Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
Risk-off dynamics accelerate as Chinese coronavirus worsen
Peter Garnry
Chief Investment Strategist
Summary: Equities in Hong Kong are down almost 3% as the coronavirus in China is worsening impacting real estate, casino and car stocks. With Chinese New Year coming up the situation could get even worse so investors should have this on the radar. In today's equity update we also look at the brewing crisis at Boeing as the company has lost $4bn in free cash flow in two previous quarters and is now negotiation large financing packages with banks. UBS has reported worse than expected Q4 and FY2019 numbers sending shock waves through the European financial sector as it is still bleeding from the ECB's negative interest rate policy.
An unknown virus started small in Wuhan, China, back in mid-December 2019 with the Chinese health authorities later saying that the virus was related to SARS. Initial expectations were muted and human-to-human transmission was not presumed, but yesterday Chinese authorities announced that human-to-human transmission had taken place between patient and health worker. In addition the number of infected people was on rise. The reaction function has been prompt with Hang Seng futures down 2.8% in today’s session led by real estate, casino and car stocks. While we don’t know the direction in equities from here related to the coronavirus, history tells us that there are many unknowns and that the initial reaction often fails to discount the true extent. Short-term this could get much worse for Asian equities as the Chinese New Year means that millions of people will be travelling potentially spreading the virus fast over large areas.
Boeing crisis could get very ugly
As the grounding of the 737 Max continues the crisis deepens at Boeing with news out yesterday that the company is in talks to secure $10bn financing as the aircraft producer is hemorrhaging cash. In Q3 the company delivered negative $2.9bn in free cash flow (FCF) following negative FCF of $1bn in Q2 and this number could worsen in Q4 which we will know when Q4 earnings are released next Wednesday. Boeing has maintained CAPEX and dividends levels which has forced the company to increase debt to avoid depleting cash reserves. The total debt has risen to $25.9bn in Q3 2019 from $11.9bn in Q3 2018.
The stock price is down 25% from the peak in March 2019 and is pushing towards dangerous levels that could make many fund managers to reverse their long-term views. Despite the stock is down 25% the enterprise value to total assets ratio is still close to all-time highs reflecting a high degree of confidence in the value of the balance sheet and thus future cash flow generation. If these expectations are shattered next week at the earnings release then the crisis could become severe.
UBS sends a warnings shot to Europe’s banks
UBS shares are down 5% as the bank misses fiscal year profitability and cost targets in addition to trimming its mid-term goals. UBS has been hit by wealth management outflows, negative rates and poor performance in its investment banking division. This obviously sends a warning to investors if they thought overweight European banks was a good idea. Negative rates will continue to haunt European banks until the ECB changes its mind on negative rates.
Rethink equity valuation on monopolies
Clients are often telling us that equity valuations do not make sense any longer and we observe same phenomenon in public discussions between market participants. But as we argued lately we believe investors have to contemplate the fact that equity valuations could potentially eclipse the levels from the dot-com bubble if rates continue at these low levels and the global economy continues to expand. That mix drives TINA (there is no alternative) behaviour and reprice equities closer to bonds, especially the monopolies with robust cash flows. Is Microsoft really expensive with a free cash flow yield of 3% and revenues growing at 12% y/y given 10-year US Treasuries offer 1.8% with rising deficits and potential inflation?
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