Weekly Wrap Feb 17: More confusion in French elections

Its once again a difficult environment to be investing in. This is such a trite statement, but it recalls historical conditions which have been regarded as difficult.

In the US, companies and analysts have become more optimistic about growth prospects going forward. The 2017 EPS growth estimate stands at 10.2%. The number of companies beating estimates (Q4 2016) has, however, slowed to below the 5 year average. The 12 month forward PE for 2017 is at 17.6, the highest since 2004. Credit spreads have also tightened considerably in the last 12 months, really to the low end of their historical ranges, mirroring the valuations in the equity market. So there is a lot of hope and expectation built into the US equity market. There is some justification for that hope as globally, growth is rebounding. PMIs, industrial production and manufacturing production have been trending positively, and inflation has also been rising into what is considered a healthy range. That said, protectionism and geopolitical risk hang over the global economy.

Macro:

In China, CNY loan growth moderated while TSF continued to expand. This is evidence of the PBOC attempting to cool the economy, as we have seen in its administrative measures and repricing of repo. The divergence illustrates the difficulty of controlling credit in an increasingly complex and maturing economy. We expect further tightening from the PBOC to moderate the sharp increase in credit in 2016. Control is most immediate in CNY loans and most fluid in shadow banking channels such as trust loans and bank acceptance bills.

And in the run up to the French elections, more confusion. The left threatened a joint candidacy on Friday before Hamon and Melenchon traded barbs. Emmanuel Macron’s attempts at conciliatory rhetoric regarding French rule of Algeria (which ended in 1962) was regarded as unpatriotic. And finally Marine Le Pen caught up with Francois Fillon by being accused of misuse of public funds. French bonds spread over bunds widened.

Equities:

Equities continued to climb as investors remained risk on.

Economic growth is rising globally as the manufacturing sector recovers from the side effects of the trade war. Also, global trade has recovered, even if such recovery may be a temporary respite in a more deep seated de-globalization trend. Nothing goes in a straight line.
Investors had held too much cash in late 2016 and have been slow and steady at redeploying.

What are the prospects for equities? Generally, momentum trumps value in the short term while the converse is true in the long term. What equities have in their favour is that economic growth is readjusting to the new phase in the trade cycle and is likely to accelerate.

General conditions are good and equities should benefit on a broad base.
Countries with large consumer bases will benefit. China and the US are stand out examples. However, valuations are stretched in the US.
Small caps which are more domestically focused and less impacted by complex regulation should benefit more than multi nationals and exporters.
There is a renaissance in luxury companies.
Energy, metals and mining to benefit from the new phase in manufacturing and trade.
Dividend stocks and bond substitutes like defensive sectors, REITS, telcos and utilities are likely to suffer from their perceived duration characteristics.

Bonds:

The growth scenario under Equities has the same constructive implications for credit, however, they also imply pressure on duration. The optimal trade expressions involve buying bonds and hedging their duration. In fact, value has shifted from HY to IG as HY spreads have tightened aggressively. The difficulty with trade expression here is that a long IG short duration trade is too capital intensive for investors who cannot buy unfunded exposure.

One natural trade expression is an outright long position in leveraged loans. Leveraged loans were very much out of favour in 2015 but came roaring back in 2016 especially when the Fed began to signal more hawkishness, when Trump won the election and when LIBOR broke the 1% floor. Unfortunately, the flood of retail money into loans has taken loan prices close to par, and in the case of performing loans, above par. Loans are par assets with constant call or repricing risk.

US non agency RMBS. This remains an area of value although the asset class has been slowly and steadily repricing up. A dearth of new issue means that it is losing viability as a scalable investment. Fortunately, the agency CRT market is expanding with growing issuance. This is one bright spot in the bond markets but which is still difficult to access and usually features as a small allocation in some multi strategy bond funds.

Week ahead:

Feb 20