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Investment strategy – January 2018


Expect different interactions between business and financial cycles

Geopolitics is fluid and will remain so in 2018.

The near term macro-landscape is more supportive than in last years, with very good visibility. Central banks will refrain from repressing all volatility like it did over the past several years. This will gradually come to an end under the leadership of Anglo-Saxon central banks. The name of the game is desynchronization among G3 central banks, as featured by a unusually large US-Bund 10y spread.

Too low volatility has eventually spelled too high risk appetite

Private individual investors have finally been rushing into risky assets for a couple of quarters now. The equity bull market used to be the most unloved across history, up to Spring 2017. Things have changed markedly since then. A very long period without any significant market correction (the whole 2017) fuelled high confidence, if not a ¨sense of invincibility¨ among amateur investors / weak hands.

A concerted attack against cash

Cash is the ultimate safe haven, the usual de-correlated asset of last resort. It is also a means of action and a symptom of economic agents’ mood for central banks. Developments of the ¨preference for liquidity¨ used to be a pillar of economic textbooks in former… centuries! Things changed dramatically. A few major central banks have imposed negative rates. India forced the demonetization of the country. Digital, say crypto-currencies are invading the monetary spectrum, putting governments, central banks and financial services sector in front of a severe challenge. Adopt, by-pass, condemn, or forbid it? No one knows for sure, of course. Nonetheless the ¨blockchain¨ technology is a new paradigm which will feature an accelerating digitalization i.e. transform the nature and circulation of money over near time.

  • We do not expect the Great Day (i.e. the Great Rotation out of bonds) to happen soon. Still uncertainty is definitely growing for expensive fixed income markets
  • We consider that the equity bull market has more room to go in coming years
  • Investors’ euphoria and gregarious instinct need to dissipate to avoid dangerous bubble formations
  • Expect more challenging time ahead for the conservative institutional investors (forced into riskier assets) and for ¨amateurs¨
  • Some short-term / tactical restraint in terms of asset allocation makes sense in this sort of environment


Baseline scenario: the tale of a prolonged cycle

On the macro side, we expect the disinflationary boom regime to continue. We barely modified our mapping of the 4 largest economic giants compared to last Fall. We re-confirm the ¨neither too hot, nor too cold¨ sort of a macro environment for the coming quarters.
Global cyclical developments over next quarters will be very positive, as world growth is gaining significant speed. The recent print of +4,5% in T3 actually exceeds the long term run rate (of approximately 3,8%). World expansion is expected to hover around 4%+ in 2018, with a homogenous pattern. The recent regime of very low volatility of expansion will not be challenged before 2019 earliest. Structural deflationary forces remain in place. These headwinds will fortunately be challenged by a significant cyclical rebound of CPI’s, allowing for central banks to further engage in their tentative normalisation.

Risk scenario(s). What could derail this long cycle ?

An oil spike. Very low probability

In the past, all sequences where oil rose by 50% in a few quarters fuelled a recession. In theory, if the barrel was to stabilise above $70 durably, that may qualify. Except that oil collapsed dramatically a few years ago before that. In practice, we consider that oil should rise at a higher price (say around $100) to trigger, this time, such a shock for world economy. This should not occur, absent a direct confrontation between Saudi Arabia and Iran.

A policy mistake (monetary / fiscal). Low odds

US fiscal plan will add little extra-growth to the US. But it will raise the budget deficit and possibly also concerns on its refinancing. A lower deductibility of interest rates expenses is also a meaningful change having potentially important consequences on leveraged economic agents and possibly on housing. It must be monitored carefully. This plan doesn’t solve at all the trade deficit, quite the opposite! However, it would have a 6 to 8% positive impact on EPS.
Risks of a ¨trade war¨/ unilateral tariffs are on the rise. On the positive, if fixed capital investment was to accelerate markedly, it would result in higher productivity and wages, which may fuel much higher long-term rates and USD. This is a very friendly economic scenario for 2018, and possibly 2019. On the flip-side a) it would absorb the – net – investable $ liquidity and b) reduce the durability of the cycle (and raise the odd of a US slowdown / recession in 2019/2020).

Japan and Europe are intensifying efforts to complete their free trade deal. Most obstacles seem to have been removed. This will actually open a large economic zone of about 30% of world GDP and cover about 600m people. China economic transition is doing fine so far. Granted, the party fired on all cylinders (monetary and fiscal) up to summer 2017. Some – welcome – policy re-calibration is underway, paving the way for a measured slowdown in 2018. We do not expect the excess leverage of the private sector to turn into a disarray, as policy makers will effectively use carrots and batons policy to avoid it.

A sharp – durable – inflation ¨resurrection¨? Low probability, but watch for an eventual cyclical rebound

We expect a cyclical rebound to occur in 2018, but no regime change i.e. no inflation spiral à la 70’s/80’s. The (structural) Great Divergence, between services (inflating) and goods (deflating), is set to continue. Two (new) fundamental drivers may gradually affect long-term inflation trend, protectionism and China.
Short-term, the US government seems to favour a pragmatic approach, namely with its strongest trade partners (say in
Asia if not in Europe). Watch for negative developments on North-Korea. US may try to use the trade / financial weapon – i.e. impose tariffs – to twist Xi’s arm. A possible dramatic outcome of NAFTA talks would also deserve attention in this respect.

Financial in-stability. Rising, but acceptable risks, short-term

China private sector debt is problematic. Policy-makers continue to address it, at a pace and with an energy that look effective. Eurozone ¨systemic¨ risks have significantly diminished in H1 2017.


Currencies : no significant imbalances

Do not bury the USD too fast

Investors did not appreciate President’s Trump unpredictable policy. This has weighed on the USD despite that the Fed has continued to tighten monetary policy. Its weakness was also driven by lower 10y US Treasury yields. A tighter Fed monetary policy than currently priced in by the market, due to higher inflation pressure, would push long-end of the yield curve higher too. Even more when the USD has not reached yet extreme valuations levels compared to other main currencies. This would support the USD, even more when the overall market positioning and consensus have a negative bias on the US currency.

The EUR/USD upside risk is more a 2019 story rather than 2018

The EUR upside momentum will be challenged next year. The 2017 surprise was the EUR strengthening. The EUR/USD has risen by more than 10% on expectations that the ECB is moving towards a less accommodative monetary policy. Moreover, stronger than expected growth in the eurozone and lower perceived political risks have boosted direct investment and portfolio flows. Investors are convinced that a stronger euro has further to go. This market conviction of a higher euro is visible in the reluctance of the EUR to move lower and the persistence of the excessive net-long euro positions. As long as investors will remain convinced that the EUR will rise in 2018, it is unlikely to happen. This is because they are already positioned for it and there is a lack of new buyers.
GBP strength is modest
At the start of the year, market consensus was that GBP would be vulnerable. Early in the year, we signaled well in advance that GBP would unlikely move lower because of the huge net GBP shorts. Furthermore, we always argued that GBP has been extremely cheap and still is. Therefore, the risk was for a higher and not a lower GBP. Our base case is that the UK and EU will reach a “win-win” agreement. This would be a constructive scenario for GBP.

Key JPY drivers i.e. government bond yields spreads will resurface

In 2017, the JPY has outperformed the USD while it has weakened versus the EUR. For 2018, we expect the USD/JPY to move modestly higher. This spread would widen because of our higher US yields forecast. Japanese 10y government bond yields are being kept by the BoJ, which is purchasing bonds to keep yields close to zero. We do not expect a significant change in the target in 2018 even if Mr Kuroda’s term expires in April. Second, the 10y real rate spread USJapan is also a crucial factor. This factor is positive for USD/JPY as we expect a somewhat higher inflation in Japan. As the 10y Japanese government bond yield is fixed by monetary policy, such an increase in domestic inflation will probably weigh on the JPY via a less favorably real yield spread. Third, the divergence between monetary policy of the Fed and the Bank of Japan will increase too. However, the JPY remains the cheapest developed currency.

A light CHF weakness

The SNB FX reserve slipped from a record high in November. The sight deposits have fallen to reach their lowest level since June 2017. Sight deposits are considered as the indicator of intervention of the SNB on the FX market. So, at the current level, the SNB is no longer intervening and not in a hurry to intervene. Policymakers have more room to wait and see. The SNB would soften its complaint over CHF strength, but would reiterate that the CHF is still “overvalued”.

EM vulnerable currencies are the most exposed to a risk repricing

EM currencies strengthening vs. USD over the year was mostly driven by broad dollar weakness, rather than a pure EMFX appreciation. According to REER metrics, EM FX are slightly overvalued in aggregate. This comes mainly from a CNY overvaluation. The risk is mainly posed by a hawkish Fed, even if it is not as great as in 2013 (Fed tantrum), massive 2017 inflows could sharply reverse and penalize EM currencies. The external position of EM economies has become more robust since then.


Fixed income : no bear markets yet, but volatility probably

Central banks are veering

The rolling 12-month change in the combined balance sheet of the 4-main developed central banks will fall. The flow will decrease to 2015 levels and would tend to zero by August 2019. Since the global financial crisis, it has only happened in Q2 2013 just before the Fed tantrum episode. Bond market would experience resurging volatility and yield curve steepening.

A more challenging budget deficit funding

The reduction of central banks’ purchases could happen at a time when there is some increase in governments spending. The US tax plan would lead to additional deficit and eventually to treasury issuance. The recent released UK budget includes some loosening of the fiscal purse. Even in Germany, the recent election uncertainty could include some fiscal stimulus. So, the tide is turning away from ultra-loose monetary and relatively tight fiscal.

Inflation, no one is waiting for it

In 2018, QE will slow just when inflation starts to surprise on the upside. In the US, the real GDP growth over the past 20 years has been a relatively reliable indicator of future core CPI, 6-quarters ahead. A reason for the weak/disappointing core CPI over the last year was the lagged impact of the growth weakness in Q4 2016/Q1 2017. The similar relationship is working well between the core CPI and the ISM.

A transitory year for credit markets

There are no major threats, no big events with deadlines that could derail credit aggressively. But, as always, several factors can shape the performance.
Yields are back down to almost mid-2016 troughs. The low level of credit yields does not matter as much as the low level of spreads does, the depress breakeven levels (by increasing duration) becomes alarming. Global credit break-evens are well below the mid-2014 troughs now. Low break-evens mean that the cushion for spread widening is thin.
We have already expressed our concerns about the corporate leverage. The median Debt/Equity ratio is just about to hit the peak of the previous cycle. Leverage is above the 2008 peaks, and close to the 2003 peaks. Balance sheets leverage – i.e. Net Debt/EBITDA – is still low. It has come down from the early-2016 peaks, and has dropped in Europe too. But should investors really care about the current levels of Net Debt/EBITDA? Increasingly, it is a lagging indicator of spreads, not a leading one.
Corporate default rates remained low through the year. We had more upgrades than downgrades through the year, something which does not tend to happen frequently. Moody’s rating drift ratio is very rarely positive. Since mid-2016, this ratio has been on the rise. We believe downgrades will soon start to exceed upgrades. Default rates would stay stable. However, default rates are backward-looking indicators, while rating changes tend to paint a slightly more positive picture looking ahead.

US HY is less attractive than IG

Corporates’ ability to service their debt is hardly likely to be a big worry in 2018. HY tight valuations and challenging fundamentals will be challenged by investors. In Europe, we think the prospect of ECB tapering combined with tight valuation levels will fuel more decompression in 2018.

EM remain exposed to portfolio rebalancing

Emerging bond markets have registered historical inflows. If the current trend of downgrades continues over the coming year, coupled with a slightly hawkish Fed, the flows could rapidly reverse. The average global portfolio allocations to EM bonds is already back to pre-crisis levels. Any developed yields repricing could trigger outflows.


Equities : tactical caution, short-term

Time has come for an equity market consolidation after 12 months of continuous rise. We observe complacency, notably in sharp increase in technology and e-commerce stocks, sectors that had entered a highly overbought technical area.
At 6-12 months, the bull market remains valid, but headwinds are setting up
Equity markets are supported by sound fundamentals. Economic growth is global and synchronized. In the United States, fiscal policy (tax reform) will take over from monetary policy. Donald Trump will relaunch his infrastructure investment program in 2018. The market is also expecting a softening of the banking regulation coming from the Fed’s next new president, Jerome Powell.

Corporate profits are strong. The annual growth is expected at 10% between 2017 and 2019 in the United States, while we expect an average annual growth of 12% in Europe and Japan, and +15% in China.
Revenue growth is estimated at around 5% over the next 3 years, in line with GDP growth. This would mean that corporate margins will continue to improve, according to analysts’ estimates, while the S&P 500 has a record high net margin.

But margins can’t be improved indefinitely, and profit growth exceeding 2 or 3 times GDP growth is not sustainable in the long run. Since 1950, the average annual increase in profits is 6.6%. In the United States, margins could continue to improve in 2018 thanks to tax reform and protectionist measures, but beyond 2018, we are cautious about forecasting 2digit profit growth.

In 2017, companies benefited from the flat labor costs and very low interest rates, conditions that are unlikely to repeat in 2018 and beyond. The cost of labor has been very low in recent years and this situation can’t last; in general, the cost of labor is between 65% and 75% of total costs. In 2016, wages in the United States accounted for 43% of GDP against 47% for the long-term average.

US profits also benefited from the drop in the dollar in 2017. In the S&P 500, 30% of total revenues and 40% of total profits come from abroad. According to FactSet, companies in the S&P 500 with sales abroad above 50% saw their profits grow by 13.4% in 3Q17 against +2.3% for those with sales in the United States higher than 50%. In view of a rise in US interest rates, the dollar should appreciate, thus changing the positive trend of profits from abroad. This change in environment should make European and Japanese stock markets more attractive.

European and Japanese equities have a significant potential

In real terms, the rise in profits is less impressive. For six quarters, the recovery of profits of oil companies is reflected in a powerful base effect. Secondly, the major share buyback programs benefited earnings per share (EPS). In the long term, the consultant Research Affiliates observes that the new share issues, which reduce the increase of EPS, are more important than the share buybacks : between 1988 and 2017, the dilution effect is on average 1.2 % per year. According to S&P, share buybacks have slowed for more than a year. Investors should no longer rely on a new share buyback boom, unless the tax reform encourages companies to buy back their shares, but we are rather anticipating that companies will invest in the real economy and/or make acquisitions.

The US tax reform, with a cut from 35% to 20% in the tax rate, will be mainly favorable to domestic companies. According to S&P, the S&P 500 corporate effective tax rate is 24.8% and that of the large multinationals (technology, pharma, staple), which earn a large portion of their profits abroad, is less than 20%. If the tax reform is promulgated in 2018, analysts calculate a positive impact of 8% on earnings per share. Repatriation of profits in the United States could encourage capital goods.

In the United States, the business costs to US GDP ratio (Yardeni Research) is 66%, a percentage lower than previous economic cycles. See chart below. Yardeni Research has found that net margins only return to its mean when the business costs/GDP ratio rises rapidly. That’s not the case today. According to their conclusion, there is still no risk of a return to the mean for net margins in the immediate future. Business costs definition : compensation of employees plus private nonresidential fixed investments spending.

Alternative Investments

Tax policies and growth, a nice cocktail for oil and industrial metals

Demand for oil rose 1.5 million barrels per day to 96.94 million bd in 2017, supported by all regions, especially China. The United States accounts for 21% of global demand, Europe 14.6% and China 12.6%. On the supply side, the United States increased its production, while OPEC managed to reduce its production to 33.2 million bd. For 2018, demand will continue to increase to 98.45 million bd, while supply is expected to reach 98.5 million bd. As in 2017, 2018 will be marked by a balance between supply and demand, with an adjustment factor that will be Saudi Arabia. China will contribute 30% of the increase in demand. In this environment, prices will remain well supported.

Industrial metal prices will also rise thanks to Chinese and developed country demand. The major infrastructure project One Belt One Road will contribute to the increase in demand. Donald Trump will start early in 2018 to revive his $1,000bn infrastructure project.




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