The world economy is gradually deteriorating and things are getting worse in a turbulent political environment. This was evident in the latest developments in the trade conflict between the US and China, when on 10 May Donald Trump introduced a further increase in customs tariffs, which China was quick to respond to. In reality, the tariff war is a red herring and the conflict between the two nations is over technology. It is set to last and is likely to cause a crisis of business confidence, as illustrated by the US ban prohibiting Google access for future Huawei smartphones. At the same time, the World Trade Organization (WTO) has sounded the alarm, revising down international trade growth for 2018 and 2019 and forecasting that this will be accompanied by a worldwide industrial slowdown.
Growth figures in the first quarter were surprisingly high, but they should be viewed with caution.
We remain pragmatic. Growth figures in the first quarter were surprisingly high, but they should be viewed with caution. In the US, growth stood at 3,2% in the first quarter of 2019, but this figure should be qualified, as it conceals sluggish consumption, especially of consumer durables, a slump in imports and high levels of company inventories. In May, the minutes of the FOMC meeting revealed that members of the Fed are discussing the possible composition of the institution’s balance sheet so as to be able to adequately respond to a potential economic slowdown.
In China, growth reached 6,4% in the first quarter. This is admittedly a positive surprise, but does not resolve all the difficulties China has been facing over the past few months, including a dip in industrial production, a gradual fall in retail sales and struggling consumer durable consumption, as reflected in the continuous drop in car sales to individuals since July 2018 (according to the website China Automotive Information Net, car sales decreased by 17% in April 2019). And these disappointing figures were published even before Donald Trump hit China with further sanctions. We can therefore expect more economic difficulties from China.
In Europe, the growth rate is as forecast, at 0,4% quarter-on-quarter and 1,2% year- on-year.
That said, we have noted some worrying signals, such as the general downward trend in the purchasing managers’ index (PMI) for both manufacturing and services. Germany has felt the effect particularly strongly in its industrial sector, as its manufacturing purchasing managers’ index stands at 44,3, falling far below 50, which is the limit between economic contraction and expansion. This is the first time in two years that unemployment has risen (60,000 more unemployed in April). Although there is no objective reason to start panicking, this marks a break with the conditions seen until just recently, which included a labour market that was "solid" in spite of discouraging macroeconomic figures.
Across the globe, increased trade tensions and lasting industrial weakness prompt us to maintain our prudent allocation by underweighting equities. We are opting for a defensive positioning in bonds, as the correlation with the equity markets has convinced us to underweight credit to companies issuing bonds in euros. We also reduced our exposure to cyclical sectors, switching from overweight to neutral for the energy sector and from neutral to underweight for the information technology sector, and particularly the semi-conductor segment, which is highly dependent on how healthy the global economy is.
Do things your own way in May.
The period from 30 April to 24 May was far from memorable in terms of returns calculated in euros, which were all in the red, with -3,74% for the MSCI World index, -4% for the MSCI Europe index, - 3,88% for the MSCI North America index and -8,48% for the MSCI Emerging Markets index.
Stock markets had been rebounding strongly since the start of the year but stalled in May. This consolidation phenomenon does not necessarily need to be a major concern, however. We believe that it should be put into perspective and that the actual facts should be remembered, such as the gains on the main stock markets, amounting to 15% since the start of the year. This can be seen all over the world, as emerging market gains have also risen by nearly 5%, despite the sharp fall in May.
Actually, it is their riskier profile that makes the emerging markets more vulnerable to shocks, as in periods of upheaval there is a flight to quality by investors wishing to divest themselves of riskier assets in favour of safer, higher quality assets. They are also feeling the full brunt of the tariff war and the strong dollar, which is making exports and debt in foreign currencies more costly.
From a geographical viewpoint, the US is hanging in there, maintaining its position as a flagship market, with the buoyancy of its economy showing no signs of faltering and its labour market continuing to be a model of robustness. This can be seen in the GDP growth and unemployment figures for the first quarter of 2019, which came to 3,2% and 3,6% respectively. The icing on the cake is the Fed's more conciliatory attitude, which should maintain abundant liquidity, supporting the markets through a knock-on effect.
The financial markets may have been restless in May, but this is for a number of reasons. Firstly, the month was true to its bearish reputation. As the saying goes, "sell in May and go away", and some investors preferred to jump ship, driven by returns worthy of annual earnings generated in just a few months. Secondly, international trade is hardly in good shape, as relations between Beijing and Washington became increasingly hostile against a backdrop of customs tariff hikes and a decree prohibiting the use of certain foreign devices, especially from China. Finally, some lead indicators, such as the US purchasing managers’ composite index, confirmed a slowdown in economic activity, with a figure of 50,9 this month, versus 53 last month.
It can’t be denied that the environment is still risky and threatens to usher in a return of volatility, as the Brexit situation has not yet been resolved, the tariff war is in full swing, there are high political tensions in the Middle East and the financial position of some emerging countries is alarming. We are therefore persisting with our prudent approach to the equity markets and are endeavouring to reduce our portfolios’ volatility.
In terms of sector recommendations, we continue to favour communication services and real estate. We decided to further reduce the portfolios’ cyclicality by decreasing our exposure to oil stocks and the most cyclical segment of the IT sector, namely semi-conductors.
Our geographical preferences:
We have maintained our neutral exposure to the manufacturing sector. We recognise that the macroeconomic environment is complicated. Since the start of 2018, lead manufacturing indicators have been falling, reflecting the wait-and-see attitude of the sector given the many risks it faces: the slowdown in global economic growth, the conflict between the US and China and political risks in Europe are all factors weighing on investment decisions.
However, there may be a light at the end of the tunnel: it remains to be seen whether the recovery of most of these lead indicators in March is a secondary effect or simply the start of a new, more favourable cycle. In any event, the sector valuation remains reasonable at current levels, which justifies our conviction that the potential risk/return profile is currently balanced.
Interest rates are admittedly low and central banks’ monetary policies are accommodative again. We still prefer to be underweight the sector, however, as it continues to suffer from the secular trends weighing on energy prices (due to the development of renewable energy) and energy consumption (greater energy efficiency) as well as the rates of return on regulated activities (interest rates stabilised at low levels). All these factors are tending to limit the potential growth in earnings, and especially dividends. The sector is also trading at valuation levels that are not in keeping with its low growth rate.
The issues of drug prices and the inefficiency of the US system have returned to the spotlight, which is set to weigh on valuations. Furthermore, the sector’s growth should suffer as a result, as the majority of labs generate a large share of their income in the United States. Innovation is also not supporting the sector as much as it used to. Valuations already partly price in this scenario.
Valuations are still attractive. We are nonetheless maintaining our neutral view of this sector given the current economic slowdown. The various institutions’ world growth and inflation forecasts have been revised down, which is likely to affect the banking sector. In addition, rates are expected to remain close to zero for several more quarters, which should have an impact on banks’ profitability. Even in the US, banks are no longer expected to benefit from rate hikes by the Fed as they have in recent quarters.
Real estate: overweight
In an environment in which rates are unlikely to significantly rise, we believe that the real estate sector could generate good performances. Property companies have the option of implementing acquisition strategies at a low cost while benefiting from the increase in the valuation of their asset portfolios. From an operational perspective, they have managed to withstand competition from e-commerce after restructuring their asset portfolios, which can currently be seen in the rent increases achieved during commercial lease renegotiations. Lastly, the sector offers high visibility thanks to its commercial leases negotiated over several years, which is a positive factor in the context of a slowing economy.
Consumer staples: neutral
We have opted for a neutral recommendation as stocks in the sector are trading at reasonable valuation multiples, reflecting the moderate growth profile of the sector’s companies. Food inflation is also picking up again, encouraging the sector’s largest operators to raise prices. Unfortunately, competition is intensifying, which should put pressure on margins. Many companies have also announced the launch of investment programmes to improve their growth profiles. This will have an impact on short-term cash generation without any certainty that returns on investments will be adequate.
Our sector preferences:
Consumer cyclicals: neutral
Valuation multiples reflect highly optimistic scenarios despite consumer confidence indicators losing ground. The sector still benefits from wage growth and the solidity of the labour market. Nevertheless, certain risk factors, such as protectionism, are making future results less predictable. We therefore prefer to opt for a neutral stance.
Communication services: overweight
This new MSCI sector was created at end-2018 to bundle Telecommunications stocks with select IT and consumer cyclical sector stocks (such as Google, Facebook, Netflix and Walt Disney). The composition of this sector is particularly mixed, benefiting from a defensive anchoring thanks to telecommunications companies and a "growth" factor associated with tech companies. The common denominator of these companies is that they are focused on content, as well as the networks transporting this content, which is consumed by individuals. The sector is buoyant, as consumer demand for content is growing and this supports investment requirements. Against the current backdrop of economic uncertainty, we expect this sector to outperform the benchmark index due to its defensive nature combined with sustainable growth. We therefore increased our exposure to this sector in May.
The IT sector’s underlying indicators are particularly good. IT expenditure is reaching historically high levels and is supported by secular trends affecting the whole economy. The sector is less cyclical than in the past due to this environment. Despite these encouraging factors, our view of the semi-conductor segment of this sector is negative. Firstly, stock valuations are reaching high levels compared to historical averages. Secondly, several final markets (computers, cars and smartphones) are showing growing signs of fatigue, which threatens to weigh on the potential value creation for shareholders.
We remain cautious with regard to this sector as the bases of the chemical industry’s cycle lack stability, due to declining vehicle sales, a slowing real estate market and a fall in international trade. Lastly, the strong dollar poses a risk to emerging markets and is creating a situation in which the potential demand on those markets could fall.
The sector is trading at very attractive valuations, especially if we take into account current oil prices and geopolitical instability. Despite this, we have reduced the portfolio’s exposure to the sector because of its sensitivity to the economic cycle, which applies especially to US stocks. Investors fear that falling oil prices could trigger a de-rating of the sector due to a knock-on effect.
On the credit market, May saw a fairly continuous rise in risk premiums, as macroeconomic and geopolitical fears trumped the search for yield. Last month we referred to the fact that the strong performance of credit had until then been contradictory given the economic environment. The fall in demand seen in May is therefore unsurprising. European bond yields in fact returned to lower levels than before quantitative easing was introduced and to levels similar to when the Central Bank was at its most accommodative.
Since then, however, investors’ fears have increased, as the European economy has slowed, followed by the Chinese economy, and international tensions have intensified. This has driven investors to reassess the situation and therefore risky assets. On the other hand, this state of affairs is hardly new, so why have the effects been felt recently? Firstly, the Chinese economy still seems to be in poor health, despite the many measures taken by the government to give it fresh momentum. Demand in the country has in fact weakened, as have its imports. At the same time, the US economy reported a contraction similar to the German economy when it published its purchasing managers’ index. And the last factor, but not the least, is that geopolitical tensions are making a big comeback in the Middle East, and particularly in Iran.
Investors’ fears coming true has therefore had a major impact on them, explaining the higher risk premium. We believe that this should continue or even intensify in the coming months, as long as uncertainty remains regarding the outcome of the China-US tariff war.
Sovereign yields and bonds
As the continued strength of European and US economic growth hung by a thread, the escalation of the trade war between the US and China exerted significant downward pressure on yields for sovereign bonds, which are viewed as safe haven securities.
In Germany, the sharp downward revision of the country’s growth forecast by the European Commission, combined with the raising of customs tariffs on Chinese goods by the US, did not prevent a further fall in the 10-year Bund’s yield into negative territory. Despite GDP growth of 0,4% in the first quarter of the year, investors still seem wary and fear that the German economy may slow for the rest of the year.
In the US, industrial production is losing ground and investments are showing signs of faltering in an environment where there is little sign of an inflationary risk emerging. We therefore predict that the Federal Reserve’s governors will extend the pause in key rate hikes over the coming months.
Finally, in light of the environment, in which inflation expectations are barely rising, and given that the trade war threatens to drag on, we are reiterating our neutral positioning in sovereign bonds.
In May, the euro dropped to 1,1129 against the dollar, given investors’ flight to the US following disappointing economic data from the eurozone. Although the US macroeconomic data were less pleasing than in the past, investors still put more faith in assets denominated in dollars.
If we believe the market, the Fed could cut its interest rates again, as US inflation is at rock bottom and the superpowers are at daggers drawn over trade. As the President of the Federal Reserve Bank of Saint Louis, James Bullard, explained, the trade tensions are a real threat to economic growth on a global scale. The euro has appreciated sharply as a result of this situation, which has pushed up the exchange rate to 1,1240 against the US dollar.
Given the relatively stable interest rate spread between the eurozone and the US, we believe that the euro will not fall below the 1,12 threshold, as investors have already factored in a flow of economic data arriving straight from the eurozone that are far more depressing than they are in reality. The euro could benefit from this, but that depends on what the Fed announces next, which we will be watching closely. If the Fed decides to start cutting interest rates, the dollar will weaken. Otherwise, the euro should experience a limited rise.
In our scenario of a return of volatility to the equity markets, gold as an asset class is likely to perform well. This strong performance would mainly be due to its status as a safe haven offering security and the preservation of value over time. This is proven by the change in its price between October and December 2018, a period when gold gained 7,5% (in dollars), which gave thesector’s mining companies a 14% boost.
There have been many short contracts that have limited the rise in the price of gold. That said, this asset class is still supported by very strong demand, especially from central banks, which are quite willing to increase their gold positions to diversify their currency reserves in order to anticipate and protect their countries from economic and geopolitical risks.
The range that we forecast for an ounce of gold is therefore between USD 1.280 and 1.350.
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