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Chief Investment Officer's team, 14.01.2019
The US Federal Reserve has of late been on a communication campaign to clarify its stance towards the intended tightening path in 2019. The ensuing message marks quite a dovish shift against the previously communicated “dots”. In particular, both the minutes of the December meeting and Powell’s remarks last week laid emphasis on patience, implying the Fed would be on hold for weeks or months. As a consequence, risk premia across asset classes dropped in January, with the largest rallies recorded in equities and oil. Although this change in tone might be more style than substance, as the Fed has declared over and over that policy remains data-dependent, it has implications for asset classes. Gold has rallied slightly more than 10%, EM currencies about 4% and Brent crude 20% from their respective lows of 2018.
Gold as a non-yielding asset is a primary beneficiary of a less hawkish Fed. While most investors tend to focus on its safe haven’s role, we look to US real rates as the primary driver of the yellow metal. We started to increase gold allocations late last year, based on investor excessive short positioning and on the assumption that real rates north of 1% would be capped. A stable or even toppish dollar, as the US versus rest-of-world growth differential narrows, would also be a positive, which has historically shown a consistently negative correlation with the US currency.
EM assets reached oversold levels in late 2018 according to our models, and undershot fundamentals on the Chinese slowdown and tariffs. Interest rates differentials drive money flows between the developed and the emerging markets. Hence, the Fed temporarily pausing offers a window of opportunity for EM assets to make up for lost ground and adjust to more favorable global financial conditions.
The effect of Fed policy on oil prices is more indirect, yet no less relevant. Concerns about a possibly restrictive stance in 2019 weighed on growth expectations, contributing to the collapse of crude prices, alongside supply concerns. Brent crude managed to put in a low at $50/bbl in August, and then rallied towards $60/bbl on a more favorable policy outlook and the reiterated commitment of the OPEC+ countries to cut production from January 2019.
It should also not be overlooked that the PBOC is playing a primary role in the stabilization of global markets as well. While trade frictions continue to be in the limelight, the slowdown in the Chinese economy was started by the hard deleveraging forced by the authorities, and only exacerbated by Mr Trump’s stance. We expect it to be only a matter of time, before the repeated rounds of monetary and fiscal easing work their way through the system and engineer a recovery in financial assets as well, primarily across EM Asia.
Overall, we hold the view that more favorable monetary conditions and a weaker dollar should support risk assets in H1 2019, harking back to what happened during the 2011 and 2015-15 slowdown phases. To be sure, this time around an additional threat is overhanging markets: Quantitative Tightening, the run-off of central bank balance sheets which is taking back liquidity out of the system. While central banks can always stop shrinking their balance sheet if need be, until QT remains on autopilot investors should brace themselves for persistently higher market volatility amidst dropping liquidity.
Fixed income update
The backdrop for US data has been relatively soft. The US inflation report showed consumer prices fell 0.1% during December while the minutes of the FED’s Dec. 18-19 policy meeting published on Wednesday showed “many” officials were of the view that the Fed “could afford to be patient about further policy firming.” The US Government shutdown (23 days) is now the officially longest in history.
The outlook on the US Dollar, the FED’s dovish stance and lower oil prices have provided a window of opportunity for yield hunters. After the significant repricing of yields in Emerging Markets debt, investors are finding renewed comfort on some of the attractive real yields EM Sovereign nations offer. Indonesia sold more bonds than it expected in its first auction of 2019, with the biggest issuance in three years. The real-yields in Indonesia and India, in particular, are becoming seemingly interesting given the benign inflationary outlook.
The World Bank cut its 2019 global growth forecast to 2.9% from 3% and lowered its estimate for emerging markets to 4.2% from 4.7% while maintaining US growth unchanged at 2.5%. In its semi-annual “global economic prospects” report, the World Bank said: “International trade and manufacturing activity have softened, trade tensions remain elevated, and some large emerging markets have experienced substantial financial market pressures”. The World Bank stated that the US was expected to slow to 2.5 per cent this year, from 2.9 per cent last year.
The Kingdom of Saudi Arabia sets the stage for the first blockbuster transaction this year with a $7.5bn dual-tranche (10Y & 31Y) bond sale. The primary order book stood over $27bn. The attractive pricing demonstrates that on a ratings-adjusted basis (KSA rated A1/A+) the regional Sovereign GCC states offer compelling returns with the current macro fundamentals. The first Asian Sovereign bond sale by the Republic of Philippine (Baa2/BBB) had seen a strong appetite at spreads of over 110bp over the US 10Y benchmark Treasuries.
Year to date most major equity markets are in the green: the MSCI World Index is up 3.9%, the S&P 500 is up 3.6%, the Nasdaq is up 5.1% and the EuroStoxx +3.3%. The MSCI EM Index is up 3.8%, however Indian markets fell as an effect of rising oil prices and currency weakness (all indices, total return in USD). Globally energy is the best performing sector in 2019 up 7%, in tandem with the rise in oil prices. The MSCI GCC Index closed the week up 4.3% led by the KSA, with banks continuing to lead returns, as in 2018.
Major U.S. indices finished up for the week, the S&P 500 closed +2.6% the NASDAQ Composite (tech centered) was up 3.5 %, and the Russell 2000 (small and midcap) was up almost 5%. Supporting the move were talks of negotiation on trade between the US and China, a reversal of previously oversold conditions and improving investor sentiment. It is also on the cards that China’s chief trade negotiator, will be visiting Washington later in the month, placing further conviction on the progress of talks.
US 4Q earnings season is set to kick off next week, beginning with Citigroup. According to Factset consensus estimates for the S&P 500 companies are for earnings growth at 11.4% in Q4 and revenue growth at 6.1%. This is below the 24% earnings growth and the 9% revenue growth seen in the first three quarters. However positive surprises could lead to a 4-5% upside on current projections as recent downgrades have been severe. The newly constituted communications sector is expected to report the highest earnings growth at 13% and revenue growth at 20%.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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