Investors focus on US-China trade talks

Market analysis - 11/15/2018

The equity market rebound continued but with a little more volatility. The unsurprising US midterm results reassured investors. Any other outcome would have worried them.

A Republican clean sweep would have allowed the Trump administration to prolong tax cuts, a reflationary element at a time when concerns over economic overheating are mounting. And a similar Democrat victory would have fuelled uncertainty over the fate of Donald Trump’s previous reflationary measures.

As it is, markets can now focus on a resumption in US-China trade talks. This will be key to future market directions as some of the recent rebound was based on them resuming. Elsewhere, the European Commission has asked Italy to revise its budget draft to avoid the deficit running out of control. Rome has so far refused to budge. And with Brexit talks hotting up, the coming weeks should provide us with a clearer picture.

Political issues are likely to dominate markets up to the end of the year but note that China’s October composite PMI fell to 50.5, an indication that the economy is slowing faster than expected. President Xi Jingpin is now openly expressing concerns over the slowdown. Italy’s latest data also point to a sharper downturn than in the rest of Europe. This is problematic as Target2 balances also show capital outflows from the country. Any return to stagnation in Italy would only exacerbate its budgetary woes as the government would come under political pressure to go for economic stimulus. 

  European equities

European markets reacted favourably to US midterm results which rebalanced the Congress. The mood was reinforced by Germany’s industrial production for September which rose by 0.8%, or more than expected.

As the earnings season progresses, like-for-like results have risen by a robust 5.6% on average but margins have been under pressure due to energy and commodity prices rises. Performance has been very varied between sectors. Autos have fallen sharply due to WTLP standards and an overall drop in production while industrial cyclicals, apart from civil aviation, and luxury have lost steam even if sales are still at high levels. Continental’s third quarter results were in line but the group lowered its market guidance for the end of 2018. BMW disappointed due to WLTP, currency effects and higher R&D while Ferrari's net results fell short of consensus expectations due to currencies and a less favourable product mix.

However, consumer staples enjoyed more visible growth, partly due to Asia for businesses linked to luxury items like spirits and cosmetics, but also because of robust consumer trends elsewhere and higher prices. Ahold gained from this trend in the US and in most European companies with excellent like-for-like growth and EBIT.

Pharmaceuticals, in particular, saw sales accelerate. Within the sector, Fresenius Medical Care rebounded sharply after California voted against capping reimbursements of dialysis treatments.

In financials, Crédit Agricole and Société Générale posted upbeat results with a lower-than-expected cost of risk. LCL’s results offered confirmation that its French retail banking arm was on an uptrend. In Italy, Intesa Sanpaolo’s operating profits improved while UniCredit, despite underlying strength, fell after a €150m writedown on its Turkish exposure. Its solvency ratio also declined on currency effects and wider Italian bond spreads. 

  US equities

The S&P500 rebounded by 3% and the Nasdaq by 2.4%. The US mid-term results were as expected with the House of Representatives now under Democrat control and the Senate still in the Republican party's hands. Republicans, in fact, did better than expected in the Senate and this augurs well for Donald Trump’s deregulation drive to be reinforced. As for the legislative agenda, draft bills on issues like infrastructure and drug prices might see bipartisan compromises in 2019. As expected, the Fed left its rates unchanged and reinforced the likelihood of another hike in December.

As the earnings season nears its end, 77% of the 75% of S&P500 companies to have reported have beaten expectations. Energy stocks have done particularly well with operational cash flow in excess of investment spending but consumer stocks have disappointed. Coty and Kors, for example, fell heavily on their results. As Canada’s Bombardier showed, the slightest disappointments or doubts on the future were met with heavy selling. Apart from mention of a little more pressure on margins from wage costs and commodities, there were no real changes in company comments on growth prospects.

The post-election rebound saw hedge funds betting on the same themes as before but with less conviction this time. Healthcare and financials led rises while energy and consumer staples lagged. 

  Japanese equities

Japanese stocks rebounded after the US mid-term elections sent the VIX index, an indicator of US market volatility and investor sentiment, lower. The TOPIX gained 1.36% for the week.

Unlike the one-way trend in October, stocks gradually began to reflect company fundamentals again in November as market volatility eased and third quarter results came in. So far, earnings have been mixed.

Rakuten surged 10.42% on stronger profits and Eisai soared 8.29% after the company revised 2018 guidance higher. Oil & gas producer Inpex (+4.28%) and Daiwa House Industry (+5.65%) also rose on upbeat earnings. Mining, Pharmaceuticals, Electric Power & Gas, Services and Real Estate outperformed.   

On the other hand, Rubber Products, Precision Instruments and Machinery underperformed. Bridgestone lost 1.78% on a lacklustre earnings outlook and Kyocera shed 4.82%. FA pneumatic control equipment manufacturer SMC lost 5.76% after revising guidance lower for 2018 on concerns over a cut to spending on capex. SUV auto producer Subaru fell 7.17% on disappointing news of recalls. 

  Emerging markets

The China Banking and Insurance Regulatory Commission (CBIRC) is asking banks to support the private sector. At least one third of new corporate loans should go to private sector companies for big banks, two-thirds for mid-small sized banks, and 50% of new corporate loans should be used to support private companies in the next 3 years.

Export trade number growth remained resilient at 15.6%, led by exports to the Asian Pacific regions, but slowing US demand became more visible after tariff hikes in the third quarter. China’s domestic automobile sales continued to slow and CAAM now estimates a 20% drop YoY in October, the fifth month of contraction. It could result in a full-year drop.

Companies reporting their third quarter results remained cautious on the economic outlook: Alibaba cut full-year revenue guidance by 4% to +50-53% YoY amid macro uncertainties and the postponed monetisation of newsfeed products; Ctrip reported inline results with 15% topline growth but the bottom line fell back into the red. Guidance of 15-20% revenue growth for the fourth quarter was underwhelming as margin improvements will be slow due to international expansion.   

In a short holiday week in India, domestic equity flows increased 11% MoM in October, an incrementally positive factor given current liquidity constraints.

In Mexico, a local newspaper said a senator from AMLO’s party was unexpectedly preparing a bill that would ban certain banking fees. Walmex’s same-store sales increased by 3% YoY in October, below consensus expectations of +5.5%, partly due to calendar effects. The news arrived just one week after the referendum vote in favour of cancelling Mexico City’s new airport project.

Brazil’s October inflation was lower than expected. Banco do Brasil saw ROE rise from 11.8% to 13.2% in the third quarter with EPS up 26%. Randon beat expectations by 35% due to operational leverage and currency depreciation effects on exports. Credicorp reported upbeat results due to 10% loan growth and management left guidance unchanged. Bancolombia, as expected, reported weak results, driven by higher provisions. Management provided guidance with a better outlook.

In Russia, CPI rose 3.5% YoY in October, undershooting consensus expectations while food inflation continued to rise to 2.7% YoY vs. 2.5% in September.

Ahead of the G20 summit, Argentina and China have signed a currency swap for another $8.7bn, taking the total amount to $18.7bn. 

  Commodities

In only one month, Brent crude prices have fallen from $85 to $70. Oil futures showed the curve shifting from heavy backwardation to a flattening and even a contango on a 6-month horizon. This indicates that worries over short term supplies have evaporated, mostly due to the Trump administration deciding at the last minute to grant exemptions to its ban on importing Iranian crude. The exemptions concern 1.25 million b/d, essentially in China (360,000 b/d), India (300,000) and South Korea (200,000) with the balance spread between Japan, Turkey, Italy, Greece and Taiwan. The fact that China is included is interesting and might be interpreted as a good sign ahead of the G20 summit. All these countries will, on average, have to halve their Iranian imports over 6 months. The ultimate objective is still to scrap Iranian exports altogether.

However, falling oil prices have raised question marks over Saudi Arabia which, just after the US midterms, mooted the idea of OPEC cutting its production. So all the preceding talk, both in the US and Saudi Arabia, was only designed to get prices lower.

OPEC/non-OPEC countries are meeting on November 10/11 for the Joint Ministerial Monitoring Committee but we should not expect any major decisions to be taken. The meeting is scheduled to monitor each country’s production levels although other subjects could be discussed. Any big decision will be made on December 6 when OPEC holds its six-monthly meeting. We can expect a pragmatic decision depending on oil prices. The $70-80 bracket looks like the best news for both producers and consumers. 

  Corporate debt

 

Credit

The Xover tightened by 8bp over the week. Investors started the week in wait-and-see mode ahead of the US midterms and the Fed meeting. Markets advanced when the election turned out as expected with Democrats winning the House of Representatives and Republicans retaining control of the Senate. The Fed, meanwhile, confirmed its tightening trajectory. Concerns over Italy’s budget persisted. Eurozone finance ministers urged Rome to revise their draft and the Commission said Italy’s budget deficit would balloon if no changes were made.

Financials outperformed over the week. The EBA stress test results held no major surprises and showed banks were now in a more resilient position. Spain’s banks performed particularly well after the country's Supreme Court ruled in their favour over who should pay stamp duty on property sales and quashed worries that the proposed measure might have been retroactive.

Japan’s SoftBank saw sales rise 5.5% and EBITDA up 13.9% while UPC Holdings reported a 5% drop in sales and EBITDA down 7.9% due to competitive pressure in Switzerland. Telecom Italia released satisfactory figures but wrote down some assets in Italy and abandoned its goal of taking leverage to 2.7 times. Newlook (Caa2/CCC) improved its results: focusing on profitability hit sales but adjusted EBITDA soared by 106%.

After cutting its objectives back in July, Hapag-Lloyd (shipping) beat expectations with third quarter sales up 8.6%. The group now sees full-year results at the top end of its guidance spread. CMA CGM has not yet released its results but came under pressure after Moody’s downgraded its outlook from positive to negative, citing its acquisition of Ceva Logistics and the impact of US-China trade tensions. Cosmetic group Coty's bonds fell after results fell short again. Sales dropped 9.2% and operating profits tumbled 28% due in part to problems over logistics.

Nyrstar’s bonds lost ground after the group decided to shut down some of the Port Pirie plant in December to comply with lead emission constraints.

In new issues, administrative services leader Intertrust (Ba2/BB+) raised €500m over 7 years at 3.375%. 

Convertibles 

The European primary market revived with repeat issuer Qiagen, a life sciences and molecular diagnostics company, coming to market with a $500m 6Y 1% convertible to refinance its outstanding 2019 convertible after its cash conversion.

On the earnings side in Europe, Inmarsat disappointed with revenues down 6% YoY in its maritime division which is core to FCF generation. Adidas announced mixed guidance: the company raised its FY profitability target with gross margins set to reach 51.4% but lowered its FY sales growth guidance from 10% previously to 8-9%, citing lower than expected growth in Western Europe. SGL Carbon issued strong Q3 results with revenues up 24.3% YoY thanks to strong growth in its Graphite Materials & Systems division and boosted its FY sales growth guidance to 15% from 10% previously.

In the US, Twillio pushed cloud names higher this week after impressive quarterly results, the cloud communications company posted sales growth of 68% YoY and the shares jumped 33%. Microchip reported good Q2 results with better execution on the Microsemi integration, however the next quarter guidance of $1.4bn was below consensus due to weakness in the auto sector.

In Japan, Toray posted better-than-expected results as the company cut its FY operating income forecast by less than feared. It now sees JPY 160bn instead of 165bn due to increased costs in a new carbon fibre facility. The shares rose 4.5%.

 

 

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