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Chief Investment Officer's team, 31.03.2019
The past week was business as usual for investors, dealing with the uncertainties related to a chaotic Brexit, the continued slowdown phase of the global economy and ongoing trade negotiations between the US and China.
PM May was defeated for a third time in parliament on her deal agreed with Europe, and she might be considering a fourth vote this week. Monday a round of indicative votes on rival plans will be held. In case a majority is found, legislation would be introduced on Thursday to force the government to accept the new way forward. Odds of early elections to solve the impasse are increasing, even as the clock towards the new April 12 deadline set for the UK exit out of the EU is ticking fast.
The preliminary business confidence readings in the US, Europe and Japan were not encouraging and confirm that the slowdown phase, the second longest since the Great Financial Crisis, is continuing in the current quarter. Bond yields dropped across all DM countries, reflecting accommodative conditions, soft data and tame inflation.
US president Donald Trump said Friday that trade talks with China were going very well and that he wanted a “great deal”. The expectation is that some sort of agreement eventually will be reached on specific trade measures, in order to spare financial markets and bring home some much needed success. A narrow and patchy deal will be better than none at all for financial assets.
Asset classes USD % total return, YTD 2019 and week
It is a paradox that an exceptionally strong quarter for risk assets is capped by the inversion of the US yield curve, usually a harbinger of recession further down the road. Global equities have almost entirely retraced the steep losses recorded in the last quarter of 2018, and yet government bond yields have slumped alongside. Investors on both sides of the risk spectrum must be cheered by the market windfall, wondering at the same time which leg of the trade will have to give in. Our conviction remains that bond yields have overshot fundamentals and equities will be eventually rerated higher by central bank stimulus.
One should not rush to conclusions based on statistics related to the yield curve. While it is true that 7 out of the 8 US recessions since the ‘60s have been correctly predicted by a curve inversion, it is also true that historically equities have rallied after yields of 10-year Treasuries have dropped below the level of 3-month T-Bills. However confusing this may sound, investment horizons do make a difference. In the short term, an inversion means that investors discount lower growth ahead and at least a pause in monetary policy, if not rate cuts outright. The combination of a pausing Fed and lower long bond-yields becomes a strong driver of equity gains, considering that easier credit conditions lead economic improvements. Yet, the cycle-end can be delayed, but not avoided, so on average a couple of years after the curve inverts a recession follows.
Fundamentals are still mixed, as confirmed by the latest disappointing release of business confidence indicators. Manufacturing activity both in Europe and Japan is shrinking, while the first green shoots of a rebound are visible in the March reading of the China Manufacturing Purchasing Manager Index. Persistent Brexit uncertainty is not helping either, while China-US trade talks continue, with slightly higher odds of a positive outcome. The bundle of economic reports coming this week, the most important of which are various business confidence readings and the US jobs report, will be helpful for divining market direction.
The Fed dovish pivot is driving the easing of financial conditions globally and dampening asset volatility. Conditions are again favorable for carry trades across asset classes and investors have piled back in on corporate credit and EM local-currency debt. With long bond yields capped by tame inflation and soft growth, the ‘Goldilocks’ environment supporting credit should persist throughout 2019.
The US dollar has shown unusual resilience in the face of the dovish shift of the Federal Reserve and the slump in Treasury yields, trading close to the highs of the year against DM peers. As a mid- to high-yielding currency supported by the relative strength of the US economy, it is unlikely to weaken significantly, unless the outlook for the rest of the world takes a marked turn for the better.
Tactical Asset Allocation: simplified positioning
TAA – relative positioning – moderate profile
TAA – YTD indicative performance
Fixed Income Update
Bond markets are currently more pessimistic about the outlook for the economy than equities. Treasury yields drifted to the lowest levels since December 2017 to 2.33% before retracing to settle at 2.40%. Global bond markets are now pricing in significant future economic weakness, with yields at new lows in Germany, Japan, Australia and New Zealand. The difference on long-dated bond maturities versus the shorter-dated maturities in German Bunds and Canadian bonds has also flattened significantly. The spread on the ten-year bunds over three-month bills has fallen from 100bps at the start of the year to the current reading of 45bps. This week the focus will turn to the US Payrolls report, following the February poor reading of a mere 25,000 job increase. The median survey for March is 175,000 jobs, while the rate of unemployment is widely expected to remain at 3.8%. Moreover, several Fed officials are slated to speak over the week. Fed funds futures imply that policy rates will be cut by about 25bps this year. Last month the median projection of Federal Open Market Committee members was for the rate to remain steady throughout 2019.
Global backdrop supportive for EM debt: The inclusion of Chinese bonds (Sovereign and policy banks) into the global bond indices is set to occur on April 1. Inflows have been dominated by central banks and sovereign wealth funds. Market participants expect to see capital inflows of at least USD100bn for this year. The volatility on Turkey’s FX and swap markets has subsided ahead of the March 31 elections. The TRY swung sharply, slumping to an YTD low of 5.75 to settle at 5.57. Yields spiked across domestic bonds and Eurobonds to retrace most of their losses. While near-term volatility is likely to weigh on investor sentiment, our constructive view on the Eurobonds issued by corporates and banks remains unchanged. Although Turkish banks’ NPL ratios remain significantly high, we find valuations compelling amongst the senior unsecured bonds, underpinned by a strong capital structure. Also, adequate liquidity and low leverage have been supporting factors in the current, challenging macro backdrop. We would consider any further repricing on the back of socio-political events as a buying opportunity.
Egypt maintains policy rates on hold: The Central Bank of Egypt’s Monetary Policy Committee decided to keep the overnight deposit rate, lending rate, and the rate of the CBE's main operation unchanged at 15.75%, 16.75%, and 16.25% respectively, and maintained its stance on targeting inflation at 9% (±3bps). Real GDP growth increased modestly to 5.5%in 4Q18, from 5.3% in 3Q18. T-bill yields on the EGP 9bn six-month tenor dropped by 29bps to 17.11%, while yields on the EGP 9.5bn 12-month tenor declined by 33bps to 16.99%.
Fixed Income key convictions
Fixed Income valuations
Chart of the week: Foreign investors' holdings of Chinese bonds surge
Most major global indices returned in excess of or close to 10% in the last quarter, recouping 4Q18 losses. US Markets scored their biggest quarterly gains in a decade, on the conviction that the Fed would hold interest rates at current levels, as growth slows. The S&P 500 Index (total returns) ended the quarter +13.6%. China leads returns globally this year amongst the major economies +17.7% (MSCI China USD) and technology leads global sector performance. Energy stocks have followed gains in oil prices, making the sector the next best performer. Lower bond yields hurt Financials. Markets were largely positive last week, but oscillated between gains and losses, given the ongoing uncertainty over Brexit, trade talks and the soft Euro flash PMI data. We expect equities to trade sideways as we head into the 1Q earnings season. A number of markets are trading at their fair values (the GCC, Europe and the US) and we need more conviction on earnings growth to raise our fair values. Concerns around global growth, corporate earnings, margins, Central Bank direction and geopolitics remain in the forefront for markets.
The technology sector has rallied this year along with the more cyclical sectors such as Industrials. The MSCI World IT Index closed the quarter +17.7%. The rebound is attributed to the continued adoption of cloud services, a solid IT spending environment and robust demand for AI-based solutions. Balance sheets in the technology sector remain solid with large cash balances and relatively low debt providing room for M&A activity. Lyft Inc., is the first online ridesharing service to go to IPO and popped 8% on its debut, valuing it at USD 22.4bn. The well-established market leader, Uber follows it to the public markets shortly. Uber is rapidly expanding outside the US and recently announced an acquisition of Careem, a MENA based ridesharing service for USD 3.1bn. Lyft is yet to make profits and investors are focused more on its strong revenue growth. The importance of bottom line growth is evident as Snap Inc. closed its first day of trading up 44% in 2017, while Alibaba finished its debut up 38%. Snap now trades at less than two-thirds of its listing price while Alibaba has tripled its market value.
A very positive quarter for the GCC with the KSA Index +13.2% and the Dubai and Abu Dhabi indices +7.4% and 7.7% (total returns). KSA banks still lead with the Index +19.4% last quarter. According to Standard & Poor the KSA is expected to maintain a pace of moderate economic growth and retain strong balance sheets over the next 2 years as it tries to reduce its budgeted expenditure by 2023 and reduce the reliance on oil and imported labor. Saudi Aramco, the world’s largest oil producer and the world’s most profitable company in 2018, according to an extract of the firm’s accounts published by Fitch Ratings will buy a 70% stake in SABIC for USD 69.1bn with the aim of integrating assets to boost growth at SABIC. Further bank consolidation too, is on the cards in the KSA, as the National Commercial Bank, has begun talks of a merger with Riyad Bank – this would create the GCC’s third-largest lender with USD 182bn in assets.
Equity recommended regional positioning
Major indices performance (TR, US$) and 2019PE
Global sector performance (TR, US$) and 2019PE
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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