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Chief Investment Officer's team, 19.11.2018
Last week was negative for Developed Market risky assets: MSCI World delivered a -1.5% net return expressed in US Dollars, homogeneous between the US, Europe and Japan. This risk-off mood translated into some support for safe havens such as DM Govies, but logically affected spread-driven bonds, especially High Yield. Another sharp drop in Oil price was an additional reason for corporate bonds to suffer.
By contrast, Emerging Equities were up 1% over the week (MSCI EM in USD), led by China (with hopes on discussions on trade) and India (positively affected by lower energy prices). A softer USD was also supportive.
In Europe, all eyes were on Brexit and we’ll elaborate on it below.
Our recommendations for the medium term are unchanged with a positive stance towards equities over bonds (with a preference across asset classes for US and EM), as well as a position in gold.
Cross asset considerations
Investors interested in gauging the effects on financial markets of pronouncements made by high-ranking US officials, should look no further back than to the past week, fraught with declarations made by Federal Reserve board members and the US president. Global stocks retraced more than half of their weekly losses and EM stocks and currencies closed in positive territory, following news that Mr Trump seeks a trade deal with China. The US dollar and 10-year Treasury yields tumbled after Fed vice chair Clarida’s dovish statements on policy.
Receding fears related to two major market risks, tighter Fed policy and the US-China escalating trade war, should trigger a year-end rally in oversold risky assets, in line with our base-case scenario outlined in past issues of this publication. Although at the December G-20 meeting President Trump and President Xi are unlikely to reach a compromise deal which could defuse trade tensions, the sheer agreement on a negotiation framework, a net incremental positive, would be enough to support markets.
Gold closed up 1.1% for the week. A string of remarks made by Fed officials suggests that the Federal Reserve will take into account the deteriorating global outlook for policy decisions, and that US growth may have peaked in 2018. The core inflation reading was also soft for October, and inflation trends will be important to support further tightening in H2 2019. Overall, these developments point to limited upside for long-dated Treasury yields, lending comfort to our bullish stance on gold expressed with a tactical overweight on the asset class. Gold’s advance was mirrored by a setback in the US dollar, which should halt its upward trending phase if we are proven right in our view that risk-on sentiment should take hold in the next few months.
The yield on US high yield closed for the week at 7.2%, according to a Bloomberg Barclays gauge, the highest level since June 2016. Non-investment grade corporates, which had proven resilient to rising market volatility in Q1 this year, caught up with the reality of sharply lower crude prices and lingering concerns about economic growth.
On our multi-asset portfolios we maintain an underweight stance on the asset class, offset by an overweight on equities, offering in our view a superior risk-reward profile. On average high-yielding bonds have historically peaked one year in advance of a US recession, whose probability one-year out remains relatively low according to most models.
Where are we in the Brexit process?
Last week, the UK finally announced that a deal agreeing the terms of the United Kingdom’s exit from the European Union had been agreed with the EU. However, despite a ‘collective’ agreement by her Cabinet, Prime Minister Theresa May is battling not only to save her Brexit deal, but her position as prime minister as several ministers, including the Brexit Secretary Dominic Raab resign. Whilst the UK Cabinet has approved the Brexit deal, it still requires approval by an EU leaders’ summit, the House of Commons and the European Parliament. The deal that has been announced is a 585 page document that is the separation agreement between the UK and the EU, covering several main areas: Britain’s financial settlement or divorce bill; the rights of EU citizens in the UK and British citizens in the EU post-Brexit; how to prevent a hard border in Ireland; the transition period; the customs union of the UK/EU; oversight Governance of the withdrawal treaty. The agreement does not go into detail about the future trading relationship between the UK and the EU, although it includes a declaration on the preferred relationship.
It has undoubtedly been the most turbulent few days of Theresa May’s premiership, and despite calls for her resignation, she has vowed to “see it through”. With the most notable resignation of her second Brexit Minister amongst others, and a growing number of signatures from her party calling for a vote of no confidence, Theresa May is facing her biggest political challenge yet. The treaty may have been collectively approved by her Cabinet, but Theresa May faces significant challenges to get it through parliament.
An immediate reaction to this turmoil on 15 November was a weakening in sterling, with cable falling 2% from 1.2775, and slightly recovering to 1.2840 at the time of writing, but far from the 1.20 that some commentators had warned of. It also sank about 2% versus the euro. A shift to the safety of UK gilts pushed the 2-year yield to 0.72%, below the Bank of England’s base rate of 0.75%, whilst ten year yields have fallen to 1.40%, having recently peaked at over 1.70%. Equity markets however, as evidenced by the FTSE100, did not react as badly as sterling, suffering some volatility but ending slightly up on the day. UK equities are supported by a weaker sterling, as it boosts the income of overseas earnings – a major constituent of the FTSE.
While UK inflation has been above the target for a longer period, we expect the Bank of England to tread cautiously, despite obvious inflationary pressures (wages and goods) within the system. Should there be a definitive outcome of Brexit, then a sterling relief rally will ease inflationary pressures as well as the Bank of England’s need to raise rates. Indeed, the Brexit chaos reduce market expectations of interest rate hikes next year, as the Bank of England’s Governor Mark Carney warned in this month’s inflation report that rates could go in “either direction” in response to a no-deal Brexit.
There are a number of possible outcomes, whether it is a deal with an orderly exit, or a no deal, resulting in a renegotiation, a chaotic exit, a general election or indeed a second referendum. It is clear that Theresa May will have to use her considerable skill, not only to convince lawmakers in Parliament to back her deal, but also to prevent a challenge to her premiership, and the coming few days are critical. There will continue to be a period of political turmoil, to which financial markets are inextricably linked. As always, investors should be attuned to the risks of these unchartered territories. Indeed, should the deal be agreed and resolved by the current government, the next steps will for the UK to extricate itself from the transition period, the customs union and all that it entails.
We expect markets to be range bound until the multiple tensions of Brexit negotiations and the negotiations between US and China come to a conclusion. The path of Fed hawkishness is clearly spelt out for the short-term. Uncertainty is the markets enemy. Asian countries have found themselves in the center of the increasingly tense US-China spat. At the Asia Pacific Economic Co-operation meeting on Sunday, the leaders failed to issue a joint communiqué for the first time in the summit’s 29-year history. The US VP Pence’s threat that China needed to change its ways, is seen by some as indicative of the start of a cold war.
All major global indices are now negative year to date. The MSCI World is -4.8%, and the MSCI EM Index though it had a positive week is –14.9% year to date. The S&P 500 had a down week (-1.6%) but has retained November gains and is +0.9% this month and in positive territory year to date. We are seeing a clear defensive positioning with healthcare and consumer stocks gaining and technology stocks, which are more volatile on account of high earnings growth expectations, selling off. There are pockets of outperformance from what we would term as the safer investments, with the cyber security index +15% year to date. We have written earlier about semiconductor demand as a proxy for global growth and Nvidia guiding down next quarter revenue was not well taken. Fundamental data on retail sales remains strong but is not buoying the market. Black Friday at the end of this week, though no longer seen to be as important as China’s Single Day, remains an important gauge to assess investor sentiment with one third of the US participating. The US still seems in healthy shape whether it be earnings growth or consumer demand and markets should bounce once the overlaying of global tensions get sorted.
European indices fell in line with the US last week, however remain in deep negative territory year to date. At the moment we see no respite with no catalyst and a lackluster earnings season. The next seven days are important for the UK as Brexit negotiations need Parliament approval.
Fixed income update
A dovish stance by the Fed chair J.Powell helped fueled a rally on US Treasuries pushing yields to 3.06 percent while their UK Counterparts saw Gilts drift higher to 1.40 percent on the back of the Brexit event that unfolded last week. Renewed concerns after a failed attempt at the APAC meeting between US and China could see demand for safe-haven assets, particularly for the US Treasuries. Market expectations for a December policy rate hike are already priced in, and we see a strong case for US Treasury yields to remain range bound.
The sell-off on Investment Grade corporate debt has finally abated, dropping more than 4.5 percent so far this year, and is on track for its worst year since 2008. The market fell by about 1.5 percent last month, its biggest October loss in a decade. Global corporate investment grade bonds had been under pressure as tight valuations have been unable to withstand the ongoing policy tightening by the Fed officials together with some concerns over valuations and corporate balance sheet leverage, and when compared to higher short-term interest rates. That said, our stance on corporate investment grade remains positive, and the average spread offered at 125bp looks appealing on a risk-adjusted basis.
On Emerging Markets, Global investors have shown renewed interest towards India’s sovereign bonds after shunning them for most of this year. Whether the interest will sustain depends on the price of oil and the upcoming elections next year together with the feud between RBI and the Government. Overseas holdings have risen 80.1 billion rupees ($1.1 billion) in the previous three weeks, data from the Clearing Corporation of India Ltd. show. The inflows have coincided with a swift drop in crude costs and debt-buying support from the central bank, helping put the benchmark 10-year bonds on course for their first quarterly gain in more than a year. That said, Indian public-sector banks have cut holdings by a net 290 billion rupees ($4 billion) this quarter. The selling has been particularly severe in the benchmark 10-year IGB, which makes up most of the daily volume, causing them to underperform shorter tenor debt. The RBI’s open-market purchases of debt have also been concentrated in the shorter segment, generating more replacement demand in the maturities. With real rates now closer to 4.55 percent, and expectations of RBI pausing on the monetary policy front, our conviction remains intact.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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Sharp correction in equities
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