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Chief Investment Officer's team, 17.12.2018
After a brilliant 2017, investors are looking forward to ending a much more volatile 2018. The last week saw a mix of volatility and downward trends across assets. We still haven’t see the tangible signs of fundamental deterioration which would justify the current price action. However, market participants see the proverbial glass as being half-empty, despite a more dovish Federal Reserve and the US/China truce on trade. Instead of acknowledging progress on what were the key concerns some weeks ago, risky assets have reacted to the mixed data from China and Europe. Equities lost 1% across regions, fixed income was flat, oil was down 2.7%, and the US dollar was firmer against all major counterparts.
We stick to our view that markets undershoot fundamentals but keep our overall modest absolute allocation to risky assets unchanged: this period of the year is anyway not appropriate to take new positions, as lower volumes can lead to erratic price variations.
Markets are still caught in the grips of end-of-cycle concerns, fueled by US growth rolling over and the rest-of-world failing to pick up. US growth is tracking a robust 3.5% annualized in the current quarter, while news from Europe and China continues to be disappointing. Globally, forward-looking subcomponents of the headline business confidence index, new orders and future outputs, have dropped further, suggesting that the turning point in the current slowdown phase is not round the corner.
The ECB struck quite a fine balancing act in the latest meeting, remarking that downside risks to the outlook have become more uncertain while confirming a narrative of above-trend growth and rising inflation. Investor attention will be caught by this week’s Fed policy decision, almost certainly a hike, and language, expected to strike a more dovish tone, highlighting data dependency and possibly a shift to a lower number of rate increases than previously planned by the Federal Open Market Committee.
Negative US equity performance this year can be explained by multiples contraction driven by the Fed tightening cycle, compounded of course by specific geopolitical risks. Historically, the S&P500 forward-looking price-to-earnings multiple has tended to drop during times of tighter policy, this year being no exception, and if anything representing payback for when the price to earnings ratio expanded in the face of higher policy rates in late 2017.
What remains surprising is the deterioration of the economic outlook priced in by markets in general, in spite of almost record-low global unemployment, forecasts of above-trend global expansion rates next year and short-term positive news flow represented by the recent shift in Fed tone and the 90-day truce in the US-China trade war. Noteworthy is the inversion of the 5-3 year yield curve on the US Treasury market, that has historically preceded peak policy rates by some months. This means on a more practical note that investors are pulling forward the time when they think that US growth will peak, which should occur according to the market-implied view by the end of 2019.
Under this scenario, a positive performance of risk assets would require looser financial conditions and improvements in non-US growth. The Fed would be required to strike a more reassuring note at the forthcoming meeting, the US dollar to weaken against major peers in 2019 and Europe and China to reverse their sluggish growth. Indeed, a slower end-of-cycle pace of Fed tightening is usually associated with the outperformance of DM reserve currencies against the US dollar, which would help ease global financial conditions and support the emerging countries. The effects of China stimulus should kick in by that time, providing that marginal macro improvement which markets have so far continued to look for in vain.
In the shorter term there seems to be no obvious catalyst reversing rising asset volatility; hence markets are unlikely to find a direction until end-of-cycle concerns are dispelled –or confirmed. This supports our overweight positioning on gold, offering value in absolute terms against the backdrop of a shorter Fed tightening cycle, as well as in relative terms as a hedge to rising portfolio risks.
Fixed income update
Asset class returns and recent market gyrations are a function of how macro fundamental data and investor sentiment interact. The underlying story continues on waning global growth as reflected in some of the recent data prints. Chinese retail sales and industrial production both came in below expectations, but not a surprising level given China’s measure to curb credit and leverage in the system. China’s November release suggests that weaker external demand has started to pressure economic activity while domestic demand as evidenced by weaker-than-expected retail sales came in softer.
The slowdown in export growth alongside industrial production growth has renewed worries for a hard landing.
We, however, maintain our view that authorities would extensively fine-tune monetary policy to manage the situation. What remains upbeat are signs of stabilization on property investments. The PBOC governor Yi Gang said on 13 December that the central bank needs to strike a balance between internal and external equilibrium when it determines policy. In a cyclical downturn, the domestic economy should be prioritized, and monetary conditions should be relatively loose, though caution is needed because too low an interest rate will affect the exchange rate.
In the US, the 10-year government yields (2.88%) are well supported and likely to remain range-bound as investors wait for December 19 FOMC which would be accompanied by a press conference. Additionally, the White House and many of the federal agencies are on advanced preparations for a partial government shutdown, as President Trump and congressional Democrats appear unlikely to resolve their fight over the Mexican border wall.
The ECB will stop their quantitative easing program (€2.6tn) in January, and governor Draghi said that while risks are still “broadly balanced,” they are now “moving to the downside”. This tone pushed the benchmark 10Y Bund yields lower to just under a quarter of a percent.
Emerging Markets debt has staged a strong comeback after the summer sell-off. The exacerbation was broad-based in our view with markets not being able to concise risk from idiosyncratic country-specific to simply beta de-risking. During the last few weeks, we witnessed several central banks fine-tuning their policies, and showcasing their willingness to adapt to macro changes and manage liquidity. The resignation of RBI’s top chief around questions on independence didn’t trigger an apocalypse on Indian assets. The Central Bank of Russia hiked interest rates by 25bp last Friday, taking the policy rate to 7.75%. The Central Bank of Turkey kept all policy rates unchanged with the repo rate at 24%. The monetary policy committee statement tilted towards a slightly more hawkish bias.
Broadly, we believe that EM central banks would observe inflation very carefully, and get some margins of leeway should US Dollar stabilize or weaken at a point. Inflation data has been undershooting of late predicated with lower oil prices, stable FX backdrop, and benign food prices.
The three major US indices entered correction territory as retail sales data, and industrial production from China and PMI data from Europe disappointed investors. On Friday, the S&P 500 and Dow Jones indices reversed gains made till Thursday. The Nasdaq is the only major US index still positive for the year while net total returns for S&P500 and Dow Jones are negative. Losses in December to date are c.5%. Slowing growth is seen to be the predominant and the end of year rally may thus not happen without a catalyst – relief on the US/China trade front has not been enough. Strong economic growth in the US is expected to be tempered by peaking corporate margins. Though the Fed has a dovish message and the fear of rising rates in 2019 is diminished, rising wages and input costs continue to put pressure on margins.
The picture is however less miserable when looking at valuations. For the S&P500, applying a reasonable multiple of 16.5X to 2019 consensus EPS of $178 would lead to significant upside to the current levels. Applying our own conservative assumptions leads to fair value around 2830.
Without visibility on tariffs, US companies keep on favoring share buybacks over investments – reaching $200bn in Q3. Short-term impact is mathematically positive on earnings per share, but investments are paramount for sustainable returns.
The 2018 picture is worse outside of the US. The Eurozone is down 13.3% and Japan 10.4% (MSCI Total return USD indices). Emerging markets lost 14.2% but are somewhat stable – and outperforming DMs - since October. The German DAX, which has the highest exposure in its revenue amongst European countries to overseas markets almost mirrors the MSCI EM, with an important representation of the automotive sector. The shift to predominantly electric vehicle production by German manufacturers is somewhat dependent on China, currently the largest market for EVs.
Equity market (total) returns for GCC countries YTD are mixed: the KSA is up +13.5%, the UAE is split between (DFM) at -19.8% and Abu Dhabi (ADX) at +15.5%Kuwait is positive +4.4%. The GCC corporate sector appears to be stable, backed by (as yet) benign oil prices and economic growth. However, external factors and government reforms could put pressure on companies’ cash flow in 2019. According to Fitch, because GCC economies are generally pegged to the US dollar, they are exposed to global monetary tightening policy and higher interest rates.
Companies in the region are focusing on technological innovation. Saudi Aramco has signed an agreement with global technology and innovation leader Raytheon Company to set up a cybersecurity joint venture aimed at providing best‐in‐class cybersecurity services across the region. Raytheon Company, is a specialist in defense, civil government and cybersecurity solutions.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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