The rebound in stocks may have hit a ceiling! · 2019-04-02 · stocks are a bargain versus U.S....

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EQUITIES The rebound in stocks may have hit a ceiling! There is clearly fresh speculative interest in riskier assets after the 2018 rout, stocks, corporate bonds, cyclical sectors, and Emerging Markets assets benefiting. With more than 50% of all MSCI World stocks being above their 200 days moving average (versus 15% at the end of last year) and about 4% of MSCI World firms recording new 52-weeks highs, the stock market extended its broad-based rally since Christmas (+15%, in euro). And this time, the “weak” stocks are leading the way as small caps are outperforming large caps and high volatility stocks are beating low volatility stocks. Thanks to the surprise pliability of Federal Reserve Chairman Jerome Powell and his counterparts around the world, easing trade tensions (President Donald Trump delayed the date for increasing tariffs on Chinese imports, raising hopes for an end to the trade war) and signs that China is bolstering its economy, the equation on stocks has changed for many investors. With the global economy widely forecast to decelerate, major central banks are having to delay their plans for “normalizing” monetary policy by withdrawing some of this excess liquidity, which means the party continues for risk assets. For some observers, a modest easing of financial conditions globally is likely sufficient to stabilize growth in the second half of 2019. For others, any decisive move in global monetary and fiscal positions toward a more growth-friendly stance could trigger a renewed bull market. But what investors seem not to be discounting is that the more volatility declines (the VIX index has fallen to its lowest level since early October) and talk of complacency heats up, the more inclined the Fed might be to raise interest rates, maybe not this quarter or the next, but possibly in the second half of the year. The Fed would almost certainly continue to shrink its balance sheet, withdrawing some $50 billion of liquidity from markets each month. Furthermore, weaker growth, lower consumer confidence and disappointing PMIs are pushing some market participants to question the rally, while cheap valuations are making it tricky to sell equities. So in these markets the question is: should investors stick or twist? Money managers surveyed by Bank of America Merrill Lynch aren’t convinced by the new-year equity rally and prefer cash to stocks. Their global equity allocations in March fell to the lowest level since September 2016 and their cash allocation is the highest since the 2009 financial crisis, even as the MSCI All Country World index is up almost 13.5% (in euro) in 2019. That indicates a deep lack of conviction in the sustainability of the rebound among traders! For our part, we caution against chasing the rally in risk assets, particularly in areas vulnerable to growth downgrades, geopolitical risks or sudden shift in supply/demand dynamics as the Global Uncertainty index, a measure of unpredictability in 20 countries, reached a record level. The index, developed in 2016 by the Economic Policy Uncertainty researchers Scott Baker, Nick Bloom and Steven Davis, is based on the frequency that newspapers cite "uncertain" or "uncertainty" in relation to economic policy. This indicator has risen to a record amid what seems like higher than normal political uncertainty and the very real prospect of another U.S. government shutdown in coming days as well as the U.S.-China trade talks, which are due to wrap up March 1 with or without a deal. Add in the U.K.’s continuing Brexit follies, the fact that Italy’s not so insignificant economy has formally entered a recession, and political strife in Venezuela to name just a few potential headwinds, and one quickly realizes that a lot has to break right for stocks to continue their rally. Furthermore, the New York Federal Reserve’s recession probability gauge, which uses the 10-year/3-month Treasury yield curve to predict the chance of a contraction in the next 12 months, recently hit its highest since 2008 (24%). Of the 11 times the indicator has risen through this level since the 1960s, eight have been accompanied by a recession! All these concerns over the economy is on display in the global bond markets, specifically in the rising amount of global negative-yielding debt, which Bloomberg puts at $9.4 trillion. That is the most since 2017 and up from about $5.7 trillion as recently as October 2018. In other words, investors wouldn’t be scrambling into safe government debt, bidding up prices and pushing yields below zero, if they thought all was right in the world. Falling yields could suggest that bond investors are seeing greater dangers than equity investors have in recent weeks. It is also hard to ignore the angst being signaled by the price of gold, which has surged about 12% since mid- August 2018 to just above $1,300 an ounce. While the naysayers might say gold’s price is only back to where it was in May 2018, that is the wrong way to look at the action in one of the world’s most visible haven assets. The better way to understand what is going is through flows and the fact that the price of the metal is at a record high in 72 currencies other than the dollar. What began for gold as safe haven flows during rising volatility on financial markets could become a story of a less hawkish Fed as speculation mounts that the Fed could hit the pause button on interest rate hikes in 2019. Furthermore, the rally in stocks since Christmas is lacking a few critical ingredients that normally accompany such a rapid rise. First, Investment Company Institute data show flows into equity mutual funds have been minimal relative to the outflows saw in the second half of 2018. Second, trading volumes are muted, with the amount of S&P 500 shares changing hands averaging just above 37 billion shares quarterly over the last year, down from a recent high near 47 billion in 2016 and less than half of peak trading volume recorded early this century. Third, and perhaps most unusual, the outlook for corporate profits this quarter and next is bleak, with many strategists forecasting an earnings recession (meaning two quarters of negative growth). Consensus expectations imply earnings growth will slow in the year ahead, resulting in 2019 average earnings per share gains of 3.4-3.2% in the U.S. and at the world level. There is kind of a danger zone when earnings estimates start the year where they are! Most of the time when you are expecting less than 5% at this time of the year, you get a negative number as full-year earnings estimates normally drop by about 0.5% each month. The disconnect between the economy and economic-cycle sensitive stocks is so strong that we decided to reduce our positioning on equities and on commodities from neutral to underweight, while we keep our preference for “low beta” assets (such as defensive stocks, big caps or gold) which are typically less volatile. At the same time, we increase our weight on bonds, in real estate and in cash. 1.1 Regional allocation 1.1.1 Euro-Area: neutral On the 10th anniversary of the start of the global equity bull market, European stocks don’t have that much to celebrate. While the Stoxx Europe 50 index has gained about 80% since March 2009, that is equivalent to about a fifth of the whopping returns that the S&P 500 index has enjoyed. Volatile politics, a debt crisis and slowing profit growth are to blame for European equities’ laggard status. Europe increasingly looks like the biggest threat to global growth. Deteriorating demand is evident across the 19- nation Euro-Area as it finds itself squeezed between international and domestic drags. That leaves its expansion at risk of barely topping 1% this year, a sharp slowdown from 2018, with even continental powerhouse Germany in trouble. The extent and surprising suddenness of the weakness reflects that the slowdown is hitting the core of the region. While the likes of Greece were at the root of past sluggishness, this time Germany’s prospects are crumbling after a protracted slump in manufacturing. Household spending has also ground to a halt in France, which is beset by the Yellow Vest protests. Together those two countries account for about half the Euro-Area economy. The problems don’t stop there. Italian bond yields have started to creep higher again amid doubts over fiscal management, the health of banks is questionable and Brexit remains unresolved. European elections in May could see gains for anti-EU parties, something that is already worrying some companies. That is why the European Commission warned that the Euro-Area’s outlook faces “substantial” risks. It slashed its growth forecasts for all the euro region’s major economies from Germany to Italy and warned that Brexit and the slowdown in China threaten to make the outlook even worse. In its forecasts, the commission sees the 19-nation Euro-Area economy expanding 1.3% this year down from 1.9% projected in November. For 2020, it sees growth of 1.6%, down from 1.7% forecast earlier. Italy’s downward revision was the starkest, with the commission seeing growth slowing to 0.2% - the lowest in the bloc by far - compared with its previous forecast of 1.2%. The lowered outlook comes two months after Rome and Brussels reached a compromise over Italy’s deficit target and will likely make it more difficult for the populist coalition to carry out its expansive spending plans. That increasingly anemic economy will test the resolve of the European Central Bank in sticking to its plans to gradually pare back its crisis-era stimulus. ECB policy makers already walked a fine line in December by downgrading economic forecasts at the same time as ending net asset purchases that have helped buoy Euro-Area demand. Money markets are betting that policy makers will raise the benchmark deposit rate in only June 2020, compared with earlier expectations for a liftoff this year. That is spurring a rally in nearly everything from benchmark German bonds to Belgian and Spanish debt securities (more comment in the bond section) . The global bull run has seen Europe’s benchmark add about €0.4 trillion from its late December trough. The Euro Stoxx 50 is up 12.5% this year, on track for its biggest three-month gain since 2015. For most of 2019, any signs of froth have been justified by expectations for further monetary support and valuations crushed by last year’s sell-off. European stocks are a bargain versus U.S. and world peers: the Stoxx 50 trades at a forward P/E ratio of 13.5. That compares with 16.9 for the S&P 500 and 15.2 for the MSCI World index. In term of forward yield gap (3.7%), European stocks have never been cheaper relative to sovereign bonds. But the faster and more furious it gets, the harder it is to overlook the growing risks of Europe’s slowing economic data and its still turbulent politics. Many of Europe’s political issues are existential, and with weaker earnings and economic growth, there is little incentive for overseas investors to even try to understand them. For now, consensus estimates are still projecting faster earnings growth for the Stoxx 600 in 2019 (5.9% versus 5.8% in 2018 and the average of 3.5% a year in 2014-2017) but that is probably too optimistic, taking into account growing margin pressures and the Citigroup’s Earnings Revisions index which shows the deepest profit downgrades by analysts since 2015! 1.1.2 Emerging Markets (versus Developed Markets): overweight => neutral First, the bad news: corporate earnings across emerging markets (EM) aren’t as good as analysts hoped. In four out of every five emerging economies, company have fallen short of estimates that were made 12 months ago, according to a study of 25 benchmarks. That is even after analysts cut their forecasts by 50% since a peak in April. If earnings growth is slower, there is a risk that investors will skip the increased risk of EM and invest in developed markets. Now the good news. Stocks across developing nations aren’t as risky as their U.S. counterparts, and they are good value. Thanks to a sell-off in 2018, $11 trillion of equities are about the cheapest since the financial crisis. It may be hard to convince investors to return to EM based on earnings alone, but the combination of low valuations and reduced volatility could make the asset class too good to pass up in 2019, especially if there is a real trade war détente, as expected after the recent G-20 summit. The MSCI EM index is trading around 12 times estimated earnings for the next 12 months, a level just above the historical average! Emerging Markets stocks rose more than 11% (in euro) since end October 2018 after markets learned President Donald Trump is interested in reaching an agreement on trade with China's Xi Jinping. The two leaders have agreed on a temporary truce after the latest G-20 summit. That is important as the trade war has been partly to blame for the recent equities rout, so any signs that the two powers are making progress will encourage investors to put risk back on the table and pick up stocks at bargain levels. Henry Kissinger, the 95-year-old foreign policy guru to world leaders, said he was “fairly optimistic” the U.S. and China could avoid a wider conflict that would devastate the current world order! As Democrats won a majority in the House and Republicans held their majority in the Senate, this situation dims chances for any major fiscal initiative from the US administration that might have pushed yields higher and strengthened the greenback and will reassure — at least temporarily — foreign observers who became more prudent about EM assets. Emerging Markets climbed also on growing speculation that the Federal Reserve will pause rate hikes in 2019, easing pressure on riskier assets. Fed Chairman Jerome Powell’s suggestion that the U.S. central bank is approaching the range of estimates for a neutral interest-rate has seen the greenback trading off its highs of last year - potentially adding to the allure of EM assets that have been pressured by rising dollar borrowing costs. The Fed’s shift to a prolonged pause in its interest-rate hiking cycle will lift pressure off its EM peers to hike in tandem. Central banks in Chile, Indonesia, Mexico, the Philippines, Russia, South Africa, and Thailand are among those that have raised rates in recent months, some seeking to blunt the dollar’s rise against their currencies. The Fed’s four rate increases in 2018 were a central reason. You would certainly hear now a sigh of relief in a lot of central banks in EM as the Fed signaled that it is done raising interest rates for at least a while and "will be patient" regarding future hikes, while adopting a flexible stance in reducing its bond holdings. EM currencies that have strengthened in recent weeks (+1.5% since the end of last year) due to a fading of the dollar saw more gains after the Fed’s announcement. Finally, stronger oil prices are a two-sided coin for the collection of assets and economies classed as Emerging Markets. Many of the countries, such as Gulf nations like Saudi Arabia or Russia, are energy exporters that suffer when prices decline. Others, like Turkey, India or South Africa, have to import fuels and so benefit from cheaper energy. 1.1.3 Japan: neutral Japanese gross domestic product is forecast to recover from its drop in the third and fourth quarter of 2018 (0.1% and 0.3%, from about 2.5% at the end of 2018), driven by the biggest drop in business spending in nine years amid a series of natural disasters and to regain strength until a sales-tax hike in October 2019. But the impact of a slowdown in China and trade tensions are likely to keep the expansion modest. Reports that President Donald Trump will hold off for now on imposing tariffs on imported Japanese cars and auto parts keeps one of the largest threats to Japan’s economy at bay for the time being. As Japanese corporate earnings are highly cyclical - on a market-weighted basis, companies on the Topix index derive more than 37% of their revenue from abroad -, that explains why the Topix, which had lost nearly 20 % between October and December last year, has rebounded this year by 7% (in euro). At the same time, the Bank of Japan (BOJ) is in a tight spot with some people thinking it should raise rates to help alleviate pressure on the profits of regional banks and limit risks to the financial system. Japan is about to mark 20 years since it adopted zero rates, a salient warning to others central banks about just how long “extraordinary” monetary setting can last! The problem is can it really raise rates when the economy is not really strong? To complicate the issue further, the Federal Reserve’s move away from a steady path of monetary tightening in the U.S. could spur the risk of a yen-surge scenario as the BoJ may not have options to manage the case of very strong yen appreciation. An increasing yen, of course, is seen as bad news for the Japan’s legion of exporters, as it inflates the value of their overseas profits when repatriated. For memory, a weaker yen — driven by the BoJ massive easing — was the main lever that lifted Japan from deflation to inflation and lifted Japanese stocks. Over the past decade, the linkage between the Nikkei and USD/JPY exchange rate has been fairly tight, with a correlation of roughly 0.6 over the period. More favourable liquidity backdrop in Japan compared to the other regions and a weaker yen explained why Topix companies have reported total adjusted earnings per share growth of 90% since end 2016. In this context, we prefer to keep our neutral positioning on Japanese stocks even if their earnings and dividend yield-based valuations are still attractive. The Topix is trading at 13.2 times current earnings, trending down from above 20 times in 2013 and trailing by 21% the MSCI World index’s current level of nearly 16 times. Its 12-month dividend yield (2.4%) is about 2.4% higher than the 10-year Japanese sovereign yield (-0.03%). 1.1.4 United States: neutral Maybe President Donald Trump knows more about the stock market than his detractors give him credit for. Trump tweeted last year on October 30 that “if you want your stocks to go down, I strongly suggest voting Democrat.” The implication was that the Democrats would block, reverse or otherwise obstruct many of the market- friendly policies his administration has carried out. But many did vote for Democrats in the midterm elections, allowing them to regain control of the House of Representatives and “pro-Trump” stocks underperform. In 2016, Morgan Stanley created an index of 54 companies called the “Long Trump Basket” that were most likely to outperform if Trump won the presidential election. That index outperformed the S&P 500 from the election through the beginning of 2017. But it then performed in line with the broader market through the first quarter and has underperformed since it appeared the Democrats might win back the House. It has gained less than 1.5% since end 2016, compared with the S&P 500’s 15% gain. The Trump bump is turning into a significant Trump discount. His trade-war maneuvers morphed into a general sense of gloom about the global economic outlook. All told, the S&P 500 index is now 11% cheaper than it was before Trump was elected president, with the gauge trading at 16 times next year’s expected earnings, down from just under 18 in early November 2016 - by comparison, they rose 16% in Barack Obama’s first two years in office. Worries about a trade war have been a big part of that drop. The biggest portion of the drop-off in stock market valuations happened in late January and early February 2018, when President Trump made clear that he was going to go ahead with tariffs and other measures to block trade with China and others. Another sign the U.S. equity rally may be looking stretched, the forward dividend yield on the S&P 500 has dropped below the return on Treasuries (-0.4%) for the first time since 2011. Shares in Europe and Japan, by contrast, continue to yield well above their equivalent government bonds. Investors looking for income have more incentive to cast aside U.S. stocks for Treasury bills than they have in the past decade. The S&P 500 index closed last month with a dividend yield of 1.9%, or 0.40% less than the bond-equivalent yield on three-month bills. Returns from owning U.S. stocks rather than bonds have fallen too far. The inflation-adjusted equity risk premium (2.7%), calculated since the end of World War II by Pacific Investment Management, is still one of its lowest level since October 2008, when a global financial crisis was under way. MARCH 2019 The analysis of Thierry Masset The rebound in stocks may have hit a ceiling! The disconnect between bonds and stocks is coming back Some commodities signal risk assets rally has gone too far ECB may have made European banks even less attractive Forgetting tragedies, investors give Greek assets a chance Sweet spot for convertible bonds

Transcript of The rebound in stocks may have hit a ceiling! · 2019-04-02 · stocks are a bargain versus U.S....

Page 1: The rebound in stocks may have hit a ceiling! · 2019-04-02 · stocks are a bargain versus U.S. and world peers: the Stoxx 50 trades at a forward P/E ratio of 13.5. That compares

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EQUITIES

The rebound in stocks may have hit a ceiling!

There is clearly fresh speculative interest in riskier assets after the 2018 rout, stocks, corporate bonds, cyclicalsectors, and Emerging Markets assets benefiting. With more than 50% of all MSCI World stocks being above their 200days moving average (versus 15% at the end of last year) and about 4% of MSCI World firms recording new 52-weekshighs, the stock market extended its broad-based rally since Christmas (+15%, in euro). And this time, the “weak” stocksare leading the way as small caps are outperforming large caps and high volatility stocks are beating low volatility stocks.

Thanks to the surprise pliability of Federal Reserve Chairman Jerome Powell and his counterparts around the world,easing trade tensions (President Donald Trump delayed the date for increasing tariffs on Chinese imports, raising hopesfor an end to the trade war) and signs that China is bolstering its economy, the equation on stocks has changed for manyinvestors. With the global economy widely forecast to decelerate, major central banks are having to delay theirplans for “normalizing” monetary policy by withdrawing some of this excess liquidity, which means the partycontinues for risk assets. For some observers, a modest easing of financial conditions globally is likely sufficient tostabilize growth in the second half of 2019. For others, any decisive move in global monetary and fiscal positions toward amore growth-friendly stance could trigger a renewed bull market.

But what investors seem not to be discounting is that the more volatility declines (the VIX index has fallen to itslowest level since early October) and talk of complacency heats up, the more inclined the Fed might be to raiseinterest rates, maybe not this quarter or the next, but possibly in the second half of the year. The Fed would almostcertainly continue to shrink its balance sheet, withdrawing some $50 billion of liquidity from markets each month.

Furthermore, weaker growth, lower consumer confidence and disappointing PMIs are pushing some marketparticipants to question the rally, while cheap valuations are making it tricky to sell equities. So in these markets thequestion is: should investors stick or twist?

Money managers surveyed by Bank of America Merrill Lynch aren’t convinced by the new-year equity rally andprefer cash to stocks. Their global equity allocations in March fell to the lowest level since September 2016 and theircash allocation is the highest since the 2009 financial crisis, even as the MSCI All Country World index is up almost13.5% (in euro) in 2019. That indicates a deep lack of conviction in the sustainability of the rebound among traders!

For our part, we caution against chasing the rally in risk assets, particularly in areas vulnerable to growthdowngrades, geopolitical risks or sudden shift in supply/demand dynamics as the Global Uncertainty index, ameasure of unpredictability in 20 countries, reached a record level. The index, developed in 2016 by the EconomicPolicy Uncertainty researchers Scott Baker, Nick Bloom and Steven Davis, is based on the frequency that newspaperscite "uncertain" or "uncertainty" in relation to economic policy. This indicator has risen to a record amid what seems likehigher than normal political uncertainty and the very real prospect of another U.S. government shutdown in coming daysas well as the U.S.-China trade talks, which are due to wrap up March 1 with or without a deal. Add in the U.K.’scontinuing Brexit follies, the fact that Italy’s not so insignificant economy has formally entered a recession, and politicalstrife in Venezuela to name just a few potential headwinds, and one quickly realizes that a lot has to break right for stocksto continue their rally.

Furthermore, the New York Federal Reserve’s recession probability gauge, which uses the 10-year/3-month Treasuryyield curve to predict the chance of a contraction in the next 12 months, recently hit its highest since 2008 (24%). Ofthe 11 times the indicator has risen through this level since the 1960s, eight have been accompanied by a recession!

All these concerns over the economy is on display in the global bond markets, specifically in the rising amount of globalnegative-yielding debt, which Bloomberg puts at $9.4 trillion. That is the most since 2017 and up from about $5.7 trillionas recently as October 2018. In other words, investors wouldn’t be scrambling into safe government debt, bidding upprices and pushing yields below zero, if they thought all was right in the world.

Falling yields could suggest that bond investors are seeing greater dangers than equity investors have in recentweeks.

It is also hard to ignore the angst being signaled by the price of gold, which has surged about 12% since mid-August 2018 to just above $1,300 an ounce. While the naysayers might say gold’s price is only back to where it was inMay 2018, that is the wrong way to look at the action in one of the world’s most visible haven assets. The better way tounderstand what is going is through flows and the fact that the price of the metal is at a record high in 72 currencies otherthan the dollar. What began for gold as safe haven flows during rising volatility on financial markets could become a storyof a less hawkish Fed as speculation mounts that the Fed could hit the pause button on interest rate hikes in 2019.

Furthermore, the rally in stocks since Christmas is lacking a few critical ingredients that normally accompany sucha rapid rise.

First, Investment Company Institute data show flows into equity mutual funds have been minimal relative to theoutflows saw in the second half of 2018.

Second, trading volumes are muted, with the amount of S&P 500 shares changing hands averaging just above 37billion shares quarterly over the last year, down from a recent high near 47 billion in 2016 and less than half of peaktrading volume recorded early this century.Third, and perhaps most unusual, the outlook for corporate profits this quarter and next is bleak, with manystrategists forecasting an earnings recession (meaning two quarters of negative growth). Consensus expectationsimply earnings growth will slow in the year ahead, resulting in 2019 average earnings per share gains of 3.4-3.2% inthe U.S. and at the world level. There is kind of a danger zone when earnings estimates start the year where theyare! Most of the time when you are expecting less than 5% at this time of the year, you get a negative number asfull-year earnings estimates normally drop by about 0.5% each month.

The disconnect between the economy and economic-cycle sensitive stocks is so strong that we decided to reduce ourpositioning on equities and on commodities from neutral to underweight, while we keep our preference for “lowbeta” assets (such as defensive stocks, big caps or gold) which are typically less volatile. At the same time, weincrease our weight on bonds, in real estate and in cash.

1.1 Regional allocation1.1.1 Euro-Area: neutral

On the 10th anniversary of the start of the global equity bull market, European stocks don’t have that much tocelebrate. While the Stoxx Europe 50 index has gained about 80% since March 2009, that is equivalent to about a fifth ofthe whopping returns that the S&P 500 index has enjoyed. Volatile politics, a debt crisis and slowing profit growth are toblame for European equities’ laggard status.

Europe increasingly looks like the biggest threat to global growth. Deteriorating demand is evident across the 19-nation Euro-Area as it finds itself squeezed between international and domestic drags. That leaves its expansion at risk ofbarely topping 1% this year, a sharp slowdown from 2018, with even continental powerhouse Germany in trouble.

The extent and surprising suddenness of the weakness reflects that the slowdown is hitting the core of theregion. While the likes of Greece were at the root of past sluggishness, this time Germany’s prospects arecrumbling after a protracted slump in manufacturing. Household spending has also ground to a halt in France, whichis beset by the Yellow Vest protests. Together those two countries account for about half the Euro-Area economy.The problems don’t stop there. Italian bond yields have started to creep higher again amid doubts over fiscalmanagement, the health of banks is questionable and Brexit remains unresolved. European elections in May couldsee gains for anti-EU parties, something that is already worrying some companies.

That is why the European Commission warned that the Euro-Area’s outlook faces “substantial” risks. Itslashed its growth forecasts for all the euro region’s major economies from Germany to Italy and warned that Brexitand the slowdown in China threaten to make the outlook even worse.

In its forecasts, the commission sees the 19-nation Euro-Area economy expanding 1.3% this year down from1.9% projected in November. For 2020, it sees growth of 1.6%, down from 1.7% forecast earlier. Italy’s downwardrevision was the starkest, with the commission seeing growth slowing to 0.2% - the lowest in the bloc by far -compared with its previous forecast of 1.2%. The lowered outlook comes two months after Rome and Brusselsreached a compromise over Italy’s deficit target and will likely make it more difficult for the populist coalition to carryout its expansive spending plans.

That increasingly anemic economy will test the resolve of the European Central Bank in sticking to its plans togradually pare back its crisis-era stimulus. ECB policy makers already walked a fine line in December by downgradingeconomic forecasts at the same time as ending net asset purchases that have helped buoy Euro-Area demand. Moneymarkets are betting that policy makers will raise the benchmark deposit rate in only June 2020, compared with earlierexpectations for a liftoff this year. That is spurring a rally in nearly everything from benchmark German bonds to Belgianand Spanish debt securities (more comment in the bond section) .

The global bull run has seen Europe’s benchmark add about €0.4 trillion from its late December trough. The Euro Stoxx50 is up 12.5% this year, on track for its biggest three-month gain since 2015. For most of 2019, any signs of froth havebeen justified by expectations for further monetary support and valuations crushed by last year’s sell-off. Europeanstocks are a bargain versus U.S. and world peers: the Stoxx 50 trades at a forward P/E ratio of 13.5. That compareswith 16.9 for the S&P 500 and 15.2 for the MSCI World index. In term of forward yield gap (3.7%), European stocks havenever been cheaper relative to sovereign bonds.

But the faster and more furious it gets, the harder it is to overlook the growing risks of Europe’s slowing economic dataand its still turbulent politics. Many of Europe’s political issues are existential, and with weaker earnings and economicgrowth, there is little incentive for overseas investors to even try to understand them. For now, consensus estimates arestill projecting faster earnings growth for the Stoxx 600 in 2019 (5.9% versus 5.8% in 2018 and the average of 3.5% ayear in 2014-2017) but that is probably too optimistic, taking into account growing margin pressures and the Citigroup’sEarnings Revisions index which shows the deepest profit downgrades by analysts since 2015!

1.1.2 Emerging Markets (versus Developed Markets): overweight => neutral

First, the bad news: corporate earnings across emerging markets (EM) aren’t as good as analysts hoped. In fourout of every five emerging economies, company have fallen short of estimates that were made 12 months ago, accordingto a study of 25 benchmarks. That is even after analysts cut their forecasts by 50% since a peak in April. If earningsgrowth is slower, there is a risk that investors will skip the increased risk of EM and invest in developed markets.

Now the good news. Stocks across developing nations aren’t as risky as their U.S. counterparts, and they aregood value. Thanks to a sell-off in 2018, $11 trillion of equities are about the cheapest since the financial crisis. It may behard to convince investors to return to EM based on earnings alone, but the combination of low valuations and reducedvolatility could make the asset class too good to pass up in 2019, especially if there is a real trade war détente, asexpected after the recent G-20 summit. The MSCI EM index is trading around 12 times estimated earnings for the next 12months, a level just above the historical average!

Emerging Markets stocks rose more than 11% (in euro) since end October 2018 after markets learned President DonaldTrump is interested in reaching an agreement on trade with China's Xi Jinping. The two leaders have agreed on atemporary truce after the latest G-20 summit. That is important as the trade war has been partly to blame for the recentequities rout, so any signs that the two powers are making progress will encourage investors to put risk back on the tableand pick up stocks at bargain levels. Henry Kissinger, the 95-year-old foreign policy guru to world leaders, said he was“fairly optimistic” the U.S. and China could avoid a wider conflict that would devastate the current world order!

As Democrats won a majority in the House and Republicans held their majority in the Senate, this situation dimschances for any major fiscal initiative from the US administration that might have pushed yields higher andstrengthened the greenback and will reassure — at least temporarily — foreign observers who became more prudentabout EM assets.

Emerging Markets climbed also on growing speculation that the Federal Reserve will pause rate hikes in 2019,easing pressure on riskier assets. Fed Chairman Jerome Powell’s suggestion that the U.S. central bank is approachingthe range of estimates for a neutral interest-rate has seen the greenback trading off its highs of last year - potentiallyadding to the allure of EM assets that have been pressured by rising dollar borrowing costs.

The Fed’s shift to a prolonged pause in its interest-rate hiking cycle will lift pressure off its EM peers to hikein tandem. Central banks in Chile, Indonesia, Mexico, the Philippines, Russia, South Africa, and Thailand areamong those that have raised rates in recent months, some seeking to blunt the dollar’s rise against theircurrencies. The Fed’s four rate increases in 2018 were a central reason. You would certainly hear now a sigh ofrelief in a lot of central banks in EM as the Fed signaled that it is done raising interest rates for at least a while and"will be patient" regarding future hikes, while adopting a flexible stance in reducing its bond holdings.EM currencies that have strengthened in recent weeks (+1.5% since the end of last year) due to a fading ofthe dollar saw more gains after the Fed’s announcement.

Finally, stronger oil prices are a two-sided coin for the collection of assets and economies classed as EmergingMarkets.

Many of the countries, such as Gulf nations like Saudi Arabia or Russia, are energy exporters that suffer whenprices decline.

Others, like Turkey, India or South Africa, have to import fuels and so benefit from cheaper energy.

1.1.3 Japan: neutral

Japanese gross domestic product is forecast to recover from its drop in the third and fourth quarter of 2018(0.1% and 0.3%, from about 2.5% at the end of 2018), driven by the biggest drop in business spending in nine yearsamid a series of natural disasters and to regain strength until a sales-tax hike in October 2019.But the impact of a slowdown in China and trade tensions are likely to keep the expansion modest. Reportsthat President Donald Trump will hold off for now on imposing tariffs on imported Japanese cars and auto partskeeps one of the largest threats to Japan’s economy at bay for the time being. As Japanese corporate earnings arehighly cyclical - on a market-weighted basis, companies on the Topix index derive more than 37% of theirrevenue from abroad -, that explains why the Topix, which had lost nearly 20 % between October and Decemberlast year, has rebounded this year by 7% (in euro).At the same time, the Bank of Japan (BOJ) is in a tight spot with some people thinking it should raise rates tohelp alleviate pressure on the profits of regional banks and limit risks to the financial system. Japan is about to mark20 years since it adopted zero rates, a salient warning to others central banks about just how long “extraordinary”monetary setting can last! The problem is can it really raise rates when the economy is not really strong?

To complicate the issue further, the Federal Reserve’s move away from a steady path of monetary tighteningin the U.S. could spur the risk of a yen-surge scenario as the BoJ may not have options to manage the case ofvery strong yen appreciation.An increasing yen, of course, is seen as bad news for the Japan’s legion of exporters, as it inflates the valueof their overseas profits when repatriated.

For memory, a weaker yen — driven by the BoJ massive easing — was the main lever that lifted Japanfrom deflation to inflation and lifted Japanese stocks. Over the past decade, the linkage between theNikkei and USD/JPY exchange rate has been fairly tight, with a correlation of roughly 0.6 over the period.

More favourable liquidity backdrop in Japan compared to the other regions and a weaker yenexplained why Topix companies have reported total adjusted earnings per share growth of 90% sinceend 2016.

In this context, we prefer to keep our neutral positioning on Japanese stocks even if their earnings and dividendyield-based valuations are still attractive. The Topix is trading at 13.2 times current earnings, trending down fromabove 20 times in 2013 and trailing by 21% the MSCI World index’s current level of nearly 16 times. Its 12-monthdividend yield (2.4%) is about 2.4% higher than the 10-year Japanese sovereign yield (-0.03%).

1.1.4 United States: neutral

Maybe President Donald Trump knows more about the stock market than his detractors give him credit for. Trumptweeted last year on October 30 that “if you want your stocks to go down, I strongly suggest votingDemocrat.” The implication was that the Democrats would block, reverse or otherwise obstruct many of the market-friendly policies his administration has carried out. But many did vote for Democrats in the midterm elections,allowing them to regain control of the House of Representatives and “pro-Trump” stocks underperform. In 2016,Morgan Stanley created an index of 54 companies called the “Long Trump Basket” that were most likely tooutperform if Trump won the presidential election. That index outperformed the S&P 500 from the electionthrough the beginning of 2017. But it then performed in line with the broader market through the first quarter andhas underperformed since it appeared the Democrats might win back the House. It has gained less than 1.5%since end 2016, compared with the S&P 500’s 15% gain.

The Trump bump is turning into a significant Trump discount. His trade-war maneuvers morphed into ageneral sense of gloom about the global economic outlook. All told, the S&P 500 index is now 11% cheaper thanit was before Trump was elected president, with the gauge trading at 16 times next year’s expected earnings,down from just under 18 in early November 2016 - by comparison, they rose 16% in Barack Obama’s first two yearsin office. Worries about a trade war have been a big part of that drop. The biggest portion of the drop-off in stockmarket valuations happened in late January and early February 2018, when President Trump made clear that hewas going to go ahead with tariffs and other measures to block trade with China and others.

Another sign the U.S. equity rally may be looking stretched, the forward dividend yield on the S&P 500has dropped below the return on Treasuries (-0.4%) for the first time since 2011. Shares in Europe andJapan, by contrast, continue to yield well above their equivalent government bonds.

Investors looking for income have more incentive to cast aside U.S. stocks for Treasury bills thanthey have in the past decade. The S&P 500 index closed last month with a dividend yield of 1.9%, or 0.40%less than the bond-equivalent yield on three-month bills.

Returns from owning U.S. stocks rather than bonds have fallen too far. The inflation-adjusted equity riskpremium (2.7%), calculated since the end of World War II by Pacific Investment Management, is still one of itslowest level since October 2008, when a global financial crisis was under way.

MARCH 2019

The analysis of Thierry Masset

The rebound in stocks may have hit aceiling!

The disconnect between bonds andstocks is coming back

Some commodities signal risk assetsrally has gone too far

ECB may have made Europeanbanks even less attractive

Forgetting tragedies, investors giveGreek assets a chance

Sweet spot for convertible bonds

Page 2: The rebound in stocks may have hit a ceiling! · 2019-04-02 · stocks are a bargain versus U.S. and world peers: the Stoxx 50 trades at a forward P/E ratio of 13.5. That compares

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While trade fears are still an issue, worries have shifted recently from trade to growth as the Trump tax cut seemsto be coming up short. The reduction in the corporate rate has certainly boosted companies’ earnings in 2018.The bottom lines of corporations in the S&P 500 are expected to have risen around 20% in 2018. But much of thatseems to be a one-time boost, and not the sustained higher growth that Trump and his advisers promised from lowtax rates. Analysts are now expecting 2019 earnings growth to slow to 3.7%, nearly three times less than the growththey were predicting back in June 2017, six months before the passage of the tax cut. There is kind of a dangerzone when earnings estimates start the year where they are! Most of the time when you are expecting less than 5%at this time of the year, you get a negative number as full-year earnings estimates normally drop by about 0.5%each month

Over the last decade, U.S. companies have been the most generous to investors. Since 2009, S&P 500 membersshelled out more than $8 trillion in dividends and buybacks, propelling the longest bull run in history. Investors arenow more skeptical, because several of those trillions were funded by debt. The median S&P firm’s net debt-to-equity ratio doubled, to 61% last year from 31% in 2010. According to the latest survey of fund managers by Bank ofAmerica Merrill Lynch, a net 33% of investors think the payout ratio in the U.S. is too high.Furthermore, cracks are starting to develop in some significant parts of the U.S. equities market. The Russell2000 index that tracks the shares of smaller companies, which theoretically should be the prime beneficiaries of theWhite House’s “America First” agenda because they mainly have a domestic focus, has fallen off a cliff. The gaugeis down 8% (in euro) since end August 2018 while the S&P 500 index, which is stuffed with large multinationals, haslost about 0.2%.

1.2. Style allocation1.2.1 Defensives: overweight (versus Cyclicals)

Corporate profits and the shares of companies that are most sensitive to the earnings cycle (cyclical stocks)have been moving in opposite directions recently. That doesn’t happen often, but when it does, it almost alwayssignals trouble.

Stocks of US companies in cyclical sectors, such as industrials, banking and energy, have beenoutperformers this year. The spread between the MSCI US Cyclical and Defensive sectors, which, as the namesuggests, measures the relative performance of cyclical stocks against defensive ones, is up 8% (in euro) since thebeginning of January.

The problem is that profits are painting a different economic picture. Earnings for the companies in the S&P500 index are expected to fall 2.7% in the first quarter compared with the first three months of 2018. At the start ofthe quarter, analysts had predicted 3% growth. While the government shutdown was surely a drag in the firstquarter, second-quarter profit expectations are also dangerously close to falling into the red. Analysts now thinkbottom lines will be up just 0.7% in the second three months of the year, down from a gain of 3% at the beginning ofthe year. It is rare to have an earnings recession without an economic recession, though it happened as recently as2015!

On top of that, the recent run in cyclical stocks may not be as bullish as it appears; it could just be the marketplaying catch-up. A year ago, the cyclical-defensive stock story was the reverse of what it is now. European Cyclicalstocks underperformed defensive ones by about 8% in the first six months of the year despite the perception of a robusteconomy. The drop in cyclical stocks was raising concerns about the economy. In part because of President Trump’s taxcuts, though, growth remained strong and cyclical stocks rebounded. Those stocks are up nearly 14% in Europe andabout 17% in the U.S. (in euro) this year, slightly more than the market and higher than the 10% return for defensive ones.But the price-to-earnings ratio of the stocks in the MSCI US cyclicals index is 17 times next year’s earnings. That’s downfrom 22 times in September and is below the nearly 17.6 times earnings that defensive stocks are trading at, as measuredby the MSCI defensive stock index. Cyclical valuations have come back to the pack. The disconnect last year between theeconomy and economic-cycle sensitive stocks was resolved with those stocks catching up to the economy. But if they gettoo far out front this time, the outcome won’t be as pleasant.

If the recent macroeconomic data weakness is sustained it may provide a more fundamental catalyst to a selloff inmarkets. Just a few months ago trade growth was being cited as one of the main causes for a robust streak in the globaleconomy but there are now fears that we are beginning to see a slowdown in global trade growth linked to thepotential trade wars. As corporate earnings are highly correlated with the state of the business cycle, thisevolution could slow the earnings growth. While we do not expect the U.S. to soon enter a recession (the probability ofrecession in the next 12 months is around 24%, according to the Fed), investors could end up deciding to cut theirexposure the U.S. stock market if U.S. earnings begin to stagnate. And as U.S. equities account for 55% of global marketcapitalization, this could limit the upside for global equity indices.

To hedge against elevated risks, we keep our defensive positioning by favoring defensive sector (healthcare andconsumer staples) and value stocks, companies with big capitalization, stronger balance sheet or low volatility, stocks withhigh and stable gross margins, and stocks with high dividends.

1.2.2 "Value" stocks: overweight (versus “growth” stocks)

The worst fourth quarter for global equities in six years has been painful for stocks investors in 2018 as concern about thesustainability of earnings growth amid tightening financial conditions add to a laundry list of worries from global trade toItaly’s debt crisis. But, after years of underperforming their growth counterparts, value investors, who follow WarrenBuffett mentor Benjamin Graham’s strategy of looking for cheap stocks through fundamental analysis, are nowoutperforming investors in faster-growing companies. The MSCI World Value index’s ratio to the MSCI World indexbegan rising in September 2018 after falling below its reading from December 1975. A similar rebound started in 2000,after an Internet-driven bull market wiped out almost two decades of gains.

What is encouraging for cheaper shares (stocks that have relatively low price-to-earnings ratios and a solid history ofsteady dividend payouts) is that, while they have beaten the broader market during the latest bout of turmoil, they still lagsignificantly behind over a longer time-frame. Since the beginning of 2000, European value shares underperform worldstocks by 45% (in euro). After tracking gains in U.S. Treasury yields for most of 2016, shares of value stocks are stillnearing a dot-com era record low relative to growth stocks, such as tech giants. That means they have a highappreciation potential !

It is somewhat surprising that the ratio has not rebounded earlier as there is typically a strong positive correlation betweenthe relative performance of value versus growth stocks and the direction of bond yields: value equities do perform wellin periods of increasing yields. The Federal Reserve’s nine rate increases (in December 2015, in December 2016, inMarch 2017, in June 2017, in December 2017, in March 2018, in June 2018, in September 2018 and in December 2018)should have contributed to the outperformance of value stocks.

To crown it all, rarely have value stocks looked more appealing on a relative basis, with their forward price-to-earnings ratio being 40% cheaper than growth stocks in Europe and 30% cheaper in the U.S.

Finally, although we don’t expect a recession in the short term, in a typical late cycle, characteristics that distinguishresilient equity portfolios include low beta and value-style investing.

1.2.3 Big capitalization stocks: overweight (versus small caps)

Small-Cap stocks are among the best-performing equities out there, even though the only thing everyone seemsto agree on is that we are late in the cycle. These stocks have risen more than 15% (in euro) in 2019, outperforming by2.2% their large-cap counterparts. That has happened even as earnings forecasts for the MSCI World Small Cap indexwere slashed by 6.2%, compared with around 3.3% for the MSCI World Big Cap index. In other words, traders appearwilling to take on greater risk for relatively lower returns.

For our part, we still prefer global big caps, in particular in the U.S, as we think that the divergence trade that hasseen riskier U.S. assets outperform the rest of the world is not sustainable and as cracks are starting to develop in somesignificant parts of the U.S. equities market and especially among smaller companies.

The Russell 2000 index that tracks the shares of smaller U.S. companies, which theoretically should be the primebeneficiaries of the White House’s “America First” agenda because they mainly have a domestic focus, is in a lessgood position. The gauge is down 8% (in euro) since August 2018 while the S&P 500, which is stuffed with largemultinationals, has lost about 0.1%.

Such moves may be an early sign that, with a U.S House controlled by Democrats, there is a chance that the Trumppro-business policies that have helped small businesses and financial firms, such as reduced regulations and lower taxes,may be blocked. Given large budget deficits, any major new stimulus to generate faster GDP is improbable, therebylimiting any need to bump up (earnings) forecasts.

A number of other factors tend to make investors especially wary of smaller stocks in late economic and investmentcycle:

Smaller firms are often more dependent on strong economic growth and suffer more during periods of slowdown.When the stock market drops, mid- and small-cap equities suffer more and quicker due to their lower liquidity andthe lack of buyers.Mid- and small caps tend to be more volatile as their profit swings can be much stronger than those of largercompanies.

1.3 Sectorial allocation:

1.3.1 Global sectorial allocation:

1.3.1.1 Healthcare: overweight

Even if cyclical sectors outperform since the end of last year, healthcare stocks are still the best-performing sector at theworld level on a longer time frame. Weakness of the euro, a less aggressive drug-price plan from the U.Sadministration and fears that we are beginning to see a slowdown in global trade growth linked to the potentialtrade wars, has brought back some life into defensive stocks and more specifically into pharmaceutical companies whichoutperform the DJ Stoxx 600 index and the S&P 500 index by respectively 9% and 5% (in euro) since end 2017.

The more defensive nature of their business models brings them back on investors' radar screens as they usually rewardcompanies that return the most cash and are hunting for stocks priced cheaply relative to earnings. The group now tradesin Europe at a forward P/E multiple of about 15.3x, and at a relative P/E to the Stoxx 600 of just 1.1x (versus 0.86x inthe U.S.), versus highs of 1.25x in September 2014 and lows of 0.94x at the end of 2016.

No other industry comes close to replicating the resilience of health care when markets are turbulent. Going backalmost three decades, there are four periods when valuations lurched up and down by more than the 30-year average ofstock-price swings. Those were the 12 months ending December 31, 1990; the seven years from 1997 through 2003; thesix years between 2007 and 2012; and the latter part of last year, of course. The more than 60 publicly traded companiesthat make up the benchmark Standard & Poor’s 500 Health Care index are the sole mainstay among the market’s winnersduring all those periods, according to data compiled by Bloomberg. Rising demand for health-related products andservices, regardless of the economy’s cycle, military conflicts and political firestorms, helps explain why health-careinvestors can ignore Trump’s daily tweets and his tariffs on trade with Canada, China, Mexico and the EU.

Furthermore, investors can be confident that aging populations in the U.S. and other countries will keep their moneysecure. 60% of the U.S. population was 65 or older in 2018, up from 12.7% a decade ago, according to the U.S. CensusBureau. Across the globe, 9.1% of the population was 65 or older last year and is projected by the Census to climb to10.2% by 2024, an increase of 2.6% since 2009.