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Weekly – Investment Adviser– 18 October

PERFORMANCES 2019

EquitiesBonds
MSCI World+16.5%CHF Corp+2.5%
S&P 500+19.3%US Govt+7.8%
Stoxx 600+16.5%US Corp+12.9%
Nikkeï+12.2%US HY+11.5%
SPI+23.9%EUR Gvt+9.5%
Chine+30.0%EUR Corp+7.5%
Emerging+6.0%EUR HY+7.6%
CurrenciesCommodities
USD index+2.0%Gold+16.2%
EURUSD-3.5%Silver+12.4%
EURCHF-2.4%Brent+9.4%
USDCHF+1.2%CRB index+3.0%
USDJPY-0.8%
EM FX-2.6%

Warts

Lots of things – not to say everything – distinguish between the two most powerful world leaders, Trump and Xi. But, ironically, since a few weeks, they share a similar problem. Both endure a severe domestic shock, the Hong Kong revolt and the Impeachment process. These quite unusual shocks actually relate to the bedrock of their power. Indeed, they will, eventually, challenge the loyalty of their current political party (Republicans) / factions (at the Politburo). Both shocks are complex and involve vindictive and commit-ted stakeholders, defending ideological motivations…

Fragile bedrocks of power

Since the mid-term elections, Trump is facing stronger Democrats in the Congress. In principle he can count on the loyalty of Republicans, in order to ultimately block the Impeachment process. But, obviously his room to maneuver has significantly reduced over the past year. The Impeachment Process will oblige Trump and his administration to change tack and attempt to coalesce back around him. But let’s face it, Trump’s corrosive style alienated lots of natural supporters of the Republican party as well as beyond…

Xi, a Chinese Nationalist, is a central figure of the fifth generation of leadership of the People’s Republic. He joined the Politburo in October 2007. He was Vice-President of Hu Jintao between 2008 and 2013. Xi has a legitimacy problem. Indeed, his track record during these 5 years proved very lackluster. His bold anti-corruption campaign impacted prominent incum-bents and retired communist party executives, including members of the Politburo Standing Committee. It is an understatement to say that Xi ascension was corrosive. He doesn’t have lots of friends in the executive political body of the country.

Two years ago, he managed to modify the Politburo structure, in order to broaden his supportive base. Now, with his three allies, he has a 4 vs. 3 favorable balance of power in the PSC (see table below).

politburo - EN

Xi has been severely criticized internally since the trade war began, for having discarded the mantra of Deng Xiaoping’s strategy: ¨hide your strength and bide your time¨. The famous People’s Daily newspaper (still a strong of the Jiang faction) actually published critical articles since July 2018. On September 16th, 2018 Deng Xiaoping’s son officially called for China to ¨know its place and not over-bear¨.

The domestic stronghold of both Trump and Xi have significantly weakened lately

US-China talks. End of corrosive posturing, for now
Trump wanted a comprehensive deal. He used the maximum pressure strategy with lots of tariffs and other threats. He asserted that China is boring the brunt of the war and that US consumer are unscathed… China stopped buying US commodities. It accused the Western countries of supporting HK revolt…

A new trade truce with China is in the making

US trade rhetoric is hardening against Europe, the next convenient political scapegoat

  • No doubt, the latest cease-fire is rather good news
  • But don’t believe – Trump – hype. A comprehensive, sustainable, deal is still far away
  • Xi and Trump are incapacitated on the domestic front. They will remain reluctant to engage in a grand bargain over next months
  • Improvement in sentiment will not suffice to turnaround benign (weak) macro and complicated geopolitical fundamentals

 

Fixed income. US Inflation conundrum

Consumer Prices Index (CPI) grew at its fastest pace of the cycle for a second straight month even if PPI have declined for an eighth straight month. The core CPI, excluding food and energy, rose at 2.4%, its current cycle highest level. Full employment, rising wages, and low interest rates are supporting manageable inflation growth going forward.

Regional Fed inflation measures and accelerating - EN

However, stronger inflation could complicate the Fed plans. In the latest Fed minutes, many participants cited low inflation to justify another rate cut. There were also robust talks on market positioning for future Fed cuts. A few mentioned the Fed may have to better align its policy rate forecasts with market ones. Dots still show that 10 of 17 FOMC members expected to keep rates unchanged through year-end. Ensuring a stable inflation is half of the Fed dual mandate, the core Personal Consumption Expenditures, the Fed’s primary consumer inflation gauge, is trending back towards 2.0%. Historically, core CPI runs 0.25–0.5% above the PCE. Market expectations look too lows given the recent developments.

US inflation expectations at current cycle lows - EN

At the latest FOMC, greater prominence was given to discussion about its longer-term strategy for monetary policy. Years ago, the Fed amended its dual mandate by adding an explicit level to its price stability target i.e. 2.0% PCE. Officially, the Fed targets the headline, but the core seems to be substituted when it suits them. The Fed still frets missing its 2.0% inflation target. The problem is that central banks have made the inflation target an ultimate goal, when it was only supposed to be an intermediate one. The inflation target was not the goal itself, but hitting this target, on average, would help deliver those other goals.

Since January 2000, the US PCE has met or exceeded 2.0% in only 88 months or less than 40% of the time. It falls to 30% if we use the core PCE, and most of them happened before 2008. This doesn’t mean that monetary policy was too tight – merely that the target was the wrong number. Since January 2000, the cumulative annual inflation misses totalized more than 5%. According to Clarida, when the Fed misses its target, it should not consider this a “bygone” as it currently does. It should try to make up for that loss. Past years accommodative policy plus trade tensions are helping inflation to resurface. For once, oil prices are not to blame!

  • Favor US Treasury

 

Equities. A welcome short-term relief

Donald Trump lost. In launching his trade war against the whole world, he said that “a trade war is easy to win”. Against China, he wanted A big global trade agreement or nothing, he had time, but today he has to settle for phase 1 of a trade agreement. We are not fooled: his “great qualities” of negotiation simply make it possible to return to the situation that prevailed before the trade wars, as for China or the great USCMA agreement, roughly equivalent to NAFTA.

He must be content with a partial agreement with China, because he has no time. He must quickly show a victory to his voters, because he is losing on several fronts:

  1. Procedure of impeachment by the Democrats of the House of Representatives.
  2. General animosity (even of the closest Republi-cans) facing his posture in Syria.
  3. A federal court requires Donald Trump to provide his financial information to Congress.
  4. A judge said that Donald Trump was breaking the law by using Pentagon money, with the argument of national urgency, to build his wall between the United States and Mexico. The decision to build a wall is the responsibility of the Congress.

A partial agreement, and then? What about past rate hikes? Will Donald Trump remove them? And the possible financial war announced 2 weeks ago? Will it penalize Chinese companies listed in the United States? This phase 1 of a more global trade agreement will not prevent the economic slowdown, and especially not the decline in profits in 3Q19. We enter into the majors on Tuesday 15th and Wednesday 16th with the results of major US banks and Netflix (Wednesday).

According to CNBC Trade index, US companies the most exposed to China by revenue

Pic - no name - EN

According to Goldman Sachs, US companies of the Russell 1000 with the largest exposure by revenue to China

Companies with the highest china revenue exposure - EN

  • A US-China trade agreement, even partial, is positive in the short-term for the stock market
  • Further rise of interest rates would be positive for the Value segment, banks and industrials leading the way. But we still need US 10y government bonds to break through 2% for the value segment come back to be durable
  • If the dollar falls, this is positive for emerging and European equities
  • In the case of a Brexit with agreement, companies like Lloyds Bank, Royal Bank of Scotland, Kingfisher or Next would be favored
  • But these bullish movements are very tactical so far. Indeed, the risk of recession in 2020 remains

 

Equities. We talk again about 5G

Since May, with the US embargo on the Chinese Huawei and the constraints on US technology companies selling products to some Chinese tech/telecom companies, investors have talked much less about 5G, which is for sure in an expansion process. The US-China technologi-cal war too.

Recently, the United States has been clear: Huawei is becoming dangerously dominant in the 5G and offers to subsidize / support without concession Ericsson and Nokia. The US government recognizes that the US lost its superiority in telecom equipment some decades ago. Huawei, Ericsson and Nokia each hold about 25% to 30% of the global network market for mobile telecommunica-tions, followed by another Chinese ZTE (15%), then Samsung (3%), NEC, Fujitsu, … No American company is present in the infrastructure for mobile telecommunica-tion. Some US officials would suggest pushing Oracle and Cisco into the radio transmission market, but both companies have rejected such an idea because of the exorbitant cost of catching up with key players and the “waste” of time. The government could also put in place an attractive tax policy for US start-ups developing the next generation of telecom technology.

In its latest report, the European Union identified a series of security threats posed by Chinese telecom equipment manufacturers, particularly Huawei, which has very close ties with the Chinese government. Several countries have banned Chinese groups in telecom equipment.
On the other hand, if the United States favors Ericsson and Nokia, it will be more difficult for them to penetrate the markets under Chinese influence.

  • Outside China’s zone of influence, Ericsson and Nokia will strengthen their positions
  • Buy Ericsson with a target price of SEK 96 (17% upside potential) and Nokia with a goal at € 5.7 (23% potential) at 12-18 months

Disclaimer
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