Banking and referendum worries. Release the bull, it’s spring!

Will this year be better?

Fredrik Tauson and Magnus Nilsson, who manage Catella's fixed income funds, discuss the future with Ulf Strömsten, who manages the Catella Småbolagsfond and Catella Hedgefond funds.

Actually, it is unusual for the stock market to move as clearly alongside oil as it has recently. At the start of the year, there was something that at least resembled a temporary floor for oil prices, and the same can be said of the stock market.

In the case of oil, the capacity reductions that have been made, particularly in the US, suggest that prices may be near a bottom.

"This is supply-led and driven by production, not least of America's shale oil, as well as by the agreement to ease sanctions against Iran. We also believe that we are reaching something of a floor. Plenty of capacity is being shut down in the US since it is unprofitable at current levels," says Fredrik Tauson.

The price pressure means that reports from producers are increasingly deteriorating, and their balance sheets are becoming more stretched. There are few bonds in the Norwegian oil services and oil production industries at their maturity value – most in the high-yield sector are between 30 and 70 percent of par, which means the investor community has already taken a sort of loan loss.
How much of a loan-loss approach an investor has in mind when making investments linked to these companies varies, says Fredrik Tauson.

"It depends on whether there is capital to inject from a strong shareholder, and whether they have the backing of a bank that can ease the payments. It very much depends on the individual company – there is no general risk premium," he says.

We have Saudi Arabia with around 90 percent of its revenues from oil, and in principle no taxes and free medical care. Russia has double-digit inflation, a weak ruble and big problems, Brazil has huge problems and Venezuela is more or less bankrupt. How will developments impact these countries?

"An important aspect is the importance of oil in terms of cash flow to cover expenditure in these countries," says Ulf Strömsten, and points to the conflicts that are holding back potential changes.

"Saudi Arabia has taken initiatives to restrict production, but does not want to do this unilaterally without Iran joining in. Iran has underinvested for a number of years during the sanctions, which means it needs to make enormous investment to catch up, and it needs the export revenue from oil. In the near term, it is difficult to see that Saudi Arabia and Iran, which do not even have diplomatic relations, will agree on joint production cuts," continues Ulf Strömsten.

Low oil prices benefit many companies, and especially private individuals, with cheaper fuel and lower heating costs. This should in turn mean they have money over to spend on other things.

The world's central banks have continued their powerful stimulus approach, which means the ten-year German bond yield is now down to 15 basis points and the Swedish 50 basis points. The lack of returns in traditional fixed income has led to very vigorous flows to corporate bonds and various funds.

Concerns have spread across the fixed income markets, most recently apparent in the uncertainty about Deutsche Bank's debt. According to Fredrik Tauson, the latest wave of unrest originated in the Mediterranean region.

"It started in the Portuguese and Italian banking systems, with the prices of their issued bonds decreasing, and the unrest began to spread. Then Deutsche Bank issued a very weak report, and this is a bank that brings its own uncertainty – Deutsche Bank has a completely different capital adequacy ratio than Swedish banks, at around 11 percent compared to 20 percent for the Swedish banks," says Fredrik Tauson.

The uncertainty was whether Deutsche Bank will be able to meet its interest obligations on junior debt, known as CoCos – contingent convertible bonds.

"Deutsche Bank's junior debt traded down by 25-30 percent, which affected the entire market. When such large repricing occurs, it rubs off on similar assets, even if they are issued by better rated banks like the Swedish ones. So everything followed a downward price movement, which we think was a quite substantial mispricing," says Fredrik Tauson.

He points out that Handelsbanken's junior debt is still rated as investment grade, with a BBB rating, despite an expected return of 7.5 percent.

"There is nowhere else in the world you can find a BBB rating that provides an expected return of 7.5 percent, so we believe there must be a mispricing somewhere," says Fredrik Tauson.

Magnus Nilsson adds that, for some time now, the banks have been regulated increasingly harshly in terms of their ability to take risk. This is a global phenomenon, and the ability of banks to hold inventory of different types of security has decreased successively since 2008-2009. Meanwhile, the credit asset class has grown very strongly.

When the asset class dips, people start to sell, and it easily becomes a one-way market, with very little capital able to absorb the risk.

"The movement and volatility in the market is greater than the fundamental situation warrants, and this also very much applies to bank bonds," says Magnus Nilsson.

Catella's fund managers have previously held CoCos with Swedish banks, and they are still attractive, believe Fredrik Tauson and Magnus Nilsson.

"We have been attracted to this asset class since we believe there is a mispricing, given the kind of banks we have in Sweden, based on a branch network and not on investment banking. If you then get 7 percent or 7.5 percent on a bond issued by Handelsbanken, it's a definite buy," says Fredrik Tauson.

Do you think more buyers will return to the market?

"Yes, I think so. Firstly, the traditional interest rate options are too unattractive, and secondly, I envisage some form of positive growth – I do not envisage an economy in recession. Sweden looks amazing and Europe is muddling through with positive overtones, as is the US. The economic picture looks far from pitch black," says Magnus Nilsson.

On the equity side, the year-end reports published so far have been more or less in line with expectations. According to Ulf Strömsten, anything unexpected has been mostly about comments from the companies regarding 2016. Quite small deviations from expectations have, in many cases, been severely punished, and the reporting period has been characterised by large price movements – both positive and negative.

Sweden was one of the countries that demonstrated the best growth in the past year, much of it driven by increased private consumption. The conditions look very different in the rest of the Nordics.

"Sweden and Denmark have good outlooks, while Norway and Finland are facing much weaker prospects – for Norway in the wake of lower oil prices, of course. And the picture in Europe is very fragmented," says Ulf Strömsten.

US reports have been a mixed bag, with earnings per share in several cases below analysts' expectations.

Is this a sign that earnings growth is slowing, and that the US market is overpriced?

"There is an obvious risk of that. Looking at ISM data (purchasing managers index), there have been quite a few months of falling ISM for manufacturing, while the PMI for services remains high. This also aligns well with US consumers being relatively strong, but companies are worried and we are not seeing investment at the same level as before," says Ulf Strömsten.

Sweden's NIER economic indicator fell slightly in February, but it still indicates stronger than normal growth.

"The fundamentals for Swedish industry have remained strong throughout, even in 2015. Sweden is one of the European countries with the highest growth, and we have a good balance in terms of employment. However, we are dependent on exports. What we saw in 2015 was that our main export markets did very well. But Norway is now starting to break following oil price decline, and this will become apparent in the Swedish economic indicator if the unrest is protracted," says Ulf Strömsten.

If we compare large caps and small caps, small companies have experienced stronger share price trends over the past three years. But this year there is not much difference. Shouldn't small caps have fallen further?

"The small companies have greater exposure to markets that have been stronger, and the small caps sector also has many more growth companies, with growth that is not cyclical and where the companies are growing for other reasons. But at the start of 2016 there was initially a fairly sharp fall among small caps. There is no doubt that numerous investors took the opportunity to take profits in many of the small caps that had experienced very strong performance," says Ulf Strömsten.

The key for stock market to end full-year 2016 in positive territory will be developments in Europe, according to Ulf Strömsten. He believes that Europe is very much the master of its own destiny, since most of its trade is with other European countries.

Later in the year will be the British referendum on remaining in the EU, which will significantly impact the market.

"When I look at the stock market, I think we will see a mirror image of last year: a weak start that will continue for a while, and then perhaps a stronger finish when we take back much of what we lost," says Ulf Strömsten.

For the stock market as a whole, we expect greater willingness among private equity and industrial players to buy companies – when organic growth slows, the need grow through acquisitions, and the interest, increases. If the market is characterised by falling stock prices, the prices of unlisted companies will naturally also track downward, which could lead to even greater increases in mergers and acquisitions.

Will it be a bullish year overall in stock markets?

"I think we will take back what we have lost. We should probably not hope for any major gains, but we will take back what we lost in the second half," says Ulf Strömsten.

He is backed up by Magnus Nilsson.

"I can only agree with Ulf. We also expect continued volatility and movement in the financial markets. But valuations have become so low that this will provide positive sentiment as we move into the summer," he says.

Fredrik Tauson sees great opportunities for investors seeking risk.

"The flow into money market funds or bank accounts during the first two months of the year is unlikely to stay there very long, and it will seek out risk again. Then comes the question of where to find the best upside – there are great opportunities in high yield since many bonds have fallen 20-30 percent for reasons of liquidity rather than fundamentals," he says.

Important Information
Investments in fund units are associated with risk. Past performance is no guarantee of future returns. The money invested in a fund can increase and decrease in value and it is not certain that you will get back the full amount invested. No consideration is given to inflation. The Catella Balanserad, Catella Credit Opportunity, Catella Fokus and Catella Hedgefond funds are special funds under the Swedish Alternative Investment Fund Managers Act (SFS 2013:561) (AIFM). Catella Reavinstfond and Catella Småbolagsfond may use derivatives, and the value of the funds may vary significantly over time. The value of Catella Sverige Index may vary significantly over time. Catella Avkastningsfond may use derivatives and may have a larger proportion of the fund invested in bonds and other debt instruments issued by individual national and local authorities and within the EEA than other mutual funds, in accordance with Chapter 5, Article 8 of the Swedish Investment Funds Act (SFS 2004:46). Catella Nordic Long Short Equity and Catella Nordic Corporate Bond Flex may use derivatives and may have a greater proportion of the funds invested in bonds and other debt instruments issued by individual national and local authorities and within the EEA than other mutual funds. For more details, complete prospectuses, key investor information, and annual and half-yearly reports, please refer to our website at catella.se/fonder or phone +46 8 614 25 00.