Excessive enthusiasm?

Market analysis - 03/03/2017

It was a good week for equity markets, especially in Europe which had been drifting lower for weeks. The global economic environment and earnings outlook remained encouragingly upbeat.

Reflationary trends have now been in place for a year and there are hopes this will mean better sales figures and improving company margins. 

Donald Trump’s accent on bringing the country together in his address to Congress reassured markets even though he postponed providing details on his fiscal reform plans. The Fed suggested that, given the current favourable environment, it might increase rates in March. This sent the US dollar as well as financials and cyclicals higher. 

We are, as a result, still structurally bullish on equity markets but have tactically trimmed positions as we worry that today’s market enthusiasm has insufficiently discounted political risk and the new administration’s delay in introducing measures. 

  European equities

In another week of quarterly figures - 85% of reports are now in - the CAC40 hit its highest level since November 2015 in spite of unsettling news on the domestic political front. Donald Trump's confirmation of big spending on infrastructure spurred a rebound in construction and materials but the sector was also galvanised by upbeat results from companies like Vinci and Saint-Gobain

Cyclicals announced improved guidance overall. Lafarge reported better-than-expected results and said the outlook had improved. Thales posted strong cash flow generation. Croda returned to like-for-like growth after 4 quarters of contraction in a row and Arkema increased sales and margins in China. 

Valeo confirmed that higher financial targets for 2017-2021. GKN and Meggitt also reported better-than-expected results and prospects. 

Utilities were rerated following news that Engie’s transformation programme had worked well and that the outlook was rosy. Banks followed suit. Intesa jumped, dragging up the entire European sector, after it walked away from its plan to acquire Generali. The group said the project was too low on value creation compared to the risk to its solvency. 

Elsewhere, the talks between Peugeot and Opel seem to be going well but the LSE / Deutsche Börse tie-up has been undermined by “excessively” demanding European Commission conditions. 

  US equities

Another up week in the US took YTD gains for the Dow Jones and S&P to more than 6% and close to 9% for the NASDAQ. Revised fourth quarter GDP growth came in at 1.9% while manufacturing ISM remained on an uptrend, reaching 57.7 in February compared to 56 in the previous month. The PCE index showed inflation rising 1.7% in January or in line with recent trends.

Several regional Fed heads spoke during the week in favour of raising rates over a relatively short term horizon. Donald Trump’s address to Congress failed to provide details or the timing of his reform measures but he adopted a conciliatory tone designed to bring people together. 

Recent earnings reports included disappointing like-for-like sales for retail players like Kroger, Best Buy and Target due to the ongoing consumer switch to e-commerce. Over the last 5 trading sessions, healthcare and utilities led gains while consumer staples and technology fell.  

  Japanese equities

Over the week, the TOPIX edged 0.5% higher to hit its highest level since December 2015 on Thursday. US President Donald Trump's first speech to Congress provided support as his mild tone contrasted with previous big speeches before his inauguration. Fed chair Janet Yellen signalled a possible rate hike in March, buoying financials on expectation for a rise in US treasury yields. The yen weakened by 0.9% to 114 against the US dollar, pushing exporters higher.

The best performing sector was Securities & Commodity (+2.4%) while Mining sank 1.9%.

Daiwa Securities and Nomura Holdings, Japan’s two largest brokerages, rose 2.7% and 1.9% respectively amid strong market momentum. Investors reacted positively to comments from Daiwa Securities’ CEO that he was keeping an eye on the possibility of raising the payout ratio or launching a share buy-back. 

Rakuten, which runs Japan’s biggest e-commerce platform, dropped 2.8% as investors took profits on domestic demand-related shares. 

  Emerging markets

A correction in commodity prices and US dollar appreciation halted the solid YTD rise across emerging markets. Brazil and Argentina, which had led advances, came under pressure this week. Commodity prices are, of course, a big driver for emerging market performance but growth differentials and EM vs. developed market credit performance are even more important. And if anything, they were rather favourable this week for the emerging zone.   

The minutes of Brazil’s central bank meeting, published one week after a 75bp cut, reinforced the positive outlook. They said that easing would accelerate provided reforms were effectively implemented.  The expected new round of cuts in April could exceed 75bp. How deep the easing reduction cycle will prove is not certain but Brazil still has ample room to move. A drop to 9.5% by year end, vs. 12.25% today, remains the positive base case.

In China, the annual National People’s Congress will open on March 5.Premier Li Keqiang will conclude the work report for 2016 and set the key economic growth targets for 2017. He is expected to unveil more supply side reforms, particularly in the materials and industrial sectors. The steel sector might target a 50m tonne reduction, in addition to ongoing efforts to eradicate small private induction furnaces. No export tax adjustment is expected as the government feels exports do not require help due to strong domestic demand and reduced supply. Note that for the past 12 months, the trade balance on iron ore and steel between China and the US has been close to zero so any new US import tariff policy would have very little impact. Further capacity closure efforts are expected in cement, coal mining and aluminium.     

Sberbank, Russia’s largest which is 50% owned by the central bank, released a solid set of fourth quarter results. Net interest income rose 20% YoY and earnings came to RUB 141bn, significantly above market expectations on strong interest income and a sharp drop in provisioning. Return on equity jumped to 20% over the quarter. Full-year profits hit a record RUB 540.5bn with ROE of 19.2%. The capital ratio improved in the first quarter of 2017 to 12.3%, up from 11.2% in last year’s third quarter and beating the bank’s own objective of 12%. The stock is trading at an attractive Price/Book of 1.1 times.  

  Commodities

Despite the rising US dollar, industrial metals performed relatively well. February's PMI data confirmed that manufacturing activity was generally accelerating, especially in China and the US. This augurs well for base product demand. China’s policies should remain crucial this year in determining how commodity markets perform: China cut steel capacity by 65m tonnes in 2016 and is expected in 2017 to focus on rationalising aluminium production while maintaining efforts in steel. According to rumours, the Hebei province is planning to reduce aluminium and alumina production by 30% during the winter of 2017. Aluminium and iron ore fell 2% over the week on the news. No change in copper with the world’s largest mines, Escondida in Chile and Grasberg in Indonesia, still idle. Chile’s copper production fell 2.6% in January and was expected to show a further slowdown in February because of these stoppages. On the demand side, China's 2017 budget will increase spending on electricity networks by 6% YoY but the expected 25% YoY increase in cable volumes to 58km is the most positive news for copper demand. As a result, the red metal ended the week higher. 

Gold shed 2% to flirt with USD 1,225/oz on the higher US dollar and various comments from Fed officials in favour of raising rates in March. The probability of a move this month has risen to 90% compared to 40% at the end of last week. Gold mines had risen 16% YTD but tumbled 8.5% over the week to levels which strike us as interesting entry points. We are reaffirming our buy recommendation on the sector and recommend it as an insurance against ongoing geopolitical risk like the revival in populist and protectionist sentiment on the back of Donald Trump's election, looming elections in Europe and Brexit. 

Oil lost ground over the week after US crude inventories remained unchanged and the US Department of Energy said output increased by 31,000 b/d to 9.03 million. But the good news was that China's crude imports jumped 27.5% in January while consumption of oil products remained buoyant at +4.5%.  

  Corporate debt

 

Credit

Despite fresh pre-electoral tension in France and a looming rate hike in the US, European high yield markets were stable and valuations remained lofty. The iTraxx Over actually tightened to 277bp last Thursday. Political risk is higher for France’s banks but financials continued to perform well. 

This context was good news for new issues: Rexel (Ba2/BB) raised EUR 300m with a senior unsecured NC3 bond at 7.25% NC3 to refinance its USD-denominated 2020 maturity at 5.25%. Nyrstar (Caa1) also issued an unsecured bond due 2024 for EUR 350m to refinance its 2018 convertibles. In the pipeline: a EUR-denominated issue from Nemak S.A.B (Ba1/BB+) and a USD/GBP bond from Aston Martin

In financials, Barclays raised GBP 1.25bn with a Perp-6y AT1 and Bankia EUR 500m with a 10y NC5 bond. 

The results season continued with results from the newly merged Fnac-Darty (Ba2/BB) beating estimates. Sales came to EUR 5.36bn and management said it was now targeting synergy objectives by the end of 2018 rather than during 2019. 

Standard and Poor’s downgraded Vallourec from B+ à B (while keeping the company on negative watch), citing the prospect of EBITDA largely remaining in negative territory at minus EUR 100m (vs. estimations of +EUR 200m previously) and the likelihood that margins would remain under pressure. 

Convertibles 

It was a busy week for the convertible primary market with 6 new deals. German chemical giant BASF came to market with a USD 600m 0.925% coupon, 6Y convertible in a bond + warrant deal. In the US the end of the fourth quarter earnings season and the rise in equity prices provided a perfect window for a flurry of new deals dominated by the tech sector. Optical products and network solutions company, Viavi, issued a USD 400m 7Y convertible which it will use in part to refinance its outstanding 2033 convertible. Silicon Laboratories (fables semiconductors) issued a USD 350m 1.375% coupon 2022 convertible bond to help fund future M&A deals. Square Inc, the disruptive mobile payments company run by Twitter founder Jack Dorsey, issued a USD 400m 2022 convertible with a 0.375% coupon. Lumentum (optical and photonic products) announced a USD 350m 2024 convertible to fund potential M&A and to increase capacity and inventories. Finally, debt management company, Encore Capital, came to market with a USD 125m 2022 convertible.

In earnings news, oil services company Subsea 7 posted a very solid fourth quarter EBITDA margin 31% above consensus and gave more positive comments on possible future contracts. The shares subsequently rallied 7%. In the US, cloud CRM software giant, Salesforce, reported its strongest quarterly billings in over two years and raised sales guidance for 2018. In contrast, cyber security company Palo Alto disappointed investors with a very weak quarter due to changes in its sales strategy that resulted in fewer closed deals. The shares plummeted 23% on the day. In Asia, Bangkok Dusit reported a deceleration in revenue growth to +6% in the last quarter of 2016 which was in part due to the Erawan Shrine incident which lowered international patient numbers. The company also unveiled a 10% capital increase.

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