Page 8 - GIF

Banking
Mind the gaps
finance share buybacks). We view this as an early warning of a worsening in credit quality, which in due course will result in a rise in defaults. Prudence is warranted in the US. Conversely, credit trends are more supportive in the eurozone where balance sheets do not exhibit the same strains.
Over the past 18 months, two key factors have driven the outlook for corporate earnings in the US and the eurozone: oil prices and foreign exchange rates. Interestingly, the effects have been opposite on each shore of the Atlantic. US corporate profits have been hard hit by the decline in the energy sector and by the impact of a stronger dollar on multinationals and US exporters. On the other hand, a weaker euro and cuts in energy bills have boosted eurozone profitability. These effects will however begin to reverse from Q2 2016 onwards.
Alternative investments
Potential upside in equity markets will be con- strained by the current high valuations and the outlook for earnings growth. In this low growth environment, security selection becomes key – in particular, companies demonstrating an ability to grow their sales and cash flows despite new competitive pres- sures should do well. Further, Japanese and eurozone equities will remain supported by abundant liquidity.
We continue to see potential in non- directional investment strategies. In particular, alternative investments should benefit from higher dispersion of performance, in strategies such as Global Macro and Long/Short Equity. In addition, the unique characteristics of convertible bonds make them a valuable adjunct to portfolios in a low- return world. In 2016, careful portfolio construction and diversification across themes will prove key.
In summary, the gaps listed above argue for another out of sync year for economies and the financial markets. As the global economy exits the zone of turbulence which will be generated by the shifts in monetary policy, the outlook for 2016 does look more attractive. However, high valuations in both fixed-income and equity markets still translate into very slim margins of safety. Mind the gaps indeed.
By Xavier Denis, Global Strategist, Societe Generale Private Banking
Financial markets often seem fickle. Some of the strongest returns in
equities, for example, are recorded when the outlook appears bleakest. Part of the explanation for this can be found in the study of behavioural finance. The latter stages of a bear market often see investors herding together, all seeking to liquidate positions at the same time. And such consensus means that when the selling pressure is eventually exhausted, it becomes easier for the market to rally. In addition, such moves do not require a shift in fundamentals – the easing of negative news-flow can suffice.
In the same vein, markets often fail to move in line with improvements in the macro picture. As a bull market develops, valuations tend to rise and in its latter stages there remains little room for multiples to increase further. Such gaps between market performance and economic fundamentals can be tricky to navigate.
We also see a number of gaps looming in the economic background for 2016, in the outlook for inflation, in central bank policy settings, in corporate leverage and the credit cycle and in corporate earnings growth.
Regarding inflation, the picture has been muddied by the impact of the slump in energy prices, which has pushed the headline index close to zero in the US and below that in a
number of eurozone economies. We expect the gap to widen in 2016. As the US reaches full employment, wage pressures will start to build, feeding a pick-up in core inflation in the US next year. In the eurozone on the other hand, unemployment has declined to 10.8% but remains well above the pre-crisis low of 7.2%. In consequence, wage pressures are largely absent and inflation is well below the European Central Bank’s 2% target.
The US Federal Reserve (Fed) recently hiked its interest rates for the first time in almost ten years – employment continues to improve and wage pressures to build, reducing the need for such extreme policy set- tings. In Europe, the ECB faces a sluggish economy, low core inflation and a banking sector which is trimming its loan book to bolster capital buffers. It is no surprise that Chairman Draghi was so vociferous about his intention to ease policy further.
This divergence has been widely flagged to markets, proof that the bout of nerves displayed by emerging market bond investors during 2013’s “taper tantrum” has taught pol- icymakers a lesson. Back then, the Fed spooked markets by intimating an early “tapering” (reduction) of its Quantitative Easing (QE) programme, leading to worries of a sharp liquidity squeeze. This time, investors have had ample forewarning of the opposite moves planned by the Fed and the ECB.
The US economic cycle is well advanced, with the recovery now in its sixth year. We note however a steady rise in corporate borrowing (to refinance maturing debt, fund mergers and acquisitions and
Convertible bonds, the best of both worlds
www.privatebanking.societegenerale.com /hambros
Source: (SGPB, Datastream. Data as of 7 January 2016)
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