We believe the reflation trade will end in Q2 with a healthy correction in global equities.
Our Q1 view that Chinese and EM equities would underperform did not prove right as our stronger dollar forecast did not materialise with the USD Index down 2.4% year-to-date easing conditions for EM equities. At the same time, sentiment on China strengthened significantly over the quarter adding tailwind to key commodity markets benefiting countries like Brazil up 11%
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Although we missed the direction and sentiment on China and EM, we certainly got our sector calls right. In our Q1 Outlook we said:
“The obvious equity strategy, if rates continue higher, is to be overweight financials (excl. real estate), information technology, consumer discretionary and health care because these four sectors have the lowest net-debt-to-EBITDA ratio.”
Three out of our four top sector picks were all the best performing sectors. The only miss, and a big surprise to us, was financials that clearly did not respond as positively as we estimated on Fed’s rate hike and the reflation trade.
However, with EM equities at some of the highest valuation levels in six years and the reflation trade potentially ending in Q2, we believe EM equities this time will be the underperformer. As they say, when in trouble, double. In a more cautious risk-off Q2 environment we also believe investors should overweight low volatility and high quality stocks while selling strong momentum and value stocks.
Our big bet in Q2 is that European equities will outperform against US and Japanese equities.
Technology stocks will continue to do well simply because it’s the only sure way of getting a growth component into the equity portfolio. The fading reflation trade will likely also lead to underperformance by financials, but stronger performance among consumer stocks. The real estate sector could see outperformance as inflation and macro data disappoint, dampening the outlook for higher rates.
Energy and debt
As we have been saying for quarters now and again in our Q1 Outlook, the energy sector looks very vulnerable. The outstanding debt to assets is the highest since 1995 fueled by cheap credit and elevated oil prices.
The net-debt to EBITDA is also high at 3.4x coming off 7.6x back in August, but still at very elevated levels historically. Unless the oil price goes higher we estimate that a refinancing crisis could start again in Q2. The US High Yield Energy OAS Index is at around 485 bps, up almost 100 bps from the lows in January but off the highs of 1,600 bps in February 2016.
With Brent pulled towards $50/barrel due to increasing supply from the US, Iran and Libya, we see little upside and thus expectations will have to be revised down massively. Over the next 12 months analysts are expecting EBITDA to grow by 112% among global energy companies and then steady by 10% the following years.
Our view is that the global energy sector has an unsustainable capital structure given the current oil price outlook and that debt restructuring is the only way to restore balance in the sector. We remain underweight the energy sector.
Inflation pressure to fade
Another short-term argument against the reflation trade is that under the assumption of no change in the oil price, which is our base case scenario, the impulse from oil into inflation will go from 55% year-on-year to 2% y/y. The impulse from Chinese producers will remain high in Q2 with China PPI at 7.8% y/y in February keeping the inflation outlook stable but not accelerating which is needed for this market to continue repricing asset classes.
The 5-year breakeven rate is at 2% and has stalled in recent weeks and with economic surprise indices across major economies at multi-year highs, macro data could also disappoint investors in Q2 leading to a new narrative. This narrative might well be stable inflation, but not accelerating, and there will only marginal positive economic growth input from Trump as he lacks backing from GOP on a lot of his policies.
A French surprise
The first round of the French election on April 23 could be the decisive upside catalyst for European equities as the political noise has put a discount on European equities which are now trading at a 20% discount to US equities, the highest discount since 2012.
While investors are focusing on Europe’s political landscape with upcoming elections in France and Germany, they seem to have missed the fact that Europe’s GDP growth has surged to almost 3% annualised, estimated by the euro-coin indicator from Bank of Italy.
The drivers are improving financial conditions, upward pressure on prices and increasing business confidence. This improved economic picture and outlook is at odds with the valuation discount to US equities and one of the main reasons behind our overweight Europe and underweight US theme. If Macron wins the French election we believe French equities will outperform in Q2 against other European equity markets.
In addition the Q4 earnings season showed that revenue and operating profits are bouncing back in Europe. We expect this trend to continue in the Q1 earnings releases and in general, we expect accelerating revenue growth among European companies in 2017.
Another trend that we expect to see continuing in Q2 is outperformance among defence companies already outperforming the overall equity market since Trump’s victory. Defence spending in the Western world is historically very low, but the Trump administration in forcing other Nato members to step up the game and commit to the 2% military spending of GDP as agreed to in the treaty. This new focus on military spending and increasing geopolitical risks close to Europe’s border will add a prolonged tailwind for defence companies.