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Chief Investment Officer's team, 26.02.2019
The chart speaks for itself: so far, 2019 shows a “rally of everything”. After the late 2018 capitulation, we saw value in risky assets and moved our positioning accordingly, using our overweight positions in DM government bonds as a funding source. Since then, markets have been lifted by both the Fed's dovish turn and the US-China dialogue. Our tactical asset allocation is guided by a valuation discipline which we believe is paramount in volatile markets. Some DM equity indices are getting closer to our year-end fair values, but the macro backdrop doesn't support upgrading them. We have thus decided to reduce the weight of DM equity by 2 percentage points in the Cautious and Moderate profiles, and to keep the proceeds in USD cash. We will as a result be slightly underweight on the asset-class across profiles, with an overweight in cash, which will allow us to seize any opportunity which could arise in a "not-too-distant future".
It is notable that the divergence between real data and market performance has continued to increase, with equities recording to-date one of the most impressive rallies following the Great Financial Crisis and business sentiment sagging. Asset managers have been forced into buying, following a recovery in risk assets which, starting as a rebound from oversold conditions, morphed into a market chase. Lower volatility has been driving the allocation to equities higher, as managers scrambled to make up for their light average positioning in the asset class. As volatility keeps on dropping more buyers are lured into the market, at least until valuations have caught up with fundamentals.
The global cycle for now remain soft. Capital expenditure dropped throughout 2018 and 'capex' leading indicators are showing no signs of a rebound in the short term. Indeed, manufacturing sentiment releases point to a deepening of the slump, and CEO business confidence suggests this is going to continue, possibly into mid-year. Also, the slowdown in earnings is reinforcing the message related to the weakening of equipment spending. Although stronger sentiment in the service sector and solid labor markets will limit the damage, we hold the view that upside in risk assets is limited until growth conditions improve.
Developed market equities are close to fair value across geographies. In the absence of positive growth shocks, it is prudent to trim down the DM equity allocation and increase cash positions, to be redeployed when assets offer better value. We continue to hold overweights in EM equities and bonds, supported by the effects of the Chinese stimulus, which we expect to be starting to kick in by Q1-end this year.
Eventually, the stepping up of the easing efforts in China will spill over to Europe as well, overall sensitive to EM demand, at least as far as listed equity companies are concerned. It is for now difficult to ascertain when the Chinese reflationary wave will affect Europe, hence we do not take a positive view on equities, but rather express it indirectly by recommending an absolute underweight position in German 10-year bunds. Germany long-dated yields already discount an Armageddon scenario, following the tumble in European and German growth, underpricing the positive effect that credit creation in China has historically had on the whole European economy.
Fixed Income Update
China has continued to dominate headlines for all the reasons starting from the ongoing trade talks with the US to liquidity injection, and the sporadic defaults by private and state-owned enterprises. In the latest report, Qinghai Provincial Investment Group (QPIG), a small and medium-sized primary aluminum manufacturer, enjoying 45% market share in Qinghai province and 2.5% in China has missed a coupon payment on their USD 300mn debt maturing in 2020. QPIG falls under the Local Government Financing Vehicle (LGVF) and is 50.9% owned by the Qinghai provincial government. China's local governments have been under pressure to tighten their fiscal policies. Moreover, the PBOC has been trying to promote bank lending since the Q4 of 2018, through encouraging banks to recapitalize via the issuance of hybrid debt instruments, cutting reserve requirement ratios, and incentivizing to lend to smaller businesses. According to the PBOC, new yuan loans jumped to CNY 3.23tn last month, almost triple December's CNY 1.08tn. This included issuance of short-term discounted bills of CNY 516bn, some 15 times the level of a year earlier. The PBOC's statement came after Premier Li Keqiang made a rare warning on Thursday that rapid growth in bank bill issuance and short-term loans could lead to new potential risks.
US economic releases have shown some weakness, against the backdrop of continued turmoil in Washington, with President Trump declaring a state of emergency over the funding of the wall on the US border with Mexico. The US retail sales recorded their most significant drop in more than nine years in December, suggesting a slowdown in economic activity at the end of 2018. December's sharp decline in core retail sales suggested moderation in the pace of consumer spending in Q4. Moreover, Friday’s US Industrial production was also on the weaker side, with a 0.6% drop in January, the first in eight months, in spite of the 0.1% downward revision of the December reading from a 0.3% gain. Production remains 3.8% higher in January than it was a year earlier. The manufacturing sector faces headwinds from slowing global growth, trade tensions and the strong dollar.
Emirates Development Bank (EDB), wholly owned by the federal government of the UAE is close to finalizing their roadshow activities ahead of a potential sale of benchmark US dollar-denominated five-year bonds. Emirates NBD Capital along with other banks have been mandated on this maiden Eurobond transaction. EDB is rated AA-minus by Fitch. The proposed offering would set the stage as the first debt offering at the UAE federal level. The average global AA option-adjusted spreads on the five-year maturity bucket range anywhere between 45bps to 70bps over the equivalent US benchmarks, and are at similar levels for GCC highly rated Sovereigns/GRE's. We expect this deal to be well placed and received by global investors. Furthermore, Saudi Arabia's Almarai is also expected to offer a benchmark US Dollar senior unsecured sukuk this week. Founded in 1977, Almarai is now the world's largest vertically integrated dairy company. The group is active in five sectors across the Middle East and North Africa region: dairy (liquid and foods), juice, bakery, poultry and infant nutrition.
A Fed economic report released on Friday showed why concerns about weak inflation have suddenly raised concerns. After lifting rates sequentially throughout 2018 amid faster-than-expected growth, the Fed said a series of developing risks likely began slowing the economy late in the year and into 2019. The recent incoming data prints on US retail sales, business investments including Industrial production have renewed concerns on the outlook for the economy prompting Eurodollar futures to signal towards a potential rate cut by the Fed within the next 12 months. US Treasuries are now well supported at 2.65% while the slope of the yield curve has remained put. Are we to witness a bull-steepening or a bull-flattening of the US yield curve? This is a decisive question. Structurally, we see inflation as benign and global growth trends been broadly revised lower. We advocate that interest rates are at an inflection point, and that long-tenor bond yields could arguably fall faster than those of shorter tenure.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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