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Resurgence of the political risk

Market analysis - 4/13/2017

Equity markets marked a pause in a short Easter-week with most stock markets closed for Good Friday. And yet behind the calm facade, equity volatility rose as investors sought to hedge positions against a possible drop.

The trend was underpinned by the resurgence of the political risk premium on other asset classes as hard-left Presidential candidate Jean-Luc Mélenchon rose in opinion polls and fresh tension emerged in Syria and North Korea. US and German government bond yields fell, with 10-year Treasury yields retreating to last November's levels while the yield on the 10-year Bund fell back below 0.20%. In addition, French, Italian and Spanish spreads all widened further with Germany. The shift was more pronounced in French and Italian spreads which revisited last February's highs and at times even went higher. Meanwhile, safe haven assets like gold and the Yen gained ground.

Ahead of the earnings season- US banks were due to report on Thursday- and with no major economic data, investors were left to focus on political risk. The first round of France's Presidential elections is in less than 2 weeks.

We have as a result, maintained balanced risk profiles in our portfolios. We continue to prefer eurozone equities to US equities. On bond markets, we are focusing on subordinated financial debt and, to a lesser degree, on high yield bonds. We are more cautious on eurozone government debt and neutral on US Treasuries.

  European equities

It was a short week due to the Good Friday holiday but trading was nevertheless complicated and markets moved lower amid higher volatility. Donald Trump’s comments on the US dollar, the Fed’s interest rates and the international political scene all weighed on markets. Tensions were reinforced by French opinion polls which suggested we might be in for a non-consensual play-off in the second round of the Presidential elections. All of which overshadowed a slight downward revision in French GDP growth estimates.

Initial indications from the first batch of quarterly results to be released were encouraging. In the consumer discretionary sector, luxury plays reported excellent numbers. LVMH saw like-for-like growth between 13-15% in fashion, leather goods and wines & spirits but all divisions were on form. Christian Dior reported 13% like-for-like growth over the first quarter. Daimler also swept past expectations with strong performance in autos and trucks. Air France announced a 4.6% rise in passenger traffic in March compared to +4.1% at Lufthansa, providing confirmation of an upturn in pricing. Figures from Carrefour and Sodexo came in as expected.

Henkel is to propose a record 15% jump in its dividend for financial year 2016 and Gemalto advanced after unveiling a partnership with Softbank. But Dialog plunged more than 30% on rumours that its biggest client Apple might cancel its outsourcing contract.

In M&A, rumours that Bombardier and Siemens might be mulling a tie-up hit Alstom’s share price while SCA gained on reports that its hygiene division might be targeted by a bid.

  US equities

Markets edged lower in a thin week for big economic data. The confidence index for small and mid-sized companies was in line but remained at lofty levels.

In company news, BlackBerry was awarded USD 814.9m in an arbitration case against Qualcomm for royalty overpayments. In freight and logistics, Swift Transportation and Knight Transportation are to merge to create a new USD 6bn entity with annual revenues around USD 5bn. The deal values Swift at USD 22.07, a 10% premium to the last quoted price. Completion is expected for the third quarter of 2017 and both stocks surged on the news.

Over the last 5 trading days, property, consumer staples, energy and utilities led advances. In contrast, technology and financials fell by more than 1%.

  Japanese equities

The TOPIX ended the period 0.7% down. Large-cap stocks edged lower, while small and mid-cap stocks were relatively resilient. The market was hit by the yen’s rise against the US dollar amid growing geopolitical tension. On Wednesday, the Nikkei 225 hit a low not seen since last December, dragged down by the US dollar clearing 109 and spreading risk-averse sentiment. Investors were increasingly worried after Donald Trump tweeted a warning to North Korea and the US missile strike on Syria.

Over the last four trading sessions, the best performing sectors were Iron & Steel (+1.2%) and Real Estate (+1.2%), while Securities & Commodity Futures, Banks and Transportation Equipment sector remained weak. Electric Appliances and Precision Instruments stocks came under selling pressure from non-Japanese investors.

Real Estate stocks such as Daito Trust Construction, Mitsui Fudosan and Sumitomo Realty & Development advanced over the period.

Defence-related Ishikawa Seisakusho and Howa Machinery surged by the maximum daily limit on Wednesday due to mounting geopolitical risk.

Toshiba Corporation was volatile during the period and dropped 1% on Wednesday. Delisting worries spread after the group released a financial statement without obtaining its auditing firm’s approval the previous day.

  Emerging markets

Amid political tension over North Korea, markets turned cautious in a short Easter-holiday week. The Pyongyang regime is reportedly planning a “big event”. The most pessimistic commentators fear yet another missile launch but possibly joint pressure from China and the US, for once in agreement, might stop Kim Jong-Un escalating his threats. Chinese media said that international journalists arriving in North Korea to cover the event and Saturday’s Day of the Sun holiday had received a warmer welcome than usual. A sign of something dire in the works or an easing in tension? The Chinese are going for the second option. The Day of the Sun commemorates the founding of the current dynasty by Kim Il Sung. The anniversary generally features missile launches. This year there is talk of a nuclear test in a tunnel so the situation is some way from stabilising.

China could rapidly crush the North Korean regime with economic measures as the North Koreans use China’s roads and sail through its territorial waters. And the country’s mines are mainly run by more than 150 Chinese companies.

China also employs a good many North Koreans in factories and farms and represents 60-80% of North Korea’s foreign trade. If China has so far avoided putting pressure on Pyongyang, it is for historical reasons connected with the Chinese Communist Party. The end of the Korean War in 1953 has since been presented by Beijing as a total victory on the West. This makes it essential to present the North Korean regime as courageous and exemplary. The war resulted in heavy Chinese fatalities and its success must be seen to justify the sacrifice and help maintain the dogma of an infallible Chinese Communist Party.  

At the same time, last weekend’s meeting between China’s President Xi Jinping and Donald Trump marked an improvement in Sino-US relations. The US seems to have dropped accusations against China as a currency manipulator and trade imbalances between the two countries could be solved by granting US companies easier access to China rather than the US imposing further trade barriers on Chinese imports.
Elsewhere, Brazil’s central bank cut is benchmark SELIC rate by 100bp as expected. Another 100bp cut is expected in May.

  Commodities

It was a short but busy week for news on commodity markets. Due to persistent concerns over mounting geopolitical risks in the Middle East and in Asia, the gold ounce broke through USD 1,285, a 5-year high. People are buying gold for its safe haven status, especially with the French elections looming. The gold price was also helped by US dollar weakness and we expect it to remain strong in today’s unstable climate.

Elsewhere, metallurgical coal soared 60% over the week to USD 300/t, a level last seen in November following China’s temporary clamp down on supply. This time, the rise was due to Cyclone Debbie disrupting production in Australia, the world's biggest exporter. Heavy rain flooded rail connections and stopped trains reaching ports. This triggered panic buying, especially from Japanese and Korean steelmakers. However, the situation should return to normal in a few weeks’ time.

In contrast, iron ore prices capitulated, losing 10% over the week. Prices have now fallen below the USD 70/t mark, down more than 20% since the February highs. The correction was set off a few weeks ago when major producers struck a more cautious note on the outlook for the sector and it intensified when traders started to worry about tighter lending conditions in China and a possible impact on demand for homes. We think the correction was necessary but we remain upbeat on iron ore’s prospects as global demand for steel is still strong. Chinese demand is still buoyant, largely due to spending on infrastructure.

Oil also gained on geopolitical tension and Brent crude ended the week at USD 55, a level seen in January and February. The market was also helped by positive comments from Saudi Arabia - the country wants to extend the production cut agreement by 6 months- and by a fresh production stoppage in Libya’s El Sharara field (213,000 b/d). OPEC compliance with cuts moved to 104% in March, a sign of a very strong commitment to reducing global inventories. And trader sentiment was also lifted by weekly data from the US Department of Energy which said inventories of crude and products like petrol and distillates had also fallen.

  Corporate debt

 

Credit

Trading was quiet ahead of the Good Friday and the Easter Monday bank holiday when Euronext markets will be closed. However, the “France risk” resurfaced when left-wing Presidential candidate Jean-Luc Mélenchon shot up in opinion polls. The OAT/Bund spread widened sharply at the beginning of the week and the Xover followed suit, moving from 284 to 296bp.

New issues: Colfax (engineering equipment and services for the energy sector, Ba2/BB+) raised EUR 350m in 8NC3 notes and Grifols (Spain, healthcare) issued a EUR 1bn bond to repay another EUR 1bn issue. Burger King, owner of Financière Quick (B3/B-), raised EUR 550m at fixed and variable rates to reimburse Quick bonds. SNF Floerger (Ba2/BB+) is to raise USD 450m with a 2025 NC3 maturity. A rumour suggested BBVA would bid for Banco Popular.

Convertibles 

The convertible universe stayed rather mute in this holiday-shortened week (no primary, low volumes on the secondary) partly because investors were waiting for the first quarter earnings season.

In Asia, geopolitical tension surrounding North Korea and the possibility of US unilateral action drove the markets lower. This sent the Yen higher which weighed heavily on Japanese convertibles and also affected peripheral markets like HK, and especially financials.

China’s CRRC has just won a contract with Malaysia to build 22 trains. Folli Follie Group (Luxury goods) posted strong full-year numbers  for 2016 (EUR 1.337bn) mainly due to an impressive fourth quarter which saw sales jump 20% QoQ. One of the major concerns had been the level of capex but it came in at EUR 98m or in line with company guidance. 

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