Sources of volatility on the rise

Market analysis - 01/12/2017

With persistently bullish economic statistics and confidence surveys at levels not seen in years, investors are gradually turning to inflation data and various financial stability reports.

In its latest Beige Book, the Fed reiterated its view that US growth was proceeding at a modest and moderate pace with, as yet, no sign of overheating despite historically low unemployment. And yet, inflation has been rising albeit in line with overall expectations according to a survey. It says several pointers suggest inflation has picked up speed in recent weeks after months of stagnation even if many regions are only seeing moderate wage increases. At any rate, these pointers should help justify a new rate hike on December 13 when the Fed next meets. 

In Europe, certain factors had weighed on underlying inflation, but recent data showed that it is rising YoY even if this modest rise is due to a recovery in oil prices. Unlike the US, European inflation is struggling to recovery. The Markit survey shows that Europe’s service companies are finding it harder than industrials to raise prices. The services sector has been facing rising costs but has only managed marginally to pass on these increases. 

The second issue concerning asset valuations came from this week’s ECB financial stability report which warned investors that global asset prices might be in for a strong correction due to greater risk taking by investors and moves by major central banks to raise interest rates. The bank cited property, especially in the commercial sector as one of the most overvalued assets and also said certain Eurozone corporate bonds were far too expensive. The ECB will be keeping a close eye on the situation throughout 2018. In today's environment of mounting sources of volatility, we are sticking to our tactically cautious stance on equity markets but are waiting for better entry levels to reweight our portfolios. 

  European equities

European markets edged higher, moving in line with news on US tax reform developments and resulting euro/dollar shifts while inflation data were in line with expectations and still below targeted levels. 

The big event was a sell-off in European tech stocks which was probably triggered by reduced guidance and lay-offs at Autodesk in the US. STM, SOITEC and ASML all came under attack. Dialog was particularly hard hit after Japanese press reports said Apple wanted to develop its own power management chips. 

Distribution however performed well due to expectations that traditional and online retailers would reach agreements. Casino, for example, unveiled an agreement to use Ocado’s e-commerce platform. Carrefour rose on the news and also because of the possibility of an alliance with Fnac Darty to create a joint buying agency for electronic and household appliances. Ahold also rose on upbeat figures from its US peers. 

In autos, Peugeot fell after it claimed it had been misled on Opel’s carbon reduction progress before it made the acquisition. It is seeking at least €500m in compensation from GM, the previous owner. Volkswagen, however, advanced on hopes of strong end-of-year sales and the group raised its operating margin target for 2020 from at least 4% to 4-5%. Altice hit fresh annual lows on persistent tensions over its debt load. The group said it had reached an agreement to sell some of its Swiss businesses to InfraVia Capital Partner

In M&A, Altran fell on news that it had paid €1.7bn for Aricent in an attempt to become the undisputed global leader in R&D services and engineering. The deal is expected to complete in the first quarter of 2018 and will be funded by a €750m rights issue. The acquisition should generate €150m in additional revenues and €25m in operating synergies. Allianz is paying a 20.7% premium to buy in the minorities in Euler Hermes. After acquiring some of Bayer’s agro businesses and Solvay’s polyamide division, BASF is pressing on with its strategic reorganisation and is now in talks over merging its Oil & Gas business. Fresenius confirmed that it had acquired Akorn in the US as well as Merck’s biosimilars business. In its ongoing refocusing drive, Royal Philips sold 12% of Philips Lighting

  US equities

Equity markets had a buoyant week with the S&P gaining 1.7% but sector rotation was at its highest since Donald Trump's election victory. As a result, volatility jumped from last week’s 9 to 11, a rare occurrence in a rising market.

PCE inflation, the Fed’s favourite criterion, rose 1.4% or in line with expectations. And the consumer confidence index hit 129.5, its highest level since November 2000. 

Vigorous stock rotation was due to (i) progress in talks on tax reform, (ii) Powell’s comments that bank regulation was excessive, (iii) the looming year end and (iv) the extent to which tech and internet stocks were over-held.

Rotation resulted in massive selling of the sectors with the best YTD performance and a switch into laggards like telecoms and energy as well as financials which found new favour thanks to the future Fed chair’s wish to reduce bank regulation. The finance commission approved the tax reform bill for Senate discussion. 

Elsewhere, Janet Yellen said the US economy was growing across the board and that the stage was set for a rate hike in December. 

  Japanese equities

Tokyo had another steady week and the TOPIX gained 0.65%. Stocks saw buying from overseas investors and bounced back on Wednesday after the Dow Jones hit a fresh record high. Although semiconductor oversupply concerns in October hit electronics firms, growing expectations of ETF purchases by the BoJ lifted the market and financials were relatively strong.

Currently investor appetite is shifting from growth to undervalued stocks. North Korea’s missile launch on Wednesday had only a limited impact on the market.

By sector, the best performers of the week were Iron & Steel (+5.38%), Insurance (+4.65%) and Other Financing Business (+4.32%). Steel makers such as JFE Holdings (+7.95%) and Nippon Steel & Sumitomo Metal Corp (+7.59%) were buoyant. Financials were upbeat including insurers Sompo Holdings (+5.74%), MS&AD Insurance Group Holdings (+5.70%) and Tokio Marine Holdings (+2.97%) after their US peers gained ground on Wednesday.

In contrast, Electric Appliances (-2.76%), Machinery    (-2.13%) and Textiles & Apparels (-1.89%) were relatively weak. Selling hit high-tech names, Tokyo Electron Limited (-11.07%), Murata Manufacturing (-5.57%) and Sony Corporation   (-2.29%) as the SOX, the Philadelphia Semiconductor Index, tumbled more than 4% on Wednesday.  

  Emerging markets

Despite a small break in November, overall news flow on MSCI emerging markets remained positive with the slight exception of India. China’s PMI rose 0.2% MoM to 51.8% in November. The services sector continued to see steady growth.

In Brazil, unemployment fell further to 12.2%, down from 12.4% in September and 13.7% in March. Real wages increased by 4.2% and should help lift consumption. Nevertheless, the government played down expectations that pension reform would be approved this year.

In India, growth remained slightly subdued with annualized GDP running at +6.3% in September. Investment continued to be soft, falling to 26.4% of GDP vs. 27.1% last year. However, we should bear in mind that the initial negative impact of GST implementation was probably responsible for this relatively weak performance. The fiscal deficit was at 98% of the targeted deficit 4 months before the end of the fiscal year ending March 2018.

Barring strong monetary tightening in the US, we remain optimistic on emerging markets for 2018. Even if Chinese growth should be softer due to less a buoyant property market, stricter environmental rules and tighter local government financing controls, the quality of growth should be better as the country is moving up in the value chain. In Brazil, the job market is recovering fast and ASEAN countries and India are gradually recovering. 

  Commodities

Given oil price levels in the last month -$62-64 for Brent crude and $56-58 for WTI- and very high long positions, the outcome of the November 30 OPEC/NOPEC summit might have set up a serious correction. But the Saudi oil minister, Khalid Al-Falih, set the tone in his opening speech by stressing how much progress had been made and how much remained to be done. So far, surplus OECD oil inventories have been halved and oil product stocks like petrol and distillates have returned to normal. The fact is that from the moment the Saudis and the Russians began to share the same market analysis, an overall agreement was easier to reach. On January 1st 2017, OPEC countries agreed to cut output by 1.2 million b/d and NOPEC states by 600,000 b/d. They have now decided to extend the cut to the end of 2018 and review the situation in June 2018 to see whether any adjustments should be made.

As the summit’s conclusion were largely expected, we might have seen a “sell the news “reaction. Instead, prices more or less stabilised at $63 for Brent and $58 for WTI. Libya and Nigeria, which are OPEC members but treated as special situations, have seen output rise over 12 months, from 400,000 b/d to 1.5 million b/d for the former and from 1.5 million to 1.8 million b/d for the latter. Both countries say that production in 2018 will not rise above 2017 highs, a commitment that reinforces the scenario of a further fall in crude oil inventories in 2018. 

Visibility is improving on the oil market but there are still 2 question marks, demand and US production. Since 2015, demand has been rising by 1.5 million b/d or above its long-term trend (1 million b/d). Higher prices could reduce appetites, but we are not worried at current price levels. US production has rebounded sharply in 2017 from the mid-2016 low point, gaining on average 600,000 b/d this year and 900,000b/d from December 2016 to November 2017. Expectations for 2018 are currently around +800,000b/d. However, US E&P companies have just changed strategy and now want to focus on generating value (i.e. free cash flow) rather than volume. We will have to wait and see if this stance is respected but it would certainly help stabilise the market even more. Today’s conditions suggest a price spread of $55-60 for Brent crude. 

  Corporate debt

 

Credit

Credit spreads tightened as yields remained relatively stable. The iTraxx Crossover moved from 238 to 231bp.

Among new HY issues, CeramTec (CCC+, ceramic hip implants) sold a 5.25% bond which was a big success. Telenet (BB-) issued a 2028 maturity at 3.5% and UK travel agency Thomas Cook a 6-year maturity at 3.875%. 

In this week's news on portfolio holdings, OHL signed the sale contract for OHL Concesiones with IFM, an important step before the completion of this transforming deal. In financials, UniCredit remained focused on selling its non-performing loans. 

In new issues, Talanx issued a Tier 2 2047NC10. 

Convertibles 

The European convertible bond market was in the spotlight this week with three new issues. French homeware retailer, Maisons du Monde, made its market debut with a 6-year, €200m convertible at 0.125% and with a 42.5% premium; the proceeds will be used to partially refinance the company’s existing term loan and to support the company’s Europe-wide expansion. Dutch semiconductor equipment manufacturer, BE Semi, returned to the market for the second time in just over a year with a 7-year, €175m convertible at 0.50% and with a 40% premium to further expand its production capacity and finance shareholder returns. In addition, French holiday property operator, Pierre et Vacances, launched a new 6-year, €100m convertible at 2 and with a 30% premium; the proceeds will be used to refinance the company’s existing 2019 convertible.

Elsewhere, primary activity was subdued as we saw only one other significant issue from Hong Kong-listed provider of semiconductor foundry services, SMIC, which raised $481.5m with a perpetual convertible at 2% and with a 20% premium to finance capacity expansion and for general corporate purposes.

In the news this week, US cloud software provider, Workday, reported strong third quarter results and better-than-expected guidance but the share fell 3% on the day on concerns over the company’s full valuation.US biotech Medicines Company announced that it had sold its infectious diseases business to Melinta Therapeutics for $270m in upfront payments and a stream of royalties while Melinta will assume all payment obligations. In Europe, Swiss specialty pharma player, Basilea, extended an existing license agreement with Pfizer to market its antifungal treatment, Cresemba. This will now include China and 16 other countries in the Asia-Pacific zone.

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