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CIO Weekly View | 8th May 2017
Gary Dugan | Chief Investment Officer | Emirates NBD
– France ‘is working’ so Eurozone equity markets have in our view a further 5% upside in the near term
– Emmanuel Macron will promise much but he needs the National Assembly elections to deliver like-minded deputies
– Oil price under technical downward pressure
More disruptive characters take to the political stage. Emmanuel Macron’s emphatic win in the French Presidential election brings a further new face to the global stage as voters still thrash around seeking solutions to their problem. Like Donald Trump, Mr Macron has been a catalyst for a sharp rise in optimism – the French equity market is up nearly ten percent in barely three weeks. However, pending National Assembly elections in June may take away some of the excitement if Mr Macron fails to muster a majority of like-minded deputies to support his policies. For the moment though enjoy the ride higher in European equities.
Emmanuel Macron may have won the battle of the Presidential election, but few believe that is the end of the political war in France. The Presidential election has pitted two candidates who did not come from the mainstream parties, however it won’t be lost on the French population that Mr Macron comes from the political elite. Whether he manages to carry the vote in the French National Assembly elections in June will be the acid test of whether the new President will have the support to carry a reform programme forward.
Highlights of his policies
· €50bn of public investment plan for job training, shift to renewable energy infrastructure and urozonetion
· Cut in corporation tax and leeway for companies to re-negotiate the 35-hour working week
· Cut in jobless rate to 7% from 9.7%
· Reimbursement of full cost of glasses, dentures and hearing aids
· Ban on mobile use in schools for under-15s and €500 culture pass for 18 year-olds
Although Mr Macron may be reform-minded, there are many political commentators characterizing him as a French Donald Trump who will promise anything that people want buy and possibly fail to deliver. Today he has no sitting delegates in the National Assembly as his party was only formed some months ago. And even when he was the economy minister in Mr Hollande’s government, he faced substantial opposition and at time violent protests against his attempts at labour market reforms.
Having the backing of the National Assembly is crucial to Mr Macron’s plans. Many a French government has travelled aimlessly when the President and Government are in what is called a ‘cohabitation’- in essence when the government and President come from different ends of the political spectrum. However, he faces some hurdles. While the established parties could not muster a credible candidate for President, they are likely to muster votes in the National Assembly elections in June. Macron has no sitting MPs and seems intent on luring existing MPs to his fold or bringing in candidates from other parties who have little or no political experience aligned candidates.
For the record, a recent opinion poll by Opinonway projected that En Marche would win between 240-286 seats, the centre right Republicans and their allies 200-210, 15-25 for the National Front and the Socialist party support would drop to 28-43 seats from the current 280. However, opinion polls can be very misleading just after a Presidential election. Also, bear in mind that the French have sometime preferred to vote for a ‘cohabitation’ in order to keep the President-of-the-day in check.
The election of Mr Macron will provide a further near-term impetus to the European equity markets that have enjoyed a strong run of late. The MSCI urozone index has outperformed the global index by 7% since mid-February, partly on stronger economic data and partly on the prospect of Mr Macron’s election. The limit of that outperformance was probably the relative peak of early 2015, when the index was higher by ten percentage points. However, that outperformance came after 30% depreciation of the euro against the dollar allowing for a short term boost to corporate profits growth. On this occasion, the euro has been strong against the dollar, up 12% since mid-2016. Hence a more likely target is a further 5% gain taking the eurostoxx 50 back to its 2015 high of 3828.
Technical analysts remain concerned that oil prices could be headed lower still, maybe towards $40. The oil price rebounded in the last trading session of the week, but appears to be still under downward pressure. WTI fell 6.3% on the week after a rebound of 1.3% late in the session on Friday. Both Brent and WTI touched levels not seen since November last year before OPEC reached an agreement to cut production. A decision by OPEC and non-OPEC countries to extend their production cuts may bring some stability to the market, but unless they collectively increase their target production cuts, it doesn’t seem that we will see an early marked recovery in oil prices.
The ongoing added production from the US and the still-high inventories of oil are substantial challenges to the oil market. US oil production is up 10% since mid-2016. US companies continue to add production rigs; last week a further six were added for the 16th week in a row despite the weakening oil price. The first quarter results by Continental Resources, one of the largest on-shore oil companies, only exemplified the challenge being laid down to OPEC. The company is nearly doubling its capital investment in 2017 compared to 2016 and expects to achieve 20% annual production growth from 2018 to 2020. Just by way of an example to show how the efficiency of energy production is impacting the market and weighing down on energy prices more than had previously been expected, the EIA recently estimated that new well gas production in the United States increased by nearly 26% in just the last year.
The energy sector has underperformed by 15% versus the global equity market index, a reflection of the weakness in the oil price. Meanwhile, BP has tripled its profits and Shell doubled its profits compared to the same period last year. Exxon, Chevron and Total also reported robust first quarter results. Part of the problem is that despite the good results, analysts continue to cut their corporate profit forecasts. We believe that as long as the majors can defend their dividend payments, the stocks represent good long-term value at these levels. Cost cutting and improved productivity are ensuring that the oil majors can maintain their high dividend pay-outs. BP currently yields 6.8% and Royal Dutch Shell 7.1%.
The lofty valuations of the technology sector are being offset by a strong pace of earnings growth. Earnings from the technology giants have been impressive last quarter with revenue growth of +20% and earnings growth in the teens. Apple retains its position as the world’s most valuable company with the stock up 61% over the last one year. Despite reporting an unexpected drop in iPhone unit sales in the March quarter, revenue grew 5 per cent. Investors await the fate of the over quarter trillion dollars of cash with the company, with hopes of any tax amnesty ensuring further buybacks or investment in research. Apple, in line with President Trump’s policy of keeping jobs in America, also announced a new $1bn fund for US “advanced manufacturing”, signaling a change away from manufacturing overseas. Facebook’s revenues have increased by almost 50 per cent to $8bn in its first quarter, and the stock continues to perform, +26% over one year, though the company has stated that advertising growth would slow down “meaningfully” in the second half of the year. Tesla’s market cap is greater than Ford and GM though it continues to make losses, however conviction in the shift to electric vehicles away from gasoline ensured a quick recovery in its share price after a sharp drop post announcement of results. The stock is up 43% over one year. Technology companies need to maintain their strong growth for investors to keep faith with the tech-laden Nasdaq breaking records. Just eight technology companies account for almost 50% of the S&P gains this year.
The lower oil price is keeping GCC equity markets under downward pressure. The DFM index is technically in no-man’s land with a risk it falls back to the 3200 level from 3384 currently. The Saudi equity benchmark has maintained its trading range and looks well supported.
The fall in the oil prices is providing a further challenge to those who expected inflation to become a problem this year. In this vein, the US April inflation data due to be reported this coming week will be one of the key data points for the markets. Last month inflation surprised to the downside, and core inflation was particularly weak. The market is expecting core inflation of 2.0% unchanged from last month.
In the US demand for inflation-linked bonds (TIPs) has remained weak particularly amongst retail investors who still don’t believe that inflation is about to take off even with the unemployment rate at a cyclical low. Indeed, in the most recent weekly mutual fund sales reports retail investors have been a net seller of TIPs. The implied levels of inflation priced into TIPs has slipped back to 2.05%.
In contrast to recent weak US economic data reports, the much-awaited US labour market release had supporting data for both the bulls and bears. The bulls will point to the better than expected headline jobs growth and the unemployment rate. The bears will point to the downward revisions to previous jobs growth numbers and the lower than expected wage growth. Wage inflation hit 2.5% year-on-year compared to 2.7% expected.
Even if wage growth picks up, there are still limited signs that the US householder is willing to spend their money. US auto sales in April were below expectations. All of the major auto companies suffered significant falls in sales, down between 4% and 7% year-on-year. Inventories of cars have climbed to 70 days of sales compared to 55 two years ago. Consumers seem satiated on buying cars after the credit binge of buying cars on credit. Auto loans increased to an aggregate $1.2 trillion recently and have until very recently risen at a faster pace than any form of consumer credit. 25% of auto loans are to subprime borrowers. US auto stocks have been perennial underperformers versus the US equity market- that is likely to continue.
China remains a concern for the markets particularly given increasing investor fears of a credit crunch. Much of the focus is on the shadow banking industry where the wealth management products have provided a significant share of corporate funding in recent years. JPMorgan estimates that these types of financial products account for US$4.2 trillion (over 30% of GDP). The issuance of the WMPs is estimated to have recently fallen by 15% year-on-year, hence leading to fears of a credit crunch. While larger Chinese banks face little in the way of a liquidity crisis the smaller regional banks could be challenged. Although any problem in the financial sector is probably manageable, were a crisis to occur in a dysfunctional way where the authorities struggle to take immediate control, the global asset markets could suffer. One only has to remember how fear gripped the financial markets in the first quarter of 2016, based on worries about China, to see that there could be a spike in volatility.
Chinese equities are at a crucial technical support level with the possibility of 10% downside. Of late, volumes in the equity market have been light. Hence, the markets appear to be waiting for further signals from the economic data to justify either a further sell-off or a rebound. Key data this coming week includes the inflation and money supply releases, plus aggregate financing data. Any sign of a more striking tightening of credit conditions could lead to a meaningful setback.
Global credit markets were well bid amidst stronger US economic data towards the end of last week. The probability of another lift-off on US policy rates is nearing the 100% mark for the June FOMC. The benchmark 10-year US government bond yields were well supported at 2.34% post the strong payrolls data. The yield differential between the US and Germany 10 year bonds have fallen to 1.93% from their recent high of 2.35%. We expect this differential to mean revert in the long term towards its 1.23% five-year average as ECB readies to taper in 2018 and normalize policy rates at the end of next year, given supportive macroeconomic trends in the Eurozone.
We expect emerging market bonds as an asset class to continue to do well judging by the success of recent new issues. The Democratic Socialist Republic of Sri Lanka returned to the debt capital markets by offering US$1.5bn of 10-year maturities priced at a yield of 6.20%. Investor demand topped US$11bn with US investors accounting for 58% of the book followed by Europe 22% and Asia 20%. The initial price guidance of 6.625% was lowered to 6.20%. We expect the new issue do well in the secondary market. The Republic of Turkey priced US$ 1.75bn of their 30-year bonds at a yield of 5.875% after their initial price guidance of 6.125%.
In GCC bond markets, investors await the Sovereign Sukuk issuance by the Sultanate of Oman as well as from the Saudi Electricity Company.