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New Horizons

Pascal Blackburne & Luc Synaeghel 2019-01-10

The first day of 2019 saw the NASA spacecraft “New Horizons”, launched in January 2006, reach the Ultima Thule comet in the Kuiper Belt, at the outer limit of our solar system. “New Horizons” took some 900 amazing pictures per second during its flyby, before continuing its voyage at a dazzling speed into the unknown territory of the wider galaxy.

On January 3rd, the Chinese spacecraft “Chang’e-4” made a successful landing on the dark side of the moon. Its mission will be to measure radio waves in space without the disturbance caused by our own planet. This transceiver was co-developed by Dutch institute Astron and the Chinese government.

Scientists will hopefully share the valuable information they gather for the better good of mankind, showing political leaders that collaboration rather than conflict is the best way forward. Also at the onset of this year, President Trump signalled “serious progress” in negotiations with China regarding the trade war that he triggered last year, and that has caused much uncertainty in the business and investor spaces. Entrepreneurs became cautious and adopted a “wait and see” approach, delaying or cancelling investment decisions. Economic growth projections were thus revised downwards by most supranational institutions. Adding to investor nervousness were repeated attacks by President Trump on the Federal Reserve’s interest rate tightening policy aimed at preventing an overheating of the American economy (which could result in above-target inflation). Market participants demanded a higher risk premium on their investments, driving a very serious correction in global stock markets during the last quarter of 2018.

On January 4th, however, Fed Chairman Powell assured investors that he is not blind as to what is happening in the economy and financial markets, and that the US monetary authorities will continue on their path of gradual interest rate increases only if and when economic data deems it necessary. He also stressed the independence of the US Central Bank and said that he would remain in place even if President Trump were to ask him to leave.

That very same day, the US Bureau of Labor Statistics reported that 312’000 jobs were created in December, well above expectations. Where is the so feared recession?

After last year’s disastrous stock market performance, we expect a much better 2019. Following the fourth quarter 2018 correction, the MSCI World index is trading at an acceptable price-to-expected earnings ratio of 13.3x, leaving room for a positive return this year. On condition, of course, that President Trump continues to measure his success in terms of the level of the S&P 500.

That said, bond markets remain dangerous with interest rates moving up, and risk spreads and term premiums to normalise as central banks worldwide gradually undo their stimulus measures. We wish you a Happy New Year.

Another President Twitter Year

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Photograph: Jinping in Beijing on November 8, 2017. Photo: Reuters

Unpredictable as he is, twittering about everything that comes into his head, creating global chaos and fighting personal wars all over the place, President Trump has recently become the financial markets’ top fear factor. During the last quarter of 2018, this led investors to demand higher risk premiums, triggering the largest correction in years.

We do not expect President Trump to change his attitude, so we must gear up for another very volatile year in financial markets – which does not necessarily mean negative returns, as markets already discount a lot of potential bad news.

Trump and Xi Jinping

By now, it has become clear that the trade war sparked by President Trump to rebalance US trade accounts versus the other major economic blocs (China and Europe) has resulted in a number of unforeseen and unwanted consequences. As we asserted in a prior investment letter, far from improving, the US trade deficit actually widened. Also, due to retaliatory measures by the other blocs, global trade has taken a hit, weighing on world economic growth.

Import tariffs on Chinese goods risk to be increased from 10% to 25% if President Trump does not strike a deal with his Chinese counterpart before the end of the 1st quarter. It is impossible to expect President Xi Jinping to comply with all the US requirements, so a compromise will have to be found such that President Trump appears the (short-term) winner and President Xi Jinping does not “lose face”.

This will be no “walk in the park” but President Trump has by now experienced how far stock markets can plunge when investors get nervous, thereby hurting the value of his voters’ pension plans (and of course his own pockets). Meanwhile, President Xi Jinping wants to keep his economy on track. We thus expect some form of a deal, perhaps after an extension of the current (unrealistic) time schedule. Until then, financial markets will remain (very) volatile.

Trump and Powell

After numerous attacks by President Trump on the Fed and its Chairman Powell, as regards their policy of steady and gradual short-term interest rate hikes, a consensus seems to be in the making. Powell has assured financial markets that he will remain in place, even if President Trump were to ask him to leave, and that the Fed will go forward with its progressive rate hikes only if economic data requires so.

That being said, recent reports such as December job creation and wage growth indicate that the US economy is still doing very well and that the labour market is becoming very tight. The Fed’s dual mandate is to obtain full employment in a low inflation environment. The US have been very close to full employment for some time already, so it is quite normal for the Fed to have shifted its priority towards containing inflation via rate hikes and reducing its (still huge) balance sheet.

We expect the Fed to continue to fulfil its dual mandate in an independent and reasonable manner. Skipping one or two of the rate hikes foreseen for 2019 is not impossible, should the US economy show serious signs of a slowdown. This would be the case for instance if President Trump pursues his trade war against China and imposes a 25% import tax on European cars in the spring. The European Commission has already stated that, were such an import tax to be imposed, very serious retaliatory measures would immediately be taken.

A full-fledged trade war would, without a doubt, be a horror scenario for the global economy and financial markets.

Trump and Nancy

Having recently vetoed the 2019 budget amid a dispute with the Democrats regarding the “Mexican wall”, President Trump is keeping some 800’000 civil servants at home because there is no money to pay them until the budget has been approved. Nancy Pelosi, the new Speaker of the House of Representatives after the Democrats regained the majority in the mid-term elections (and a very tough lady), has already stated that it is out of the question for Congress to approve a budget that includes the USD 5.6 billion requested by President Trump to build the wall. She was loud and clear: no money for that wall. Some extra budget for better border control is presumably negotiable, but no more than that.

Whether President Trump likes it or not, he will have to deal with Nancy from now on, for everything that he wants to achieve within the US. They have at least something in common: a desire to invest in infrastructure. This was one of President Trump’s major promises during his election campaign, on which he has not yet delivered, perhaps because his fellow Republicans balked at the budget deficit already created by the tax cuts afforded to wealthy US citizens and the corporate sector (estimated at over USD 1’000 billion per annum), as well as the ever-increasing pile of government debt (already above 100% of US GDP).

Should serious investing in infrastructure be decided upon in the current context of high (although slowing somewhat) economic growth and full employment, then interest rates will have to be raised by the Fed faster than President Trump would like, in order to prevent serious wage inflation from kicking in. Chairman Powell would then certainly find himself again bombed by “presidential twitters”, much to financial markets’ distaste.

Trump and the rest of the world

Supranational organisations established after WWII, such as the World Trade Organisation and the United Nations, have been rendered obsolete by President Trump’s “America first” policy and his abuse of US “national security law” to enforce import tariffs and revoke international agreements on the environment and immigration, areas in which the US had been frontrunners before he took office.

Shocking his geopolitical allies – Europe, Israel and Saudi Arabia to name but a few – by attacking NATO and then more recently deciding to pull troops out of Syria and Afghanistan, thus paving the way for much greater Russian and Iranian influence in the Middle East, does not help in making the US be considered a reliable partner for the future.

Perhaps most amazing is the fact that Republicans are allowing President Trump to go forward in his own unpredictable way, with party heavy weights such as Paul Ryan preferring to retire rather than oppose him. Although the decision to oust General Mattis as Secretary of Defence did trigger a clear warning flag amongst US Army leaders and some Republican spearheads.

President Trump might have crossed the red line this time and lost the absolute, although often reluctant, support of the GOP. We will see what happens if Special Counsel Robert Mueller comes out with his report on the Russia probe during the coming weeks, particularly if he concludes that President Trump is not completely innocent.

Towards Another Europe?

On January 15, the British Parliament will vote on the deal between the UK Government and the European Commission regarding Brexit. If Parliament rejects the deal, then only two options will remain: a hard Brexit or an adjournment followed by a new referendum. Both scenarios mean chaos, particularly the first since neither the UK nor the EU are prepared for its consequences. Trade between the Union and the UK would suffer serious short-term disturbances, weighing on economic growth on both sides of the Channel and hurting the earnings of numerous companies. It is not difficult to imagine what would happen to stock markets if this nightmare becomes true.

Between May 23 and May 26, EU citizens will elect a new European Parliament. Much has changed in Europe since the elections in 2014, mainly due to the immigration issue, so it would not be surprising to see the composition of the European Parliament undergo a major shake-up. If the results of (recent) national elections in member states come to be reflected in the new composition of the European Parliament, populists from the left and right, as well as environmentally-oriented parties, will make considerable gains and seriously weigh on the future policy direction of the (not elected) European Commission.

Also during the course of this year, ECB monetary policy will gradually evolve from aggressive money printing and negative interest rates to a more normal and less interventionist stance. Hopefully, this transition will not cause a sudden correction in the euro bond market, whether government or corporate paper, with interest rates still very depressed and inflation well below the central bank’s long-term 2% target. Risk premiums are still far from normal and term premiums are non-existent. The sudden demand for a higher risk premium in equity markets during the fourth quarter of 2018 and the 20% correction that it provoked demonstrate how fast and far markets can move if investors change their mind.

2019 will certainly be a challenging year for Europe, its stock market(s) and its bond market(s), even without accounting for the possibility of much higher US import taxes on European goods and cars.

Our Portfolios

Our portfolios had a very disappointing final quarter of 2018, with their return badly hit by the unexpected oil price crash and then severe overall correction in financial markets.

Rather substantial positions in oil-related stocks, as well as European bank stocks and their perpetual bonds, meant that we got hit twice.

We nonetheless remain convinced that US oil stocks (especially shale producers) and European banks are extremely undervalued, so did not sell or cut our positions. With the oil price set to normalise during the course of this year (Saudi Arabia is targeting at least USD 80 per barrel) and the ECB expected to abandon negative interest rates (which will be positive for banks), we believe that oil and bank stocks could be the outperformers of 2019.

Our pocket of hedge funds also proved disappointing in 2018. Although their relative performance was not that bad on average, we did elect to reduce exposure to 15%, deploying part of the proceeds into US equities which, following the sharp December correction, we now consider to be more or less correctly valued.

In the fixed income space, we remain cautious but have slightly lifted our exposure to European high yield bonds in view of the considerable spread widening of the last couple of months – resulting in a 6%+ yield to maturity (duration of ca. 4 years).

2019 will certainly be another difficult year for investors, with interest rates still (very) low and seriously higher stock market volatility. Considering, however, that a lot of potential bad news have already been discounted, any good news could spark a market rally, for instance an orderly exit of the UK from the EU or the agreement between the US and China on trade barriers and intellectual property.

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