EQUITIES

A polarizing president begets a polarized equity market

So far, Donald Trump is proving a friend to stock investors and a foe to holders of bonds. The president-elect’sspending pledges drove the MSCI World index up 4.5% (in euro) in November, the most since July, while spurring a record-breaking global debt rout. The net result: the gauge of developed equities beat the JPMorgan Global Bonds index over theperiod by the most (4.6%) since late 2011.

While it is common for stock market volatility to surge after U.S. elections, initial moves don’t tend to prove long-lasting and that has also been the case with the Donald Trump’s victory like it was the case in the wake of Britain’s June voteto leave the European Union (“Brexit”). The 10-day volatility index for the MSCI World All-Countries tumbled 62%, as themeasure of market turbulence retreated from a four-month high reached before the elections.

Stock rallied after the initial shock (the largely unexpected win for Trump triggered a knee-jerk selloff in equities and rushinto haven assets for a few hours) gave way to optimism that Trump’s plans for fiscal stimulus and spending of asmuch as $1 trillion to rebuild U.S. infrastructure (a programme already called “Trumpeconomics”) will provide aboost to the global economy. Domestic growth will pick-up: an Atlanta Fed index estimated that the U.S. economy isexpanding at a 3.1% annual rate this quarter, signalling the U.S. may be on track for its strongest back-to-back quarters since2014. This will be good for corporate earnings and more positive for equities, though the sector rotations will be significant(see below), than for bonds, as bonds are going to get penalized by higher debt burden and inflation.

U.S will need to sell more bonds as spending needs will grow. The government’s marketable debt has more thandoubled under Obama’s stewardship, to a record of almost $14 trillion. And the deficit is expanding again, afternarrowing for four straight years, just as overseas holdings of Treasuries are shrinking at the fastest pace since 2013.According to estimates from the Committee for a Responsible Federal Budget, Trump’s economic proposals wouldresult in $5.3 trillion of borrowing and push America’s debt burden to 105% of its gross domestic product(GDP), from 75% of GDP now. This situation calls for lower bond prices (and thus higher yields). The more the U.S.

NOVEMBER 2016

The analysis of Thierry MassetA polarizing president begets apolarized equity marketTrump’s infrastructure plans shakedebt marketsWave of optimism for industrial metalsEuropean stock with high debtpunished by bond routThe Tesla shock on gasolineconsumptionFed hike is certainty for bond traders

(GDP), from 75% of GDP now. This situation calls for lower bond prices (and thus higher yields). The more the U.S.government spends, the more bonds it sells, increasing supply, depressing prices and increasing yields and, moregenerally, borrowing costs worldwide.

Fed officials said that the pace of price gains has increased, and a steepening in the Treasury yield curvesince August suggests bond traders agree inflation is picking up. If the economy starts running hot even beforenew fiscal spending, the combination may spur inflation to rise more quickly, undermining the value of bonds’ fixedpayments. The gaps between yields on 10-year Treasuries and similar-maturity Treasury Inflation Protected Securities,known as break-even rates, surged by the most since September 2012 (+0.5% since end August). The measuresindicate traders’ expectations for the average annual inflation rate until the debt matures.

“Trumpeconomics” implies a likely faster pace of Federal Reserve rate hikes next year. It is clear that this wave ofpopulist vote has reflected, in part, dislike of tight fiscal and easy monetary policy. If we are now seeing a shift in the U.S., thenthat means markets will have to reprice this. The scenario of quicker growth and inflation may push Wall Street to ramp upexpectations for Fed hikes and anticipate higher yields for years to come.

In this context, we understand why Donald Trump is shaking up a market that prior to his presidential victory hadshown little differentiation among stocks.

A basket of stocks identified by Morgan Stanley as most likely to benefit from a Trump win surged 17% sincethe Trump’s win. The group includes 53 companies ranging from drug makers to construction-materials producers.

The decreasing spread of performance between loved and unloved stocks by fund managers (-2.5%) couldbe seen as good news for stock pickers, whose performance has suffered partly because discerning goodand bad companies is harder than ever. Before the day of the U.S. election, the gap in returns between the best andworst performing industries stood at -14% in July 2016, one of the highest since 2013.

It’s hard to make a directional bet as no one knows for sure what Trump will do, but bets that are relativelycertain include some cyclical or value stocks.

Along with the potential for a lighter regulatory burden, banks and insurers were boosted (the S&P 500Financials index soared 17% (in euro) last month to levels last seen in June 2007) by soaring bond yields asinvestors’ inflation expectations climbed on speculation a Trump administration and Republican Congress willramp up spending and ease banking regulations to lift growth.Industrial companies were the S&P 500’s second-best performer (+13% in euro), fueled by Trump’spromises of massive infrastructure spending increases and unfriendly trade policy.The U.S. Healthcare index (+6.4% in euro) and the Nasdaq Biotechnology index (+15%) had their best monthsince 2000 on relief that Democrat Hillary Clinton’s plans to rein in prices were dashed. We can expect in thissector more M&A and more capital returned to holders on greater likelihood of lower corporate taxes. President-elect Donald Trump has laid out little in the way of health policy plans, though he has called for repealingObamacare, which extended insurance to at least 20 million people. He has also criticized the high cost ofprescription drugs, saying individuals should be allowed to import cheaper pharmaceuticals from abroad.A contrario, bond proxies such as Utility and Real Estate stocks, traditional havens, fell (respectively -2.7% and-0.8% in euro).

The other big story of the last month was the underperformance of emerging equity markets due to fears thatPresident-elect Trump’s protectionist proclivities will crimp their exports. The MSCI World index of developedeconomies rose 1.7% (in USD) post-election while the MSCI Emerging Market index fell 4.3%.

Of 68 emerging country stock indices tracked by Bloomberg, 51 fell after the election. Latin America took the biggest hitwith Mexico, Brazil, Argentina and Colombia being the world’s worst performers. The U.S. ranks among all fourcountries’ top three trading partners.While more developed stock markets fell (18) than rose (8), the damage was much more limited. Only five droppedmore than 2% - New Zealand, Portugal, Spain, Denmark and the Netherlands.

In the meantime, while the support of central bankers will not disappear anytime soon, we must nevertheless admitthat they are running into diminishing returns from their use of easy monetary policies. Investors are no longercounting on central bank support to the extend they used to in the U.S. and in the Euro-Area: the Fed is preparing for anotherrate hike and the European Central Bank has signaled limits to its willingness to keep loosening monetary policy. As yields arenow facing upward pressure from rising doubts about the sustainability of monetary stimulus via bond purchases andbecause growth and inflation may surprise to the upside on the back of more fiscal easing, we continue to:

buy bonds that protect against inflation amid the risk consumer price gains will exceed the target (2%) of theFed and BoE (more comments in the Bonds section),sell some bond proxies assets such as Telecoms & Consumer Staples and keep our overweight on valuestocks with particular emphasis on Energy (overweight) and US financials,reduce our exposure one Emerging Markets assets (bonds & equities),keep our underweight on sovereign bonds,be more careful on Real Estate.

1.1 Regional call

1.1.1 Euro-Area: underweight => overweight

Developed-market shares, such as the ones in the Euro-Area, and the dollar have been among the biggest winnerssince Donald Trump’s surprise election victory fueled speculation of more fiscal stimulus in the U.S.

As traders resumed speculation that the European Central Bank will maintain current levels of monetary stimulusand probably extend its 1.7 trillion-euro quantitative-easing program beyond March next year, further diverging fromthe U.S., where the Federal Reserve is preparing to raise rates, the Euro Stoxx 50 index is now 13% above its June’s levels.

Investors reassessed also the outlook for higher inflation. The 5-year, 5-year forwards - one of the European CentralBank’s key gauges of inflation expectations - are near their highest level since January. That is good news for ECBPresident Mario Draghi, who is not in an easy situation as the “Brexit” vote, the political instability, the earnings weakness anda less effective monetary policy are fueling uncertainty, complicate decisions for policy makers as well as businesses andinvestors:

The U.K.’s exit may damage trade and encourage other members to renegotiate their relationship with theEU, signalling scope for further losses in the Euro-Area (seven of the U.K.’s nine biggest trading partners are in theEU).The European Central Bank (ECB) is approaching the limits of its monetary policy, and further expansion of itsasset-purchase program could give rise to legal and financial stability concerns, Governing Council member &president of the Dutch central bank Klaas Knot said. According to him, “the marginal benefit of taking more measures isdiminishing” and quantitative easing leads to “higher risks of undesirable side effects like bubbles, an unhealthy searchfor yield, a rolling over of problematic loans, increasing wealth inequality and an addiction to low interest rates”. Anotherpotential consequence is that governments become less inclined to work on structural reforms and reduce debt, giventhe generosity of monetary policy. “The ball is now clearly in the court of the politicians”, Knot added.A message that seems to be understood by the European Union which has admit that “the efforts should focus ongrowth and avoiding or cushioning austerity.”

Among other arguments explaining why European equities have proved relatively calm, even as Italians prepare to vote on aconstitutional referendum and the campaigns to choose the next French and German leaders are under way, a weaker eurowill be positive for European exporters.

Nevertheless, we must avoid that stock swings are probably underpricing political risk. While the volatility of the EuroStoxx 50 index (the VStoxx index) has dropped 20% since a high earlier this month, the BNP Paribas gauge measuring thelevel of geopolitical risk priced in by Euro-Area assets has soared.

But if you believe that we will avoid a global recession and that fears about deflation are overdone, there is a lot ofattractively-priced assets in the Euro-Area.

1.1.2 Japan: underweight => neutral

The impact of a Trump presidency for Japanese companies will depend on what priorities he follows.If reflationary policies such as infrastructure spending and tax cuts are prioritized, then higher U.S. bond yields and aweaker yen will be positive for Japanese exporters.Conversely, protectionism and isolationism will foster economic uncertainty, and likely feed through to a stronger yen.

Trump’s campaign promises included protectionist steps such as withdrawing from the Trans-Pacific Partnership,stoking concern among many observers that export-dependent countries like Japan could be hurt. Given the tradedependence of Japan’s gross domestic product growth, even a marginal setback in exports could possibly tip the economy

back into a recession.

But Trump’s promise of a sizable cut in taxes may boost Japanese earnings next year as about 14% of the profits thatJapan companies makes come from North America-based production.

Our hope is that President Trump turns out to be a pragmatist and dealmaker. U.S. industry, which relies on the rest ofthe world for almost half its sales, is poised to work overtime to prevent a Washington-led global trade war.

That explains why Japanese shares surged 6.5% (in euro) since the Trump’s election victory, while the yen slid (-4% against the U.S. dollar) and global stocks rallied on speculation the incumbent U.S. president will bolster spending in theworld’s biggest economy. The bets that Trump will fuel inflationary pressures drove up global yields and added to the case forthe Federal Reserve to raise interest rates. Even without any additional expansion of stimulus by the Bank of Japan, thatmeans the power of policy easing will strengthen automatically in Japan.

Emerging Markets (versus Developed Markets): small overweight

Price swings in Emerging Market (EM) stocks are widening as traders try to measure the impact of higher FederalReserve interest rates against improving corporate profits in developing nations. Thirty-day historical volatility inMSCI EM index has jumped, as futures traders raised the odds of a December Fed increase to 100%, a move that wouldstrengthen the dollar and reduce the appeal higher-risk assets.

As stock markets are becoming nervous about the prospect of rising interest rates and a stronger US dollaragainst a background of moderate profit growth and relatively higher valuations, we have taken some profits onour call on EM equities.

Fund outflows from EM will probably continue for a while and then investors will see if Trump will carry out somepolicies he has mentioned before the election, such as fiscal stimulus and protectionist-type trade policies.

Nevertheless, EM assets have not lost all their appeal:The MSCI’s EM stock gauge is up 12% (in euro) this year, almost two times as much as the broader MSCI World indexof developed-nation stocks, but that should be seen in the context of the group still down as much as 40% relativesince’11.The price/book ratio of MSCI Emerging Markets index is 35% cheaper than the ratio of the MSCI G7 index and is still25% below their long-run mean!Meanwhile, an index of 20 developing nation currencies has lost 6% in 2016 since the Trump’s win.

The earnings yield on the MSCI Emerging Markets index has risen to one of the highest level since 2014relative to junk bond yields (1.2%), meaning investors get a bigger return on investment from equities. Analysts’increasing projections for company earnings and a rally in higher yielding debt in an era of negative interest rates arebehind the divergence between stocks and bonds.

Some of the most troubled emerging economies and companies in recent years are actually giving moneymanagers reasons to pile in.

China is now on pace to hit its growth target, while Brazil and Russia are poised to emerge from their slumps.Developing nations have also boosted their foreign reserves by $144 billion to $9.9 trillion after they sank to a three-yearlow in March.The more than 800 companies in MSCI’s Emerging Markets index posted average growth in earnings-per-share of 47%in the latest quarter.Companies and households in developing nations are starting to reduce borrowing as a percentage of their economies.Excluding China, the credit/GDP ratio has dropped to 127%, from 128% at the end of last year, marking the first declinesince the global financial crisis. Emerging-market companies in particular are slashing debt levels that had becomeincreasingly worrisome amid a tumble in currencies in recent years.

Finally, China seems to have (for now) avert a hard landing scenario. Chinese leaders appear to have stabilized their$10 trillion-plus economy by relying on a tried and true playbook: unleash a torrent of credit to power a borrowing surge andspending splurge.

The flood of money has helped house prices rebound, spurred investment, stabilized markets and buoyed consumers.It also ensured that gross domestic product (GDP) in the third quarter came in at a 6.7% gain from a year earlier,matching expectations and well within the government’s 2016 target of 6.5% to 7%.Yet behind China’s improved GDP performance lurk some long tail risks. Credit growth exploded in the firstquarter, in an economy already awash in debt and industrial overcapacity. The China’s credit/GDP “gap” (thedifference between the credit/GDP ratio and its long-term trend) stood at 30.1%, the highest for the nation indata stretching back to 1995, according to the Basel-based Bank for International Settlements. Readings above 10%signal elevated risks of banking strains. A blow-out in the number can signal that credit growth is excessive and afinancial bust may be looming.The borrowing binge spurs questions about sustainability, and may create thornier challenges later unlessPresident Xi Jinping’s government follows through on its goals of restructuring bloated state-owned enterprises andcleaning up a bad-debt encumbered banking sector. Some analysts argue that China will need to recapitalise its banksin coming years because of bad loans that may be higher than the official numbers.

1.1.4 United States: underweight

The U.S. election’s over, but for equity investors it’s the same old bull market. Donald Trump inherits a 2,826-day-old rallyin U.S. stocks that has defied history, overcoming anemic economic growth and a 15-month earnings recession that pushedvaluations to a seven-year high. Squeezing out even a couple more years would be a feat of unprecedented longevity, withAugust 2018 looming as the month the advance will exceed all that came before.

Maybe it will keep going forever - it’s already 32 months longer than the average advance since the 1930s. But if it doesn’t, anew president’s best hope often is that equity pain hits fast. Just ask Barack Obama and George W. Bush. Luckytiming on market cycles has been a blessing for three straight presidents, helping them enjoy powerful advances by theirsecond term.

Among arguments for continuation of the U.S. rally, the start of a new administration is often a bullish time for equities.Since the 1928 presidential race, the S&P 500 has rallied an average of 5.1% in the first full year after an election, Bloombergdata show. That includes gains of at least 23% in 2009 and 2013, following the two most recent votes.

Furthermore, earnings recently turned higher, a sign of momentum that has historically proven hard to reverse. Amongthe nine instances since 1936 when companies emerged from an extended streak of profit declines, stocks posted gains inall but two. The S&P 500 rose an average 12% over the following year, compared with an annualized return of 6.3% in thepast eight decades. On the three occasions when the earnings contraction wasn’t accompanied by an economic recession,as is the case now, stocks rallied an average 13%.

Finally, our economists remain of the view that U.S. policy makers will adopt a slower pace of tightening in the future:50 basis points in 2017. That should also be good for the U.S. stock market. U.S. stocks have gained an average of 11% overa year’s time when the Federal Reserve takes a gradual approach to raising lending rates. That compares with a 2.7%average decrease during faster rate cycles. Moving slowly after liftoff would give policy makers time to assess the impact ofhigher rates on the economy and reduce the chances they would overshoot and raise rates too high.

There are no alarm bells going off right now, but something will eventually come along and jolt the economy in anegative way. Bull markets don’t just die solely from old age. There’s always some sort of contributing factors. Theseinclude the fact that hedge funds turned outright bearish on U.S. equity futures for the first time since April with theS&P 500 index on the verge of breaking through the lower bound of a three-month trading range. Large speculators wereshort a net position of 2,200 contracts, after staying long for 25 straight weeks, according to the latest data from CommodityFutures Trading Commission. The pace at which sentiment worsened is at the fastest since 2011!

Rising valuations have also given bulls reason for pause:At 20.5 times earnings, the S&P 500 trades almost 20% above its 10-year average.In the Fed model that plots earnings yield against 10-year Treasury payouts, the S&P 500 is also less cheap.

1.2 Style call

1.2.1 Cyclicals versus Defensives: neutral

The recent rally in companies most dependent on the economy is unwarranted given the risks in global growth andgiven the fact that valuations of cyclical companies reached a two-year high relative to defensive bets. TheBloomberg World Consumer Cyclical index, which includes mainly industries such as industrials, consumer discretionaryand consumer staples, has rallied 7.6% (in euro) in November, almost two times more than a similar gauge trackingdefensive companies. That has pushed their valuation to more than 15.5 times estimated earnings, near the highest sinceNovember 2015 relative to defensives.

The significant rotation into cyclicals in recent months suggests those equities are now more vulnerable to anydisappointment as the market has been pricing in a too optimistic environment.

While we think that rates should go up in the medium term and while we know that such a bearish bond environment hurtsdefensives equities and bond-like stocks (the direction of the movement in bond yields was in the past a very goodindicator of the relative performance between cyclical and defensive sectors), the outperformance of cyclical sharesdoesn’t seem to be yet in the cards.

1.2.2 “Value” stocks: overweight (versus “growth” stocks)

Traders from America to Europe are increasingly turning to a portion of the stock market that they have shunned since thefinancial crisis. Value shares, those that are cheap relative to their earnings and asset value, are trading at their highestvaluations since 2009 versus growth stocks in the U.S., while in Europe they have become the costliest since May.

The change of heart underscores newfound investor daring after years of central bank efforts to restore confidence in theeconomy, just as Donald Trump’s presidential win led to increased bets for faster growth and inflation.

The Federal Reserve’s first rate increases since 2006 (in December 2015 and probably in December 2016) shouldcontribute to the shift, because the companies in the Value stock category have more to gain from an increase of interestrates. Rising bond yields are supportive of value stocks as there is typically a strong positive correlation between the relativeperformance of value versus growth stocks and the direction of bond yields.

The macro environment is still slightly biased toward Value on the basis that global growth is improving (while onlyslightly) and that bond yields should trend higher over time.

On the long run, value stocks perform better than growth stocks. While it is true that relative performance is reversedduring contractions, the duration of expansionary periods tends to be greater. Therefore, investors can profitably adopt apassive holding in which, for example, they buy only value.

Growth stocks, which we define as those with the highest price/book value ratio (P/B), are still trading with a valuationpremium to value stocks.

1.3 Sectorial calls:

1.3.1 Global sectorial calls:

1.3.1.1 Energy: overweight

Trump’s victory will support U.S. oil and gas production, with less regulation on exploration and a lifting of drillingrestrictions in certain locations.

But the impact could be initially offset from renewed sanctions on Iran, which could prompt the Persian Gulf state tomaximize production in the short term rather than comply to an Organization of Petroleum Exporting Countries (OPEC)freeze.

Even if the production curb happens (the proposed deal would reduce production by anywhere from 200,000 to 700,000barrels per day to 32.5 to 33 million barrels a day), analysts say it won't matter much, anyway. As OPEC is at or closeto its maximum production, agreeing to a small cut is not much of a concession, especially given the history ofthe Iranian/Saudi relationship (Iran, Nigeria and Libya are exempt from the deal) and potential additional supply whichcould come on line (through non-OPEC production and inventories).

It is challenging for the group to follow through on the cuts and, historically, there has been a credibility problem.The market has rewarded the OPEC rhetoric (Brent futures increased 16%, in euro, to $48 a barrel). Let’s see if theirdeeds match their words.The real significance of October’s framework OPEC production agreement is not the size of the implied or actualoutput cut, but the fact that Saudi Arabia and OPEC have returned to active market management.While it is difficult to overstate the importance of this change and while it is unclear how the plan will be implemented,Goldman Sachs calls for oil prices to climb between $7 and $10 per barrel in 2017, and possibly higher if theOPEC production reduction deal goes through.We believe that the 2016 likely oil price range is $40-55 per barrel with risk to the upside and the likely 2017 range is$55-70 per barrel, as the OPEC’s decision should reduce oversupply in global oil markets. In this context, we are morepositive on Energy on both side of the Atlantic with particular emphasis on integrated oils which shouldoutperform refiners and oil & Gas services.

Since the September 28 decision by the OPEC, oil prices and oil major’s shares have surged, forcing traders tounwind positions that would benefit from a decline. This seems to be a sector where stock-pickers are being rewarded for thefirst time in a while. When there are concentrated short positions and an upcoming risk event, you have to be careful if youown those shorts. But with them now cleared out, it can actually be healthy for the market.

Now that investors aren’t so concerned that an unchecked surplus of crude will decimate the industry, traders canfocus more on the individual attributes of energy stocks. That would be a major shift for a sector that’s fluctuated on thewhim of oil prices over the past 18 months.

1.3.2 U.S sectorial calls:

1.3.2.1 Financials: overweight

The U.S. Election and the Trump’s victory accelerated the rotation into Banks and Insurers as higher yields couldmean billions in extra income. Bank executives, who have seen theirprofits squeezed as yields have fallen, may now get a long-awaited bump as the gap widens between what they pay ondeposits and what they earn on investments. Known as net interest income, it makes up on average about 65% of banks’revenue. According to Paul Donofrio, Bank of America’s chief financial officer, a percentage-point increase in yields across allmaturities would lift the lender’s net interest income by $5.3 billion in the next 12 months.

That is a good news as the S&P 500 Financials index snapped a multi-year revenue drought in the third quarter witha quarter-over-quarter sales and earnings growth of respectively 6% and 12% (versus +1.3% and -5.5% the previousquarter). You have to go all the way back to 2009 to find back-to-back quarters of double-digit earnings growth for the sector!

It’s too early to say, of course, whether the third quarter’s results represent a turning point for U.S. financials, but there aresigns that some investors are regaining confidence in the sector, especially after the Trump’s win. The S&P 500Financials Index has returned 41% (in USD) since the year’s market low on February 11 through end of last month, while theS&P 500 has returned 21% over the same period.

Given the wide valuation gap between financials and other sectors, it’s no exaggeration to say that a bet on valuestocks is a bet on financials and that a bet on growth stock is a bet against financials.

Financials are by far the most prominent sector in U.S. large-cap value indices, which is a collection of thecheapest U.S. stocks. They represent 23% of the S&P 500 value index and 24% of the Russell 1000 value index.Financials are also the most cheaply valued sector based on fundamentals, whether measured by assets orincome. U.S. Financials trade at an estimated price/earnings ratio (P/E) of 16.9 and a price/book (P/B) ratio of 1.4. Thenext cheapest sectors trade at a P/E ratio of 15.4 (telecom) and a P/B ratio of 1.9 (energy and utilities).