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Chief Investment Officer's team, 01.10.2018
Last week saw some consolidation with slightly negative returns across asset classes, with the exception of oil prices, sharply up (Brent ended the week at US $82.7).
This Friday also marked the end of the third quarter. As our regular readers know, we entered the second half of the year with the explicit hope for better returns on risky assets looking forward (see our quarterly publication “The Changing Face of Globalization”), with a contrarian overweight in US equities. More recently, we also went overweight on Emerging Market equities in mid-September, as we thought the consequences of the escalation of the US/China tariffs provided a compelling entry point for the long-run.
In Q3, the total return of global equities was +4.3%, led by Developed Markets (+5%) and the US in particular with +7.6%. EM Equities were negative (-1%) with China the worst contributor (-7.5% in US$). However, since mid-September EM equities are up.
Back in July, we had serious hopes that the US administration would not implement tariffs on all the Chinese exports, and the recent months have proven us wrong. However, investment is not only about what happens, but about what’s priced in and as we now work on the assumption that every single Chinese export to the US could be hit by a 25% levy. We still see a compelling case for EM assets for the long-run, given their valuation compared to their secular prospects, as well as the mitigation measures decided by the Chinese government.
As we are currently working on our next quarterly publication, we can already say that we remain confident in the near-term. US mid-term elections will be the key event to watch in early November and serious support to volatility, but the strength of the cycle, the visibility of monetary policies, market valuation and investors positioning are supports for the months to come. The next decade will be tough, but we don’t believe that the rally is over yet.
Key risks are well identified
Although on the surface, the past week offered the usual mixed bag of economic releases pointing to no significant improvements in the global business cycle, some meaningful events raised the medium-term risks to the outlook. In Europe, the Italian government announced budget plans putting it on a collision course with the European Union, while in China, the first negative impacts of Trump’s tariffs showed up in markedly lower business confidence readings.
Late Thursday, the Italian government released public finances objectives for 2019, with a planned 2.4% budget deficit, a U-turn compared to a previously expected 0.8% target, and out of line with much needed stable borrowing costs. Future larger deficits will set the Italian debt, the second highest in Europe and third-largest in the world, on an unsustainable path – at the time when the ECB will stop its asset purchasing program. The European Commission will most likely reject the budget, leaving Italy vulnerable to downgrades. With a sovereign rating two notches above junk, even one downgrade would put Italian assets further under pressure, and produce higher interest costs offsetting the benefits of the stimulus measures taken by sacrificing financial discipline. Two primary rating agencies are scheduled to review their rating of the Sovereign this month.
The euro, a victim to the spendthrift Italian authorities, tanked for two consecutive sessions. A Bloomberg columnist appropriately labelled the failure to address long-standing debt issues an “extraordinary act of self-harm”. As long as domestic investors are happy to buy Italian debt, there is no danger of an imminent catastrophe, so European cohesion will be thoroughly put to the test not before the next downturn looms large. The common area currency is unlikely to rise above 1.18, unless fundamentals in Europe improve sharply and help investors forget about the powerful thrust of populism spreading in Italy.
The impact of US tariffs is showing its first signs on the Chinese economy. Both measures of Chinese business confidence, one released by the government and the other by a private entity, dropped more than expected in September, with declines across most components. It is now likely that the US will go ahead with a plan to subject all Chinese imports to 25% tariffs, which could translate in a 1% hit to Chinese growth in 2019, according to some studies. China is expected to react with increased monetary and fiscal stimulus measures, leaving its economy only marginally affected by the escalating trade war. But this will come at a cost. A smaller external surplus and lower policy rates will weaken the renminbi, which in turn will put pressure on Asian currencies, as neighboring countries will try not to lose competitiveness with China.
A fully-fledged trade war will China is still manageable with the help of Chinese stimulus, yet in the medium term it could generate significant volatility. In the short run EM assets are oversold, undervalued and offer decent growth rates or yields. They offer some appeal to investors who are truly long-term oriented, and are ready to stomach Mr. Trump’s next step against China in his ‘America First’ campaign.
FED’s tightening cycle – what is the “New Normal”?
As widely expected, the Federal Reserve raised the Fed Funds rate by 25 basis points at their September meeting to the target range of 2.0% – 2.25%. The minutes and commentary by the Fed officials reinforced market optimism about growth and inflation (to an extent) and pointed to labor market tightness. While the market-implied probability is nearing almost 70% for an additional hike in December, the Fed’s dot plot suggests a long-term rate of 3.25% – 3.5%, which is higher than the prior projections.
We wouldn’t take this level for granted (we see it as a bit high) given the multiple factors involved, including ever-changing political dynamics, and the structural challenges the US grapples with – surging debt levels and larger than expected funding needs by the Treasury Department.
We reiterate that investors should position on the short belly of the curve where the value is the most attractive. The US yield curve flattened as the FOMC’s hike lifted the short end, which, in the midst of benign inflation, pushed the yields on 2-Year (2.82%) and 10-Year (3.06%).
Finding “yield” and “shield” in EM
With EM central banks adjusting their policy rates and EM FX stabilizing broadly, capital inflows to bond funds have continued to recover and recorded the largest flows since April this year. That said, we foresee further volatility for EM debt in the coming weeks driven by tighter liquidity conditions and higher US rates environment (funding backdrop for the US dollar), increased trade tensions and perhaps country-specific risks to resurface given the weaker fiscal and trade imbalances in some of the EM nations exposed. However, some of the recent developments on Argentina (IMF funding) and measures by India on the reduction in government borrowing plan and policy adjustment in Indonesia and Turkey could be mitigating factors for the discerning bond investors. The yield on the broader EM hard-currency benchmark index has risen by 135bps to 5.82% and appears rewarding for the risks associated.
Equity update: US shines, bright prospects for KSA
US equity markets defied odds and had a positive September. It was a standout quarter, the S&P 500 closed up 7.2%, its best quarterly performance in the last five years. The NASDAQ too closed the quarter up 7% but the Dow outshone ending Q3 +9%. Trade tariffs haven’t affected investor sentiment in the US, as the Dow Jones index with a 22% weight to the industrial sector turned out to be the best performer. Earnings season kicks off on 12th October with the banks reporting, and a 20% earnings growth is the consensus expectation for Q3. The MSCI world Index lagged the US last quarter, closing up 3.7%, dragged down by EMs which have only begun a recovery as of late. The MSCI indices are considering an increase weight of China A-shares, from the current 5 to 20%. China is the second largest by market cap globally; yet, its weight in global indices is low, as share trading on the mainland has been restricted.
Last week had its usual tech drama with Tesla shares plummeting on news of a SEC investigation. Elon Musk has been compelled to give up his Chairman role and pay a fine. This at least settles the uncertainty around the company’s future. Facebook admitted to a security breach which affected 50 mn users’ data but stated that it had been fixed. Cyber security is increasingly becoming an area of concern for governments and corporates. However, particularly vulnerable to attack are social media groups with terabytes of member data and payment services companies such as Equifax (145 mn users were affected) with bank and credit card details. Cisco’s focus and strength in security software and applications have been a key driver of its 50% share price rise over the last one year.
The KSA budget was higher than initially forecasted; it focused on job growth, providing impetus to KSA economy to eventually support its markets. Public spending is expected to reach 1.1 tn riyals ($295 bn) in 2019, 100 bn riyals more than last year’s projection. The government expects GDP to expand 2.1% this year after contracting 0.9% in 2017. The Tadawul Index is +10.7% YTD, led by the banking sector. Consumer companies have been a laggard.
Demand for Saudi oil is expected to increase as U.S. sanctions against Iran take some of its barrels off the market. The Saudi Energy Minister has stated that demand for Saudi crude in October could range from 10.5 mn to 10.6 mn barrels a day. The KSA produced a near-record 10.4 mn barrels a day in August, the country told OPEC.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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