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Chief Investment Officer's team, 28.01.2019
Another positive week
A buoyant Friday session confirmed the very good mood of markets so far in 2019. Last week, as there were converging indications that the US Federal Reserve will be patient, the US dollar was weaker, supporting Emerging Markets and all segments of fixed income. Global equities gained 0.2%, lifted by +1.4% in Emerging Markets and positive performances in non-US Developed Markets. Oil prices slightly consolidated, and Gold was up 1.8%.
So far, 2019 starts extremely well, with all major asset classes in the green, from equities to commodities including fixed income. If the direction was not a surprise to us (we added to equities earlier in the year), the pace is impressive. We keep an eye on valuations (our year-end fair values) and will closely watch the earnings season as well as the FOMC this week, to confirm the trend or already consider taking profits.
Cross asset considerations
Asset allocators tend to rely on the inverse correlation between equities and government bonds to protect portfolios during turbulent times. When equities drop, high-quality bonds tend to gain amidst rising uncertainty. This sounds so obvious that most investors are oblivious to the fact that, historically, a positive correlation between the two asset classes has been the norm, rather than the exception. For instance, in the thirty years up to the new millennium, US equities and Treasuries tended to move in the same direction. The relationship flipped around the year 2000 and has ever since been inverse. One explanation is that during deflationary times what is good for bonds, extremely low prices of goods and services portending lower economic growth rates, is not good for stocks, hence the inverse correlation. During reflationary periods, rising inflation coming with a stronger business cycle tends to be bad for both asset classes, which more often than not move in the same direction.
Since the Great Financial Crisis deflationary threats and uncertainty about the macroeconomic outlook have prevailed, making US Treasuries the perfect safe-haven. Is there reason to believe this could change? The answer may be positive. For instance, according to some studies, in the Q4-2018 market tumble US 10-year Treasuries rallied much less than in the past decades for each unit drop in the S&P500, so it seems that safe bonds are starting to be less effective at absorbing shocks. A possible change in the correlation regime could have to do with the shift from monetary to fiscal policy, so far has gone pretty unobserved, yet full of implications for asset behavior.
Monetary policy has exhausted most of its tools and there is not much political appetite for central banks to extend their activism indefinitely in time and magnitude. Typically, monetary policy inflates markets much more than the economy. The recovery since the Global Financial Crisis has been pretty anemic measured in terms of its economic growth rate, yet the accompanying rally in financial assets has been much stronger than the average past bull market, being underpinned by multiple rounds of Quantitative Easing across the globe. Ben Bernanke, himself, in the now famous Jackson Hole speech, in 2010, tipped off investors that more monetary support was on the way, and the S&P500 was propelled higher alongside global equities by the so-called ‘Fed put’.
Fiscal tools are most likely going to replace monetary stimulus, as governments must still find ways to support the economy and at the same time try to bridge the inequality gap which has only widened. Fiscal policy tends to boost GDP much more than financial assets. There is now a distinct trade-off: if governments achieve their purpose, then inflation and growth will push higher, forcing central banks to tighten monetary conditions; and if they do not, market disappointment will follow. Either scenario is incompatible with above-average returns. Governments will need to increase the supply of bonds allowing them to use fiscal leverage. This kind of stimulus will exert pressure on bond yields and cap equity returns. Eventually, equities and bonds should go back to a regime of positive correlation amidst tighter financial conditions.
In the shorter run, monetary policy is still the investors’ main focus. Markets are looking ahead to the Fed’s meeting this week to assess for how long the US Central Bank is going to pause, what its next move is going to be and whether Quantitative Tightening remains on autopilot. An encouraging message by Mr. Powell would be making up for disappointment in recent macroeconomic releases. US growth remains solid amidst a mixed bag of rest-of-world data as Europe continues to lag. Although the most leading components in the Global Purchasing Manager Index are inflecting higher and Chinese Fixed Asset Investments firming, more signs of stabilizations are needed for risk assets to bottom out and volatility to subside. In the meantime, support is still provided by US equity buybacks, which in Q4 2018 continued apace funded by high cash-flow levels and repatriation of assets held overseas.
Fixed Income update
The first Federal Open Market Committee (FOMC) due this month (29th – 30th) will be key to assess the path for rate hikes and policy setting. Market expectations and positioning are now converging as compared to what we witnessed throughout 2018. The market implied probability of a 25 bps rate increase for the first half of this year is just under 25%. Any change in the Fed wording would have a direct impact on the shape of the US yield curve. As of last week, the FED-dated OIS is pricing in the current hiking cycle to end around September at just eight basis points off a further hike. US government bonds have been supported by lower growth expectations, trade tensions, as well as US government shutdown. We have reduced DM government debt, but the US remains our preferred region within the sub-asset class.
The pursuit of inflation from global central banks has not been very successful so far. The ECB acknowledged downside risks to both growth and headline inflation. In the US, the same trend can be read from break-even rates, with the ten-years currently at 1.78%, i.e. below the Fed’s target. Although global high yield has shown a strong comeback recently, our concerns remain on the fundamentals of the underlying sectors, particularly within the high yield segment. EMD constituents are comparatively defensive with a better credit quality as compared to their DM high yield counterparts. The recent stimulus by China on both fiscal and monetary fronts is a positive catalyst.
The deluge of supply from EM borrowers this year has been well received with demand oversubscribing multi folds. Despite the various comments on debt and growth, Chinese borrowers have managed to lure capital from every corner of the world, representing 25% of all 2019 EM bond sales so far. The GCC region has followed with important transactions led by the Kingdom of Saudi Arabia. We do expect to see several pipeline transactions to emerge given the refinancing requirements both by corporates and governments. Meanwhile, Dubai Investments Park have been meeting investors and gathering interests on their upcoming five-year Sukuk transaction which will be due shortly. Emirates NBD has been mandated on this transaction along with other banks.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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