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Chief Investment Officer's team, 18.03.2019
Last Friday ended a bright week for global markets. All major asset classes delivered positive performance, with equities up almost 3% across geographies, printing double digit returns for the year so far. Bonds and commodities were also well oriented.
The political news flow was however not very inspiring. On the trade front, it became clear that Mr. Xi won’t visit the US in March, which means that a final deal is not imminent. In Europe, the Brexit drama continued in Parliament. Theresa May’s deal was rejected last week, as well as the no-deal option. Parliament will vote again next week in a last attempt to approve the deal with a short delay extension, or probably take the route of a longer extension.
Economic data was better. Yes, global GDP growth is slow in Q1 but there are no signs of further deterioration. As the current rally caught many participants by surprise, this might have been enough for some hesitant investors to jump in, especially as the end of the quarter is approaching.
We welcome the good news, but are happy to have taken partial profits on the overweight position in risk assets we started the year with. We have a slight underweight in equities (but overweight in EM), in High Yield (we prefer EM bonds) and are overweight cash, ready to seize the next opportunities. The very low levels of implied volatility points to some vulnerability to any unexpected bad news.
Asset classes USD % total return, YTD 2019 and week
Markets continue to rebound from their December lows, with equity inflows beginning to track positive price momentum and suggesting that the current rally is more than just short-covering. There are hints that activity in Europe and China may have bottomed out, although it is still early days to signal the all clear. The Euro Area Economic Surprise Index has been climbing since mid-February and Chinese data has started to show consistent signs of improvement. This explains for instance the 16% rally in European equities, the most under-owned and loathed asset class year-to-date, since the 2018-end lows. It would be no surprise after the fact, since stocks have tended historically to anticipate turning points in the economy by a couple of months.
It is not totally unwarranted to extrapolate the above dynamics and conclude that, as long as labor markets in the major economies remain healthy, the combined action of monetary support from the Fed and fiscal stimulus in China should set a virtuous circle in motion, preparing the ground for a better second half this year. Investors should be warned, though, that the absolute upside in risk assets, and in particular in DM equities and credit, appears to be limited from present levels, given the diminishing returns of policy stimulus. With global trade activity still flagging, we do not see the recovery proceeding without fits and starts, and countries will have to rely more on domestic demand than external impulses to lift themselves out of the current soft patch.
In the long run, things are not looking up at all. The famed investor Jeremy Grantham is expecting dismal returns in the next two decades from US equities, not more than 2 to 3% in real terms, which compare quite closely with our forecasts for US equity nominal returns of about 4% in the next ten years, if one pencils in an average 2% inflation. Valuations and the inability of policy support to “get blood out of a stone” are the main reasons for the grim prognosis. This ties in with the “shocking” US debt growth lamented by celebrated bond-fund-manager Jeffrey Gundlach, who sees the surging debt load weigh on business activity and the US dollar.
As observed in our 2019 Investment Outlook, navigating the next decade will require that portfolios are skewed towards absolute return strategies and gold for hedging shocks. Growing debt levels will eventually require that central banks stoke up inflation in order to diminish debt burden in real terms, increasing the allure of gold versus fiat money. At the same time, hedge funds will make portfolios less volatile and less dependent on market direction. This comes with a caveat, though. The potential for idiosyncratic returns in the hedge fund space is remarkable, provided that investors select the best ones with the required due diligence. Hedge fund returns compare unfavorably with equities’ in strong bull markets, with the relationship reversing in high-volatility regimes. It is our view that the shift to increased market turbulence has recently taken place, as Grantham’s and Gundlach’s insightful comments remind us.
Tactical Asset Allocation: simplified positioning
TAA – YTD indicative performance
Fixed Income Update
Inflation gauges in the US (consumer and producer), industrial production data and the Empire manufacturing report last week came below expectations, stoking demand for US Treasuries and pushing yields lower to 2.58%. This week, focus will turn to the FOMC (March 20). The Federal Reserve is expected to maintain rates unchanged and provide further guidance on the trajectory of the balance sheet normalization. The shape of the yield curve has witnessed some bull steepening pushing the spread on 30Y minus 5Y to above 60bp. This is a pure reflection of the inflation expectations and policymakers pause on the rates outlook. That said, the move witnessed on the front end of US rates are now reprising the FED OIS signifying a 25bp cut by at least to September 2020 meeting and close to 10bp of rate cuts by the end of this year. Moreover, on yields, Germany Bund yields have priced-in the macroeconomic challenges cited by Mario Draghi earlier this month and appears to be moving towards zero. The ten-year maturities are currently at 0.07% while the term premium for maturities up to nine years are negative.
US industrial production rose 0.1% in February, below consensus of 0.4% raising investor concerns on the broader outlook on the manufacturing sector which could dampen current benign growth expectations. The series of recent economic data releases have been below expectations and could potentially see some repricing of credit spreads on valuations that have been stretched (or looking rich on a relative basis). The option-adjusted spread (OAS) on the US high yield has enjoyed a strong spread compression benefitting from the “Risk-on” sentiment as policymakers pause their aggressive monetary policy stances. US high yield spreads have compressed from 537bp to a current reading of 388bp. The trailing 12-month U.S. high yield bond default rate will hit a five-year low this month, according to Fitch Ratings. The agency reported that default rates would drop to 1.4% this month from last month’s reading of 2.5%, and maintains 1.5% default forecast for this year.
Coming up this week, global central banks from the FED, U.K., Brazil, Colombia, Iceland, Switzerland, Philippines, Indonesia, Russia, Thailand and Norway are scheduled to release their rate decisions.
Fixed Income key convictions
Fixed Income valuations
Chart of the week: The Bull Steepener (30Y minus 5Y)
On March 18th, tranche 1 of Saudi Arabia’s s inclusion in the FTSE EM index will be effective. Post the completion of a five-stage process by March 2020, Saudi Arabia will constitute 2.99% of the FTSE Emerging Index. According to FTSE, around US$200 bn of passive assets track the FTSE EM Index implying US$6 bn of passive inflows to KSA equities by March 2020. Additionally US$49 bn of potential inflows from MSCI inclusion are expected. Foreign ownership is at c. 2% leaving plenty of room for additional investment. We have been overweight the KSA equity markets since the second half of 2017 and have seen considerable gains since then. Trading volume has improved, as passive funds are continuing to trade names from the EM constituents list; ahead of the official day. KSA equities have historically traded at a premium to emerging markets, leading to a continued divergence in valuations. The Tadawul Index trades at a forward Price to earnings of 15.3X compared to the MSCI EM Index at 12.5X.
Global equities had a stellar week. The S&P 500 was up 2.9% ending the week on a year to date high of 2822, as investors set aside worries on the trade tariff deal delay and rising wage costs. U.S. equities saw inflows of US$ 25 bn last week, according to EPFR Global, reversing a trend of outflows. Our fair value for the index stands at 2825 and we are already there. The equities uptrend remains intact but US markets may be stuck in a consolidation pattern until signals emerge to support the outlook for stronger earnings growth. Adjusted-net-income expectations for Q1 are being lowered, with forecasts for Q1 reversed to a 3% decline from 3.4% growth at the start of the year. Revenue revisions are less severe. After 6% growth in 4Q, the S&P 500's top line is estimated to grow 4% in H1 (lowered from 5%). ROE remains supportive, at the highest level in decades, at 18.6% for the S&P 500 in 2018. The Technology sector had a strong week and tech now leads returns in the US and globally, taking took over the leadership role from industrials. Industrials and technology, the two industries we would expect to be most impacted by the US china trade conflict are surprisingly the best performers in 2019. We maintain a selective positive stance on US technology, even though growth is slowing, as we see continued pockets of outperformance. Info tech margins are twice as high as S&P 500 margins, keeping the sector attractive. According to a report from Goldman Sachs the S&P 500 has returned 17% annualized (incl. dividends) over the last 10 years, however with just 10 stocks accounting for one quarter of the performance. Boeing which is a member of this elite club however, may lose its coveted position, after the two accidents with its 737 Max 8.
Emerging-market valuations remain deeply discounted to developed markets, even after a strong start to 2019. The exception remains India, which whilst expensive relative to EM peers (at 19X forward earnings for MSCI India), is seeing strong FII inflows at US$4.5 bn year to date. Indian markets are still lagging with the MSCI India Index up + 5.7% compared to the MSCI EM Index +9.7% (year to date total returns USD). India’s higher valuation multiples are justified by the high earnings growth of 15-20% expected in 2019/ 2020.
Equity recommended regional positioning
Major indices performance (TR, US$) and 2019PE
Global sector performance (TR, US$) and 2019PE
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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