Volkswagen (€ 235 billion), and ahead of the Renault-Nissan-Mitsubishi alliance (€ 172 billion), Daimler (€ 167 billion), Ford ($ 160 billion), GM ($ 147 billion), Honda (€ 133 billion), BMW (€ 97 billion).
The current market capitalization of the two groups is € 43 billion, which we estimate at € 60-64 billion in the medium term in the case of a successful merger, up 40-45%, due to the estimated cost synergies at € 4 billion and development potential thanks to geographical complementarity. We will be closer to the valuation ratios of the German manufacturers and GM.
FCA-PSA will obviously have more strength in the development of electric cars and other technologies such as autonomy and connectivity.
But some challenges remain: 1) managing jobs in France, Italy and the United States with political and union aspects, 2) PSA and FCA are weak in China, the largest global market, 3) bad reputation (lack of reliability and quirks) of Peugeot, Citroën and Fiat brands in the United States; in the 70s, the TV series of the famous detective Columbo with his ratty convertible Peugeot left this negative image for decades.
- Buy FCA and PSA with price targets (taking into account the merger) of € 20 and € 32 respectively in a 2-year horizon
Equities. European banks suffered last week
The banking sector has outperformed, like the whole value segment, since early September. Investors are looking for sectors / stocks that have underperformed in recent years with low valuations.
European banks suffered a slump last week due to mixed results. Banco Santander saw its profit fall by 75% following a 1.5 billion depreciation of its UK subsidiary, despite rising revenues and good results in Latin America. Deutsche Bank and Credit Suisse have disappointed. HSBC has posted underperforming results and announced restructuring with job cuts. Conversely, BNP Paribas posted some interesting figures.
According to the P/Book value, one of the benchmark ratios for the banking sector, European banks are cheap compared to US banks: the average of the European banking sector is 0.65, half of that of the US sector. The 2 weak points of the European banks are their profitability and the non-performing loans compared to the total loans, in particular for the Italian banks. US banks have strong balance sheets, supported by the recent success in stress tests.
The outlook is still uncertain with low interest rates and risky economic growth.
- If the Value segment continues to outperform, banks will benefit, even European banks
- We recommend buying BNP Paribas and Santander, whose recent fall in the share price is an opportunity
- In a soft Brexit, Lloyds and RBS are the best positioned
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