A surge of optimism

Market analysis - 2/17/2017

Europe will continue to enjoy economic growth judging from the European Commission’s decision to raise its forecasts. And with the Philly Fed index back to a 1984 high, momentum is also strong in the US. Growth drivers are still US consumers - retail sales rose again - and the reinforcement of the reflationary trade.

The latest inflation figures in the US and China rose more than expected. Underlying inflation in the US also rose by 2.3% in January. Central banks appear unfazed: Janet Yellen recognised that Fed jobs and inflation targets were almost reached but she left the door open for the next rate hike to occur in the second quarter rather than in March. Meanwhile, the ECB reminded markets that it would press on with its very expansionist monetary policy. 

All this encouraged equity markets to make further gains, particularly at the beginning of the week. US earnings remained upbeat with average rises of 46% year on year and further support came from Donald Trump who promised spectacular tax cuts for US companies. Markets responded by hitting fresh all-time highs, led by financials, healthcare and industrials. European markets rose too but kept a close eye on political trends, especially in France and Italy, and ongoing talks between Greece, the EU and the IMF. 

We maintained our pro-equity bias but still took some tactical profits. The medium term fundamentals are still good. Europe’s risk premium dipped a little but only because it had been at historically high levels and due to higher interest rates. Tensions on eurozone spreads, including in France, should fall back once visibility has improved. And earnings are being revised higher across the globe. We have maintained our bond market positions and remain neutral on US and European duration but with a negative bias on core countries and a positive stance on curve steepening strategies and inflation-linked bonds. 

  European equities

European markets continued to advance on rather favourable earnings up to last Thursday. Healthcare, banks and auto led gains. Renault, Peugeot and Daimler all advanced on upbeat January car sales in China and analyst upgrades. Michelin also rose after reassuring investors with its 2016 figures and 2017 guidance; the group says higher prices will offset rising commodity prices. Cognac exports in January threw a favourable light on LVMH which stands to gain as the US market increasingly moves towards premium brands.

Capgemini reported upbeat results and excellent free cash flow. Banks also outperformed with Credit Suisse and ABN Amro both reporting good figures. In France, the only negative in Crédit Agricole’s fourth quarter results was the contribution from international retail banking. Overall revenues, however, beat consensus expectations by 6% and loan quality improved. Allianz posted very good quarterly results and, as expected, is to launch a EUR 3bn share buyback. The group’s targets for 2018 are unchanged. 

In contrast, Nestlé’s results fell short and the group’s guidance for like-for-like growth 2017 is now a cautious +2-4%. Danone was also cautious on future sales but unveiled a EUR 1bn cost cutting programme designed to improve procurement/supply management and marketing while centralising support functions. 

In M&A, the Zodiac/Safran merger is being contested by the TCI fund which is demanding a shareholders' meeting before the deal goes through out of respect for minority shareholders. Peugeot rose on news that it might acquire General Motors’ European businesses. 

  US equities

It was another week of record highs for equities with the S&P up 1.7% over the last 5 trading sessions. 

SME optimism remained at historic levels, on a par with 2004, and producer prices ex food and energy rose 0.4% in January MoM and consumer prices by 0.3%. 

Banks continued to enjoy the benefits of the reflation trade and yield curve steepening. According to the Wall Street Journal, banks have cut costs by 13% since 2013. This should help them tap into strong operating leverage if the current bond yield momentum lasts. Donald Trump’s deregulation promises are another performance driver. 

In results, Cisco (+3%) beat expectations. Kraft, however, dropped 4% from record highs when its US sales fell. Mondelez International and General Mills lost 5% and 2% respectively on CNBC reports that Brazil’s 3G Capital, which holds a stake in Heinz, had abandoned the idea of selling the ketchup maker to another sector giant. On-line travel agency TripAdvisor tumbled 11% after missing earnings expectations. And disappointing quarterly figures also sent Avis and Avon Products more than 10% lower. 

Financials and healthcare led weekly gains while energy and telecoms declined. 

  Japanese equities

The Japanese stock market climbed with gains in the JASDAQ section and among insurance shares. The JASDAQ index, comprised of young companies having a unique business model or technology and growth potential, rose above 130 points and hit a 25-year high. On the macroeconomic front, Japan’s Oct-Dec GDP grew 1.1% growth on a year-on-year basis supported by robust growth in exports (+2.6% YoY) and capex (+0.9% YoY).

Insurance stocks soared 6.9% led by Tokio Marine Holdings (+8.7%) and Dai-ichi Life Holdings (+8.1%), on widening yield spreads after comments from the US Fed chair. In contrast, the Fishery, Agriculture & Forestry sector sank 1.1%.

Harmonic Drive Systems, the 3rd largest firm in terms of market cap on the JASDAQ Standard board, hit its highest level since its 1998 listing. The company makes mechatronic products and speed reducers for industrial robots and earnings rose almost six-fold on strong demand for speed reducers over the last 18 years.

Shiseido, Japan’s cosmetic giant, tumbled 7.4% after reporting 2016 results. Investors reacted negatively to lower-than-expected sales and operating profits which were hit by increased M&A costs and the stronger yen. 

  Emerging markets

Emerging markets continued to rise. Hong Kong-listed Chinese stocks, Brazil and Poland went up by more than 3%. India was stable while Egypt dropped by more than 3% although its currency rebounded by a further 10% WoW. This was due to January’s improved foreign reserves, up to USD 23.1bn vs. 21.2bn, a sign of net inflows. The Egyptian pound has been floating since November 3rd and is still down 44% since that day. The Brazilian real, Russian rouble and South Africa rand were strong against the US dollar this week, with the real benefiting from higher iron ore prices.

China’s January inflation came in higher than expected. Producer prices rose 6.9% YoY and consumer prices by 2.5%. The PPI has continued to surprise on the upside but should, theoretically, start decelerating from March. The base effect, from last year’s sharp increase in commodity prices, is expected to start softening. But this doesn’t mean the end of the industrial earnings recovery in China. In fact the positive boost to prices has not yet started translating into higher earnings growth: in December 2016, Chinese industrials reported close to zero earnings growth QoQ.  

India’s January inflation stayed at comfortable levels, rising 3.2% YoY but up 0.4% MoM. Further monetary policy easing will be put on hold for now. The RBI announced a change in its policy stance from accommodative to neutral. Indonesia is on the same trajectory: its central bank kept its policy rate on hold at 4% for deposits and 5.5% for lending.

Hong Kong-listed Sunny Optical (2382 HK) reported very strong January sales. Handset lens shipments rose by 88% YoY, auto lens by 14.7% and modules by 103%. The company has a leading position in a broad range of products and appears well positioned to take advantage of upcoming major technology trends like, (1) dual-camera smartphones; (2) virtual and augmented reality (3) smart cars (4) 3D Sensing.

Netease, China’s largest PC & smartphone game maker (Tencent is the largest in terms of game distribution) massively beat expectations with fourth quarter 2016 revenues jumping 53% YoY and profits soaring 68%. Its top games are ranked #2, #3, #4 and #5 for sales to China’s iPhones. The company plans to launch 80 new games this year, some in cooperation with Blizzard, as well as the much expected Minecraft by the summer. In February, it will launch its China blockbuster Onmyoji in Japan on both iOS and Android platforms. 

  Commodities

Oil prices were very high in 2016 but the start to 2017 has seen Brent crude stabilise around USD 55, while speculative positions remain at highs, limiting the possibility of marginal buying and therefore temporarily putting a lid on prices. In the US, investors remained concerned by rig activity – another 8 rigs were added this week - while weekly inventories increased by 9.5 million barrels, rising for the 6th week in a row. But even if US stocks continue higher due to seasonal effects and high imports, the IEA expects OECD inventories to fall in the first quarter due to OPEC's efforts to cut production and resilient demand. Note that at the end of December, stocks in Europe and Asia revisited levels close to the 5-year mean.

Compliance with the production cut is still encouraging - 93% according to OPEC’s monthly report compared to 90% in the IEA report - but Reuters says the cartel is thinking about extending the agreement by 6 months if global inventories fail to fall enough. The news was confirmed by Russia’s oil minister who added that the extension might also concern the non-OPEC agreement. In any case, an OPEC/non-OPEC meeting of oil ministers is scheduled for March 22-23 in Kuwait. As for non-OPEC compliance, Russia confirmed reports that it had more than doubled its targeted reduction in January and reaffirmed its commitment to cut by 300,000 b/d by May. There were similar encouraging signals from Kazakhstan and Azerbaijan.

Base metal prices consolidated over the week after last week’s hefty rebound. Despite ongoing stoppages at Escondida in Chile and Grasberg in Indonesia, copper prices dipped back below USD 6,000/t. The Indonesian government has just given into pressure from miners in the Grasberg (Freeport) mine who were threatening to strike and has issued permits to export copper concentrate for 12 months.

Nickel broke back above USD 11,000/t for the first time since mid-December amid persistent uncertainty whether 21 mines in the Philippines would be closed for good. Iron ore moved above USD 90/t for the first time since August 2014 on last week's import figures in China where demand continues to be strong. 

  Corporate debt

 

Credit

Trading was quiet on European debt markets and despite a busy political schedule, risk premiums remained tight. Markets were relatively untouched by the Fed’s hawkish tone which could mean more rate rises and the absence of any substantial news in the ECB’s dovish message. Mario Draghi intends to maintain a firm grip to reassure markets and look beyond the current spurt in inflation. But political issues in Greece and France hit risk premiums on domestic corporates, notably banks, utilities and telecoms. 

There were no new Euro high yield or subordinated financial issues but a few deals in the investment grade bracket. 

In the ongoing results season, Bombardier posted a net loss of USD 1.02bn for 2016 but the figure was in line with management’s transformation plan. Selecta had a mixed first quarter 2017 and net leverage rose. Air France-KLM beat expectations for 2016 but is very cautious for this year - due to high uncertainty over unit receipts and oil price trends. So far, however, the year has proved "resilient" and the group is sticking with its deleveraging targets.  

Convertibles 

The focus of full-year earnings switched largely to Europe and Asia this week. Air France rallied 13% on the back of stronger-than-expected Q4 results. FY EBIT increased 53% YoY as the company reduced unit costs and January unit revenues were quite resilient. Ageas reported a miss in Q4 net profit owing to one-off charges and weakness in UK operations. However, management highlighted better profitability in life assurance in Belgium.

In China, Semiconductor Manufacturing International Corporation reported a weaker-than-expected EBIT margin that declined 7.9% to just 6% in Q4. In Japan, Asics guided for a significantly lower operating margin in 2017 owing to higher advertising and procurement costs.

One notable earnings release in the US came from health insurer, Molina Healthcare, which reported a very weak quarter with a loss per share of USD 1.54, much lower than positive profit estimates. The company also lowered guidance due to challenges in the Affordable Care Act marketplace and the stock subsequently declined 18%.

In new issues, US producer of security, optics and medical monitoring systems, OSI Systems, issued a 5-year USD 250m convertible bond at 1.25%. And, following last week’s issue of a convertible bond, Severstal returned to the market with a 4.5Y USD 500m straight bond priced with a 3.85% coupon. Elsewhere, Aperam was raised to Investment Grade (Baa3/Stable) by Moody’s, reflecting the company's strong cash flow generation and low leverage.

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