Uncertainties over QE sustainability

Asset Management - 10/28/2016

Government bonds remained under pressure and the negative trend was most acute in Europe and especially in Germany. The culprit was not economic data which were generally better but greater uncertainty over how long quantitative easing could last, notably in Europe. Yields on the 10-year German Bund jumped 16bp over the week.

So far, ECB statements have stressed that:
-the bank will revisit the question of inflationary momentum when it meets in December (but with inflation so low, it will be difficult to query QE arrangements in the coming months)
- QE may end up creating problems and is essentially a temporary measure even if, for the moment, there are no visible issues.

One senses that the ECB regrets that governments have not taken advantage of central bank generosity to coordinate improved fiscal policies and roll out structural reforms. At the very least, the bank is reminding us that it will seek to taper as soon as conditions are right, i.e. when inflation has risen, and that is hardly news.

Bond market shifts in recent days are a reminder of how expensive government bonds have become; they inevitably come under attack as soon as even the shadow of a doubt is cast over the duration of unconventional monetary policy. But in our view, prices have so far not moved far enough to warrant reinvesting in the segment. This week’s economic surveys were generally sunnier with composite PMI reports rebounding both in the US and in Europe.

 

  European equities

Markets lost ground despite an improvement in eurozone activity in October and a better-than-expected composite PMI (services and industry).

The market was swamped with the first batch of quarterly earnings reports but there was no clear direction of travel. So far, some weakness is apparent in defensive consumer stocks. Heineken’s like-for-like growth only managed 2% instead of the 4% expected due to Africa. It was the same disappointing story for AB InBev which was hit by poor performance in Brazil and Mexico. In advertising, Havas followed on from last week’s downbeat report from Publicis with weak sales outside Europe. The group has reduced its annual guidance.

But in more positive news, banks gained from Europe’s improved environment and posted the best returns of the week. BNP’s results jumped 18% with strong performance in investment banking and improved solvency ratios.

Orange proved particularly resilient in France and reported upbeat results. STM was actively traded thanks to excellent gross margins and strong prospects.

Airbus revised its deliveries for 2016 higher, a move which implies a strong fourth quarter. Sanofi advanced after raising its earnings guidance for 2016. Results from Safran, Bayer, Peugeot and Renault were all in line. The best of the bunch was Kering which posted what will probably be one of the best achievements in the sector with like-for-like growth of 11.3%. This was attributable to a recovery at Gucci which saw like-for- like quarterly growth of 17%.

Disappointments included Cobham which issued another profit warning due to delays in its KC-46 Tanker programme, Schneider which missed expectations, and Nokia which triggered investor concerns by sounding cautious over future growth.

A crop of M&A deals in the US had impacts on European companies. The acquisition of 25% of Hilton by China’s HNA will reinforce consolidation in the global hotel sector, a trend which is already visible in Europe. Of note also was B/E Aerospace’s acquisition of Rockwell Collins in the US, Zodiac’s main rival.

 

  US equities

Markets edged lower amid the ongoing third quarter earnings season. Durable goods orders ex-transport rose 0.2% or in line with expectations and, unsurprisingly, property sector figures also rose. Markit’s flash manufacturing PMI came in at a robust 53.2 for October. On the political front, Hillary Clinton’s victory in the upcoming Presidential elections is now once again, after the third and last debate, the most likely scenario.

In company news, more than 150 companies have now reported third quarter results. Earnings ex energy were 3% higher on the same period in the preceding year. Positive surprises are running at about 75%. In headline earnings reports, Apple reported results in line but iPhone sales were slightly disappointing given the problems its main rival Samsung is currently battling with. Google and Amazon reported in typical fashion: Google beat estimates and reaffirmed its discipline over margins while Amazon took investors by surprise by unveiling a new, colossal investment plan covering audiovisual content production, its Prime and fresh food delivery services, its cloud computing offer and plans to reinforce its warehouse network.

Over the last 5 trading sessions, consumer staples, financials and technology led gains. Property stocks and telecoms posted the worst returns.

 

  Japanese equities

Japanese stocks inched higher with the TOPIX up 0.8% on expectations for better earnings as excessive concerns over the impact of the stronger Japanese yen on first half figures receded. The yen fell 0.9% on growing confidence that the Federal Reserve would raise interest rates before the end of the year while the Bank of Japan maintained its monetary easing stance.

This week’s top gainer was Other Financing Business sector (+4.2%). Real Estate also added to last week’s gains while Marine Transportation lost 2.7%.

Share buybacks attracted investor attention. Orix Corporation soared 11% after announcing a buyback of up to JPY 50bn. The diversified financial services group decided to go for its first buyback in eight years on the grounds that the stock was undervalued in P/B terms.

On a negative note, Nintendo tumbled 7.7% after lowering its sales and operating profit outlook for this year. The phenomenal success of Pokemon Go had boosted the share price but failed to make up for sliding sales for other key games. Investors are now cautious over the sales prospects of Switch, a next-generation console, which was launched last week.

 

  Emerging markets

Emerging Market stocks slid over the week, threatening to take the MSCI EM index into negative territory for the month as the prospect of higher US interest rates and a stronger dollar worried investors.

The offshore renminbi sank to a record low this week as Chinese policy makers signalled they were willing to allow greater currency flexibility amid a slump in exports and rise in the dollar.

September quarter results from India’s leading mobile network operator, Idea Cellular, were the weakest in its history, but they were more or less in line with analysts’ expectations. Revenue grew only 7.2% year-on-year, the lowest ever growth reported by the firm. The battle between Cyrus Mistry and Tata Sons (the Tata group’s holding company) seemed to be taking an ugly turn with the former chairman writing a 5-page letter in which he raised a lot of questions on developments at the Tata group and especially its accounting policy. Most of the problems Mistry pointed out were already known to investors. However, it raised some question marks about the extent of the problems and the reliability of the group’s accounting procedures.

Towards the end of the week, Brazilian stocks rose to nearly the highest level in four years on hopes that President Michel Temer would manage to pass tough austerity measures through Congress. Moreover, the central bank started to reduce interest rates by 25bp. The easing cycle was expected , but the tone was a bit more hawkish. Vale reported strong third quarter results. Brazilian stocks have rallied 86% this year in US dollar terms, the best performance in the world, on optimism Temer will succeed in his recovery plan.

 

  Commodities

Oil prices fell, exiting the (Brent crude) USD 49-51 trading range they had stuck to in previous weeks. Iraq is the new name on the (long) list of countries that want to be exempted from any collective production cut or freeze. Iraq’s arguments are rather questionable: (i) it claims OPEC has underestimated its production levels at 4.45 million b/d in September when it says they were actually 4.77 million and (ii) its oil minister says it should be excluded from the effort as it has to fund a vicious war against Daesh. Venezuela also complained that OPEC had underestimated its output.

It is difficult to imagine an agreement will be concluded if Iraq and Iran, the second and third largest producers, are unwilling to play by the rules of the game. That would mean Saudi Arabia and its allies, the UAE, Kuwait and Qatar, taking a bigger role and suffering a contraction in market share. And yet it is not inconceivable judging from rumours reported by Reuters that Saudi Arabia and allies had offered to cut output by 4% from peak production, i.e. the equivalent of a drop of 0.7 million b/d. Bearing in mind that Russia too is in favour of an intervention, the drop could be more than 1 million b/d if we apply the same ratios.

In the US, crude inventories fell over the week with a marked reduction in petrol and distillate stocks. Weekly data showed US production increasing slightly to 8.5 million b/d, reducing the year-to-date decline to 0.7 million b/d. Gas prices continued to suffer from high seasonal temperatures in the US and forecasts of a relatively mild November.

Base metal prices shrugged off this week’s rise in the US dollar. Iron ore prices added 7% due to bad weather in Australia leading to production stoppages and a sharp rise in metallurgical coal prices. Improving economic fundamentals have allowed US and European steel makers to pass on higher steel prices to customers, thereby offsetting rising production costs.

 

  Corporate debt

Credit

Credit markets proved resilient to higher yields on risk-free bonds after the UK’s GDP data came in higher than expected. The Main index edged higher to 72bp and the Xover moved up to 329bp.

The investment grade segment saw a number of new issues. Danone sold a euro-denominated Jumbo deal for EUR 6.5bn across six maturities from 2 to 12 years. Orange issued a 10-year maturity, Merck an 8 and 20-year bond, Verizon three maturities for 5, 9 and 12 years and Publicis a 7-year bond.

Long duration bonds were hit by rising risk-free yields. The yield on the German 10-year Bund rose to 0.16%.

The high yield new issues market was also busy ahead of the results season with bonds from Snai (Italy, gaming), Domusvi (retirement homes) and furnishing store, But.

Zombie bonds returned to the debt market. Codere (Spain, gaming) and Greek telecoms group Wind Hellas both defaulted in recent years but this week tried to sell new bonds.

In financial debt, BFCM and SEB issued LT2 bonds. CoCo bonds performed well over the week while Insurance sector debt suffered because of its duration.

 

Convertibles 

The busiest week in third quarter earnings resulted in many big convertible bond moves. In Europe, STM jumped 10% after raising its fourth quarter outlook, citing strong demand in the smartphone market. In the US, ServiceNow pleasantly surprised investors with 41% growth in bookings YoY and the news sent the stock up 13%. Weatherford published weak numbers with a higher-than-expected third quarter loss on a USD 200m delay in customer payments.

In Asia, China Railway Construction Corporation reported in-line third quarter numbers; total new contracts rose 22% YoY and, the company also signed a cooperation pact with Fosun Group. In Japan, Advantest gained 9% this week as the company raised its full year EBIT forecast by 31.8%. On the primary side in Europe, we had one new deal from a repeat issuer: UK real estate company Intu Properties came to market with a GBP 375m 2.875% convertible. The US saw two small issues from Theravance Biopharma and Helix Energy Solutions Group.

 

 

 

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