The ECB goes for a gentle approach

Market analysis - 27/10/2017

Markets had waited for weeks for ECB clarification but were finally convinced by Mario Draghi’s latest post-ECB meeting comments. Asset buying will be extended until the end of September 2018 at least, a decision which reinforces the idea that an initial benchmark rate rise will be put back until 2019 and sent the euro lower against the US dollar.

The ECB has effectively maintained its conventional policy but extended QE for 9 months, albeit for less as asset buying will be reduced from €60bn to 30bn a month from January 2018. This cut will reduce the ECB’s problems in finding enough German bonds to fit the programme. 

Another crucial point was that the end to the programme would not be brutal which suggests a fresh reduction in the programme’s size before buying finally comes to an end. At the same time, forward guidance on benchmark rates was maintained with indications that they would remain at current levels for some time after the end of QE. All in all, the ECB has managed to stay in the driving seat while telling markets that it would be open to another extension in the event of any news that might depress inflation. Once again, the bank is respecting its mandate. 

The other big news over the week was Shinzo Abe’s victory in Japan’s early elections. His coalition majority won two-thirds of the seats and the Nikkei surged as investors applauded the fact that the Abe-Kuroda tandem and Abenomics had won another term. With markets rallying, we chose to trim equity market weightings. We are, however, still upbeat equities with a preference for the eurozone and Japan rather than the US and emerging markets. On bond markets, we remain cautious on interest rate sensitivity, essentially at the long end of the US and German curves. 

  European equities

After a slow, wait-and-see start to the week despite upbeat results, markets were reassured by the ECB meeting. But investors were agreeably surprised by Mario Draghi’s accompanying statements which were more accommodating than expected. 

The euro immediately lost close to 1.4% against the US dollar and European export stocks rose. 

In results, Nokia stood out with third quarter figures which looked good on the surface but which were, in fact, boosted by licence revenues. The company went on to deliver disappointing guidance for 2018 with restructuring costs that will be higher than expected. The recovery has now been put back until 2019 at the earliest and the group now sees mobile revenues falling 2-5% in 2018 when analysts were expecting them to be flat. Margins in the network business will be 8/10% vs. consensus expectations of 11% and the move to merge Nokia and Alcatel products will take longer than expected. The stock slumped by more than 15% on the news.

In contrast, STMicroelectronics (semiconductors) reported excellent figures with sequential sales growth up 11%. The group still expects double digit growth in the next quarter and a gross margin of close to 40%. 

The luxury sector continued to boast very robust results. Kering’s sales surged 27% mainly due to a spectacular 50% jump from Gucci

And the buoyant trend in IT services continued due to a recovery in corporate investment and moves towards digitalisation. Capgemini’s results were driven by an upturn in North America, a return to growth in the oil sector and strong momentum in industrials. Atos continued to grow even if the group said it had not seized every opportunity in the US; it now has plans to revamp its sales organisation there. Sopra Steria continued to benefit from a strong 17% surge in banking software. 

In construction, Saint-Gobain confirmed that business conditions had rebounded in France but said that not every division would be able to make up for rising commodity prices. Lafarge Holcim’s new executive team revised down 2017 and 2018 objectives. Adjusted EBITDA growth is now seen at +5/7% in 2017 and at least 5% better in 2018 instead of double digit advances for both years. Vinci struck a more upbeat note over trading and said its concession business in airports had been spurred by buoyant air traffic. 

  US equities

US markets were slightly weaker and most of the decline occurred last Wednesday. The S&P finished 0.5% lower. 

Estimated third quarter GDP was revised higher from 2.7% to 3%. A strong 2.2% surge in durable goods orders in September suggested corporate investment was on the rise. Elsewhere, the House of Representatives adopted the budget resolution which should pave the way for tax reform. The draft proposal should be submitted before Thanksgiving. 

There are a number of controversial subjects that could prove difficult hurdles like the SALT deduction concerning state and local tax breaks. But optimism that a tax bill will take shape caused the yield curve to steepen with the yield on 10-year Treasuries rising to 2.46%. 

257 companies have now reported third quarter results with 202 doing better than expected and 19 missing expectations. The aggregate EPS came in at $32.45, a 3.7% increase on the same quarter in 2016 and 1.15% better than expected. Several tech giants reported excellent figures. Amazon, Google, Intel and Microsoft all performed better than expected. Financials gained on yield curve steepening and the possible appointment of Jerome Powell to replace Janet Yellen as Fed chair which triggered fresh hopes of deregulation. 

Schlumberger advanced on rising oil prices and the group sounded more upbeat about its prospects. The group’s business has also rebounded due to market share gains in North America in hydraulic fracking and drilling services. The healthcare sector fell sharply after stocks like Celgene and Biogen plunged on disappointing results, a reaction that seemed a little excessive. 

Among S&P sectors, materials, financials and technology all rose over the week while the rest of its sectors underperformed. 

  Japanese equities

The TOPIX advanced 1.34%, boosted on Monday by Shinzo Abe’s landslide election which saw the ruling coalition retain its two-third majority in the Diet. The Nikkei 225 advanced for a new record of sixteen straight sessions, surging to over 21, 000 during the period. 

After a one day pause on Wednesday, the market rose further as investors bought on dips amid growing expectations of strong earnings for the first half of this fiscal year. 

By sector, the best performers for the week were Banks (+3.61%), Iron & Steel (+3.42%) and Insurance (+3.28%). Financials such as Daiwa Securities (+6.31%), Mitsubishi UFJ Financial (+5.76%) and Resona Holdings (4.73%) were buoyant, led by a rise in Daiwa’s shares on news of brisk earnings and a share buyback plan. 

Steel makers JFE Holdings (+5.92%), Sumitomo Metal Mining (+4.25%) and Nippon Steel & Sumitomo Metal (+4.11%) were also strong for the second week in a row. 

On the other hand, Retail Trade (-1.08%), Other Products (-1.04%) and Construction (-0.64%) were relatively weak. Shiseido Company fell 5.32%) and Ono Pharmaceutical ended 3.41% lower. Game maker Nintendo (-2.77%) fell on broker downgrades. 

  Emerging markets

There was some profit taking on emerging markets after 10-year Treasury yields rose due to the US tax reform proposals and uncertainty ahead of the ECB meeting. 

In India, the government unexpectedly unveiled a mega $32bn recapitalisation for state-owned banks over the next two years. This is good news in our view as it will accelerate NPL resolution. HDFC reported a good set of results. 

In China, TAL reported disappointing result. Despite strong 68% revenue growth and a doubling in enrolments, gross margins and profits came in below expectations. We believe this miss is temporary due to higher investments in learning centres, which should in time translate into higher profits. Management did a good job managing Selling, General and Administrative Expenses. 

On the macro side, industrial profit growth accelerated in September due to rising sales and higher profitability. 

In Indonesia, BCA reported results above expectations due to lower provisions. 

In Brazil, CCR reported stronger-than-expected results driven by traffic growth of 4% and tariff adjustments. Renner also reported a solid 13% in same store sales and a higher EBITDA margin. On the macro side, the current account continued to improve and the central bank as expected cut interest rates by 0.75bp to7.5%. The focus will now switch to what sort of reforms the government manages to get through Congress before the year end. 

In Mexico, Banorte surprised the market by announcing a merger with Interacciones. If approved, this will raise Banorte’s exposure to government business, which we view as a departure from the company’s guidance of prioritising the consumer segment. 

In Argentina, President Macri’s party, Cambiemos, did much better than expected in the mid-term elections. The central bank unexpectedly increased interest rates by 150bp.  

We remain upbeat on emerging markets. 

  Commodities

Oil prices rose for the third week in a row on a marked improvement in fundamentals. Brent crude ended the period around $59, a level not seen since July 2015. WTI traded above $52.5 or slightly below highs seen in January and February. The spread between the two is a still a high $6-6.5 which is good news as it will tend to limit any recovery in US shale oil fields. And on the same subject, the drill count fell by 7 last week, making 9 down weeks out of the last 10. There are now 736 rigs in activity which is 32 less than the high for 2017 last August.

Oil market fundamentals continued to improve: 

1/ demand remains strong with Chinese imports up by 1 million b/d to 8.9 million b/d in September. Year to date, imports have risen by an annualised 12%

2/ Indian demand was also robust (+10% YoY in September)

3/ Compliance with OPEC/Non-OPEC quotas was at 120% in the same month and

4/ global inventories are down sharply particularly in the US. 

Saudi Arabia remains focused on achieving inventory normalisation worldwide at the same levels as 5 years ago. So far, the cartel is keeping all options on the table for a possible extension of the cuts beyond March 2018. The CEO of Aramco, the world’s largest oil company, confirmed that its IPO would definitely take place in the second half of 2018. Its market cap could exceed €1,000bn. 

In the ongoing earnings season, Total and Statoil released upbeat figures showing that they could cover dividend payments with operating cash flow. 

Gold slipped $12/oz to around $1,267 as US long bond yields continued to rise on the possibility that the new Fed chair might prove less accommodating than Janet Yellen. Mario Draghi’s post-ECB meeting statements sent the US dollar higher and the gold price suffered. 

  Corporate debt

 

Credit

Investors waited for Thursday’s ECB meeting rather than reacting to uncertainty in Catalonia. Credit markets edged higher at the beginning of the week and spreads tightened while buyers appeared for core European government bonds. Mario Draghi's rather dovish tone then reinforced the trend and the Xover tightened by 4bp. 

Ineos (petrochemicals, Ba1/BB+/BBB-) raised €550m with a senior 8-year maturity. CBR Fashion (B2/B) raised €450m with a senior 5-year maturity and Takko €510m with a 6-year senior maturity in floating and fixed tranches. 

Most results in a busy week of reporting were positive. Plastic Omnium (BBB) saw sales rise 5.5% and 7.8% like for like. The autos sector is enjoying organic growth and SCR systems to reduce diesel engine pollution are gaining ground globally. FCA (Ba3/BB) reported third quarter results which beat expectations: sales rose 2% on a constant currency basis and adjusted EBIT jumped 17%. The improvement concerned all segments and the group reiterated its full-year guidance. Ovako Group AB (B3/B-) also beat expectations with sales up 19%. Eurofins (BB+ estimated) saw sales surge 16.2% YoY, mostly due to growth in Germany and North America. 

Bombardier was downgraded by Moody’s from B2 to B3 and the outlook was cut to negative, thereby sending its bond ratings into Caa1. Moody’s said the group’s leverage was high at 14 times as of end June 2017 and worried that it might struggle to return to positive cash flow in 2019 which is the official target.

Convertibles 

The convertibles market had a volatile week amid a flurry of earnings reports.

In Europe, Outokumpu disappointed investors with weaker-than-expected third quarter results. EBITDA came in at €56m, missing expectations owing to on-off supplier issues in the Americas division, the timing of inventory revaluation and raw material hedging. Nonetheless, the company cited strong underlying consumer demand for stainless steel. Covestro posted solid results with EBITDA up 50% YoY owing to a very strong pricing environment in polyurethanes. In addition, the company surprised the market by announcing a share buyback programme for up to €1.5bn.

Ceconomy reported good third quarter numbers with like-for-like sales up 5.8% driven by a 21% surge in online business. 

In the Middle East, port operator DP World reported upbeat third quarter results with volume growth accelerating to 9.3% on a like-for-like basis despite trade restrictions with Qatar. 

In Japan, medical technology manufacturer Terumo preannounced good fiscal first half results and reiterated its forecast for the full-year despite the as yet unquantified impact of Hurricane Maria on its neurovascular operations in Puerto Rico. Meanwhile, Mitsubishi Chemical revised up its fiscal first half and full-year guidance owing to a strong pricing environment for its core MMA product and strong showing by its Performance Products business which manufacturers engineered plastics and battery materials. 

In the US, Teradyne reported good results with both third and fourth quarter guidance ahead of expectations owing to the company’s strong performance in SoC and memory testing. However, there was weaker performance from spinal hardware manufacturer, Nuvasive, and online travel agency (OTA), Expedia, both also hurt by the severe US hurricane season. Nonetheless, both signalled confidence in their underlying businesses, Nuvasive by confirming 2018 guidance and a $100m share buyback programme and Expedia by accelerating marketing spend particularly to support continued outperformance in its HomeAway business. 

On the primary market this week, BASF tapped its 2023 convertible bond issued in March for $250m. Elsewhere two Chinese companies listed in the US came to market as first time issuers: Weibo issued a $800m 1.25% 5Y convertible to finance potential acquisitions and China Lodging Group announced a $425m 5Y convertible with a pricing range of 0.5-1% to refinance its credit facility.

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