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Weekly – Investment Advisor – 14 February 2019

PERFORMANCES 2019

EquitiesBonds
MSCI World+9.0%CHF Corp+0.7%
S&P 500+9.8%US Govt+0.2%
Stoxx 600+8.6%US Corp+2.4%
Nikkeï+5.6%US HY+5.2%
SPI+9.8%EUR Gvt+1.4%
China+13.0%EUR Corp+1.6%
Emerging+7.9%EUR HY+2.5%
CurrenciesCommodities
USD index+1.2%Gold+1.8%
EURUSD-1.8%Silver+0.7%
EURCHF+0.8%Brent+20.0%
USDCHF+2.8%CRB index+5.2%
USDJPY+1.3%
EM FX+1.4%

An inevitable trade-off

So far, the transition has proved benign…
The evaporation of extremely ample liquidity conditions, featuring the end of US financial repression, has proceeded – surprisingly – well so far. It actually took about three years for the Fed to restore ¨about-neutral¨ (nominal) policy rates, without causing serious disruption, be it in terms of economic expansion or financial markets. Since then, no recession, no bear market, no systemic crisis took place. Granted, a few inevitable accidents occurred, but essentially in the sphere of bubbly / speculative segments of the markets. And, importantly, this normalization, which started in Q1 18 with the ¨Vix-mageddon¨, has developed sequentially over last year, culminating with a rude landing of equity markets (and retail investors) last December.

The good news is that the complacency and several buckets of speculation have forcefully dissipated. The inevitable tightening of financial conditions has now reached a pause phase, courtesy of change of rhetoric from the Fed.
The weaning of liquidity-addict markets is reaching a tipping point
The Fed will be torn between two incompatible objectives: growth and financial stability

 

… but financial stability remains an open issue
Regulators and policy-makers worked hard in the last decade to build a safer banking / financial system. Namely, juggernaut banks have been forced to scale down their risky operations, as well as provide greater transparency and accountability. This seems good on the surface. But a consequential flip-side of this improvement is now surfacing: the liquidity ¨bumpers¨ coming from their market-making operations has dramatically waned. A new sort of disequilibrium is consequently emerging, as investment flows are growingly set by high frequency trading, Artificial Intelligence, and quantitative models / algorithms. Multiple flash crashes and the extreme volatility of last December testify for it…

US government’s unilateralism and the lack of skills / experienced staff goes along the same line. The bail out of banks / car manufacturers and the TARP programs, about a decade ago, were remarkable. There are serious doubts regarding the reaction function of the Trump administration, if a crisis was to unfold. Particularly so with a gridlocked Congress. European populism and Brexit represent additional sources of risks. These deep political fractures / divisions would inevitably complicate a common dealing in case of a practical crisis.

Shadow banking systems developed hastily in China in past years (but not only there…). They represent a new source of challenge for the central bank, as they allow economic agents to efficiently bypass financial restrictions, circumvent regulation if not contradict the stance of authorities on monetary / credit policies. It’s a bit like the story of the doped sports’ athletes being always one step ahead of the police.

The exponential rise of ETF popularity creates side effects. For instance, the broad access to leverage loans and high yield, via daily liquidity products, is practically dangerous. Indeed, lots of these underlying assets are quasi illiquid by nature. A serious mismatch would occur, with significant price deviations, when the eventual next crisis takes places.
Powell, Draghi successor and Mnuchin will, for sure, endure further probation in 2019/2020
Beyond banks, regulators should refocus on new financial structures and investment vehicles

  • A likely new round of Reflation seems in the offing. Short-term that would support expansion and markets
  • Such positive distraction would raise the odds of serious crisis, if long-term stability issues are not addressed

Currencies. The doves are flying
The Fed last decision to put rate hikes on hold sets the tone for the world. The prevalence of dovish stances within the global central bankers’ community was apparent last week.

The Bank of England kept its monetary policy rates on hold. In its Quarterly Inflation Report, it significantly downgraded its 2019 growth forecast. While medium-term inflation forecasts were kept broadly unchanged, the market-based elements it used have significantly declined. Less tightening will be needed to keep inflation at target. The BoE continues to expect an ongoing tightening of monetary policy, at a gradual pace and to a limited extent. So, it suggested less tightening than in its November Report. Slowing growth and the weaker outlook globally makes further tightening of policy this year unlikely. In the case of a disorderly Brexit, the supply shock should push the BoE to raise rates. This looks unlikely.

The RBA just adopted a significant shift. It has lowered its growth outlook and acknowledged greater uncertainties and downside risks.

The Bank is still expecting the economy to track towards its employment and inflation targets. It does not see a strong case for a near term change in the cash rate but there has been a clear change in emphasis. In particular, the Governor has moved from a more likely rate increase in 2018 speeches, to a more balanced outlook. This is significant. It clearly establishes that the Bank is prepared to cut rates – a position that has only emerged since the housing markets have reversed.

 

AUD/USD vs. RBA cash rate
AUD or USD vs. RBA cash rate

 

The new central bank of India chief was the boldest as the RBI unexpectedly cut rates to 6.00% from 6.25%. A cut which will likely be welcomed by Prime Minister Modi as the election nears.

The rate cut decision was accompanied by a shift in its monetary policy stance to neutral from calibrated tightening earlier. Officials in the Philippines pared their inflation forecasts and those in Thailand also spoke less hawkishly.

In Latin America, Brazil central bankers signalled politicians would have to cut costs before they can reduce rates.

In Mexico, the statement of the Banxico signals that further tightening seems unlikely but at the same time, the Board stayed hawkish and kept a cautious wait-and-see approach in the near-term.

The Bank of Russia kept its policy rate unchanged at 7.75%, in line with the consensus. The commentary was less hawkish.

However, it no longer indicates a high likelihood of further hikes. Still, the list of mid-term risks remains unchanged. So, the CBR is still far away from returning to an easing cycle.

 

Emerging currencies (volatility, flow and yield)
Emerging currencies (volatility, flow and yield)

 

EM capital flows should resurface as the drop-in currency volatility continues. This improves the attractiveness of carrying outside of developed markets. The JP Morgan Emerging Market Volatility Index is down 8.2% year-to-date, like in 2012 and 2017. EM carry returns are improving and capital flows should follow if the decline in currency volatility continues.

  • The central bank community shift on the dovish side
  • Carry trades will resume side

Automobile. 2019 will be challenging
As expected, pessimism dominates for 2019. No signs of a recovery in the world’s largest market, China.

Daimler, GM, Ford, FCA, Toyota have confirmed this moody environment. Falling profits and dividend reduction at Daimler. All are worried about the decline in sales in China and the rise in metal prices associated with Donald Trump’s trade war. German automakers fear that Donald Trump may impose them a 25% import tax when he validates a trade deal with China. GM, Ford and FCA would be the big winners. The big losers: the Germans.

On Feb. 17, the US Department of Commerce is expected to announce whether car imports pose a threat to the national security of the United States. Brexit and the fall of traditional models, especially diesel, are forcing manufacturers to close production chains. If the automotive sector knows how to manage the downturn cycles, the novelty today is the important investments to come in the new technologies. Daimler has announced an extensive cost-cutting program to free up cash and investments in new technologies, such as electrification and autonomous cars. Partnerships should multiply.

Manufacturers anticipate a decline in profits in China and Europe, while the US market should remain more defensive. The results of Ford, GM and FCA are less volatile. This situation is reflected in the stock market performance: over 1 year, the US Automotive Index fell by 14% compared to -25% for the Automotive Europe Index, and in 2019 the US Automobile rose by 8% against 4.5% for the Automotive Europe.

 

Automotive sector performances over the last 5 months
Automotive sector performances over the last 5 months

 

Performances of the MSCI World Automobile and Chinese manufacturers in 2019
Performances of the MSCI World Automobile and Chinese manufacturers in 2019

 

Despite the weakness of the Chinese market, Chinese automakers outperformed the MSCI World Automotive. The Chinese auto industry has only one problem: its domestic market, since it exports only a few cars. In practice, it is ahead in electrification and batteries.

Although there has been a halt in sales in 2018 after 30 years of growth, China has a huge potential: the car motorization rate is 900 cars per 1,000 inhabitants in the United States, 600 out of 1 000 in Europe and 170 out of 1,000 in China. But this challenging environment is partially integrated into stock market valuations that are low on many metrics.

The Automobile is a deep value sector. FCA has managed to unlock value with the Ferrari’s IPO and the sale of the equipment manufacturer Magneti Marelli thanks to the Anglo-Saxon approach of the late Sergio Marchionne. Volkswagen could unlock value by introducing Porsche on the stock market: the valuation of Porsche is € 95-100 billion, while the market capitalization of Volkswagen is € 81 billion!

The 5 major trends that will transform the automotive industry by 2030:
1. Electrification
2. The autonomous car
3. The connected car
4. Car-sharing
5. Perpetual updates

Two factors would incite us to recommend buying the automotive sector: an agreement between the United States and Europe on the automotive industry and signs of a stabilization / restart of sales in China. The sector is weakly valued. The positive points are: low valuations, strong balance sheets, partnerships/mergers coming due to technological transformation.

  • We are watching the Automotive sector closely
  • In our equity allocation, we would buy the Chinese manufactures Guangzhou Automobile (2238 HK)

 

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