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Chief Investment Officer's team, 05.11.2018
October saw the worst one-month drop in global equities since the Great Financial Crisis, possibly an investor overreaction to peaking US activity and earnings growth. This is in spite of the recent newsflow delivering more of the same, which is a pretty solid US macroeconomic picture and mixed results elsewhere. In the process, the rout in risky assets has left equities undervalued, which makes the post midterm elections period in the United States, usually preceded by spells of high market volatility, a good starting point to consider adding to risk in portfolios. Treasury bonds witnessed a short-lived flight to safety, promptly eclipsed by new short positions reinstated on the very solid US jobs report at the end of last week.
Trade frictions could turn from threat to catalyst
This time around investors are called to consider other unknowns, when they try to solve the market equations, and specifically the US-China trade war, now morphing into a conflict between super-powers, the effect of new sanctions on Iran and the forthcoming US midterm elections. Before delving into the minefield of geopolitics, we would rather keep it simple by saying that both intermarket signals and technicals suggest that conditions should be favorable for equities to try to find a bottom not far from recent lows.
EM FX and Chinese equities, very sensitive to trade-war risks, have stabilized in the recent weeks in spite of rising pre-election rhetoric and escalating tensions between the US and China. In particular, since October 9th the MSCI China Index has appreciated in relative terms against the S&P500 Index, and Asian currencies retraced in the first two trading days of November erasing almost all of October’s deep losses. At the same time, breadth signals on the main US equity indices point to extremely oversold conditions, historically associated with at least rebound attempts.
What kind of catalysts could set markets up for a year-end rally? To answer this question, we must start to delve into geopolitical matters, as the US earnings season is well more than halfway through, whereas the political calendar is becoming particularly relevant in the shorter term. The major event is the G-20 Summit, where the US and the Chinese president are meeting to discuss US-China relations. While on the one hand it is becoming increasingly evident that the friction between the two powers is extending well beyond trade matters, one could argue that such matters could be fertile ground for a compromise, given that other sources of conflict, from foreign policy to geographical areas of influence to technological supremacy, will drag on for the longer term. Markets may be starting to discount the possibility that Mr. Trump and Mr. Xi could lay the foundations for more fruitful talks on tariffs.
Business as usual after US midterm elections
As for the November 6th midterm elections, we hold the view that they are unlikely to have an appreciable effect on the business cycle, assuming that the central scenario of one chamber of Congress being lost to Democrats will play out. With tax and expenditure changes, the main drivers of economic activity, already achieved by the Republicans, it is not ordinary Congress legislation that is at the forefront of economist minds. If anything, the lifting of uncertainty associated with the end of the electoral race should be a contributing factor to risk-on market sentiment, as it has historically been the case looking at past instances of this same event.
Outlook finely balanced
The risks to the outlook remain balanced. Far from being synchronized, the global cycle appears to be in slowdown mode, with world business confidence still at elevated levels, but dropping. Although labor markets are tight in the main developed countries and are expected to support final goods demand, the manufacturing sector continues to languish. Business sentiment is stagnant in Europe, took a hit in China in October and is rebounding in Japan after the recent natural disasters. We hold the view that economic drags are temporary both in Europe and in Japan, and that the effects of the Chinese multiple stimulus efforts will become more visible by year-end to counteract the impact of higher US tariffs.
US Treasuries more than a hedging instrument
The solid US jobs report reinforces expectations for a December rate hike and the Fed to keep raising rates until policy turns restrictive, although markets currently discount only two hikes in 2019 as the most likely outcome. This leaves some upside on shorter-dated yields, but little on the longer-dated ones, as historically the pass-through from Fed Funds to 10-year Treasury yields has been roughly 50% with the flattening of the curve during the tightening cycle.
This makes US Treasuries particularly appealing within the ‘risk-free’ universe, all the more so in the light of peaking US activity and considering the current yield differential with peers at historical highs. Investors with a longer-term view and a more cautious stance should consider US Treasuries as their best portfolio hedge against the possibility of a US recession.
Valuations and earnings a floor to equity markets
October posted dismal returns across markets. The MSCI World lost 7.5% in October and is now almost 10% from its January highs. The S&P500 fell by 6.8% for the month, in total returns, while EM equities fell by 8.7%. Utilities was the best performing global sector, energy and industrials the worst. Mid last week markets turned around, to stage recoveries across the board. For the week, the S&P500 finished up 2.42%, with technology rebounding strongly and the semiconductor index (SOX) up 7.6%, recovering from a 12% loss in October. The SOX remains closely watched, as a bellwether for industry growth. Technology has led the market higher for several years now, hence where the sector goes from here can be indicative of the broader market direction.
Optimism about improving US-China relations, following reports that President Trump asked his cabinet to draft a trade deal between the two countries, led to a Friday rally across most markets, which faded in the US when there seemed to be no significant progress towards a deal. Headline volatility is likely to continue into the Trump-Xi meeting at the G20. October’s equity market volatility reminds us that the US midterm elections tend to have a seasonally negative impact on equities. However, whilst volatility may subside short-term after the elections, we continue to expect sharp pullbacks and rallies.
We maintain a positive stance on US markets as analysts hold on to a $178-179 EPS forecast for the S&P500 for 2019, which indicates that US equities are undervalued. Following October's drop, S&P500 stocks exhibit considerable valuation discount. 70 companies in the index traded two standard deviations below their five-year average forward P/E.
Thus far, 75% of S&P500 companies have reported earnings. For Q3 2018, the earnings growth rate for the S&P500 is 24.9% and revenue growth rate 8.5% as per FactSet reports. The Energy sector is reporting the highest year-over-year revenue growth of all eleven sectors at 19.9%. In the headlines, Apple stock fell following weaker-than-expected guidance and the decision to not report unit sales going forward. US companies are ramping up buybacks again. According to estimates, companies announced $156bn in buybacks in Q3, following record levels in Q1 and Q2 of $242bn and $437bn, respectively. This added to growing dividends provides further reason to tide the volatility over.
GCC markets shine in the rout
GCC markets rallied last week after outperforming global equities in October. The MSCI GCC Index gained 0.4% for the month. The KSA Index has recovered recent losses and is +9% year to date. The UAE is seeing a small rally amongst Dubai real estate developers. Trading volumes are picking up both in the UAE and KSA markets. We maintain a selective stance on GCC equities, focusing on companies with strong cash flows and high dividend payouts. Results in the banking and logistic sectors, which remain our favorites, have met expectations.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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