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Weekly – Investment Adviser – 5 April 2019


Equities Bonds
MSCI World +13.8% CHF Corp +1.4%
S&P 500 +14.6% US Govt +1.5%
Stoxx 600 +14.8% US Corp +4.7%
Nikkeï +8.5% US HY +7.6%
SPI +15.5% EUR Gvt +3.2%
China +34.9% EUR Corp +3.3%
Emerging +11.8% EUR High yield +5.4%
Currencies Commodities
USD index +1.1% Gold +0.2%
EURUSD -2.2% Silver -3.3%
EURCHF +0.5% Brent +29.4%
USDCHF +1.8% CRB index +10.3%
USDJPY +1.7%
EM FX +1.2%

Conflicting signals

Take it easy…

A first, pretty serious, growth scare occurred in Q418. The rationale was that the excessive tightening mode by the Fed would ultimately overkill prosperity and provoke the end of the business cycle. Since then, risky assets have dramatically recovered in the wake of a gradual and resolutely accommodative inflexion by major central banks. The PBoC has clearly led this process (setting the stage for tentative QE and banks’ bailout), rapidly followed by the ECB (TLTRO) and the Fed (dovish guidance). So far, so good.

But over past weeks, subpar Macro data have been published from specific sectors in the US, as well as in Europe and China. As a result, safe haven assets and currencies (Sovereign bonds, JPY, CHF, utilities, etc.) have continued to benefit from significant inflows. US 10y government bond yield broke out (downwards) the prevailing range of 2,5%-3,5%, fueling renewed fears of recession. While equity markets experienced significant outflows in Q1, they have remained, so far, positively orientated. This sort of diverging trend between asset classes is not usual…

In an unusual pattern, risky assets volatility lately as transmitted, later, to bond markets

Modern markets (high frequency trading / passive investments) reinforce insecurity by fueling massive short-term flows

Lot of investors did not participate in the Q1 equity rally


Manufacturing recession, eventually

The latest data have proved decisive. Italy and Germany have entered in a recessionary phase, while UK may be on the verge of it. France will escape from it essentially thanks to Macron – non-recurring – largesse to Yellow Vests. Japan is in bad shape and trade volume contraction is confirming this negative mood.

US government shutdown has added to the bad economic figures, although it is most probably a temporary blip.

Even more so considering the quasi-exoneration of Trump from the Mueller probe, which will reinforce the negotiation posture of the US profligate Administration in the upcoming context of debt ceiling. For now, US residential capex is the only – major – factor which gave signs of a serious deterioration. Consumption and business capex remain well sustained and should remain so. US economy never entered a recession with that low level of real interest rates and without major over-capacity or over-investment.

China reflation – newly targeting consumption rather than industrial sectors – is going on. Lower policy rates will accelerate it, provided a trade agreement is concluded with Donald.

It takes more than a manufacturing recession to push world economy into a synchronized slump / recession

The pre-emptive pause of the Fed and the induced relaxation of US financial conditions reduce the odds of a US recession late 2019 early 2020

Late cycle investing is tricky, as the low visibility prohibits the formation of sustainable market’s trends


Is the yield curve inversion the precursor of a recession / deflation?

The latest message from bond markets remains highly pessimistic / puzzling, i.e. yield curve inversion. There is an old saying, upon which bond investors are more clever / quicker than equity ones, hence, earlier to gauge major trend change. Therefore, one should in principle worry when watching it. Yes, but… Firstly, at this stage, it has not yet reached alarming proportions (see graph below).

Proportion of the yield curve inverted is not as high as in other recessions

Secondly, it also must be put in recent context of its wrong messages:

  1. in Q3 2018, bonds announced… outright inflation
  2. And then, over last months, bonds shifted totally by discounting a traumatic collapse of inflation


Financial repression distorted US bond market, namely by compressing term premium

Its predictive messages have become much less readable / reliable

It’s premature to anticipate a global recession / deflation only based on bond markets

  • Bond market’s – inflationary – message proved wrong last Fall. We doubt of the reliability of its current – deflationary – indications
  • Current (positive) correlation between bonds and equities is temporary. We maintain our full investment recommendation
  • Nevertheless, we remain selective and a keep a permanent focus on ¨quality¨


Fixed income. The drivers of US yields’ collapse are vanishing

There has always been a close negative correlation between manufacturing PMI and the US 10-year yield as the Treasury has always been considered the de facto safe haven when investors panic over a global slowdown. The recent yield collapse and the yield curve flattening followed the IHS Markit manufacturing PMI release in March to a 21-month low, while the services PMI weakened to a two-month low. The manufacturing PMI fell to 52.5 from 53 in February, while the services PMI fell to 54.8 from 56.

All the attention has turned on the inversion of the yield curve. It is important to notice that there are many parts of the yield curve to focus on. Some parts of the curve inverted last year, and some other parts of the curve are still positive. While the 3m10y turned negative, the 2y10y and 5y30y remain positive. So, different yield curves segments tell us different stories. Those different signals can partly be explained by the QE driven distortion.

us yield curve

One of the key sources of stress came from China which was sharply decelerating. To fight its economic slowdown, policy makers urged banks to lend more, especially to small and private companies, to boost spending on infrastructure and promised 2 trillion yuan ($298 billion) in cuts to taxes and fees on businesses and households. Surprisingly, the official Manufacturing PMI in China rebounded strongly in March, suggesting that Beijing’s support policies are gaining traction. It marked the first increase in manufacturing activity since December last year and rose to a 6-month high of 50.5 in March from 49.2 in February, well above expectations. Furthermore , the service PMI edged up to 54.8 in March from 54.3 in February, as construction activities accelerated.

China manufacturing

  • Too much bad news is already discounted in the US bond market
  • We turn neutral on US duration


Equities. Strong performances in Q119

What recession? The stock markets ended the first quarter with strong performances. The S&P 500 and the MSCI World posted the best performances for a quarter, respectively +13.1% and +12.7%, since the 3rd quarter of 2009 and the best performances for a 1st quarter since 1998. In 1Q98, the S&P 500 had risen by 17% and the MSCI World by 16.7%; the year 1998 ended with a 31.2% increase for the S&P 500 and +26.3% for the MSCI world. It will be recalled that January 2019 was the best January ever for the S&P 500.

Performance of the main asset classes in the first quarter of 2019

The stock markets appreciate the easy tone of the Fed and remain confident about the outcome of a trade agreement between the United States and China.

The positive trend in the price of copper does not give a negative signal either.

Copper price

Chinese domestic equities, A-shares, offered the best performance in 1Q19 with +28.6%. The stock market has benefited from significant liquidity injections from the authorities to support the economy and investors anticipate a drop in the key rates by the PBoC. But A-shares have mostly benefited from their enhanced inclusion factor from 5% to 20% in the MSCI indices.

Stock Connect has shown that the Chinese regulator was strongly committed to improve the accessibility of the domestic market. In May 2019, the inclusion factor will increase from 5% to 10%, then from 10% to 15% in August 2019 and from 15% to 20% in November 2019.

weight of A shares in the MSCI emerging Index in november 2019

Logically, A-shares significantly outperformed H-shares, listed in Hong Kong. In 2019, the CSI 300 (A-shares) increased by 28% compared to +12.4% for the Hang Seng China Enterprises Index (H-shares). But today, the gap in stock valuations between A-shares (14.6x 2018) and H-shares (9.3x 2018) seems too important.

performers of A and Hshares in 1Q19

We still like Brazil. The Ibovespa index reached a historic high on March 18th, before falling 4.6%. Investors are waiting for the measures on the reform of the pension system. A reform that could boost the largest economy of Latin America. An inability to reform the social security system would be perceived negatively by the financial markets.

Brazil is one of the most generous countries in terms of pensions: 1) men and women can retire at the age of 55 if they have contributed for 35 years and 2) retired men receive 70% of their salaries. In conclusion, social security accounts for 33% of Brazilian government expenditure. Bolsonaro would like to save $270 billion over 10 years and raise the retirement age to 65 for men and 62 for women.

Average retirement ages compared to the OECD average

But the legislative and political process is long and uncertain. And Bolsonaro does not yet have the necessary coalition to easily pass the reform.

New bills in Brazil

  • We remain positive on equities
  • Overweight China and favor H-shares.
  • Brazil: we remain confident about the possibility of reforming the pension system. In case of positive news, the potential for progression of the index is important


Equities. FCA is a deep value investment

The automotive sector is under pressure due to the technological transition and falling car sales in China, the world’s largest market. FCA’s former boss, Sergio Marchionne, advocated a consolidation of the sector and had never ruled out a merger with a competitor. This week, a rumor of an acquisition of FCA by Renault emerged. Renault and Nissan would like to renegotiate their partnership and integrate FCA into a new project. The automotive sector can’t today duplicate costs in the face of significant future expenditures in technology (electrification, batteries, connectivity, autonomy). But Renault could give up Nissan and consider a merger with FCA.

A merger between FCA and a competitor would free up value for FCA. Since the acquisition of Opel, Peugeot has been able to unlock value and its share price has risen sharply, reducing its under-valuation by 40%. With a market capitalization to sales ratio of 0.18x, FCA is far from the industry average of 0.4x. A merger with Peugeot or GM would make more sense.

  • Significant free-up value potential for FCA. Buy FCA with a valuation at € 19


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