Geopolitical jitters rise

Market analysis - 11/08/2017

Tension between the US and North Korea escalated, sending volatility higher and investors into safe haven areas like government bonds, gold, the US dollar and also US equities. As often happens, Wall Street loses less than other markets if the problem comes from the US itself.

The drop in the Euro Stoxx 50 was nevertheless limited to 2.5% and concentrated on the financials, mining stocks and US tech. 

At this stage, it is a little early to imagine the global economy's strong fundamentals being undermined by reduced trade with North Korea. And recent data on inflation, especially in Europe, do not warrant any brutal reduction in global liquidity. As a result, we are maintaining our preference for risk assets, particularly in Japan and in the eurozone. 

  European equities

North Korea’s leader, Kim Jong Un, and Donald Trump threw verbal grenades at one another this week but left the pins in for the moment. European markets nevertheless viewed this duel as worrying and indices gave back the gains made in the previous week. The background remained highly geopolitical and implicit volatility rose, especially with few developments on currencies, commodities and interest rates. But, significantly, companies reporting quarterly results often referred to forex impacts. 

The end of the earnings season featured satisfying reports but they generally failed to push share prices higher. Munich Re’s net results for the first half swept past the halfway mark of its full-year guidance while cushy shareholder returns will be guaranteed by a historically high solvency ratio but it still underperformed its sector by 2.5% this week.

Ahold Delhaize received the same punishment even though EBIT, which came in a little higher than expected, should have reassured investors after a tricky June, especially as management raised its forecasts of synergy gains from the merger. The price fall was in some degree also a reflection of the group’s exposure to the US dollar. 

In contrast, winter tyre specialist Nokian Tyres bounced on upbeat quarterly figures and an upward revision in targets. Novo Nordisk also advanced on reassuring growth in its anti-diabetes treatments. Misses came from Pandora (jewellery), which issued a profits warning, and Adecco which reported second quarter sales lower than analysts expected. 

In M&A news, Fresenius Medical Care paid $2bn for US dialysis equipment manufacturer NxStage, Vantiv and Worldpay merged to create a global payment services leader and Altice bought in SFR’s minorities. 

  US equities

US indices retreated as tension over North Korea rose. The S&P500 dropped and 1.4% and the Nasdaq ended the period 1.9% lower.

Macroeconomic data were mixed. The construction index fell and producer prices were down 0.1% in July, or more than expected, because of generally soft energy prices.

With the US earnings season ending, sales have risen 5% and earnings by close to 11%. Margin expansion was driven essentially by improving interest margins among financials as well as improved profitability at healthcare and technology multinationals.

Apparel stocks like Macy’s and Nordstrom and brands like Ralph Lauren and Kors beat earnings expectations this week and confirmed that trends were stabilising. Even so, investor risk aversion remained high.  

Defensive sectors like utilities, consumer staples and telecoms proved resilient but cyclicals like financials, industrials and energy ended the period 1.5-2% lower. 

  Japanese equities

Japanese stock prices lost ground on Wednesday along with other Asian equity markets as fears mounted that the North Korean missile issue might escalate. Although almost flat on Thursday, the TOPIX dropped 0.87% over the week as the Yen appreciated due to its “safe haven currency” status. Worried by the heated exchanges between North Korea’s leader and Donald Trump, market participants opted to go risk-off ahead of a long holiday in Japan. But share prices of companies with solid earnings estimates remained relatively firm.

Prime minister Shinzo Abe’s cabinet reshuffle failed to improve his low approval rating but had no significant impact on the stock market.

Sector movements reflected growing geopolitical risk. The week’s best performers were Nonferrous Metals (+3.35%), Oil & Coal Products (+3.19%) and Iron & Steel (1.47%). In specific stock news, troubled Toshiba jumped 14.06% when its long-awaited auditors’ report for FY2016 was given a ‘qualified opinion’, which was seen as reducing the risk of a delisting. Other gainers included Sumitomo Metal Mining (+6.86%), JXTG Holdings (+4.43%) and Nippon Steel & Sumitomo Metal Corporation (+3.25%).

However, 27 out of 33 sectors lost ground, including Insurance (-2.47%) and Metal Products (-2.27%). Shin-Etsu Chemical dropped 4.97% and Tokio Marine Holdings was down 4.51%. 

  Emerging markets

This week was full of events and results. We observed some profit taking in Asia due to increasing tension between the United States and North Korea.

As for results,  we have so far had more than 30% of companies reporting second quarter figures and in general they have done better than expected with higher top line growth or lower costs.

China’s auto sector continued to perform well with car sales up 6% in July. Geely reported a stronger-than-expected 89% increase YoY in sales in July. Autohome beat expectations with strong revenue growth and margin prospects and management increased 2017 guidance as well as launching a used car platform.

In India, Eicher Motors reported robust results with Royal Enfield’s revenues and EBITDA up 28.4% and 31% respectively.

In Brazil, industrials Randon and Iochpe also beat expectations on higher car and truck production and lower costs. Yandex announced a joint venture with Sberbank to create a market place business.

On the negative side, Tata Motors reported weak results that missed estimates due to higher commodity costs, marketing expenses and discounts. Tongda announced a profit warning for the first half of 2017 due to lower-than-expected demand for its waterproof components for smartphones and higher R&D expenses for new products. NetEase also missed results due to a fall in its operating margin.

In Argentina, all eyes were on the result of the primary election this weekend.

We remain positive  on emerging markets as inflation remains under control and economies are recovering. We expect further upward revisions in earnings and valuations are currently lagging. 

  Commodities

Oil prices failed to duck the risk aversion which swept through markets over the week. Brent crude lost close to 2% to end the week below $51 and WTI finished 2% down and under $49. And yet there were a number of positive developments:

- the OPEC/non-OPEC meeting at Abu Dhabi agreed unanimously to support the production cut. Countries which had been slow to implement the cut like Iraq, the UAE, Malaysia and Kazakhstan reaffirmed their engagement.

- and OPEC’s monthly report revised demand estimates for 2017 and 2017 higher by 100,000 b/d.

- the cartel’s output for July rose to 32.87 million b/d, up from 32.7m in June, but this was expected due to rising production in Libya and Nigeria.

- Saudi’s oil minister said that any further cuts should be collectively undertaken by all 24 member states.

- oil inventories have fallen further, refinery utilisation rates are at a high not seen since 2005 and demand is still strong as we hit the peak of driving season demand.

- furthermore, US drilling has now been stable for 6 weeks.

All these points reinforce our view that fundamentals have improved substantially.

Elsewhere, precious metals gained on escalating tensions in the Pacific. The US-North Korea verbal tussle helped gold jump more than 2% to around $1,290/oz while silver and platinum gained 5% and 2% respectively over the week. Gold is the safe haven asset par excellence. Ahead of the US inflation figures, gold was also underpinned when two Fed members, James Bullard and Neel Kashkari, said soft inflation was one good reason to avoid rushing to raise rates.

Chinese steel prices trended higher on strong domestic demand. Net exports fell 35% for the 12th month in a row, an indication that China is making real efforts to cut capacity. In fact, the CISA, China’s steel producers’ association, is now worried about speculative surges on steel futures.

Meanwhile, aluminium prices bounced sharply to above $2,000/tonne following news that Hongqiao Group, China’s biggest producer, was to cut outdated capacity. 

  Corporate debt

 

Credit

Jitters over the escalating war of words between North Korea and Donald Trump triggered profit taking and spreads widened over the week. Financial bonds were particularly hard hit by a growing number of sellers of Additional Tier 1 debt, a sector which had performed extremely well year to date. Euro-denominated CoCos, for example, had risen 9.22% since the beginning of 2017. On Wednesday, selling spread to insurance groups and high yield which underperformed even though European rates began to fall that day. Selling pressure then abated but spreads continued to widen at the end of the week with the Xover and Main hitting 254 and 59. 

It was a quiet week on the primary market. British American Tobacco (Baa2/BBB+), a world leader, issued several tranches of senior bonds in euros, US dollars and sterling at both fixed and floating rates and with maturities of 4,6.25 and 12.5 years for the euro-denominated tranches. 

In financials, UBS (A-/A) issued a 6-year US dollar senior bond, non-call 5 years, in two tranches, one fixed and the other floating. 

Quarterly earnings reports continued to beat estimates. UPC Holding (Ba3/BB-) enjoyed a 5.7% rise in EBITDA, a big improvement on the first quarter, with sales up 3%. Verallia (B1/B) posted very satisfying second quarter figures with sales up 2% YoY and EBITDA jumping 7.4% on growth in Europe and Latin America. Among misses, New Look (B3/B-) saw EBITDA plunge 37.3% while sales tumbled 8.2%. The company is also burdened with significant debt leverage In car rentals, Hertz (B2/B+) and Avis Budget (B1/BB) both fell short of second quarter expectations amid pricing pressure and low sales in the US. Hertz posted a net loss of $158m and Avis Budget’s EBITDA was down 31% over a year. 

In M&A, Altice (B1/B+) is lining up a bid on cable operator Charter Communications so as to expand in the US. The deal will have to be funded by debt which could be complicated given Charter's debt levels. 

Convertibles 

It was a volatile week in the convertibles space as both credit and equity markets sold off. Nonetheless, the primary market remained strong with 2 new deals in the US pharma sector. Biomarin, a company specialized in rare diseases, issued a $450m 2024 0.6% coupon convertible to refinance its 2018 convertible. Radius Health, a biopharma company that develops osteoporosis therapeutics, came to market with a $300m 3% 2024 convertible to fund the sales launch of a new treatment.

On the earnings side, China’s Semiconductor Manufacturing International Corporation disappointed investors with weak second quarter earnings and reduced prospects due to gross margin deterioration -its utilisation rate fell to 85.7%- and delays in its 28nm ramp up. The shares fell 15% over the week.

In Thailand, CP All reported second quarter results in line, with net profits up10.8% YoY, or just above consensus estimates. Margins improved slightly and the company is on track for its long term goal of having 13,000 stores by 2021 (219 were opened over the last quarter). Bangkok Dusit Medical second quarter net profits soared 127% YoY (+92% QoQ) to THB 3.79bn. This was much better than expected by the consensus mostly because of the inclusion of the partial sale of its stake in Bumrungrad Hospital for THB 2.2bn. Note also that 9 hub hospitals were upgraded to “Centers of Excellence” as a means of expanding its international patient base.

In the US, Tesla raised $1.5bn with an 8-year straight bond to strengthen its balance sheet during its Model 3 production ramp up. Moody’s has rated the company B2 with a stable outlook.

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