Q2 Update: "The Art of The Deal"
“I've read hundreds of books about China over the decades. I know the Chinese. I've made a lot of money with the Chinese. I understand the Chinese mind.”
- The Art of the Deal, Book, D. Trump/T. Schwartz, 1987
While the above quote would surely make a few investors smile, markets were not smiling as they continued to be held hostage to the trade-spat between China and the US. As negotiations suddenly took a turn for the worse in early May, most read it the exit signal they were waiting for after the sharp Q1 rally…. Only to be wrong as the market rallied in June on the back of little new news: easing speculations, deal speculations… We finish the quarter with the market asking an all too familiar question? Shall we trust the rosy picture depicted by the credit and equity as the S&P 500 is approaching the 3000 mark? Or shall we bow in front of the impending doom implied by the sub-2% US 10 years?
The macro data update provides part of the answer and confirms the sluggish late cycle environment on our central scenarios, a scenario in which mostly the US would benefit within DM economies, mainly thanks to its blossoming innovative sectors. They continued to deliver again solid earnings over Q2 even if selection and rotation between the sub-industry remains key at this valuation levels to avoid large drawdown and control volatility. In EM, we are seeing long-term value when focusing on domestic growth especially after the trade-war pressure on equity valuations. We are however concerned for renewed uncertainty on the currency side and prefer to look at Asia. China in particular, despite being on the weaker end of the trade-war discussion, can count on the shift of its economy toward a booming middle-class. Looking at the broader picture, we are globally concerned about the situation in credit: with the hunt for yield leaving spreads at the tighter end of their range and more people chasing income through more subordinated, longer dated, less liquid structures; we see the recent headlines on illiquid funds as clear red flags.
This brings us to convertibles. stubbornly ignoring the rest of the fixed income market, they remain cheap. Meaning they are both below their historical average in terms of valuation (similarly to equity volatility), and (far) below their straight bonds peers in the fixed income market. They continued to provide a steady return, 1.32% this quarter, with a low volatility and an IG rating. They benefit from decent liquidity (despite being smaller than most fixed income market) thanks to more balanced flows in the secondary market and a solid primary market.
As uncertainty rises and valuations would become more important, a discounted asymmetric payout might be the next good deal and a safer way to see if the S&P 500 would indeed hold that 3000 level!
Key extracts:
- Valuations are stretched (again) across asset classes, Vol being a notable exception
- Credit is (even more) expensive vs. Equities
- Our base case is still for a mild recession occurring after late 2020, with equities having some little room for upside and dispersion/volatility climbing back to long term.
- Policy errors (e.g. from Central Banks/Governments) could accelerate a recessionary environment and are the main downside risk. Visibility remains low. We see the Fed insurance cut as a necessary near term evil not justified by fundamentals.
- Within volatility related products, Convertibles are discounted (by 50 - 250 bps depending on segments) and offer a good place to hide as a HY replacement or an alternative to Equity L/S
- Stick with innovative sectors in the US, Global-driven companies in EMEA/Japan, Domestic-driven companies in Asia-ex.
- Focus on IG (Credit should be the first to suffer)