Weekly – Investment Adviser – 29 March 2019
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¨Postwar Germany abandoned military-based power politics and foreign adventurism and concerned itself primarily with economic development¨. Project Syndicate. Feb 2019.
- Fischer – former Foreign Minister and Vice Chancellor (from 1998 to 2005)
Cracks in Fortress Germany
Following WWII, Germany focused on its economic development to reenter the Democratic West and recapture its political sovereignty. It has brilliantly achieved these two objectives. But over the past couple of years, Trump and Brexit have started disrupting the foundations of the German model. The unrivalled prosperity of the country may prove a story of the past.
Germany is facing a growingly hostile landscape
Blame Anglo-Saxon ¨perfidy¨, really?
The two Anglo-Saxon pillars of European defense are faltering, leaving Germany on the front-line with a growingly assertive Russia. This should, in principle, help born a common defense in Europe. But, in practice, Macron calls in that direction face serious obstacles: a) Germans became pacifists after 1945 and b) France status of a nuclear power – and permanent member of the UN Security Council – is barely transportable. Nevertheless, European sovereignty is a major issue. Berlin, whether or not intended, will be obliged to address it.
The German Socio-Economic (participative) model thrived over past decades. German capital goods, machine tools, and cars belong to world class. This development has actually ¨ discreetly¨ been sponsored – if not ¨subsidized¨ – by the German State, through advantageous re-financing, help for exports, not to mention selective tariffs. Euro, a much weaker currency than the DM was, also provided for a competitive boost. Things have dramatically changed lately. Beyond the inevitable upcoming cyclical slowdown, ¨De-globalization¨ will disproportionately affect the export-based economic models of Germany and China. Trump will further target Berlin. Brexit could seriously damage German’s exports to the UK. For sure, the Government’s excellent financial shape would allow for ambitious investment / restructuring plans. But the political will and vision still need to follow…
The Golden age of Germany, the power house of Europe, might be counted…
Champion, what champion?
German banks do not belong to the top league, be it in terms of size, quality, or profitability. At first glance, Deutsche Bank and Commerzbank’s merger looks like a defensive union. There are actually fundamental reasons to criticize it:
- German banks have a bad record at mergers and integrations. Indeed, Deutsche bank and Commerzbank pathetically failed with Deutsche Post Bank and Dresdner bank. The beauty of the German participative model – and social peace – shows its limits, when downsizing and layoffs become inevitable
- The merged entity would become too big to fail, if not to bail… i.e. highly systemic. Politics will therefore continue to play an unnecessary role, potentially interfering with a sound bank strategy
- The German banking system is in a very bad shape. The toxic domination by Sparkassen (saving) and cooperative banks, entertaining dubious links with local politicians, must end. Just like in Japan, zombie companies are practicing mis -pricing and mis-allocation of capital. Germany can’t become a healthy banking place, without this deep restructuring.
Like in the ¨Wedding of the Carp and the Rabbit¨, this marriage is doomed from its start The tentative mega-bank merger is emblematic of Germany’s incapacity to revisit its socio-economic model
- Stay underweight and very selective with German equities, particularly in battered sectors, despite seemingly attractive prices
- Nimble investors could take advantage of tensions in selected fixed income instruments. The issue of solvability will take some time before to emerge…
Fixed income. Fed hiking cycle is over
As expected, the FOMC kept rates on hold but surprised to the dovish side by signaling no rate hikes in 2019 and announcing the end to its balance sheet runoff by September. The dots were sharply lowered. They are now signaling no rate hikes this year and just one next year. Five out of 17 FOMC members think the Fed is on hold at least until year-end 2021. Powell sound dovish and pointed out the global slowdown and the mixed data that the US has seen in 2019 so far.
Based on its dovish message, we must admit we misread the Fed, like most of investors given the market reaction. Our base case was that a rebound in the global economy in Q2, a US-China trade agreement and a still healthy US economy would be enough to get the last Fed hiking in S2. With the new signals, it seems unlikely for the Fed to move again on rate hikes. From previous hiking cycles, we have never experienced a long-time pausing Fed which then resumed hiking. Normally that would mean that the next move from the Fed is a cut when the economic outlook deteriorates. Markets have already started to price in cuts.
But, talking about Fed Funds cuts seems too early given the US economy is still healthy. If the Fed can move so quickly in a dovish direction in one quarter, it may happen in the other direction too.
The Fed only needed 3 weeks to make markets ready for its hike in March 2017. One trigger for a Fed Funds hike could be a rebound in inflation expectations. The current expectations are very close from the 2018 average levels – where the Fed was not that much concerned about low inflation expectations – and their past 5 years averages.
The Fed will begin tapering its balance sheet runoff from May by halving the US Treasury component ($30bn per month) and keeping the Agency component ($20bn) unchanged. The total runoff will be $35bn per month from May to September.
After September, the Fed will continue to allow $20bn in Agency securities to run off per month, but for this to be reinvested in US Treasuries. So, the Fed will shift the composition back towards government bonds.
However, we do not know yet which part of the yield curve will be favored. The Fed keeps open the possibility to tweak the yield curve, as it has already done in the past.
All told, this should take excess reserves to around $1.2trn by September, a level not seen since 2011, vs. 1.5trn at February-end. According to Bernanke 2009 remarks, the huge increase in banks’ excess reserves has stifled the Fed’s monetary policy moves and its efforts to revive private sector lending.
Since then, PMIs have disappointed. The Eurozone Manufacturing PMI sliped at 47.6 vs 49.5 expected and previously at 49.3, no wonder the 10-year German bund is going again negative, even if the service sector remains resilient. The US Markit Manufacturing PMI came at 52.5, down from 53.0 in February to reach its lowest reading since June 2017, increasing the concern around a sharper than expected US economic slowdown.
By consequence, the US 3m-10yr yield curve inverted. It does not directly imply a recession is just about to start. But it points toward the probability of a recession emerging next year.
The additional dovish tone from the Fed is leading towards a search for yield across credit. As long as interest rates volatility remained muted, it would be hard to be negative on credit markets. If history is any guide, it took on average 5 quarters from the last Fed rate hike to the first quarter of recession over the last 3 decades. During those periods, credit debt delivered double digit returns.
- Despite the dovish Fed moves, it is still too early to price rate cuts
- Market pricing moved further in the direction of rate cuts. There is scope for a repricing given that the Fed’s dovish shift is now likely complete
- For credit products, subpar but positive growth would be strong enough to support credit in a search for yield environment
Equities. The risk of recession comes back
The recent bad economic data in Europe and the 3, 6 and 12-month US interest rates equaling the US 10-year revive the debate on an economic slowdown or even a recession. 56% of investors think that the Fed will lower its key rate in 2019 and the 10-year Bund has gone into negative territory for the first time since 2016.
After a sharp rise in stock market indices over the first 3 months of the year, a consolidation is welcome. Investor sentiment indicators have never been in extremely positive area, rather neutral one. In 2 weeks, the publication period of earnings will start and it will be important, because profits should fall, the first time since 2Q2016.
The German export economy is suffering more than the others, suffering from the Chinese slowdown and Donald Trump’s attacks on the automotive sector, which is already facing a major technological transition – electrification, connectivity and the autonomous car – requiring costly restructurings, acquisitions in new technologies and investments in batteries, and which will probably face sales deferrals.
Germany has another problem: Nord Stream 2, a gas pipeline, operational late 2019, passing under the Baltic Sea, leaving Russia and joining Germany. Nord Stream 2 will double Russia’s export capacity. This $10 billion Gazprom project is under fire from US critics.
The United States says it is a Russian political project to make Europe dependent on Russia and to put more pressure on Ukraine, which receives transit taxes, because part of Russian gas passes, for the moment, through Ukrainian territory. Germany presents Nord Stream 2 as a purely economic project. Donald Trump strongly criticizes this project and threatens Germany with sanctions.
Obviously, the United States is eager to increase its market share in Europe by exporting its liquefied natural gas. Under US pressure, Germany has promised to import US LNG in the coming years and build the corresponding infrastructure, LNG terminals.
The flattening of the slope of interest rate curve, or even a negative slope, is not favorable to the financial sector. Banks need central banks less, their balance sheets are stronger; banks need higher interest rates and a positive slope in the interest rate curve to return to healthy growth.
In this environment of low interest rates and sluggish growth, the defensive sector of electricity generation is performing well. The traditional model has been changing over the last few years with the gradual abandonment of fossil fuels in favor of alternative energies and the separation of electricity generation, network and supply activities to end-users, signifying the end of the vertical model. Electricity generation becomes decentralized and local.
The system becomes complex: the electricity companies have to manage 2 flows, the one that leaves their plants and the one that arrives in the network coming from the final consumers who produce their own electricity thanks to the solar panels and the wind turbines. The system will become even more complex with the electric car whose batteries will be able to store energy and send it back into the grid during peak demand or when households can negotiate electricity directly with other customers.
There is also the emergence of a new competition coming from the integrated oil companies that, in order to survive in a low carbon world, enter into the batteries and alternative energy activities. Royal Dutch Shell acquired First Utility in 2018 and does not rule out a partnership with the Dutch electricity producer Eneco.
Graphically, after a nice stock market run, the Power generation sector is entering into an overbought zone, but it has defensive characteristics in times of economic slowdown and offers high and secure dividend yields.
- Overweight Electricity Producers
As mentioned in our latest weekly publication, on March 21st, Boeing remains an attractive equity. Even if the US investigations represent a source of risk, the equity is already discounting it. The airplanes manufacturing sector is a duopoly dominates by Boeing and Airbus.
Boeing remains the number one worldwide in term of total new orders in 2018, slightly ahead of Airbus. However, the commercial aviation is not its unique business line. It business remains equally splited between commercial airplanes, defense & space systems and aerospace services. The recent market correction, and the spike in volatility, represent an interesting timing to launch a barrier reverse convertible. With a strike 20% lower we can achieve a close to 10.0% return over the next year.
- Boeing represents a good opportunity
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