Climbing a wall of worry ?

No storm
on the horizon...
Anchors aweigh!

Pascal Blackburne & Luc Synaeghel 2017-04-07

Economic indicators are virtually unanimous in pointing to (very) strong global growth in the second quarter. Confidence is high at both the consumer and business levels, with Purchasing Managers Indices particularly buoyant – typically reliable leading indicators.

In the US, President Trump is experiencing the checks and balances of a political system, learning the hard way that a country cannot be run like a company. Having succeeded neither in imposing a ban on immigration nor in repealing Obamacare (for the time being), he is discovering that compromise is key to getting things done in politics, that compromising generally means relenting on part of your initial goals and that the negotiating process takes time. So while ambitions for a revamp of the US tax code remain, the corporate tax cut component seems to have been delayed to 2018 and there is great silence on the matter of import taxes. As for infrastructure spending plans, they will likely hinge on the terms under which the most conservative wing of the Republican party agrees to lift the USD 20 trillion debt ceiling – which has just been hit. It is hard to believe that the “Freedom Caucus” will give the green light to uncontrolled deficit spending. Eventually, disappointment about promised reflationary policies could call into question the Trump rally. Over the next few months, though, we believe that the limited danger of “bad” decisions will keep equity markets sailing north.

President Trump is learning the hard way that a country cannot be run like a company.

In Europe, economic winds are picking up, especially across the North. For the first time in many years, corporate earnings look set to really surprise on the upside. Companies have emerged lean and mean from many difficult years, suggesting that top-line growth should fall straight to the bottom line. With a reasonably priced (but not cheap) equity market and a still supportive central bank, there is still upside for stocks – particularly if Macron wins the French presidency in May. Why not put some chips on the table?

After several months of smooth sailing, energy experienced rougher seas in March. Global inventories have been falling for nearly a year, yet analysts are focussed on “sticky” US crude oil stock levels, attributing their lack of decline to either insufficient OPEC compliance with the November agreement to cut production, or rising US shale output. On OPEC, looking at oil shipments out of the Middle East, we conclude that production cuts are for real but have, until recently, been masked by a drawdown of reserves. On US shale oil, the growing rig count does not, in our view, herald an immediate rise in production. Drilling wells and “completing” them are two distinct stages, with many factors (beyond just the oil price) determining the latter. We would also point to refinery maintenance, ahead of the seasonal transition from heating oil to gasoline, as a reason for the lack of decline in US crude stock levels. Believing that the tipping point is now at hand, we reaffirm our conviction on energy investments. The March correction notably offers a good opportunity to take positions in US shale oil companies, albeit in a diversified and actively managed manner – remembering that it is a young and risky industry.

Towards a sweet spot in europe

In Europe, all eyes are – understandably – on the upcoming electoral agenda. Relief on this front is necessary before fundamental forces can be unleashed in the equity market. We believe that it will come in the form of a Macron victory in the French Presidential battle. How he then manages to form a government and achieve parliamentary support is not the issue (for now). What matters is that the risk of a populist anti-euro outcome be averted in France. We should then enter a European sweet spot, where improving economic growth and corporate earnings translate into higher equity prices – on the back of reasonable valuations (at least in comparison with US peers and outside of the multinational segment) and a still supportive central bank.

What matters is that the risk of a populist anti-euro outcome be averted in France

We expect positive earnings surprises. Remember that European companies are coming out of numerous (dis)stressed years, which forced them to slash their costs. Improving revenue growth should thus be levered into even stronger bottom-line growth.

Investors would be well advised to gain exposure to such an equity rally, recognizing that European Central Bank (ECB) support will not last forever. A reversal of its easy money policy is inevitable. Too much should not be read into the recent pullback in European inflation figures, mainly attributable to the later Easter timing this year versus last and lower oil prices. European headline price indices are very close to the 2% ECB target and second round effects will eventually show up in core inflation indices also. At that point, it will be difficult for the ECB not to change gear – or at least announce that it is reconsidering (some of) its accommodative measures.

How to normalize policy will be a complex issue for the ECB. Simply transposing the Federal Reserve (Fed) approach – taper asset purchases first then raise interest rates – is not possible. The situations, needs and interests of Eurozone members are very diverse. Core Northern countries, currently exhibit rather buoyant economic conditions while many of the Southern peripheral countries are still struggling and starved of debt market access. Also, unlike in the US, European rates were taken down all the way to negative territory.

It would not surprise us to see the ECB decide to abandon negative rates while pursuing its asset purchase program (perhaps at a lesser rate) for longer than currently planned. With negative rates amounting to a punishment on the banking system, so vital to credit creation, many voices are campaigning for such action.

European bank stocks would of course be prime beneficiaries.

What the recent US experience does teach us is that early interest rates hikes are no threat to equity markets – rather they tend to be interpreted as a positive message on economic perspectives – nor indeed to corporate investment decisions. At first, only businesses with very low margins are affected (note for instance that US commercial real estate credit has dropped abruptly over the past three months). But as rates continues to move up, an increasing number of sectors are impacted and eventually investors start to switch out of equity markets back into the relative safety of bonds. We are clearly still far from that point, and focussed on the shorter-term opportunity, but the sequence should nonetheless be kept in mind.

Why are US oil inventories not falling?

After having reached long extremes in late February, crude oil net speculative positions fell markedly during the month of March – in tandem with a near 10% drop (at its worst) in the WTI price per barrel. This correction was generally attributed to stubbornly “high” US crude oil inventories, seen as contradicting the thesis of a supply-demand rebalancing. We find the focus on US inventories somewhat disconcerting given that the global picture, as evidenced by the International Energy Agency’s revised 2016 figures, is one of oil consumption exceeding demand – even before last November’s OPEC agreement to cut production.

We also do not subscribe to the thesis that “sticky” US crude oil stocks reflect a lack of OPEC compliance. Rather, what appears to have happened is that OPEC member countries, especially Saudi Arabia, cut their production as pledged but kept oil shipments going by drawing on their own reserves. Effectively, oil stocks were shifted from the OPEC to the US – with this oil continuing to sail into the US through March. Since then, oil shiploads from the Middle East have dropped markedly. Another reason put forward by analysts for US oil inventories failing to contract is a resurgence of shale oil. Admittedly, the rig count in US shale basins is on the rise. But, we would caution, this does not mean that production will rise proportionately. Producing shale oil involves two distinct stages: wells are first drilled (using such rigs) and then they are “completed” (the actual fracking process of pumping chemicals and sand into the wells). During the crisis, drilling slowed down but continued – with many of the wells not completed. Beyond preparing for better price conditions in the future, this also reflected contractual obligations. Lease contracts generally have a three-year term, with the requirement that wells be drilled on the property during that time span. As such, contracts signed in 2014, just before the oil price collapse, involve drilling wells now, even without intent to exploit them immediately.

OPEC member countries, especially Saudi Arabia, cut their production as pledged but kept oil shipments going by drawing on their own reserves

Make no mistake, US shale oil output will eventually be stepped up. But the timing will depend on several factors: the oil price of course, but also the companies’ financial situation (many shale producers are still short of capital) and the availability of fracking material (pressure pumping equipment has essentially been out of use for three years). For now, shale production simply cannot offset the OPEC cut and call into question the overall rebalancing of the oil market. A final possible reason for US oil inventories not (yet) having fallen lies in seasonal refinery maintenance. As US refineries shift from their winter focus on low-quality heating oil to summer delivery of higher quality gasoline, they typically undergo extensive maintenance. As part of this process, capacity utilisation recently dropped to ca. 85% from its usual 95%, reducing usage of US crude oil stocks. All told, we remain convinced about the oil price upside and expect US inventory data to shortly buttress that view. We thus see the March correction as a good opportunity to add to energy exposure in portfolios.