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Capital Markets Weekly: Short covering likely driver of equity rally
This week's blog focuses firstly on the apparent paradox of equity market strength in 2019, at the same time as continuing outflows from equity funds.
The MSCI World Index has appreciated 11% so far in 2019, the best year-to-date performance since 1991, while the MSCI Emerging Markets index has improved almost 9%. Chinese stocks have performed even more dramatically, with the CSI300 index up by 26.5% so far in 2019.
However, the market's strength is not being supported by underlying institutional flows, where data looks weak. According to EPFR data, developed market equity funds have registered a steady outflow of funds since October, with a total net outflow of USD156 billion. Overall, Financial Times commentary cites analysts from Société Générale and Barclays which describe recent stock market performance respectively as a "flow-less recovery" and a "buyer's strike".
Despite this contradiction - which we assess below - equity supply has increased this week, including Lyft's filing for its IPO, a USD3 billion package of shares and mandatory convertible notes for Danaher Corporation, and a growing European calendar including a record GBP3.2 billion package of mandatory convertible debt for Vodafone.
Another equity highlight was Egypt's first privatization under its 2016 program, which was favorably received. Up to 4.5% or 101.25 million shares of Eastern Company, a profitable tobacco company, are being floated on the Egyptian Exchange. The institutional tranche was sold at EGP17 (USD0.97) each and was 1.8 times subscribed. On 5 March, Egypt Today website reported that Eastern will be followed by the flotation of a stake in ENPPI, from the energy sector. The report cited Minister of Petroleum Tarek el-Molla in suggesting this second sale will be conducted in the first half of 2019 before Ramadan. It also suggested that four other energy firms, six petrochemicals companies and three logistics entities will be included in the current phase of Egypt's privatization program.
In debt markets, Greece's new ten year bond was the key highlight. Greek bonds rallied to historic lows after the country was upgraded two notches to B1 by Moody's: on 4 March its outstanding ten-year equivalent (January 2028) bond yield dropped to 3.62%, the lowest level since 2006. Greece responded by announcing a new ten-year bond sale, its first since 2010, boosting its existing "war chest" of advance funding, already worth some EUR27 billion versus 2019 needs of EUR9.2billion.
Greece raised EUR2.5 billion on 5 March, capturing EUR11.8 billion of demand. The deal was priced at 3.9%, with a minimal new issue premium and attracted an impressive 380 accounts, with 89.5% allocated internationally. Fund managers took 68% of the deal, followed by banks with 14.5% and hedge funds with 11%. Geographically, the UK took 37.5%, followed by Germany/Austria and France, each with 9.5%, and the USA with 8%. Greek Prime Minister Alexis Tsipras described demand as having "reached a remarkable level".
The consistent net outflows from equity funds appear logical, given weaker expectations for global growth, and growing fears that the US could move into recession within the next two years, developments which have an obviously adverse potential impact on corporate earnings and thus on equity valuations.
The FT report suggests that the recent rally is thus likely to reflect "short covering" by hedge fund investors. In our assessment, this appears likely on several grounds. Firstly, sentiment was clearly negative during the last months of 2018, amidst fears of slower corporate earnings growth, weaker overall economic performance, a rising Federal Reserve policy trajectory and the significant threat from US trade restrictions. With Fed policy now adopting a more cautious and "dove-ish" stance, and wider hope that a US/China trade deal might be negotiated, it would seem logical for hedge funds to have reduced short exposures. However, such short covering is a one-off event, leaving equity markets potentially exposed once this technical correction dries up.
In this regard, China may prove an important exception: the sharply-increased MSCI index weighting for domestic Chinese shares is likely to produce sizeable new net inflows - of at least USD80 billion - as investors adjust for the index's new composition.
Prior to its latest deal, Greece already held ample liquidity fully covering its 2019 and 2020 funding needs. It has now raised EUR5 billion in 2019, with heavily-oversubscribed deals at both five and ten years. This forms part of a calculated strategy to re-establish Greece's market standing with a series of "on the run" benchmark deals. The latest deal is particularly important in providing Greece with a proper, liquid 10-year benchmark, replacing the prior use of a relatively illiquid January 2028 outstanding deal. The deal represents a clear and unqualified success. However, one caveat raised by IHS Markit sources is the suggestion that markets are discounting an electoral victory by Konstantinos Mitsotakis and the centre-right New Democracy party in Greece's next general election. This indicator will be tested by opinion polls in the coming months, with Greece's next general election due by 20 October.
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