A sea change on markets

Market analysis - 02/02/2018

There was a hint of a sea change on markets this week as investor euphoria abated a little. Equity markets had their first down week so far in 2018 and the fall on US markets was the largest since the end of 2016.

After one of the strongest starts to the year for more than 3 decades, investors took profits, all the more so as the beginning of the results season had witnessed some mixed figures from US blue chips. The general move higher in interest rates both in the US and Europe was also a contributing factor. Sector performance reflected pressure from higher interest rates: energy and financials managed to do well while healthcare and interest rate sensitive sectors like telecoms and utilities lost ground. Amid such vigorous growth, interest rates broke above levels that had not been seen since 2014. Global confidence surveys once again reinforced optimism over economic growth and the IMF even revised up its forecasts.

Janet Yellen chaired her last Fed meeting and left rates unchanged. However, the communique was more optimistic about inflation and suggested it could even rise in 2018. Further rate hikes were discussed and the probability of a move in March is now running at 99%! US 10-year Treasury yields hit 2.79%, a rise of almost 40bp since the beginning of January. European bond yields followed suit: yields on the 10-year German Bund rose above 74bp and the 5-year yield turned positive for the first time in 5 years. This move not only reflects rising global yields but also a shift in investor perception as the ECB's tone turns less accommodating. There are now expectations that QE will come to an end next year. Failing an abrupt end to QE, investors are now mulling the possibility of a gradual winding down from next September.

We have readjusted our equity market hedging, especially for US equities. In fixed income, we believe the recent move higher in yields was a little too fast and so we have increased sensitivity to European bonds. 

  European equities

European markets pulled back as bond yields rose rapidly and the US dollar continued to fall. Construction and telecoms were down due to their interest rate sensitivity.

Pharma stocks logged the biggest falls after a good start to the year. The retreat was triggered by news of an alliance between Amazon and two major financial institutions to cut healthcare costs in the US, a move that echoes Donald Trump’s declarations in favour of cheaper drugs.

Sanofi acquired Ablynx and Bioverativ, two haemophilia specialists, but the market took the view that it had overpaid. Tech stocks were hit by disappointing iPhone X sales and fears that the semiconductor cycle was about to turn down. Ericsson disappointed investors by reporting its fifth quarterly loss in a row. Infineon’s results were badly hit by the drop in the US dollar, a reminder of the sector's sensitivity to the greenback. German car makers retreated over the month for the same reason. Daimler said margins at Mercedes had also been crimped and delivered cautious guidance for 2018, citing heavy investments to come in new technology.

In Italy, banks fell sharply as investors used looming elections as a reason to offload positions. In Germany, the IG Metall union once again called on metal workers to strike for big wage increases and more flexible working hours.

On a brighter note, luxury continued to provide pleasant surprises: Swatch said its sales had accelerated significantly in the fourth quarter.

In a sign of the ongoing structural challenges facing food retailers, rumours surfaced of talks between Casino and AmazonPrime. This was followed by news that Leclerc was to launch a home delivery service in Paris. Elsewhere, talks with Telecom Italia continued on separating its fixed line network.

  US equities

Markets retreated from the previous week’s record highs with the S&P500 down 0.5% over the last five trading sessions. The FOMC meeting held no surprises, macroeconomic data remained upbeat and the earnings season continued. PCE inflation was up 1.5% YoY, or in line with expectations. Along with good job data and the impression that the Fed's tone was slightly more hawkish, that pushed 10-year US Treasury yields to 2.78%, a level not seen since April 2014.

JP Morgan, Amazon and Berkshire Hathaway have formed a joint non-profit-making venture to improve their employees’ health coverage. A million people will be concerned. Amazon has long been known to have ambitions in healthcare, but the market was expecting a move in drug distribution. The deal news was thin on hard facts but it spooked markets which immediately sold stocks in sectors that might be hit by the joint venture. Healthcare insurers and distributors fell by 4-7% last Tuesday alone.

With 239 fourth quarter company results in, 200 have beaten expectations and 34 have missed them. Aggregate EPS came to $35.7 or 13% better than in 2016 and 2.9% above expectations. Positive surprises on earnings and sales are now running at a 10-year high.

Telecoms and technology led advances while healthcare, energy and commodities all declined. 

  Japanese equities

Rising US Treasury yields and worries over the yen’s appreciation, kept Tokyo in check. Over the week, the TOPIX slipped 0.48% and the Nikkei 225 closed at 23,486.11 as the US dollar weakened to 109 against the yen. 

Although 10-year JGB yields edged higher, triggering speculation that the BoJ might be tempted to follow the US and Europe in ending its unpreceded monetary easing, the bank appeared to stick to its current easing policy with yield curve control. This stopped bond yields rising sharply and stock and currency markets from becoming too volatile. 

By sector, and in line with moves in the oil price and bond market yields, the best performers of the week included Oil and Coal Products (+1.61%) and Banks (+1.45%). Pharmaceuticals (+0.99%) also outperformed with Daiichi Sankyo Company jumping 10.28% on brisk sales of its major anticoagulant drug “Edoxaban”. 

Transportation and parcel delivery service provider Yamato Holdings also surged, rising 11.38% on higher prices to major corporate clients including Amazon Japan

In contrast, there was weakness in Marine Transportation (-4.46%) and Construction (-3.08%) on fears of higher costs. Sekisui House (-6.43%) and Daito Trust Construction (-5.81%) were hit by slowing earnings growth. Fujitsu plunged 13.77% after operating income tumbled 29% due to its unprofitable system maintenance services. Tokyo Electron (-5.91%) was also weak on worries over the stronger yen. 

  Emerging markets

China’s manufacturing momentum slowed slightly extending into the Chinese New Year with PMI at 51.3 (down from 51.6 in December). Despite top line growth of 56% for Alibaba, earnings growth was only 20% due to a slowdown in advertising fees and front-loaded investment in new retail, globalisation and logistics. Cloud activities continued to see strong growth (+104% YoY). The company agreed to take a 33% stake in Ant Fin. Alibaba’s new retail strategy is facing challengers: Tencent, Suning, JD and Sunac are to invest $5.4bn in 14% stake in Wanda Commercial, China’s largest owner and developer of shopping malls. 

In Korea, Samsung Electronics reported 64% YoY growth in operating profit thanks to strong growth in average sales prices in the memory segment, but there was weakness in handsets and lower guidance for the display business due to tougher competition in OLEDs. The company announced a higher-than-expected dividend (14% P/O) and a 50:1 stock split. Lower guidance for the OLEDs business primarily explains the poor Samsung SDI share price performance despite the earnings beat in 4Q17 thanks to the strong battery business. Amorepacific continued to experience sluggish duty free cosmetic sales in the latest quarter (sales down 13% YoY and a 77% drop in earnings YoY). 

The Indian budget’s highlight was the promise to link the Minimum Support Price for farmers to ensure they had 50% margins, a move which could create structural inflationary pressure. No excise duty hike on cigarettes was a temporary relief for ITC. Results continued to be upbeat: +22% for Titan (jewellery), +145% for HDFC (boosted by the sale of an HDFC Life stake) and stable asset quality for ICICI Bank (although results fell 32%). Larsen (construction) surprised positively with a 53% jump in results.

In Indonesia, inflation picked up to 3.25% YoY in January, mainly due to higher food prices.

In Brazil, the consolidated public sector primary fiscal balance was -1.7% of GDP in 2017, or lower than expected, and compares with -2.5% at end 2016. The overall public sector fiscal deficit (primary surplus minus interest payments) hit 7.8% of GDP in 2017 (down from 10.2% in 2015 and 9% in 2016). Bradesco’s fourth quarter 2017 figures disappointed investors due to higher provisions in the corporate segment. Bradesco’s guidance for 2018 included a 16% fall in provisions and 3/7% loan growth. 

In Mexico, inflation fell while business confidence and manufacturing improved. Nevertheless, the uncertainty over NAFTA remains, as the results of the Montreal round were pushed back to February. 

  Commodities

Oil prices ended the week unchanged with Brent crude at $70 and WTI at $66 but the price was down $2 at one point in nervous trading. The oil price rebound -Brent crude has come all the way from $44 last June - is largely due to fundamentals resulting in reduced inventories but also the 11% slide in the US dollar over the period. Uncertainty over Washington’s attitude to the weak dollar and the risk of the US quitting NAFTA will continue to create volatility on currency markets and in commodity prices. But we have to ask what impact such relatively high oil prices will have on supply and demand. 

The latest IEA report on actual US output figures (rather than weekly estimates) shows US production at 10.03 million b/d last November which is flirting with the previous record of 10.04 million b/d back in ...November 1970! 

The monthly rise was 380,000 b/d following hurricane stoppages. The same report shows November demand up by 620,000 b/d to 20.28 million b/d, a sign of the vigorous economy. 

OPEC countries meanwhile are sticking to their disciplined stance. Bloomberg estimates output was stable in January at 32.4 million b/d. Saudi Arabia increased output by 60,000 b/d to 10.01 million, offsetting a further 30,000 b/d decline in Venezuela to 1.67 million, the lowest level since 1989. 

Oil majors, meanwhile, are still cautious over investment plans. Royal Dutch Shell confirmed that it would be investing $25-30bn in 2018-2020, while spending in 2018 will be at the low end of the range. At $60 a barrel, the group will be able to generate significant cash flow after the dividend payout, quite enough to reduce gearing by 20% by 2020 while rolling out a $25bn share buyback over the same period.

The gold ounce also remained at a lofty $1,350. It is enjoying the weak dollar and has shrugged off higher US Treasury yields. The latest FOMC said inflationary pressures were building, a piece of good news for gold. 

  Corporate debt

 

Credit

Corporate bond prices fell due to further rises in European yields and a surge in risk premium volatility. Investment grade fell 0.16% while high yield ended the period 0.36% lower. 

On the new issues market, Banco Santander raised €1.25bn with a 10-year Tier 2 debt sale. In high yield, Scientific Games issued two debt tranches, raising €570m in total.

This year’s first rising star is Arcelor Mittal which has been upgraded by S&P from BB+ to BBB-. 

Convertibles 

The week saw another flurry of new deals from Chinese real estate developers. Powerlong Real Estate issued 1Y HKD 1.6bn zero-coupon convertible to repay debt and fund working capital. Future Land Development sold a HKD 1.96bn 1-year convertible for development, refinancing and general working capital purposes. China Evergrande Group issued a jumbo HKD 15.56bn 5Y convertible at 4.25%, making an 180-degree turn from the previously announced HKD 23bn perpetual convertible in an attempt to save the deal. 

In the US, data storage leader Western Digital issued a jumbo $1bn 6Y 1.5% convertible to fund a share buyback and to go on refinancing. The company was subsequently upgraded to IG by Moody’s. Another deal came from JP Morgan in the form of a cash settled $350m 5Y 0.25% bond exchangeable into shares of Voya Financial. In Japan, media company CyberAgent issued a JPY 40bn dual tranche 5 and 7Y zero-coupon convertible to fund potential acquisitions. Elsewhere, Endeavour Mining, a gold mining company listed in Canada with operations in Africa, raised $300m with a 5Y convertible at 3%. 

In earnings news, Sony unveiled a record third quarter with JPY 296bn in net income thanks to strong performance from the music division. The company also revised its FY guidance on EBIT higher to a record JPY 72 bn. It later announced the replacement of Kazuo Hirai by Kenichiro Yoshida as new CEO. 

In the US, ServiceNow posted very strong fourth quarter results with subscription billings up 40% YoY and operating margins above consensus at 18.1%. 

In Europe, Outokumpu disappointed investors with EBITDA of only €82m on higher-than-expected raw material costs and lower shipments to the US.

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