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Weekly – Investment Adviser – 7 March 2019


MSCI World+11.3%US Treasuries-0.1%
S&P 500+11.8%US Corp+2.4%
Stoxx 600+10.8%US High yield+6.3%
Nikkeï+9.0%EUR Gvt+1.4%
China+25.5%EUR Corp+1.8%
MSCI Emergings+8.9EUR High yield+3.9%
USD index+0.4%Gold+0.4%
EURCHF+0.8%Oil (Brent)+21.8%
USDCHF+2.0%CRB index+6.9%
EM FX+1.7%

An arduous second leg

In 2019, Europe engages into a phase of high intensity. It is often said that Europe only progresses through crisis… We will (very) soon know if the old saying confirms!


Fortunately, a ¨no-deal scenario¨ seems unlikely

Europe’s hard stance during the latest phase of negotiations played an important role. The stubborn strategy of T. May facilitated this option. There was little, if any, compassion in Europe for the begging divorce initiator. It was also a question of not setting bad precedent… Situation remains highly volatile and complex in the UK, for sure. And lots of twists may still happen before an actual epilogue. But the political suicide that both Tories and Labor were engaging in, for quarters, should ultimately be averted.

The growing discomfort that people expressed against their law-makers, in latest polls, eventually provoked an outburst of pragmatism. UK politicians’ clientelism should, paradoxically, save the country from the ¨abyss¨.

Time has now come for more conciliatory talks from both sides. Upcoming European elections are getting near. An appeased political climate, in which the UK would participate to the vote, would ultimately… benefit Europe, by diluting far-right populist forces!

UK political visibility is likely to remain low at least up to the summer, but…

… the latest £ and UK equities’ rebound could have legs


Tension with Italy will continue

As might have been feared following the election of a weird coalition in Rome, Italy has become the Old Continent bad boy. The current coalition can’t be prevented from provoking its best enemy, E. Macron, the neo-champion of European integration / federalism. Only new Italian elections, featuring a coalition between right and far-right parties (i.e. Berlusconi and Salvini) would stop this. Italy is reminiscent of Japan. Both have a dramatic demography, zombie-like banks, and their industrial champions are faltering. Both have current account surplus, significant private savings and a huge public debt load.

But Tokyo has a definite advantage, it can freely decide of its monetary / fiscal policy. Italy has been trapped for long in the austerity dogma of the Bundesbank and the likes. Therefore, its government debt has a worse rating than part of the private sector (namely banks)! In short, while Japan’s political center managed to hold, Italy’s exploded. These are not adequate times to engage in a fierce battle with Roma, which would inevitably favor dismantling / fragmentation among European countries.

The European Central Bank is not allowed – by law – to monetize any debt. In practice, it did when it accepted private debt as collateral, including of disputable quality like stressed Italian mortgages and Greek banks’ IOU’s… In contrast, the ECB still obfuscates buying certain government debt or excludes specific segments of bonds from its asset-purchase program. Put simply, Europe has tilted its central bank’s support toward the private sector and virtually bailed-out Ireland’s and Spain’s private banks. It eventually did less for the State of Italy. This ideological bias against anything public reflects an assumption that private debt is – by nature – of better quality. Quite the opposite to what exists in Japan. Time has come for European politicians to acknowledge for the failure of this stance and its collateral risks.

The election, next Fall, of the new ECB President is of extreme importance

As well as revisiting ECB mandate, by contemplating some sort of European risk mutualization (be it ¨Eurobonds¨ or public debt monetization)

  • The pessimistic consensus on future growth for UK and Europe may rapidly change
  • Euro, £ and related risky assets may benefit short-term
  • Europe has somehow managed to keep its optionality open after the first slalom leg…
  • … but Italy will impose it another – structural – response in the second leg


Fixed income. High-yield market skyrocketed, what next?

High-yield bonds have led the credit market recovery so far this year. It has gotten a boost from both the equity market rebound and the yields decline. After collapsing by 4.5% in Q4 last year, the US speculative-grade market has sharply rebounded and already soared by 6% this year.

USD et Eur

The HY spread has a strong correlation with macroeconomic indicators, equity markets, and the expected default rates. According to Moody’s, amongst all indicators, the HY spread exhibits its strongest correlation with macroeconomic indicators and more precisely with the Chicago Fed National Activity Index. The latest data points out that the HY market is correctly valued.

US High-yield bond yield spread bps

The strong correlation between the volatility and the HY underscores the importance of the equity market to corporate credit. All other things being equal, the default risk should decline as the market assigns a greater and more stable value to the corporate assets and earnings streams backing corporate debt. A healthy equity market enhances systemic liquidity. Financially stressed companies can more easily raise cash via assets sales when the VIX is low and PERs are high. Given the actual VIX level (below 15), the HY market still has some potential.

US high yield spread

The lower the expected default risk, the greater the company market value… Moody’s forecasts that the HY annual default rate will dip to 2.4% by January 2020 from 2.6% in January 2019. It supports a stable HY spread. Over the last year, and regardless of the challenging and volatile landscape, fundamentals have improved. Net leverage has declined to 4.2x from 4.8x, and interest coverage increased to 4.4x from 3.5x. While earnings are likely to dip in Q1 2019, they are expected to be stable this year and into 2020. The HY valuation receives support from solid fundamentals and expectations of corporate earnings growth into 2020. Even if the global market liquidity remains poor – as the regulatory constraints are still refraining dealers and investment banks to increase their inventories – new issues demand is improving.

The HY is still yielding at 6.5% in the US and 4.0% in Europe, i.e. an average excess spread of 400bps, for an average duration of 3.5 years. This must then be compared with an average yield of 4.0% in the US and 1.1% in the European credit markets, and a spread of 125bps, and a 2.7% yield on the US government bond market. Moreover, the average maturity of those segments is around 6 years.

HY Estimated Dealer Inventory

  • After a strong start, the credit market should stabilize
  • The main contributor to the annual performance going forward should be the carry


Chinese equities. MSCI will quadruple the weight of A-shares in its global indices

MSCI announced that it would quadruple the weight of A-shares in its indices. The inclusion factor will increase from 5% to 20% in 3 steps: from 5% to 10% until May 2019, from 10% to 15% until August 2019 and from 15% to 20% until November 2019.

Since the beginning of the year, the Chinese indices have risen sharply: +26% for the CSI 300 (Shanghai and Shenzhen listed A-shares) and +14% for the Hang Seng China Enterprises HSCEI (H-shares listed in Hong Kong). These performances reflect the expectations of an increase in Chinese equity weightings in the MSCI indices and the current reflationary policy. Logically, the A-shares have outperformed, but the H-shares should not concede too much ground: the HSCEI stock exchange valuation (PER 2019e 8.4x) offers a discount of 42% compared to that of the CSI 300 (PER 2019e 12x), while companies in both indices are all Chinese with revenues mainly coming from China.

Indices AH China Premium. Sur performance des actions

  • We continue to overweight China via the Vontobel China leader


Palladium and Cobalt, both related to the automotive sector, but having opposite directions in prices

For the last 6 months, the price of palladium has increased by 85% and for the last 10 months, that of cobalt has dropped by 67%.

Palladium et cobalt, les deux liés au secteur automobile

Are the rise in the price of palladium and the fall in the price of cobalt justified ?

Palladium. The main worldwide producers: Russia 39% (Norilsk Nickel), South Africa 37%, Canada 9%, the United States 6% and Zimbabwe 6%. 80% of global palladium demand is used for catalytic converters for gasoline cars. Palladium benefits from the drop in sales of diesel cars in favor of gasoline engines. In 2018, diesel vehicles accounted for 36% of new registrations in Europe, 8 points lower than in 2017 and 19 points lower than in 2011.

Demand for palladium rose 3% in 2018 and was in a 9th consecutive year in structural deficit; the deficit could grow in 2019, amplified by fears of strikes in South African mines.

Déficits structurels de palladium

The demand for palladium for the financial investment has fallen massively since the beginning of 2016 (black curve of the graph below). But the price has risen considerably (red curve), confirming the structural deficit and the rise in industrial demand. Outflows from ETFs (non synthetic) have not been sufficient to meet the demand of the automotive sector. Stopping ETF outflows would put further upward pressure on the price of palladium.

Détention de palladium dans les ETFs (ligne noire)

Automakers could use less palladium and more platinum for catalytic converters, but it is not a priority in this transition period to electrification.

However, many analysts do not explain such a price increase, as the palladium market is one of the smallest commodities markets, making it volatile. Some analysts suspect Russia of buying large quantities of palladium as a source of long-term liquidity.

Technically, the price of palladium is in an overbought zone and comes from historically low speculative positions in August 2018 to return today to neutral speculative positions (short-covering).

Ratios OrPalladium rouge et OrPlatine noire

Cobalt. On the other hand, the price of cobalt has dropped, while the expansion of car electrification is starting and the demand for cobalt for the manufacture of batteries will explode. To make the batteries, you need lithium (mainly from Latin America), cobalt, nickel and manganese.

The world’s 70% of cobalt production is in the Democratic Republic of Congo, followed by the Philippines, Cuba, Australia, Canada and Russia.

Global cobalt reserves

The global supply is therefore essentially based on an unstable African country, which worries long-term buyers. The latter are solidifying their links with Australian producers. Australia will become an important source of cobalt; in fact, the Chinese and Koreans have taken stakes in Australian mining companies.

Sales of electric vehicles are expected to soar

In the next 2 years, electric cars are expected to remain a small part of the global car fleet. The batteries will only increase exponentially from 2022, while the opening of new mines will bring an excess of supply. The DRC can produce more. Global production of cobalt increased by 50% in 2018.

Moreover, like cobalt, lithium followed the same downward trend in price (-30% in the last 10 months). With the sharp drop in prices, buyers are strengthening their supply sources over the long term, rather than accelerating the transition to electrification.

In 2018, battery manufacturers significantly increased their cobalt stocks, eliminating the risk of a supply shortfall in 2019. Prices will rise when manufacturers have to restock.

  • Palladium is in a structural deficit situation. Demand from the automotive sector and Russian supply are keys to the future evolution of the price of palladium
  • The cobalt supply is plentiful. The decline in the price of cobalt, as for lithium, reflects a lack of risk on supply and a demand that will only really begin around 2022
  • But technically, palladium is strongly overbought and cobalt strongly oversold


Liquefied natural gas. Shell anticipates a bright future

In its latest report, Shell predicts that gas will account for 40% of total energy growth until 2035. In 2018, LNG demand increased by 10% to 319 million tons thanks to Asia and China in particular, and is expected to grow by 11% and 10% respectively in 2019 and 2020.

Liquefied natural gas predicted to continue its raid rise

Global energy demand growth by fuel
Despite a bright future, LNG prices in Asia have fallen by 50% in the past three months. The price curve pr a downward price trend – in December 2018. The current price of $6.2 MMBtu is not usual for the winter season, but it is the consequence of large storage in September and October at the beginning of winter 2018-2019, because the 2017-2018 winter had been very cold, especially in China. But the 2018-2019 winter in Asia has been especially mild. Asia accounts for 72% of global demand. In summer 2018, the price of LNG had reached $12 MMBtu due to very low stocks.

Mild weather weights on Asian LNG price

Traders anticipate a stabilization of prices until summer, then a recovery with restocking before the 2019-2020 winter. See graph.

Cours du GNL et prévision à 6mois

  • Buy Cheniere Energy (LNG US / US16411R2085) over the medium-long term with a valuation of the stock price at $ 80


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