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Chief Investment Officer's team, 26.11.2018
Last week was another difficult one for global markets: in US dollars, global equities lost 2.6%, with Emerging Markets slightly better than Developed, Oil prices lost a shocking 10%, which triggered a spike in implied volatility and losses across the riskiest segments of fixed income (the only safe haven being US treasuries).
As shown in the chart above, this leaves investors with a very difficult year so far, marked by a sea of red across asset classes and regions.
Where do we stand?
As we are one month away from year-end and the high–volatility regime is not abating, we would like to share some thoughts with you about what we think it is going to happen next.
First, we shouldn’t forget that 2017 was an outstanding year for investment returns, with DM equities delivering over 20%, and close to 40% for EM, as well as robust performances from fixed income and commodities.
To that extent, markets in 2018 have mean-reverted after a buoyant year.
Technicalities apart, market concerns are at least well identified: global growth has arguably peaked, which clouds the future of margins and earnings, and more importantly it is geographically uneven: the US is the only region outperforming expectations. This supports a stronger dollar and higher rates, putting pressure on the Emerging economies. Finally, political uncertainty is everywhere, especially in the relations between the US and the rest of the world, on international trade and oil, but not only (Brexit and Italian budget in Europe, various geopolitical tensions).
These three negative catalysts (late-cycle concerns, regional divergence and political risk), alongside tighter rates in the US, have flipped markets into a high-volatility regime. This change means that many trends have broken, sometimes brutally, from the outperformance of US tech stocks to, even more spectacularly, Oil prices losing 30% in a few weeks.
What explains the recent acceleration is that these trend reversals have been terrible for two categories of market participants in particular. First, many hedge funds, who rely on trends, were typically long Oil and short US treasuries – for risk management purpose they have to liquidate. Second, “gamma negative” players (sometimes hedge funds too, but generally positions linked to derivatives) who are short volatility, as well as risk-based funds, are in a position where the more an asset fall, the more they have to sell it. Both categories are forced sellers (price-insensitive), which explains the current acceleration. Oil is at the very core of the current reversal, as lower oil prices put pressure on high yield bonds, where the energy sector is materially represented. High yield bonds going lower means a higher cost of borrowing for some corporates, which fuels in turn the macro risk. Another worrying factor is the fact that many investors are using ETFs to access the High Yield asset class, and these ETFs are arguably perceived as more liquid than their underlying assets which adds some “systemic” fears.
This is the key risk we are monitoring: a full capitulation in the short-term is always possible, and it wouldn’t be the first time (it is generally a good buying opportunity). However there are levels on Oil price and high yield bonds which could spiral in markets and translate to the real economy. We are closely monitoring these levels, and the good news is that we are not there yet.
For the near-term, we see three potential scenarios.
The worst case is the one we just described, with the market rout turning into a crash which would threaten the economy through credit defaults. As we believe that most of the forced-sellers have already liquidated their positions, we would not put a high probability on it (around 10%). Should it happen, the assets to own would be gold, long dated US Treasuries, and cash, and EM could lose less than DM simply because of less debt in their economies and lower valuations.
The best case scenario is the following: at least one serious market concern is addressed, and the ideal candidate is clearly a deal between US and China on trade. It would relief markets, boost corporate confidence, and dissipate the risks of supply-chain disruption and the associated inflation in costs. This is not to be excluded: in previous negotiations, Mr. Trump has proven very pragmatic (with Canada, Mexico, Europe, Japan, even Iran to some extent) and after the mid-term elections, the last thing he wants is a recession in the next 2 years before the Presidential elections. We would estimate a 30% probability. In this case USD would trend lower, EM would do very well.
Finally, our central scenario is simply that markets make it through the change in volatility regime (as it generally happens, see the beginning of 2018) and that investor focus returns to fundamentals. They are actually compelling: global growth is slowing but is still above trend, with global economy expected to grow by more than 3% in real terms, which supports earnings growth and ensures borrowers solvency. None of the classical market-implied recession indicators are flashing red. At current levels, equity multiples are now below their historical averages everywhere and don’t pay justice to earnings growth. Finally the least we can say is that there is no euphoria in the market. We would put a 60% probability on this scenario, which would support the typical late cycle asset, equities, especially in the US due to current earnings growth, and EM for the longer term.
As a reminder, our recommended positioning is currently quite conservative with equity weight around 32% for a moderate profile for example. Our latest change in asset allocation was to cut high yield to Underweight and go Overweight gold in October. As sources of return, we own US and EM equities as well as EM debt. To mitigate the risk, we own gold, US government bonds and cash.
To sum-it up: the short-term is highly uncertain as always in 2018 (see our Year Ahead publication “Eyes wide open”), but we are confident in the cycle, valuations, and positioning. As volatility is here to stay, holding cash and avoiding excessive leverage preserves flexibility to seize opportunities. A “systemic” risk exists, which we see as the interaction between Oil price and high yield ETFs, but we rate it with a low probability (see our comments on oil below) and monitor it closely. The other potential risk would be the Fed hiking way more than currently expecting, with a booming US economy but in this case the current concerns on US earnings would be dismissed.
Constructive on oil
Oil is making headlines, with the main benchmarks WTI and Brent, down respectively 34% and 33% since early October, the longest streak of consecutive negative sessions in 34 years. Options skew, the premium puts command versus calls at times of heightened volatility, has reached record highs, and banks that had sold hedges to producers are now scrambling to sell more crude futures to hedge their books, as the puts they sold are now closer to strike or in the money.
The combined increase in supply by US, Russian and KSA in the last six months was not offset by the expected decline in output from Iran, since the concession of waivers by Mr. Trump allowed existing buyers to continue to source crude from that country. The ensuing oversupply, which saw US inventories swell, alongside concerns about a hit to global growth from the Sino-US trade war, and the effects of speculation, magnified price movements.
So, is this the perfect storm for crude, headed towards a continuation of its newly born bear market?
We don’t think so.
US waivers, hence excess supply, are temporary and intended to last six months. Demand disruption so far has not occurred and indeed, according to the International Energy Agency, demand has been modestly rising from a year ago in 2018, with no expectation of a drop on the forecast horizon.
Also, Mr. Trump should be careful what he wishes for. Although lower crude prices amount to “a tax cut for America and the world”, they also affect US shale oil producers negatively, with many of them setting their budgets for this year at $50 (WTI closed at $50.4 for the week) or higher. US oil ambitions could be at risk.
Finally, global output might not stay at current record levels, with some of the key producers already operating at close to full capacity. The December OPEC+ meeting will have to find an optimal balance between global and regional objectives for the major players.
Overall, it seems that the oil market outlook should be much more constructive than the recent events suggest, especially in the next few months, before slowing global growth and restrictive Fed policy start to bite, most likely in the latter part of next year.
Fixed income update
Heightened policy uncertainty, global trade and rising growth concerns have repriced risk premia within the fixed income asset class, triggering a flight to safer asset, in particular cash, now boasting a significant yield.
The Fed has further to go to reach its “neutral” before this economic cycle fully matures. We wonder whether the new normal on rates could be pragmatically adjusted given structural concerns on US debt levels. With this stance, one could argue that 2.50% to 2.75% could be a “new normal” level. As regards longer term maturities, we see US 10y Treasuries hitting 3 percent before seeing 3.2 percent and foresee a flattening yield curve. On corporate investment grade, market’s optimism has been hit by the current concerns on “peak margin” and fading profitability. We are closely monitoring leverage to minimize any unexpected downside risks to our assessment. We maintain our underweight positioning on the high-yield sub-asset class given that energy and oil-related companies form a large constituent of this universe and as default levels remain unusually low. Emerging Market debt remains our preferred play, and we reiterate our recommendation to selectively position in countries and sectors with the strongest fundamentals.
In our region, the upcoming GCC summit in Riyadh next month could have significant positive implications. Kuwait’s deputy foreign minister Khaled Al Jarallah has confirmed that all six Gulf countries will be attending. Mr. Al Jarallah said the summit could present a “hope to resolve the Gulf crisis and solve the differences”. We maintain our overweight stance on the GCC bond markets. YTD, GCC bonds have been more resilient than other Emerging Market bonds with a -2% negative return. The main risk is obviously oil price (see above).
The S&P 500 fell 3.8% last week, erasing the year’s gain. The technology sector and the FANG stocks were once again in focus as they saw the maximum pain -though they still retain the best performance amongst all thematic baskets if seen over a 1 or 3 years timeframe. European markets too had downbeat performances as Italian debt and flagging growth remain concerns. Asian markets were down for the week but still up for the month (oil importers such as India have recovered in November, as has the Indian Rupee). The increased volatility in markets is still at normal levels with the Vix Index at 21. Sell offs of 5 to 10% are not an aberration but the norm as most calendar years see at least two 5 to 10% drops. . Fundamentally, expectations of slowing growth will have an impact on the profitability of companies but we believe this is now fully priced-in.
In our region, governments keep on deploying measures to support investment, real estate, and strengthen the ongoing social and economic reforms. The UAE announced reduction in government fees, eased regulations on foreign ownership of businesses outside free zone areas, and approved long-term visa system. KSA has launched numerous affordable housing programs and mega projects to support the sector. Abu Dhabi announced economic stimulus of AED 50bn for the real estate sector, business owners and tourism for the next three years. Dubai’s Expo 2020 is expected to provide a positive boost to various sectors such as hospitality, retail and real estate. There is not clear market catalyst yet for regional equities but there is little doubt valuations doesn’t reflect the growth prospects. We are confident, but patience is required.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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