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Chief Investment Officer's team, 04.02.2019
Last week was eventful, with the Federal Reserve meeting, a Chinese delegation visiting Washington, a number of quarterly earnings releases, and the US monthly job report.
The Federal Reserve positively surprised markets. The institution not only reiterated its “patient” stance in hiking rates, but also removed the tightening bias in its wording and added that it could be potentially “flexible” as regards to its balance-sheet normalization. This statement was taken very positively from investors, switching their perception of the Fed, from a threat to support. Outcome on the US/China front was benign, and quarterly earnings exceeded (relatively low) expectations.
As a result, 2019 has printed one of the best starts of the year for decades, across asset classes and regions. While US markets were directly helped by the Fed, a weakening US Dollar broadly spread optimism elsewhere.
As our readers might remember, we were positioned for a normalization after December capitulation, between our overweight on Emerging Markets and our recent increase in equities. However, the pace of the rally is spectacular, and obviously not sustainable. We haven’t reached our year end fair values everywhere yet, but prices are getting closer and we will keep our valuation based discipline.
Cross Asset Considerations: Don't Fight the Fed?
The world’s biggest disruptor last week wasn’t a tech venture, but a venerable institution, the Fed. The US Central Bank has rightly deserved a reputation for being a champion of clear communication policy, gradually adding new instruments ensuring enhanced transparency, from extended statements, to forward guidance, to board members’ projections (the dots). Yet, the January meeting may have disrupted history, as Mr. Powell surprised markets with a dovish U-turn, unexpected this late in the cycle, with full employment and high levels of debt in the US.
No sooner had the December FOMC minutes characterized US economic activity as “rising at a strong rate” and warranting “some further gradual increases”, than Fed officials decided in January to resurrect the word “patient” with reference to further tightening, to drop any upward bias in guidance and to be explicit about balance sheet flexibility. Is this and overreaction to recent market turbulence, which was threatening to feed into negative corporate sentiment, or does this mark a permanent change? In the former case, the risk is that the Fed is whipsawed by its own short-termism, laying too much emphasis on data and market moves, hardly making for a stable monetary policy framework; in the latter, recession risks would be postponed, but asset bubbles fueled.
Mr. Powell, an outsider as the first non-economist Fed Chair in 40 years, first gave the impression of pulling the ‘Fed put’ from under investors’ feet, and as quickly rushed to the market’s rescue over-delivering in terms of accommodative stance. Markets are celebrating, and rightly so. Following previous mid-cycle pauses, which only count to four since the late ‘60s, US equities rallied in the high-single digits, while the dollar declined by slightly less than half of that. Undoubtedly, the return of easy money in the short term will have the effect of expanding global equity valuations, at a time when US economic data is still resilient, but rest-of-world’s remains a mixed bag - a clear source of risk. The US dollar is an obvious casualty of the changed state of affairs with the Fed’s balance sheet run-off. Mr. Powell was not very specific on this point, but in the press meeting ensured, shrouding the topic in sufficiently non-vague language, that investors expect that Quantitative Tightening is no longer on “autopilot”, a U-turn versus previous statements.
As already mentioned in a past issue of this publications, EM assets and gold in particular should be lifted by easier global financial conditions, this time coming in the form of both easier US policy and a weaker dollar. Just going by market charts, one might have guessed that US 10-year real rates would go through the roof once the 1% resistance was cleared, but that didn’t happen, although a high of 1.17% was actually reached. Indeed, following confirmation of the change of stance on Quantitative Tightening, real rates tumbled, and gold and EM assets rallied stronger. This was in line with our positive view on both asset classes, predicated on the expectation of softer monetary policy.
Gold and EM bulls may as well be cheered by dropping US yields, although the inability of real rates to rise substantially in spite of the resiliency of the US economy portends long-term trouble. It is suggestive of an economy in need of perennial monetary support, where business cycles are prolonged by easy money and unable to bear the burden of higher real costs of funding for companies. If the Fed proves to have overreacted to recent asset volatility and global risks and reverts to its tightening plan, asset markets will be shocked eventually and drop hard from inflated valuations. If, on the other hand, the Fed has indeed changed stance and perseveres with its easy policy, recession risks will recede significantly 12 months out, but within an economy in perennial monetary support risk- assets will cease to perform as well. It is also useful to keep in mind that the US Presidential election will be in 2020.
For now, investors can continue to enjoy the ride, bearing in mind that some improvement in the global growth outlook is needed, for markets to continue to rally in the medium term, beyond Q1. Monetary policy can spark a fire, but cannot keep it going indefinitely, unless earnings and the economy add some much needed fuel to it.
Equity Update: A Glorious January
US equities are off to a strong start for the year, posting an 8% gain in January for the S&P 500 and 9.8% for the Nasdaq Index. US equities have been buoyed by better-than-expected earnings with the 4Q growth rate for S&P 500 at 12.5% for earnings and 6.6% for revenues (46% of S&P 500 companies have reported). Dovish Fed comments and strong job growth have also helped investor sentiment European stocks had a good January too, with the STOXX 600, up 6.8% in January (USD net return). However, whilst financials are the third best performing sector in the US this year, in Europe they have lagged on dismal earnings and on a bleak outlook for economic and loan growth. January 2019 seems to be an inverted image of 2018 for global sectors, with energy and industrial leading, whilst utilities are lagging. All 10 global sectors and all major geographies are positive for the year with the best January in 30 years for US equities. In a reversal of 2018, Emerging Markets with the MSCI EM Index up 8.8% in January, are ahead of developed markets with a one percent lead.
In the GCC, the KSA led returns in January as it did in 2018 and ended the month up 9.5%. The UAE indices, though positive have lagged Emerging Market returns. We see the preference for the higher yielding banking sector continue. Strong results from the larger banks in the GCC have aided good payouts and more than met expectations.
Stand out earnings in the US include energy companies Exxon Mobil and Chevron which aided the Dow Jones secure its sixth consecutive week of gains. One of the best performing stocks globally over the last decade, Amazon announced strong top line and bottom line growth for the last quarter, however, slowing penetration and regulatory concerns in India, weighed on sentiment. Whilst China has bred its own strong incumbents, India lags on digital and ecommerce innovation. Its fast-growing middle class is a key target for large US companies that have reached saturation in their home markets.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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