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Chief Investment Officer's team, 10.09.2018
This week will mark the 10th anniversary of the largest bankruptcy in history: on September 15th, 2008, when Lehman Brothers filed for Chapter 11, the bank had over US$ 600 trillions of assets, poisoned by a disproportionate exposure to the US real estate, especially the infamous subprime mortgage segment. This event was decisive in turning a US problem into a devastating global financial crisis. Interestingly enough it took another six months for markets to reach their trough in March 2009, with major equity indices losing around half of their values over this period.
There is an old saying which states that “lightning never strikes the same place twice”. Undoubtedly, ten years later, banks all over the world are far better capitalized and ruthlessly regulated, and the US real estate market is arguably not in the same deadly combination of overvaluation and irresponsible lending standards. In the meantime, the unconventional monetary tools built in an emergency to face the crisis have become mainstream globally, and the prices of almost all financial assets have dramatically risen, outperforming by far economic growth and inflation. Symmetrically, global debt has grown to levels never seen before. What has changed for sure is that the financial institutions, targeted by regulations, are not as exposed to risky assets as they were in 2008. This is good news from a systemic point of view, but it means that asset owners will have to deal directly with the next crisis when it happens. They will not be bailed out to save the world, and banks will not provide liquidity or a buffer.
Let us be clear: we are not in the camp of the doomsayers. The past decade has been prolific with incredible new sources of value (technology, EM middle class…), all assets are not indifferently overvalued, and more importantly, the cyclical forces currently at play are not exhausted.
We acknowledge that the next decade will be tougher for investors than the previous one, but firmly believe that selectivity, calibration and discipline will be paramount to protect and grow the capital of our clients.
Last week was negative for the most cyclical assets, equities and commodities, as assets from Emerging Markets were broadly sold-off, starting with currencies. The positive trend for the US Dollar only accelerated on Friday when employment numbers for August were released, showing both above consensus job creations and faster than expected growth for wages. The probability for the Fed to hike rates in September is thus extremely high. At the same time, China’s trade surplus rose to a record USD 31.1bn in August. Against such a backdrop, President Trump reacted strongly on Friday, stating that he’s willing to slap tariffs on an additional USD 267 billion on Chinese goods, on top of the 200bn he had already preannounced and of the 50bn already in place. This would exceed the total value of all goods sold to the US by China.
This is not good news and to be honest, more than we were expecting. We have little doubt that the Chinese economy can stomach this measure in itself but are not comfortable with the impact it may have on business confidence, supply chain disruptions and, of course, on financial markets. We see value in emerging assets for the long-run and are ready to act, but in this new volatile world, discipline tells us that the timing might not be right yet. The US mid-term elections in early November will be the key event to watch. In the meantime, we expect volatility but are confident and ready to add to EM assets. Ten years after the subprime crisis, the US still exports its problems to the rest of the world – short-term political goals have replaced short-term financial greed.
Fixed income update: US, India, GCC
A strong hiring report for August pushed US Treasury yields higher at 2.93 percent. The total nonfarm payroll employment increased by 201,000 in August, and the unemployment rate was unchanged at 3.9 percent. The payrolls data showed that job gains occurred in professional and business services, healthcare, wholesale trade, transportation and warehousing, and mining. The average hourly earnings were the highest since April 2009 rising to 2.9 percent for the month on an annualized basis. The uptick on wage growth is a closely watched indicator to gauge inflation pressures. Investors seem convinced for further hikes during the September and December FOMC amid the recent market stress towards emerging markets assets.
India's current account deficit widened to $15.8 billion (2.4 per cent of GDP), in the quarter ending June as compared with $15 billion in the same quarter a year before. The weakening streak of the INR against the US dollar and high crude-oil spot prices have swelled the current account deficit during the first quarter. The INR has been Asia's worst performing currency this year, touching a record 72 against the US Dollar last week. The currency, which was around Rs 63.38 on January 1, has depreciated by 13.6 per cent since the start of the year. The trade shortfall of 2.5 per cent of the GDP in Q1 is more than the Jan-March quarter’s 1.9 per cent. The widening trade gap on a year-on-year basis was primarily because a higher trade deficit at $45.7 billion as compared with $ 41.9 billion a year ago. The benchmark domestic yields have also followed the rest of the EM peers posting losses across the curve. The ten-year maturities currently yield at 8.02 percent and should recoup its recent losses towards the median consensus of below 7.83 percent, in our view. While real yields in India appear attractive, RBI’s inflation outlook during the August review forecasts 4.6 percent in 2Q of fiscal 2019 and 4.8 percent during the second half. That said, we hold the view that inflation remains in check. Favorable base effects on food, housing and gasoline, and a tight fiscal and monetary policy, together with reduced indirect tax rates on goods and services are partially countering the pressures of rising oil prices. Economic growth in India has been steady and amongst the highest in the world today. The recent GDP growth data and estimates provide us with enough conviction to hold on to our long-standing overweight positioning on the domestic debt.
The primary bond activity has picked up with several issuers slated to price in the coming days. Most of the Abu Dhabi based banks have won mandates while some have also successfully priced CNH and CHF transactions. Abu Dhabi Islamic bank is meeting with global investors for a potential tier-1 style hybrid perpetual Sukuk while Al Hilal bank is preparing for a senior unsecured five year Sukuk sale. The recent news on the consolidation of some of the Abu Dhabi based banks (ADCB, Al Hilal and UNB) have been well taken by market participants. Consolidation is generally considered as a positive from a credit perspective.
Equity update: Global, UAE, KSA, Tech
So far in the third quarter, global equities are slightly positive and highlight the glaring divergence between the US and the rest of the world. The S&P 500 has gained +5.6% this quarter-to-date, while markets in Europe, Japan and EM are negative. In EM, indices from Argentina, Turkey and Brazil have led the decline, exacerbated by sharp currency falls. The EM FX index has fallen 6.3% this quarter and 13.2% year to date. Indian equities which have had a stellar run so far (in local currency) seem to have plateaued with the INR at all-time lows. As regards styles, the spread between ‘Growth’ and ‘Value’ is still impressive with technology being the best-performing global sector, leading to a weight domination in indices, especially in the US where it cumulates 26% of the SP500.
Technology is however not a calm sea with several waves making headlines. Last week saw a few wobbles in the semiconductor sector with companies such as Micron (highly exposed to China) taking a hit. Social media stocks continue their decoupling from tech gains on regulatory issues. Elon Musk seems to be burning himself out, and Tesla shares have lost 32% from their peak. Tesla, a clear leader in EVs, is facing pressure on production and funding and the pressure seems to be affecting its CEO. At the same time, Jack Ma, China’s richest man and the founder of Alibaba, is planning his succession and retirement with a focus on philanthropy on the lines of Bill Gates. To end on a positive note, another great man reached another great achievement as Jeff Bezos’s amazing Amazon was the second company ever to reach USD 1 trillion of market cap, a few weeks after Apple.
UAE markets were dominated last week by talks of a potential merger between ADCB, UNB and Al Hilal Bank. This follows the NBAD FGB merger in the UAE in 2017 and the Saudi British Bank with Alawwal in the KSA. Banking sector consolidation in the GCC will likely improve efficiencies. Consolidation is positive for UAE banks from a return generation and cost perspective, given the fragmented nature of the market. The UAE banks sector is large with a market cap in excess of $100bn, assets over $500bn and high dividend yields currently around 6%. In terms of market cap the UAE’s banking sector is the 7th largest amongst the major EMs. While there are 21 national and 26 foreign/ GCC banks in the UAE, the top five dominate with a 58% loan market share. The three-way ADCB merger, if concluded, would create the fifth largest bank in the GCC (assets) and the third largest in the UAE.
KSA equities have lost some of their lusters with a still- unexplained 3.2% selloff mid-week – called “Saudi mystery” by Bloomberg. The KSA banking Index is up 21% for the year but down from its July highs when it was up 38% for the year have benefited from the MSCI EM inclusion announcement. The KSA Index is now up only 6.8% year to date having lost 10% in the last month.
The KSA remains a retail-dominated market, and it is possible that part of the recent impressive inflows was not only fundamental and long-term oriented, but also speculative and tied to short-term goals. Of course, the global EM context didn’t help, leading short-term investors to book profits in the rare positive EM, especially as there are some uncertainties around the Aramco IPO, and the fall accelerated when the index major support (7800) was broken, reinforcing the idea of short-term technical drivers. Some investors might also have been spooked by the introduction of derivatives to the market next year – which we see as a long-term positive and a decisive step in the institutionalization of the Tadawul. Banks and petrochemicals stocks have been the best performers in the GCC year to date, but we see an uptick in the consumer sector as higher oil prices are leading to a trickle-down effect on spending.
Gold may start to shine again
Some investors must be wondering why in the turbulent times of escalating trade wars, rising EM risk, geopolitical crispation and resurgent populism, gold has put in a dismal -8% year-to-date, rather than act as the safe-haven asset that it is usually held to be. One should argue then, that gold is rather driven by its fundamentals, than by bouts of geopolitical tensions, the cause commonly ascribed to major moves in the yellow metal. Analysis of historical data reveals some surprisingly stable relationships: an inverse one both with US 10-year real rates and the US dollar stands out. From this one can infer that gold acts as a competing safe-haven asset, it delivers higher returns at times of negative dollar performance, and that as a non-yielding asset it tends to be neglected by investors when US real rates, a proxy for long-term US growth, rise sharply. So far in 2018 US long-dated real rates have been rising consistently, and so has the dollar, reflecting a bright outlook for the US economy.
We hold the view that 2019 should see a more supportive macroeconomic backdrop for gold. US economic growth rates are expected to normalize from above-trend levels towards trend, as the effects of tax cuts start to fade and inflation, a late-stage variable, should continue to climb gradually. The combination of lower expansion rates and moderately higher inflation should not keep the Federal Reserve hawkish, providing further reason to warm up to the asset class. In the short term positioning on the yellow metal is at record-bearish levels, raising the odds of a short-squeeze, and extreme readings on other sentiment readings like options skew and momentum suggest that downside is limited. Also, upside potential on the US dollar should be modest, with the bulk of economic growth and monetary policy differential between the United States other DM countries most likely behind us. Overall, the elements for an investment case on gold are starting to fall into place.
We are conjecturing that a bottom should unfold by year end unless our assumptions of moderating US growth and tame inflation do not come to pass.
Range-bound times for the crude market
According to press reports Saudi Arabia aims to keep crude in the $70-$80/bbl band, which would be in keeping with the prevailing macroeconomic conditions of resilient global growth. The upper end of the range would be hard both on the EM-importing countries and global consumers, especially after Mr Trump’s repeated recommendations that OPEC keeps prices in check. At the same time, the OPEC would not be keen to see elevated prices bringing about a repeat of the 2014 experience, when crude collapsed after the oil market remained above $100/bbl in the previous three years, making it economically viable for shale producers to ramp up supply to the point of causing a global glut. The run rate of current production is supported both by missing Iranian barrels due to renewed US sanctions and strong demand driven by the stable global economy. It seems that under current conditions the price range invoked by Saudi Arabia has reason to last.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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