Central banks pulling out of the game. Bloomberg, Macrobond, Lyxor AM

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1 1 st QUARTER 2018 EXTRA TIME INVESTMENT STRATEGY Contact Slides updated as of 12 January Important Notice: For investors in the European Economic Area, this material is directed as clients (actual or potential) who meet the definition of a Professional Counterparty or Eligible Counterparty under the Markets in Financial Instruments Directive ( MiFiD ), and any products or services described which fall within the scope of MiFiD are only available to such clients. This communication is a marketing communication within the meaning of MiFiD.

2 Central banks pulling out of the game Bloomberg, Macrobond, Lyxor AM 2

3 Continue to Prefer Equity to Bonds Structural backdrop still conducive to risk assets Monetary soft normalization Firmer global growth Low inflation Risks Overbought markets typically call for a correction Oil surge Sudden US wage acceleration China slowdown Bloomberg, Macrobond, Lyxor AM 3

4 Within Equity: EMU & JP to outperform US The EURUSD pivotal factor Firm US growth vs. EMU & Japan acceleration US inflation creeping higher vs. stalling in EMU & Japan Monetary normalization waltz in three beats US slowly moving out of a goldilocks environment Reflation process still ongoing in EMU & Japan Thomson Reuters, Macrobond, Lyxor AM 4

5 EURUSD to reflect political risks Growth differential closed Monetary & rate gaps partially priced-in Geopolitical issues Drags on EURUSD: Spain, Brexit, Greece, Italian elections, US-Korea Drivers of EURUSD: US mid-term elections Strategic Neutral. USD firmer in H1, then weaker in H2. Macrobond, Lyxor AM 5

6 Volatility strategies to hedge geo-political tail risks Low-volatility not so rare Low economic volatility Little odds of an imminent regime shift triggered by monetary withdrawal or large macro swings Persistent geo-political risks Macrobond, Lyxor AM 6

7 US risk assets: no immediate threat 7

8 Fed policy normalization to compress the yield curve but 3 rate hikes in 2018, balance sheet reduction Rate hikes (25 bps) in Mar, Jun & Dec 18 (@ 2.125%) 2018 BS reduction $250bn Still about $200bn net bond purchases in 2018 New board, no discontinuity Jerome Powell Randal Quarles Marvin Goodfriend Macrobond, Lyxor AM 8

9 US Treasury yields to firm up alongside term premiums Target 3M: 2.75%; Target 12M: 3% YC flattening partially offset by rising term premium (+30bps) Macro volatility creeping higher Regulatory related flows likely to have peaked already Probable front loading of tax deductible pension contributions in 2017 to backslash in 2018 Upside inflation-related risk Bloomberg, Macrobond, Lyxor AM 9

10 US Equity: Expensive Valuations! Bloomberg, Macrobond, Lyxor AM 10

11 US Equity: Supportive fundamentals Solid top-line in H1; Firm margins; EPS +12% with upside Bloomberg, Macrobond, Lyxor AM 11

12 Tax reform to boost business Confidence, Capex & Wages Corporate tax cut to 21% (2018) Full Capex expensing during 5Y Interest deduction 30% EBITDA Territoriality Repatriated earnings: 15.5% on cash, 8% on non-cash Corporate AMT repealed Individual top rate down to 37% SALT deductions limited to property taxes and up to $10K Mortgage deduction for new homes worth less than $750K Individual mandate repealed Macrobond, Lyxor AM 12

13 US Capex to accelerate Most drivers flashing green Aging assets Business confidence Corporate margins Fiscal incentive Macrobond, Lyxor AM 13

14 US Capex to accelerate (2) Macrobond Lyxor AM 14

15 Firmer Wage, Core & Headline inflations Acute labor shortage Demographic shift almost completed Average Earnings growth to reach 3% Core inflation towards 2% (Telecom price war to fade; rent moderation to last) Headline inflation pushed higher by oil base effects Macrobond, Lyxor AM 15

16 Entry point in US Breakevens The inflation diffusion factor Macrobond, Lyxor AM 16

17 Still invested in US Equity at neutral weight Mixed technical signals Macrobond, Lyxor AM 17

18 Resuming the O/W US Growth vs. Value To capture US equity potential upside US expansion in a late stage, not supportive of Value Tax reform to boost capex and thus IT (~30% of capex) IT = 35% S&P 500 Growth Tech valuation stretched but far from Tech bubble levels Bloomberg, Macrobond, Lyxor AM 18

19 Resuming the O/W US Growth vs. Value (2) Tech valuation stretched, not bubbly. Banks weigh 10% of Value Energy Materials Industrials Cons Disc Cons Stap Health Care Financials Real Estate IT Telecom Utilities Weights in SP500 Growth & Value indices Growth Value 0% 10% 20% 30% 40% Bloomberg, Macrobond, Lyxor AM 19

20 O/W US Banks Yield curve; Inflation breakeven; Deregulation Macrobond, Lyxor AM 20

21 O/W US Defense Stocks amid rearmament (multi-polar world) Expensive (22% premium to S&P) but EPS upside Bloomberg, Macrobond, Lyxor AM 21

22 US Equity: other Sectors & Themes O/W Domestic / Global Amid tax reform & likely USD appreciation in H1 ST Neutral Small vs. Large Valuation premium normalized. To benefit from tax reform & firm activity. LT U/W bias amid vulnerability to wage inflation LT O/W Health Care Providers & Services fair valuation, positive LT prospects, cash-rich to increase distribution Neutral Cons. Discretionary vs. Staples rel. valuation in line with trends, issues in autos & retail, modest EPS growth Bloomberg, Macrobond, Lyxor AM 22

23 Slight U/W US High Yield until valuation reset Global hedge on risk assets. Tax reform mixed (interest deductibility) Bloomberg, Macrobond, Lyxor AM 23

24 Slight U/W US High Yield until valuation reset (2) Bloomberg, Macrobond, Lyxor AM 24

25 Japan A new dawn? 25

26 BoJ possible policy shift in 2018 Yield Curve steepening in H2? Next BoJ Governor before 19 March 2018 (Kuroda?) Mention of Reversal rate, the paradoxical tightening effect of too low IR BoJ may target the entire YC or shorter maturities once research on the Natural YC model is done Upside risk on the 10Y yield Bloomberg, Macrobond, Lyxor AM 26

27 Japan tentative exit from deflation to continue Confidence, profits, Capex, labor, wages, consumption Macrobond, Lyxor AM 27

28 No headwinds for Abenomics FY 2018 package approved: tax cut from 30% to 25% for companies raising wages by 3% (and down to 20% for increasing new Tech capex) PM Abe to amend the Constitution (Art.9) and lift restrictions on military power Referendum in summer 2019 (with upper house elections)? or delayed by Emperor s abdication April 30, 2019 Koike's coalition 13% Left 15% Others 5% Governing coalition 67% Macrobond, Lyxor AM 28

29 Retaining a slight O/W stance on Japan Equities Macrobond, Lyxor AM 29

30 Don t give up on EMU 30

31 ECB further support in 2018 with less dovish bias ECB to hike in M extension at 30B pace Leeway to extend 3M or smoothout (or favor CSPP) In 2018, ECB will buy at min the full EMU 200B net-issuance Our scenario: If possible, QE-end in Sep Less dovish guidance Deposit rate hiked in back to 0% before Draghi mandate ends EMU sovereign issuance & QE ( B) Net issuance PSPP Lyxor AM 31

32 In the short-term, prefer Bunds to OATs ECB hiking path priced in ECB distortions next year: OATs positive net-net supply (net issuance minus PSPP) ES & IT zero net-net supply Bunds net-net demand But: French supply anticipated could balance Macron-effect ES&IT are politically driven EMU sovereign net-net issuance (gross issuance minus redemptions & PSPP purchases, % of gross issuance, 2018 avg forecast of sell-side research) Germany France Italy Spain EA10 Macrobond, Lyxor AM 32

33 Slight underweight Bund 3M target 0.65%, 12M target 0.8% Macrobond, Lyxor AM 33

34 Weak inflation outlook, yet, first signs of wage inflation ST Neutral EMU breakeven until February headline CPI trough Macrobond, Lyxor AM 34

35 EMU emboldened activity recovery Fuelled by investment Macrobond, Lyxor AM 35

36 EMU Equity: recovering margins & attractive valuations Ibes, Macrobond, Lyxor AM 36

37 so/w EMU equity maintained Key factor: EURUSD Sales growth robust & Margins recovering: >> EPS growth +10% Attractive valuations and dividends relative to the U.S. Domestic investors on board, need Americans Bloomberg, Macrobond, Lyxor AM 37

38 EMU political hurdles frontloaded German Grand coalition pending Catalonia: no visibility, yet Italian elections on 4 March 2018: Rosatellum limits disruption risk French reform dynamics Greek debt negotiations likely by June 29 Euro-meeting 38

39 Catalonia: no visibility, yet Separatists won a majority but face many hurdles before being able to govern (leaders ousted, jailed ) Cs (unionist) gained the most seats. Cs, an alternative to form a government? PM Rajoy to convene new parliament on Jan 17 Parliament to choose a speaker who calls a candidate to form a government Regional president must be chosen by Feb 8 th elpais.com, Lyxor AM 39

40 Italian risk: less vivid thanks to Rosatellum Parliament dissolved Elections on 4 March Five Star still first in polls Yet, the new electoral law favors coalitions Hung Parliament and weak coalitions likely Low probability of reforms, but also low probability of Euro-breakup disruptions Macrobond, Lyxor AM 40

41 so/w France Equity amid reform dynamics Macrobond, Lyxor AM 41

42 O/W Greece Equity ahead of upcoming debt renegotiation Dec 4 staff level agreement, 2 bills to be passed by Jan 22, tranche disbursement expected Banks stress-test in Feb-May (50% NPL issue, but recent covered bonds issuance) Greece needs to regain access to markets by bailout-end. GGBs exchange prepared the terrain Debt forgiveness / reschedule likely to be the focus of 29 June Euro-meeting Macrobond, Lyxor AM 42

43 so/w EMU banks amid curve steepening, regulation pause & bettering demand (PIGS in the starting block) Macrobond, Lyxor AM 43

44 EMU sectors not (yet) pricing-in the recovery so/w Disc. vs. Staples on valuation grounds so/w Construction on recovery thematic and EPS Would extend long Telecom and short Healthcare on valuation & EPS, but need for bottom-up expertise due to concentration LT so/w small caps with H2 expected EUR strength IBES, Macrobond, Lyxor AM 44

45 so/w Europe High Yield a little longer EU high-yield expensive yet in line with other assets. Corporations are healthy and have not re-leveraged: limited bankruptcy risk. Maturity peak only in Though, spike of light-covenants & spread compression unlikely. US contagion key risk, but no imminent threat. US HY covenant quality trend indexes We stay so/w while ECB s crowding out extends into 2018, and watch US credit to decide when to turn Neutral 45

46 Prefer so/w Cocos for the ST Crave for yield continues Coco issuance increases but has regulatory-need limit Call-backs almost certain through next 1-2 years (cheaper refinancing) ECB regulator works on assetclass sustainability Safest G-SIFI Coco YTC to converge to Senior-Sub YTW >> Expected TR 4-5% Past this threshold turn Neutral Bloomberg, Macrobond, Lyxor AM 46

47 UK window of optimism thanks to Brexit bill agreement su/w Gilt ST (rather than GBP recommendation) Brexit negotiations leap forward with agreement on 55 billion bill, Irish boarder & EU/UK resident status Brexit risk premium lightened OIS priced a-minima BoE hikes although breakevens UST contagion at risk Macrobond, Lyxor AM 47

48 ... Yet, tough trade deal negotiations expected in H su/w FTSE 100 (currency & activity drags), Neutral Gilt in the LT Macrobond, Lyxor AM 48

49 EM assets: prefer equities to sovereign credit 49

50 EM uneven macro momentum & uneven monetary policy Turkey, Mexico, Brazil, India, Russia Macrobond, Lyxor AM 50

51 MSCI EM heavily weighted in China (26%) & Tech (28.5%) MSCI China: Tencent 18% Alibaba 123 Sector composition (%) MSCI EM MSCI World Information Technology Financials Consumer Discretionary Materials Energy Consumer Staples Industrials Telecommunication Services Real Estate Health Care Bloomberg, Macrobond, Lyxor AM 51

52 China tackling corporate debt and SOEs leverage Debt for equity swaps, Capacity reductions IIF, Lyxor AM 52

53 China soft landing: no major threat on onshore market Exponential growth in Chinese e-commerce Bloomberg, Macrobond, Lyxor AM 53

54 No compelling case for overall EM equities Focus on country views Macrobond, Lyxor AM 54

55 OW Korea, Brazil; take profit on Russia; UW Turkey Neutral China and India amid (slightly) hawkish monetary stance in Q1 Economic momentum Last PMI vs 3m avg Monetary policy and inflation External vulnerability Market momentum Valuation Total Weight MSCI EM CPI & mon pol stance CA/ GDP (6m) 12MF PE as of Dec 8 China = - = + = = 30.0% Korea + = + = % Taiwan + = % India + = = = - = 8.8% Brazil % South Africa - = = 6.5% Russia = + = % Mexico + = + - = = 3.0% Indonesia = = 2.2% Malaysia + = % Thailand = = = 2.3% Poland + = = = + = 1.3% Turkey % MSCI EM + = + = = = 95% I/B/E/S, Bloomberg, Markit, Lyxor AM 55

56 EM Sovereign credit (USD) downgraded to su/w Tighter liquidity conditions & Heavy Latam weight (YTM 5.2% vs. US HY 5.7%) Bloomberg, Macrobond, Lyxor AM 56

57 Long PLN Target 4 (-5%), stop loss 4.4 Pulse in European periphery EM growth w/ EU membership benefits Strong economic reading, improving external balance & competitiveness Inflation pressures building up Receding political stress Technicals, carry Risk: NBP s inflation tolerance Macrobond, Lyxor AM 57

58 Commodities 58

59 Brent: Strategic Neutral + Tactical sell target $65 Demand firm but could be peaking OPEC supply under control (compliance, output agreement extension, Nigeria included) Geopolitical risks could bring some volatility Stretched Long Futures positions US supply to disappoint? Macrobond, Lyxor AM 59

60 Brent: Speculative positions look stretched Macrobond, Lyxor AM 60

61 Crude Oil: Could US supply disappoint? US E&Ps focus on Quality & Profitability rather than Quantity Growing gap E&P stocks vs. WTI Reflects E&Ps lack of profitability Restructuring far from over Expect further M&A & asset sales Limited E&Ps capex: greater focus on Quality & Profitability More moderate US supply pressure than expected? Macrobond, Lyxor AM 61

62 sow Copper Milder fundamental support, opportunities will be tactical Unlikely repeat of 2017 returns Peaking cycle / demand Monetary normalization trend Yet, positive backdrop of firm growth, modest inflation & decent liquidity China s demand (50% of total) in a strong momentum (surging imports) Supply disruption risk in Peru & Chile (elections, major labor negotiations) Risks: extended net long futures positions, China hard landing Macrobond, Lyxor AM 62

63 Gold: Neutral around $1300/oz Resilience from low USD & real yields, tiring momentum Price likely capped: Growth + normalization + modest inflation Heavy hedging positions But prices likely floored: Persistent uncertainty Gold fundamentals marginally better ahead of Chinese new-year Better but not compelling valuation Macrobond, Lyxor AM 63

64 CROSS ASSET RECOMMENDATIONS U.S. Japan Eurozone UK EM FX Comdty Alternative (US Breakeven: Not yet) su/w US Treasuries Neutral US Equity so/w Growth vs. Value so/w Dom vs. Glob so/w Banks so/w Defense Stocks LT O/W HealthCare P&S su/w US High-yield so/w Japan Equities su/w EMU bonds agg su/w UK Gilts so/w EU HY so/w Cocos so/w EMU equity so/w Banks so/w Disc. vs. Staples so/w Construction so/w Defense so/w FR so/w Greece su/w UK Equity O/W Korea, Brazil Neutral+ Russia Neutral China & India UW Turkey suw EM Debt Neutral EM FX Tactical sell EURPLN Neutral EUR/USD Tactical sell Brent so/w Copper Neutral Gold O/W US Deep Value L/S Equity O/W Diversified Europe O/W Diversified Japan U/W L/S Eq. Neutral U/W L/S Eq. UK O/W Special Sits O/W Merger Arb. Neutral CTAs O/W Diversified Macro U/W EM Macro U/W FI/FX Macro O/W FI Arb Neutral L/S credit 64

65 Agenda Jan 23: BoJ meeting (outlook report) Feb 8: BoE meeting (inflation report) Feb 16: Chinese New Year Mar 4: Italian Elections Mar 8: ECB meeting (projections) Mar 21: Fed meeting (projections) Mar 26 Apr 8: US Debt ceiling extraordinary measures exhausted Apr 27: BoJ meeting (outlook report) May 10: BoE meeting (inflation report) Jun 13: Fed meeting (projections) Jun 14: ECB meeting (projections) Jun 22: OPEC meeting Jun 29: EU & Euro summits Jul 1: Mexico General Elections Aug 20: End of Greece 3 rd bailout program Sept 13: ECB meeting (projections) Sept 26: Fed meeting (projections) Oct: Brazil General Elections Nov 6: US Midterm Elections 65

66 CONTACT DETAILS Jeanne Asseraf-Bitton Head of Cross Asset Research Anne Mauny Research Analyst Jean-Baptiste Berthon Senior Strategist Philippe Ferreira Senior Strategist Lionel Melin Senior Strategist 66

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