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Chief Investment Officer's team, 29.10.2018
The month of October (and Q4) has been terrible for risky assets so far. Last week saw an aggressive sell-off centered on equities: MSCI World (Developed Markets) lost 3.9% and is now negative -4.3% for the year. The S&P500 lost the same percentage and its total return in 2018 is now a very modest +0.5%. Emerging Markets lost -3.3% last week, with GCC being the bright spot (positive 1.8%, led by Saudi markets). This correction was different from the one which happened in early October: at this time, bond markets reacted negatively to the good US macro numbers and the relatively hawkish Fed comments, which in turn weighed on equities. This time, markets strongly reacted to mixed guidance from US companies: as the fear was primarily that earnings might have peaked, safe-havens were this time positive: treasury bills (+0.3%), Gold (+0.6%) or Japanese Yen (+0.6%).
We have been warning about volatility all year, especially as we approach the US mid-term elections, but have nevertheless been surprised by the magnitude and pace of the rout in October. From a fundamental point of view, our stance is unchanged: the global economy is still growing, which supports earnings, and if anything valuation has moved to a more attractive territory. From a technical and behavioral point of view however, we would not buy into the current episode. Yes, indices are oversold and valuation is close to average in the US and below everywhere else. Having said that, some painful technical levels have been broken which means that there might still be some forced sellers (risk-based funds, leveraged investors, derivatives desks hedging their exposure), and not many buyers especially as the US midterm elections are now imminent with little visibility on results, and as share-buy-backs have paused due to earnings season. We are confident that the cycle is not over and that markets should not fear both overheating and peak earnings, and consider that their reaction has been exaggerated in a context where some company guidance for the future sometimes also carry a political message to the US administration. But we acknowledge that the short-term remains highly uncertain. We are confident in our current recommended positioning for cautious, moderate and aggressive profiles which weights equities at respectively 17%, 33% and 44%. We favor both US and Emerging Market equities, recommend an underweight in High Yield bonds and an overweight in Gold which plays its role as a hedge versus risk aversion.
Equity update: Halloween comes early
US stocks have endured a brutal October amid concerns on rising interest rates and trade and geopolitical tension. Guidance from industrial bellwethers and some of the technology giants, heightened fears that the best days of the economic cycle have passed. The Nasdaq, S&P 500 and the Russell 2000 indices, all closed the week with drops in excess of – 3.5 % The S&P 500, which had gained 13% from its February low, has given up all its yearly gains. The energy and industrial sectors were the biggest laggards last week. The former on a drop in crude prices and the latter on fears that a stronger dollar and higher input costs such as steel, post the implementation of trade tariffs, could impact margins. Headline news centered on the selloff in the technology sector as it constitutes 20% of the S&P 500 Index. Due to the importance of ETFs (1/3 of equity trading) and to the fact that they are the first position investors liquidate, the selling pressure is heavier on the large index components, i.e. technology and the FANG stocks. The semiconductor Index, which has more than doubled since 2016, has reversed its upward trend and is now -8% year to date – Texas Instruments guidance added to the negative sentiment. Global Tech is now slightly positive YTD, with Healthcare taking the lead. Defensive sectors, however are catching up, with the utilities sector, so far the best performer in October.
The end of central bank support for asset prices is gathering pace. At the start of October, the ECB reduced its monthly buying of bonds to €15bn and has affirmed the end of quantitative easing in December. The Fed is reducing its balance sheet at $50bn a month and continues on its path of raising interest rates. As a result, cash is back as a yielding asset class.
We need to balance the market headwinds (the end of easy liquidity, fear of corporate profits peaking, interest rates rising, China and trade tariffs, US midterms, geopolitics) with the positive tailwinds (economic and earnings growth and buybacks). US economic growth at 3.5% for Q3, backed by strong consumption numbers was above expectations. 48% of S&P 500 companies have reported Q3 earnings with an average EPS growth of 22.5%, according to FactSet data, exceeding expectations, and a healthy revenue growth at 7.6% The consensus is for a 10% earnings growth for 2019 (21% for 2018). However, the level of the S&P 500 index at 2658 is not in sync with the earnings growth. Analysts estimate an EPS of $179 for S&P 500 companies in 2019. At a Price to Earnings of 16.4X which is the 5 year average, the S&P 500 should trade at 2935. However, investors’ fear that peak corporate profitability has been reached. Guidance from companies is being closely watched to assess the strength of corporate earnings. Amazon guiding down holiday sales and Alphabet (Google) guiding down on advertising revenue (that constitutes 86% of total sales) was not well received. On a technical front, the US market looks oversold with a RSI at 30 (a traditional buy signal) but from a trend point of view short-term is very risky.
In Europe, the Stoxx 600 Index closed -2.6% for the week. Disappointing PMI numbers were not supportive. Neither was the impact of trade tariffs, which impacted Q3 auto sales. In Asia, the Nikkei Index closed the week -6%, the Hang Seng Index -3.3%, and the MSCI India – 2.8% in USD. Domestic China indices had a positive week. The benchmark MSCI Emerging Markets (USD) index is now 25% below its January high, after rising 34% last year. This should not distract from the long-term potential: 83% of the world’s population live in emerging markets, with almost half middle-class. Exponential growth in consumption is creating new domestic industries and new platforms for developed market incumbents. China and India combined will contribute to one third of global GDP growth in the next decade. Emerging market equities are trading at their steepest discount to the developed world in price-to-book terms, providing justifiable metrics for long term positioning.
The regional markets saw the Saudi Index rally 4.3% on Thursday, on strong volumes, bringing year to date gains to 8.4%. The KSA Banking Index delivered +30% year to date. UAE banking sector performance too, has benefited from the interest rate increases with net interest margins improving. The Abu Dhabi Index (+11% year to date) which has an almost two thirds weight to banks, has outperformed the Dubai Index (-19% year to date), as the latter is skewed towards the real estate sector, which has underperformed.
Cross asset considerations
The release of US 3Q GDP is particularly important in that it has revealed useful details about the economy which business surveys, though leading hard data, cannot disclose. On the surface, it looks like America is steaming ahead, as it is, achieving a 3.5% annualized expansion rate, above expectations and still a high level in absoluter terms, although lower than the red-hot 4.2% of the previous quarter. Yet, the composition of GDP should have policy makers in Washington raise eyebrows. The 3Q advance was driven mainly by consumer and government expenditure, while business investments (+0.8%) slowed significantly from 1H rates (+10.1%). How are tax increases going to pay for themselves if companies prefer to allocate excess cash to buybacks, dividends or deleveraging, than invest to enhance the structural growth of the economy?
Although one should be careful to draw far-reaching conclusions from one quarter’s worth of data, the evidence suggests for now that capital deepening has yet to occur and that US above-trend growth is still a transient phenomenon. In spite of the recent market turmoil, as per recent declarations Fed officials seem set to go ahead with the planned tightening. Investors, and likewise Mr Trump taking a swipe at the Fed for raising rates, may find it odd that the central bank makes efforts to spoil the party of strong growth and falling employment, unflinching at rising market volatility. Those same investors fail to notice that above-trend growth ultimately boosts price inflation, while prolonged asset inflation brings about economic instability. The Fed will go ahead, possibly considering pausing on the way after the December hike.
Europe continues to fare much worse than the US in economic terms, defying all prognostications of a forthcoming recovery driven by a tight labor market, a notion implicitly reiterated by ECB president Draghi in the latest policy minutes. Growth differential with the US gapped wider in October according to the latest business surveys, and the same tendency can be seen in earnings growth, running at roughly one third that of the US for European companies according to how the current reporting season is proceeding.
A common trait that both economies share, though, is the growing populism; one under the ‘America First’ motto promoted by Mr Trump, the other is the more domestically oriented version the Italian authorities are branding to justify larger deficits and boost the economy in the process. Both kinds of populism are producing the same result for different reasons, which is higher debt levels which would only be sustainable if it ultimately improves structural growth.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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