A short-lived rally

Market analysis - 8/18/2017

The week got off to a good start and markets rebounded as tensions between the US and North Korea abated. But the mood only lasted 3 days and it was the US once again that was responsible for worries resurfacing.

After the geopolitical escalation, doubts were fanned by domestic political turmoil following the Charlottesville incident and the decision by business leaders to part company with Donald Trump’s administration. Sentiment worsened on rumours that Gary Cohn, the president’s top economic advisor, had resigned, and on news of terrorist attacks in Spain. The sell-off was made worse by thin trading volumes. 

Looking beyond this volatility, markets are still in wait-and-see mode. 

  • On the one hand, economic data is reassuring. Indicators like retail sales, confidence and production still point to a vigorous US economy while GDP, unemployment and trade figures suggest the same for Europe. Only inflation remains some way from central bank targets. 
  • On the other, interest rates are still low and thus offer little protection for investors. Equities may look historically expensive but current levels are underpinned by low rates and attractive fundamentals, both as regards results and earnings prospects. As a result, equities currently provide the best risk/return profile and investors should still be overweight. 

At the moment, currencies and central banks are in the driving seat. The ECB’s recent concerns over the strong euro are revealing. Monetary tightening will therefore not be fast and Mario Draghi will say nothing new about monetary policy at next week’s Jackson Hole symposium. In the US, Robert Kaplan’s comments during the week showed how worried regional Fed presidents were about looming monetary tightening. But another rate hike before the end of 2017 and a timetable for the Fed’s balance sheet reduction plan are both, theoretically, still on the agenda. 

Over the week, we took advantage of weakness to reorganise equity hedges and increase weightings. In the same vein, we reinforced exposure to convertible bonds. 

  European equities

The verbal confrontation between Donald J. Trump and Kim J. Un abated this week, helping European equity markets claw back some of the lost ground. Most companies have now reported quarterly results so news was thin on the ground. But there were some disappointing figures from Geberit, which missed analysts’ expectations for the first half, and Coloplast which revised down its growth forecasts for the full year.

However, Wirecard confirmed sales momentum with a 25% like-for -like jump which outpaced expectations. And one week after releasing its results, Novo Nordisk unveiled the conclusion of a comparative study of its anti-diabetes treatment Semaglutide with a product from rival firm Lilly. The results, which said Semaglutide was better in several areas, suggest the drug could be approved in the US in 2018. 

The corporate rumour mill remained active with suggestions that a Chinese company had expressed an interest in Fiat Chrysler. (The offer was reportedly considered too low). Elsewhere, the activist fund Corvex bought 1% of Danone but has taken no further action so far. After a conflict lasting several months, the Elliott fund signed an agreement with Akzo Nobel and also said it now also owns more than 5% of BHP Billiton, a move which will increase pressure on the group to spin off businesses. Air Berlin went bankrupt after Etihad, its largest shareholder, refused to provide further assistance. Etihad is now mulling whether to sell the airline's planes to Lufthansa.

  US equities

Markets eventually lost ground over the period with the S&P ending 0.5% lower. Most of the correction was down to Thursday’s sell-off. Macroeconomic data was generally upbeat. Retail sales rose 0.6% MoM in July, or more than the 0.3% expected, and the Empire Manufacturing index jumped to 25 (vs. expectations of 10), its highest level since 2014. Housing starts, however, declined by 5%.

The FOMC minutes sent a chill through markets on Wednesday. Their drift was somewhat convoluted: on the one hand, the Fed clearly wants to start reducing its balance sheet soon while, on the other, there are still doubts inflation can climb to the targeted 2% level. That is why some committee members were of the opinion that the Fed could afford to be patient before continuing to raise rates. Of note also was the Fed’s decision to take the debt ceiling into account before establishing the timing for its balance sheet shrinkage.

Markets essentially reacted to Donald Trump getting bogged down over successive comments on the Charlottesville incident, a performance which triggered concerns even in his own camp. And the president’s position was weakened further when leading CEOs expressed their indignation. Donald Trump riposted by disbanding the business councils some of them sat on. The terrorist attack in Barcelona also contributed to investor nervousness.

In company news, there were encouraging figures in the consumption/distribution space from Target, TJX and Ross Stores, all of which beat quarterly expectations. In contrast, Cisco, Coach, Advance Auto Parts, Home Depot and L Brands all surprised the market by missing expectations. Tech and consumer staples were the best performing sectors over the period while telecoms and energy chalked up the biggest losses. 

  Japanese equities

The TOPIX dropped 0.2% over the week. After rising on Tuesday, stocks edged lower for two days in a row weighed down by profit taking and by the Yen’s rise against US Dollar. A wait-and-see mood prevailed in the market due to lingering geopolitical risks over North Korea and uncertainty over the Trump administration. However, the Tokyo market’s downside was limited by buying of stocks which reported brisk earnings. Trading volumes were relatively low over the period since many investors were away for the “Obon” season...  

By sector, the best performers for the week were Marine Transportation (+4%), Oil & Coal Products (+2.9%) and Services (+1.9%). Fujifilm Holdings jumped 8.2% on the back of robust April-June quarter results. Toshiba (+4.1%) and Shiseido Company (+4%) were also buoyant. On the other hand, Iron & Steel (-2.9%) and Mining    (-2.6%) were relatively weak. Steel makers such as JFE Holdings (-4.4%) and Nippon Steel & Sumitomo Metal (-4.1%) were downbeat. The stronger yen battered export-oriented names including automakers Suzuki Motor (-3.2%), Isuzu Motors (-2.4%), Mazda Motor Corporation (-2%) and Toyota Motor (-1.6%).  

  Emerging markets

Chinese IT companies Alibaba and Tencent provided the main highlight of the week with excellent second quarter results. Ping An (insurance) also reported solid and better-than- expected results.

Looking at Tencent’s results, we were impressed by strong 59% YoY top line growth thanks to gaming, online advertising and its new payment and cloud businesses. Net earnings soared 45% while the margin was stable at 29%. Its revenues and earnings beat the consensus by 5% and 10% respectively.

Alibaba’s results also proved that Chinese e-commerce players continue to gain market share from offline companies and add value to customers with cloud and media businesses. Alibaba’s revenues grew 56% YoY and the EBITDA margin expanded to 47% (and 63% in its ecommerce business). Alibaba has 466 million active consumers in its market place, an increase of 12 million on last year. Its results also beat expectations on all metrics.

The highlights in Ping An’s solid results were: 1) life premium growth of 46% (versus expectations of 35-40%) and 2) Lufax, the internet business, turning profitable. 

In Latin America, Mexico started to renegotiate the Nafta agreement with the US. The Mexican market has underperformed its EM peers on increasing concerns over the outcome of renegotiations. We do not expect any major negative surprise, such as higher import tariffs as Mexico is essential for the US supply chain and key to US export price competitiveness, especially in the auto sector. In Brazil, June retail sales surprised positively by rising 3% YoY, mainly driven by apparel sales.

 We remain positive on emerging markets. We expect more earnings revision upwards, mainly due to the economic recovery, lower inflation, lower interest rates and low capacity utilisation. Emerging market valuations are attractive at 12.5 times 12m forward earnings, with earnings seen 16% up.  

  Commodities

Gold prices were highly volatile over the week. After hitting $1,293/oz in the previous week amid rising tension between the US and North Korea, the ounce fell to $1,265 following Kim Jong-un’s decision to put his threat of missile launches against Guam on hold. But the FOMC minutes helped gold prices rally: the Fed appears increasingly ready to start shrinking its $4.2 trillion balance sheet but unexpectedly adopted a more accommodating tone. FOMC members are worried that inflation might stubbornly remain below the official 2% target and they might be prepared to vote in favour of postponing the next hike. Next week’s Jackson Hole symposium could throw some light on the question. And then the terrible terrorist attacks in Barcelona and its region revived the geopolitical risk premium and pushed gold higher to flirt with $1,300/oz. 

The FOMC also gave the already buoyant base metals sector another boost. Aluminium rose to $2,100/t, its highest level since August 2014 and copper rose to $6,500/t, a level not seen since November 2014. Even better, zinc traded at $3,100, a summit last seen in October 2007. All three are riding on upbeat PMI data, China’s spending on infrastructure and the weakening of the US dollar since the beginning of the summer. Only nickel was left out on account of less favourable supply and demand. 

Brent crude is for the moment trading between $50 and 53 and has largely ignored falling US weekly inventories. And yet, even with sharply higher production, crude inventories fell 6 times more than the average since 2010 for the traditional down period. The market is worried that the refinery maintenance period which starts in September could cause the trend to reverse. However Saudi Arabia’s decision to cut exports should help stabilise the market. 

  Corporate debt

 

Credit

Markets enjoyed a technical rebound following reassuring messages from Washington over any possible conflict with North Korea and Kim Jong-un’s decision to put his missile launch plan on hold. As a result, spreads tightened -the Xover by 7bp between Tuesday and Wednesday- and buyers returned at the beginning of the week, especially in the riskiest sectors like AT1 debt. The market then stabilised towards the end of the period with a slight widening of spreads which intensified on Friday amid fresh doubts over Donald Trump's performance as president. 

It was a very quiet week on the primary market. Trinseo (B1/BB-), a global rubber, plastics and synthetic latex player, raised $450m over 8 years at 5.375% to refinance existing debt. 

In quarterly results, Wienerberger AG (Ba2) saw revenues rise 6% and EBITDA 19% thanks to better sales and higher average prices. In telecoms, RCS&RDS (BB-) posted a strong 10.7% rise in sales while its EBITDA edged higher. Adler Real Estate AG (BB) reported rather mixed figures. Rental revenues rose 3% but property sales declined and EBITDA came in at €58.3m, down from 65.1m in 2016. K+S AG (BB+/Ba1) posted disappointing EBITDA of €210.9m in the second quarter, down from 285.3m in the same quarter in 2016. This was in part due to falling prices in its various businesses. Leverage remained at a high 8.1 times and EBITDA forecasts for 2020 were reportedly revised lower. 

Etihad, the largest shareholder of Air Berlin (CCC+ estimated) with 29%, decided not to provide further financial assistance. The airline’s board concluded that there was no viable future and filed for bankruptcy at the Berlin-Charlottenburg tribunal. Takeover talks are ongoing with other groups, particularly Lufthansa. The federal government has in the meantime given the airline a €150m bridging loan to keep the business running. 

Convertibles 

Despite being in the middle of summer, it was a busy week on the primary market, especially in the US. We saw another pharma deal from a repeat issuer, Jazz Pharmaceuticals (specialty biotech) which came to market with a $500m 1.5% 2024 convertible to repay outstanding borrowings. We also had 3 deals in the REIT space in the US: a $225m 4.75% 2023 convertible from Redwood Trust, a $200m 4.75% 2022 CB from Apollo Commercial Real Estate Finance and a $125m 4.125% 2022 convertible from Hannon Armstrong Sustainable Infrastructure Capital. In addition, US offshore drilling company Transocean issued a $660m 0.5% 2022 convertible in a private transaction to finance the acquisition of Norwegian offshore driller, Songa Offshore.

GN Store Nord (intelligent audio solutions) reported second quarter results that were largely in line with the consensus on revenues but 2.9% ahead on EBITDA; the stock jumped 12% following the release. The audio business in particular posted 12% growth, doubling consensus assumptions and, more importantly, gaining market share versus Plantronics. Meanwhile, US network and optical solutions developer, Viavi, reported better-than-expected quarterly earnings but provided weaker forward guidance owing to a lag in 3D sensing revenues.  The stock fell 4% on the news.

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