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Weekly – Investment Adviser 18 April 2019

PERFORMANCES 2019

EquitiesBonds
MSCI World+14.8%CHF Corp+1.3%
S&P 500+16.0%US Govt+1.2%
Stoxx 600+15.3%US Corp+5.0%
Nikkeï+11.3%US HY+8.5%
SPI+17.0%EUR Gvt+2.7%
China+35.7%EUR Corp+3.4%
Emerging+13.2%EUR High yield+6.0%
CurrenciesCommodities
USD index+0.8%Gold-0.3%
EURUSD-1.4%Silver-3.0%
EURCHF+1.1%Brent+33.8%
USDCHF+2.6%CRB index+10.3%
USDJPY+2.2%
EM FX+1.6%

 

Brextension

So, contrary to German expectations, Theresa May will not get a 12 months delay. Macron´s intransigence didn’t either get across. In sort of a typical European compromise, the ¨deadline¨ has been set for October 31st. Interestingly, European policy-makers paid careful attention to consider, possibly, further extension if needed!…

In practice, the UK is – again – taking back control of its political process and is no longer prisoner of the calendar. Indeed, this 6-month delay opens the door for an appropriate organization of either a second referendum or legislative elections. This spells the end of time-blackmail / pressure.

Cross-party talks will continue. They will remain complex and are unlikely to deliver immediate results. Nevertheless, this is a game changer. They open the door for a – marginally different – new Deal with Europe, namely a Norwegian-style one. Theresa May could try to emulate Trump, when he compromised with opposition, to impose a new tax reform.

  • Europe and UK finally ended-up their pathetic and unproductive blame game
  • Brextension opens the season 2 of the Brexit ¨series¨
  • Hopefully, it should have less episodes than the season 1

 

¨Unimaginable¨ European elections

Who would have thought? UK is going to participate in European legislative elections next month. For sure, UK political mess will continue and dramatically spillover to European elections. Indeed, ¨Brexiters¨ are legitimately furious and frustrated. Farage and Co. will attempt to team up with France’s National Front, or Italy’s Lega, or Spain’s Vox. Ultimately, the new European parliament could well be a lot more unruly than its predecessors.

In different but also possible scenarios, B. Johnson or J. Corbyn may become Prime Minister and add to ongoing confusion. But practically, No-Deal is now a close to a zero-probability event. It would have been, for sure, the start of a corrosive and irremediable rupture between UK and Europe.

European

The UK economy should gradually exit the tightrope mode it has been fallen into over the past few months. UK business and consumer confidence should gradually recover from here. The task of the BoE should become less tricky. This may fuel volatility on Gilt markets (which benefitted from safe-haven flows) but benefit to risky assets.

The worst scenario for the economy has receded significantly, if not completely

  • No No-deal is actually good news for the UK
  • We expect the risk premiums on the £ and on UK risky assets to decline further
  • We confirm our January recommendation to accumulate, selectively, UK equities
  • Avoid UK long-duration bonds

 

Currencies. The ECB is willing and able to act…in theory

The ECB was dovish. It opened the door for further easing, in particular the tiering system. However, the pros and cons still have to be assessed. Draghi was very careful not to use the word “tiering”. In addition to the downside-risks to growth, the ECB remains concerned about inflation expectations. Draghi played down the 5y in 5y inflation swap rate decline. He claimed that it was due to risk premiums rather than de-anchoring. He tried to explain why investors are wrong about the ECB commitment to achieve its inflation target. So, the price stability – below but close to 2% – did not imply a ceiling.

The ECB should push further out its forward guidance on the period of unchanged policy rates and ongoing reinvestments. The main refi rates will remain on hold through to 2020-end and reinvestments will continue to 2021-end.

The TLTROs details will be communicated soon. A tiering may not automatically open the door for rate cuts. The ECB is looking into this issue now because it expects the current level of negative rates to last for much longer, rather than because it is looking to cut rates further.

Draghi used to be known as an intelligent speaker. When he stressed that the ECB can allow inflation to overshoot 2% and that all options are on the table, the EUR/USD did not react. Words are no longer enough.

yield spread vs trade weighted dollar

  • The ECB did not provide arguments for the EUR/USD to fall much further
  • The EUR/USD has reached a floor

 

Fixed income. European bond market ¨Japanization¨ is confirmed

The ECB continues to support the bond market. The comments on the impact of negative rates suggest that rates will remain low for long. The ECB is still refraining from talking about Japanization.

The low level of rates still makes investing in European core countries bonds attractive for foreign investors, such as Japan, due to the positive yield pickup from the currency hedge.

Japanese purchase of European government bonds is almost like exporting yield curve control from Japan to Europe. Hence, the message from the ECB is still supportive for further spread compression between core EU and both semi-core and periphery.

european bond market hedged in JPY

Changes in forward guidance and easier conditions on TLTRO-III may not be enough given the undershoots for growth and inflation. If rate cuts are off the table, reviving the QE is still possible. The probability of a QE2 has increased, even if it is not our base case. To do it, the ECB would need to raise its issue/issuer limit above the current 33% hurdle on government bonds. It has already done it in the past on supranational bonds which was raised to 50%. Although raising the limit would likely be an uncomfortable situation for the ECB, it would do this only given the lack of other alternatives. The rally in Italian government bonds continued following the ECB comments and the 10Y spread tightened too despite the weak growth outlook presented by the Italian government. However, with investors searching for yields and no action from rating agencies, we believe there is room for more performance.

peripheral spreads

  • Reload peripheral spread compression trades via Italy

 

Equities. Results’ season has begun

Profits will decline in the United States, no doubt. A recession of profits? Not sure. It takes two consecutive quarters of decline to talk about recession. We will see the companies’ guidance to estimate the evolution of profits over the coming quarters. What seems certain is the pressure on margins in 2019 (wages, logistics and materials).

For now, the results are good with a positive surprise rate above 83% for profits, a percentage higher than the 5-year average. Factset maintains its estimate of a 4.3% decline in profits in 1Q19. Revenues however should increase by 4.8% compared to 1Q18.

Friday, JP Morgan and Wells Fargo posted better than expected results, and PNC Financial in line. The CEO of JP Morgan reports that the US economy remains strong, employment and wages are rising, financial markets are healthy and consumer and business confidence strong.

However, in the fourth quarter of 2018, the semiconductor industry had reported pressure on prices and volumes, but surprisingly, the Philadelphia Semiconductor index has risen 40% since December 24, 2018 – the lowest point of the 4th quarter 2018 correction – compared to the +23% of the S&P 500 ! We anticipate an 18% decline in profits over the first three quarters of 2019.
Concerning the breakdown of chip demand, smartphones account for 25%, cloud 15%, automotive 15% and PC 10%. But the market is focused on a recovery of profits in 2Q19 and a stabilization / recovery of economic activity in China and Europe. The more than 30% rise in Chinese domestic equities since the beginning of the year reflects the confidence that the risk of a global recession has been reduced.

This week, we will be watching results of Goldman Sachs, Citigroup on Monday, IBM, Bank of America, Johnson & Johnson, Netflix, UnitedHealth on Tuesday, and PepsiCo, Morgan Stanley on Wednesday.

  • The bull narrative is dominant on Wall Street

 

Equities. Pressure on Swiss banks

FINMA and the SNB are concerned about the rise in housing construction, prices and the volume of the mortgage market, which rose by 3.3% in 2018 to reach CHF 1’000 billion and 47% in 10 years. The macro-prudential / dissuasive rules did not have the expected result.

FINMA and SNB worry about vacancy rate at 20-year high

They advocate that banks have to tighten their lending rules by self-regulation, since they have virtually no influence on the overall level of risk. We are starting to see empty new housing in some off-centered areas. The IMF is also concerned, as it recommends taking steps to avoid overheating the real estate sector.

For the IMF, the greatest risk to Switzerland’s financial stability comes from the real estate and mortgage markets, especially residential real estate. Low interest rates have pushed insurers and pension funds to massively buy real estate for yields.

The tightening of mortgage rules will penalize Swiss local banks and large banks for their domestic activities. Credit containment would dampen economic growth.

  • We remain neutral on Swiss banks, supported by their domestic and international Wealth Management and Asset Management activities

 

Equities. TV streaming is boiling

Friday, the share price of Disney rose by 11.5% and that of Netflix fell by 4.5%. Disney+, Disney’s streaming TV, has announced the price of $6.99 for the monthly subscription starting in November with the flagship products Marvel and Star Wars, a price lower than the competition. Disney+ will instead address young people and families.

Apple has also announced its streaming TV service, Apple TV+. The undisputed world #1 is by far Netflix with 140 million subscribers, followed by Amazon Prime with 100 million subscribers and Hulu with 25 million subscribers. Disney+ hopes to reach between 60 and 90 million subscribers within 5 years. But Disney has become the majority shareholder of Hulu (60%) since the acquisition of Fox and will have to develop separate strategies between Disney+ and Hulu.

Competition increases, but entering into the streaming TV is excessively expensive. NBCUniversal will launch a streaming TV in 2020. Comcast has announced that it is not going to rush into this segment which represents an economic challenge. Will HBO be able to support the efforts of WarnerMedia (HBO belongs to WarnerMedia, which itself belongs to AT&T) in streaming? Will the consumer pay for the CBS Showtime (8 million subscribers)? And we do not know how much Apple TV will spend.

New streaming TV services will weaken existing ones. But technology groups like Netflix are more agile than traditional brands like Disney. Disney will have to manage movies that are released in cinemas. Netflix will keep its advantage for a while, because thanks to powerful algorithms, Netflix has a fine knowledge of the tastes of consumers, allowing to conceive original contents.

The great strength of Netflix and Amazon is the content, while the others are based on the catalog. So, for the moment, not too much worry for the two undisputed leaders, Netflix and Amazon, who spent $ 12 billion and $ 6 billion on content and marketing in 2018, far ahead of the followers.

subscription entertainment

Netflix is not at risk yet. Its large number of subscribers allows it to invest a lot of money in the content, unlike the others, even Disney. In 2019, Netflix is expected to spend $ 15 billion in content and marketing against $ 1 billion for Disney.

  • Disney+ is not an alternative to Netflix. In streaming TV, Netflix remains the undisputed leader. Netflix remains a buy with a valuation at $450

 

Commodities. Cobalt price is rebounding

In our Weekly of March 4th, we pointed out that palladium prices rose by 90% in 7 months and that cobalt prices fell by 70% in 9 months. We suggested adopting a short palladium-long cobalt strategy. Since March 20th, the price of palladium has dropped by 14% and the price of cobalt is rising.

Cobalt price

60% of world production comes from the Democratic Republic of Congo, followed by Russia, Cuba, Australia, Philippines and Canada between 3% and 5% each. World production is around 150,000 tons. The largest mine in the world is Mutanda (production of 25’000 tons in 2017) in the DRC owned by Glencore (18% of world production), followed by Tenke Fungurume of China Molybdenum (12% of world production). Glencore has reopened the Katanga mine (potential production of 34,000 tons) which is expected to overtake Mutanda and strengthen the DRC’s position as the world’s largest producer. China holds significant weight in DRC production; with lithium, cobalt is an essential resource in the manufacture of batteries.

The cobalt market is characterized by short-term oversupply, but in the battery sector alone, global demand for cobalt, which has tripled since 2011, is expected to increase from 46,000 tons in 2017 to around 190,000 tons by 2026, according to industry analyst Benchmark Mineral Intelligence.

  • We recommend to buy Glencore which is one of the largest cobalt producers and traders

 

Gold. China confirms its interest in gold

For the fourth consecutive month, the PBoC bought in March 11.2 tons of gold as foreign currency reserves. Its gold reserves amount to 1,885 tons. Before December 2018, PBoC had not bought gold since the last 2 years. These Chinese purchases reinforce the trend of gold buying by the central banks of emerging countries, Russia, Turkey and Kazakhstan in the lead.

2018 was the largest year of gold purchases by central banks in 50 years. 2019 is heading for a new record.

central bank activity until february

The coming into play of China is obviously a major event, as it has $ 3,100 billion of foreign reserves. Its 1,885 tons of gold represent $78 billion, or 2.5% of its foreign reserves. Developed countries have on average 65% of their foreign exchange reserves invested din gold, except for Switzerland and Japan which have only 5.5% and 2.5% respectively, Russia 19% and India 6.4%.

How much gold would China need if it were to increase its share to 10%? It is expected to hold 7,434 tons, meaning that China has to purchase 5,560 tons. Is it possible ? The annual global supply of gold is 4,500 tons, 75% coming from output and 25% from recycling. In 2018, demand came from jewellery accounting for 50%, industry 8%, investment 25% and central banks 15%. So, the Chinese process of increasing the share of gold in foreign reserves will be long because the supply surplus (74 tons in 2018) is limited, though Chinese purchases will be a powerful support for gold.

  • Chinese gold purchases will be price supportive, if a structural trend is initiated

 

5G, a theme for 2019 and beyond

The 5G will be a revolution. The interest of the 5G not only lies in the smartphone use and its applications. The speed increase and the latency reduction will allow the emergence of a huge ecosystem in which the telecom networks will connect billions of objects (IoT).

The areas that will benefit the most are: connected objects, smart grids, smart cities, smart houses, health, telemedicine, surgery, automation, robotics, autonomous and connected cars, augmented reality, virtual reality, streaming TV, mobile games, etc.

The investment cycle will be longer than the 4G one and in the United States the investment will be around $300 billion. The network infrastructure will be much wider and will require a local relays multiplication (between 10 and 200 meters). There should be 3 times more antennas. In network infrastructure, the world’s top four players are the Chinese Huawei and ZTE, the Finnish Nokia and the Swedish Ericsson.

The United States are launching the 5G in 2019. China, Japan and South Korea are following closely. On the other hand, Europe is far away behind. In the technological war between the United States and China, as well as the race for 5G, the US Administration and the US Federal Communications Commission have decided to accelerate the 5G implementation by creating a $21 billion fund and allowed antennas installation on private properties, especially in rural areas.

  • Invest in companies active in 5G, from network infrastructure to antennas and semiconductors

 
 
Disclaimer
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.