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Chief Investment Officer's team, 24.09.2018
Global markets ended the week on a positive note with the S&P 500 hitting new highs and closing the week up 0.9%. The Dow Jones is skewed towards the industrial sector with a 22% weight, ended the week up 2.2%. The uncertainty around US-China tariffs has been removed as the US announced a fresh round of tariffs on $200bn of Chinese exports. The decision to set the tariff rate at 10% rather than 25%, as previously discussed, helped assuage investor sentiment. China retaliated with tariffs on $ 67bn of US exports to China. Markets like certainty and the ability to gauge the risks.
In Asia, Japans Nikkei Index went up 4.5% last week pushing the Index to turn positive for the year. Though oil prices remain firm, the KSA was the only major GCC market to participate in the global rally. European equity indices were aided last week by a rebound in the commodity and automobile sector. Underlying supply/ demand dynamics for iron ore and copper are largely driven by EMs; a rebound in EMs is usually quickly followed by a rebound in base metals. Improving economic data in Germany also drove investor optimism. UK equities were helped on Friday by a weaker GBP, but Brexit deal negotiations have once again stalled. This paints a gloomy picture for the UK.
EMs: A value proposition
EMs have made a comeback with the US Dollar weakening, removing fears of any further or near-term currency devaluation. The MSCI EM Index was up 2.2% last week with China leading the rebound. We commented last week on our September 12th decision to increase our allocation to EM Equities, as valuations didn’t pay justice to the long-term prospects. The CSI 300 index, which tracks blue-chips traded in Shanghai and Shenzhen, rebounded last week, gaining 5%. Chinese shares are still at very low valuations. The trailing price-to-earnings ratio for the CSI 300, is at 12.3X. Chinese equities are now a value trade. The CSI 300 performance should not have been affected by the trade war ramifications, as 46% of the index by market capitalization is financials. It was more negative sentiment, which drove China equity indices into a bear market. Some volatility will persist as the trade war is not over and this will continue to be a major factor in determining investor sentiment. However, the current low valuations make a strong case for investing for the long term in an economy which is seeing continued government stimulus and consumption growth in contrast to the Western economies.
US markets: not about valuations
Gains in the September quarter (to date) of 7.8 per cent for the S&P 500 Index and 9.8 per cent for the Dow Index are against a backdrop of an escalating US-China trade war and its possible impact on economic growth and company earnings. Just short of the 3,000 point mark, the S&P 500 is up nearly 10 per cent this year and up by almost 12 per cent including the reinvestment of dividends. The Index had its 19th record closing high this year and is up 1 per cent this month, so far defying historical statistical data as September has been a negative month, 54.4% of the time since 1928 (as per data from S&P Dow Jones Indices). Markets have shrugged off the additional tariffs and focused on solid US economic data.
Apple continues to be a large contributor to performance, more than offsetting Facebook, which has been the S&P 500’s biggest drag. Apple shares are up 18.9% in Q3 so far and have contributed to 10% of the Index gain in that period. On the other hand, Facebook shares are down 14.5% quarter to date, taking away 4 per cent from the S&P 500’s gains. However, the larger social media companies are increasingly generating revenue from digital advertising and can be considered at interesting levels. Besides technology, which is still seen as the growth engine globally, we see upside from financials as real rates have begun to rise. We also continue to like industries where investment is strong such as biotech. The biotech sector has been amongst the best performers globally with subsectors such as Genomics up 33% and Lifesciences up 28% in 2018.
US equities are now a little expensive versus history across most valuation metrics, except on growth, cash flow, and in relation to bonds. The S&P 500 forward P/E is currently at 17.4. Analysts' earnings estimates for U.S. companies are rising, in contrast to the rest of the world, so we still expect a little more performance from the US.
As the third quarter comes to an end, another period of double-digit earnings growth is expected to be reported by companies. Further support for corporate profit growth can be expected not only as a result of the tax cut but also buybacks. Also, investments by S&P 500 companies have risen by 10% in 1H 2018 over the same period last year. This is the fastest growth of capex in the last 25 years, according to analysts.
A long-awaited switch in S&P Dow Jones's industry groups takes effect today. The S&P 500 Telecommunications Index will be replaced by a Communications-Services index, featuring Facebook and Alphabet.
Upbeat sentiment for risk assets has pushed yields higher across the board.
US Treasury yields at 3.06 percent are now comfortably above the 3 percent mark while the spread between long-dated and short-dated Treasury yields are in a holding pattern and in-line with our conviction of moving towards a flattening trajectory. Overall, we can see a better tone for EM debt across both primary and secondary markets. Investors are increasingly showing a keen interest in some of the recent corporate bond issuance as headline coupons are relatively attractive compared to mid-to-long-term averages. YTD, total issuance for EM hard-currency debt stands over $425bn across 730 transactions. Capital flows last week showed a small rebound as markets seem to have settled after stress for EM bonds in August. We see sporadic inflows into some of the EM local currency plays, although these are country-specific and not at a broader level. This week’s the Federal Reserve’s policy decision is due. The probability for a 25bps hike has been fully priced-in by market participants.
Last week’s Treasury international capital (TIC) flows report came in above expectations.
Total TIC flows for July were $52.2bn versus last month’s $114.5bn (expected $46bn). Long-Term flows were at the same levels with $74.8bn in inflows for July versus -$36.5bn in outflows for June. The TIC figures suggest a robust demand for US dollar based exposure which is somewhat unsurprising given ETF flows and the strong performance of US equity counterparts during this time. That said this month we witnessed little change in the US securities holdings by Japan and China. The two largest foreign holders of US debt reduced their holdings by a modest amount last month, and the move stoked concern for some investors that trade war opponents would dump US bonds. We keep a close watch on the TIC flow report albeit the nature of being a lag indicator for our empirical studies.
Are all EM bad news priced-in?
Investors may have been puzzled that in the week when the US-China trade war escalated significantly high-beta assets rallied. EM FX and base metals put in their best weekly performance year-to-date and in the last five months respectively, with safe haven assets exhibiting flattish to negative returns. Market reaction points to the fact that tariffs were to a degree discounted, in other words, that risk premia were relatively high, following increasingly negative news flow throughout the year, as well as the growing conviction amongst investors that trade friction will be the hallmark of the Trump presidency.
It is too soon to tell whether conditions are in place for a permanent change of heart towards EM assets and non-US markets. This would require subsiding trade conflicts, which now from the base case seem to be shifting to ‘tail optimism’, as well as an improving macroeconomic backdrop outside of the US. So far, there are few signs of global cyclical stocks outperforming US cyclical equities, which would be the best confirmation that the cycle in the rest of the world is catching up with the United States. We are still confident that global business confidence will not materially be impacted by the more aggressive stance in Washington, although signs of macroeconomic improvement must follow soon for the market rally to broaden.
For the short term adequate market imbalances have built up, that even bad news turns into good – discounted – news. Pessimism on EM assets is widespread, as signaled for weeks -our Risk Appetite models are at extremely oversold readings, while at the same time extreme levels of optimism have been built into the fading dollar rally. Provided the Fed meeting next week is not openly hawkish, it could provide further justification for markets to extend the rebound, convincing investors that the bulk of the tightening can be now seen in the rear-view mirror.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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