Fed rate hike is fully discounted by the market

Market analysis - 3/10/2017

All eyes were on the ECB’s monetary committee meeting last Thursday and on the looming FOMC meeting on March 14/15. Last week, Janet Yellen’s comments reinforced investor expectations that rates would rise next week.

The ECB, however, left rates unchanged and confirmed that its asset purchasing programme would remain in place until December as it is an essential tool in the effort to underpin medium term inflation. The bank reasons that February's 2% was largely due to higher energy prices and that underlying inflation is still low. Even so, Mario Draghi was more upbeat on the economic environment and risk balances. The ECB has consequently raised its macroeconomic forecasts and now sees growth reaching 1.8% in 2017. Government bond yields subsequently rose both in Europe and in the US. Equity markets started rising again, led by banks. 

As a result of economic fundamentals and upbeat company results, we are still confident for medium term equity market trends, especially in Europe. But with risk aversion at a low and various elections in the offing, we have tactically reduced exposure and adopted a more balanced investment profile. In fixed income, we remain cautious over duration but are overweight financial bonds which we see benefiting from the sector's improving profitability and the ongoing steepening in the yield curve. 

  European equities

The 2016 earnings season continued as markets headed north led by financials and telecoms. Commodities and energy, however, retreated. After a strong start to the year, base products are no longer the best performing sector year to date. Investors were reassured when the ECB said there would be no rate hike in the near future and no change to its asset purchasing programme. 

Adidas has risen more than 10% in a week after its upbeat results triggered an earnings upgrade. Elsewhere, the picture was more mixed. The good news came from Linde which saw margins expand across all regions, Dassault Aviation which offset weak company jet sales by military sales, and Iliad which increased its fixed and mobile subscriber bases more than expected. Disappointments included, once again, French food retail plays like Carrefour (which is hoping to list its Brazil division this year) and healthcare. Novo Nordisk has dropped its patient targets for 2020. 

In a busy week for company news, Deutsche Bank said it was to issue EUR 8bn in new shares while reintegrating Postbank and EDF unveiled a EUR 4bn increase of capital, with the French state contributing EUR 3bn. 

In M&A, Peugeot will pay EUR 1.3bn to acquire Opel from General Motors (along with EUR 450m for its captive finance unit) and Standard Life is to merger with Aberdeen in a GBP 3.7bn nil-premium deal. PPG Industries has bid EUR22bn in enterprise value for Akzo Nobel but the approach has been rebuffed. Intesa sold 50% of its AllFunds affiliate, Crédit Agricole is mulling the sale of its 31% stake in the Saudi Fransi bank and Royal Dutch Shell has raised USD 7.25bn from the sale of its Canadian oil sands assets.  

  US equities

Markets consolidated with the S&P500 dipping 0.7%. Macroeconomic data remained upbeat with January’s industrial orders rising 1.2% and ADP reporting close to 300,000 job creations in February, or much more than expected. 

In company news, Hewlett Packard bought data storage specialist Nimble Storage for around USD 1bn. ExxonMobil reinforced its position in natural gas by paying USD 2.8bn for Italian major Eni's Mozambique assets. 

This week’s biggest disruptive element was the steep fall in oil prices. US crude inventories, as defined by the US Department of Energy, increased by 8 million barrels to 528 million. The news forced down WTI prices and sent energy stocks 3% lower over the last 5 trading sessions. Only healthcare and technology eked out positive gains. 

  Japanese equities

The Japanese stock market failed to maintain upward momentum ahead of the US jobs report. The TOPIX ended the week 0.6% lower after an uptick on Thursday thanks to the yen depreciating. Auto shares rose on growing expectations for better earnings due to the weaker yen and the heightened possibility of a US rate hike next week. 

The best performing sector was Other Products including Games (+3%) while Real Estate sank 1.9%. 

Nintendo jumped 7.8% as early sales of its new “Switch” console released on March 3 were said to be strong. 

Suzuki Motor Corp advanced 4.8% on optimism for higher sales in India. This followed reports that its chairman and Toyota Motors’ CEO had held a meeting with India’s Prime Minister Narendra Modi. Both auto producers forged a business alliance in February. 

Nitto Denko Corporation, a manufacturer of optronics and industrial tape, tumbled 6.6% over six straight days due to selling pressure as investors took profits following almost uninterrupted gains since the end of September 2016. 

  Emerging markets

Emerging markets underwent a more pronounced correction this week, mostly on the back of falling commodity prices. But reassuringly the US dollar did not appreciate much. Currencies, like the Brazilian real or Russian ruble came under pressure, but overall this looked more like a pause for breath after a good start to the year. 

Markets like the Philippines, down 1.4% this week, also faced specific issues like an unexpectedly high inflation figure for February. It spiked 3.3% YoY, up from 2.6% at end 2016, but was due to very robust domestic demand. Food inflation, a key component of the total figure, rose by 4.1% YoY. This will probably lead to a deficit in the current account in 2017, adding pressure on the currency which in turn may mean more monetary tightening. The central bank’s next policy meeting is expected on March 23 and rates will remain on hold at best. 

Other emerging countries like China, Brazil, India or Indonesia are not seeing the same capacity constraints and their inflation is consequently not subject to the same worrying trend. Different paths are emerging among these markets for 2017.

 As a further illustration of this, China’s February inflation came in much lower than market expectations, at +0.8% YoY vs. +2.5% in January. This was due to a sharp 4.3% decline in food prices YoY while production price inflation came in above market expectations at a strong 7.8% YoY, a positive development for corporate profits. 

In Mexico, consumer confidence recovered in February from a very weak January. This is good news as it shows that the large double-digit increase in petrol and gas prices, which affected consumers confidence in January and triggered social unrest, is gradually being accepted. 

  Commodities

Oil prices slumped with WTI and Brent crude losing close to 7% in 2 sessions and revisiting levels not seen since OPEC unveiled a production cut on November 30 2016. The fallback was remarkable as price volatility had been very low since that date. The move down was prompted by a fresh rise in US weekly inventories, up for the 9th week in a row to a new record, and also by comments from OPEC countries refusing, for the moment, to commit to further production cuts after the first half of 2017. Neither news item was surprising. Refineries are undergoing annual maintenance and therefore using less crude and turning out fewer oil products. This increases crude inventories but causes petrol and distillate stocks to fall.

As for OPEC, it is still too early to gauge the impact of production cuts on global inventories. In fact, rather than looking at US inventories alone, we should be scrutinising the global stock picture. The IEA’s next monthly report on March 15 should indicate where global inventories were at the end of January. Nevertheless, in a market where traders were speculating on further rises, the initial price drop was aggravated by stop-loss limits. The market needs to find a new balance but the fundamentals are sufficiently healthy to ward off a big drop. And the IEA’s medium term outlook suggests demand will rise by a significant 1.2 million b/d by 2020 while supply side pressure should increase from 2018 if non-US investment remains at today’s low levels. 

The gold ounce also retreated, moving back below USD 1,200/oz for the first time since the end of January; the probability of a rate hike at the next FOMC meeting is now fully discounted by the market. Note that previous announcements of rate increases, in December 2015 and December 2016, occurred when gold was trading at lows of USD 1,051 and 1,128 an ounce respectively. 

  Corporate debt

Credit

High yield markets fell back as ETFs led profit taking. The iTraxx Over widened to 283bp at the end of the period. The ECB left monetary policy unchanged on the grounds that current inflation was mainly due to higher oil prices. At the same time, the bank said it was happy to report that deflationary risk had disappeared. 

Investor appetite for new issues focused on single-B rated companies with attractive coupons. Hence the enthusiasm for a EUR 400m from Nyrstar (Caa1/B-) at 6.875% and due 2024 and for a tap from Salt (B2/B) which returned to the market with two bonds for CHF 485m over 5 years and CHF 200m over 6 years. Among double-B companies, Nemak (Ba1/BB+) raised EUR 500m with a 3.25% 7NC4 bond and Nokia sold two maturities, a 1% EUR 500m 2021 and a 2% EUR 750m 2024 to refinance existing bonds. In financials, UBI Banca sold a EUR 500m subordinated Tier 2 bond. 

In full-year reports, Casino (BB+) reported a 2% rise in sales and a 3.7% increase in operating profits to EUR 1.03bn, both in line with expectations. It was the same story for Altice (B1/B+) which posted particularly strong performance in the US. Sales rose 2.7% to EUR 6.1bn and EBITDA jumped by an impressive 15.7% to EUR 2.29bn.

Convertibles 

The convertible bond primary market remained active with 3 new deals.

In the US, Pacira Pharmaceuticals (post-operation pain management drugs) issued USD 300m in 2.375% convertibles due 2022 and will use some of the proceeds to refund the existing 2019 convertible through a combination of cash and shares.

In Europe, repeat issuer Rag-Stiftung came to market with EUR 600m in six-year bonds exchangeable into German chemicals company Evonik’s zero coupon issued at 104%.

In Japan, logistics company Senko issued JPY 10bn in zero coupon convertibles. 

In earnings news, Dassault Aviation slightly missed EBIT margin targets but delivered a positive outlook for 2017. The group is confident on Rafale exports but still prudent on business jet sales. Adidas released robust fourth quarter results with strong 29% growth in the US and a 2% EBIT beat. The company increased its 2020 guidance and now expects 10-12% in top-line growth. The shares jumped 12%.

In the US, fibre optics company Finisar disappointed investors with weak quarterly results that fell short of both the top and bottom lines. Management cited technical headwinds in CFP module production. Elsewhere, Sony’s credit rating was once again upgraded (from BBB- to BBB) but this time by S&P.

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