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Chief Investment Officer's team, 12.05.2019
As we wrote in our latest Year Ahead Outlook, the ability to adapt to changing conditions is paramount. This is why we started the year with a constructive stance, before reducing Developed Market equities while favouring their Emerging Market peers. After President Trump’s tweets revived the US-China trade war, we decided to reduce our allocation to Emerging Market equities to neutrality, and keep the proceeds in cash.
This event was not expected, nor was it priced-in by financial markets. EM equities are one of the rare assets to have received positive inflows from global investors in 2019, and are close to our year-end fair value. We thus recommend taking profits on this active position. Our secular conviction for EM remains intact: we are still overweight in EM bonds, and stand ready to overweight equities again when the opportunity arises, should it be a better trade context or a cheaper valuation. A full-blown trade war is not our central scenario, but the rhetoric between the two superpowers is not calming down. China just stated that removing all extra tariffs is a pre-requisite to reach a deal. This won’t probably happen overnight, and the uncertainty from negotiations might weigh on business confidence and investors sentiment.
As a result, taking partial profits after a spectacular rally appears to be wise. We are more defensive, but remain invested, as the fundamental backdrop hasn’t dramatically deteriorated.
Lacking positive catalysts in the current quarter, the additional uncertainty caused by the resurging trade war between the US and China will most likely have a bearing on asset performance, not yet reflected in last week’s shallow market correction. Equities are down in the low-single digits month-to-date, credit spreads modestly tighter and high-beta currency have on average lost a couple of percentage points, nothing like the more severe losses suffered in different episodes last year.
Following President Trump’s announcement of extending higher tariffs to $200bn worth of imports from China, we decided to cut our EM equity overweight to neutral. The decision was dictated by the strong performance of the asset class, approaching our year-end fair value, and its vulnerability in terms of flows, since EM assets in general seem to be no longer under-owned. Barely have supply chains in EM Asia recovered from the shock of the deleveraging administered by Chinese authorities across 2017, when new challenges to global trade arise and risk delaying the recovery in developing countries.
Indeed, even before the deep disagreements between US and Chinese negotiators came to the fore, investors had little to look forward to in the short term. The first four months of the year have seen an indiscriminate rally across the risk spectrum bringing all risk assets to full valuations, alongside a dovish pivot of the Fed which leaves no room for further accommodative surprises. At the same time, the gap between solid labor markets in the developed countries and falling global business confidence has continued to widen. Growth outside of the US had just started to stabilize, with March manufacturing confidence rebounding nicely in China and no longer slumping for the month of April in the Euro Area. The threat of new tariffs on all of Chinese exports to the US would jeopardize the fragile recovery and require larger risk premia on equity and credit.
Although it is hard to tell which turn negotiations will take next, it seems clear that the parties are far from sharing a common framework to be working on and eventually agreeing to. Hence, even though it is in their mutual interest to find a solution to the current predicament, coming to that stage might take longer than expected, and in the interim, uncertainty would most likely cause further disruptions in financial markets.
EM assets, in particular EM Asia equities, and European equities, in particular the German market, have the highest beta to global trade. On the opposite side of the risk spectrum, the US dollar and gold stand to gain the most from the current state of affairs. Global government bonds seem to be already overbought and a palatable asset class only in the case of a recession, which is not our base case in the next twelve months.
Our base case remains that a full-blow trade war will be averted, hence we are ready to deploy our cash to add risk back to portfolios at more favorable valuations.
TACTICAL ASSET ALLOCATION: SIMPLIFIED POSITIONING
TAA – YTD INDICATIVE PERFORMANCE
Fixed Income Update
Bond markets YTD returns (chart) have shown a clear resilience in the recent volatile sessions. With so many geopolitical factors taking center stage together with the ongoing saga on US-China trade, it is becoming hard to warrant for the tight valuations on corporate credit spreads. That said, on average, LIBOR has fallen by circa 30bps across 3m, 6m and 12m to 2.52%, 2.58% and 2.69% respectively which also provides some reprieve for bond markets particularly for investors seeking a fixed source of income. The benign inflationary regime and dovish stance by policymakers are providing a sound fundamental rationale for the discerning bond investors.
The latest inflation readings were interesting for bonds. US consumer prices came in below expectations. The core consumer price index, which excludes food and energy, rose 0.1% from the prior month, missing estimates (survey 0.2%), while the broader headline measure rose 0.3%, also short of forecasts (0.4%, flat versus previous month). The difference between the 3-month and 10-year flattened towards zero. Moreover, China’s inflation rate rose to the highest in 6 months in April to 2.5%, while producer prices accelerated to 0.9% from the prior reading of 0.4%. Away from the trade dispute, investors have to cope with a rise in Chinese corporate defaults, within their USD 13tn bond market. Corporate defaults totaled close to USD 5.8bn of domestic bond value in the first four months of the year, some 3.4x the total for the same period of 2018 according to Bloomberg. Such nuances have been predicated towards the tight control of liquidity by the regulators which took place during 2016. Last week, PBOC cut reserve requirement ratios (RRRs) to release about Yuan 280bn (USD 41bn) of liquidity for some small and medium-sized banks. The PBOC said the reduction would be implemented in three phases, giving the dates of May 15, June 17 and July 15. “This is aimed at helping small- and medium-sized banks to better serve small and private enterprises, which will, in turn, support the overall economy,” PBOC stated.
High-yield debt offerings in the U.S. rose to USD 12bn last week across 16 issuers. The benchmark index yield increased by circa 28bps posting minus 0.51% of returns. The option-adjusted-spreads widened to 382bps over the benchmark US Treasuries from 354bps. The five-year high-yield credit default swaps remained unchanged throughout the week at 107bps while net outflows on the High-yield ETF totaled USD 674.3mn. YTD, the ETFs have seen close to USD 7.5bn of capital inflows.
On central bank monetary policy meetings, the Bank Negara Malaysia and Bangko Sentral ng Pilipinas lowered their key benchmark interest rates 25bps for the first time since 2016 to 3.0% and 4.5% respectively while Central banks from the Brazil, Chile and Peru left their respective policy rates unchanged amid a challenging growth outlook backdrop.
FIXED INCOME VALUATIONS
Renewed concerns about the impact of trade protectionism on global growth and corporate earnings led to a selloff in global markets, just as investors had become complacent and begun pricing in a strong probability of a “deal” getting done. The S&P 500 ended the week down 2.1% for its worst week year-to-date. With the S&P 500 near all-time highs, it probably seemed the best time to raise tariffs. However, this will arguably compress margins: the cost of tariffs on over 5,700 different product categories from China will have to be absorbed by American companies or passed onto consumers. Volatility spiked, with the Vix Index briefly touching 23 on Thursday, before ending the week at 16, however nowhere near the December high of 35. So far the dip in sentiment is not comparable.
We continue to be neutral the US within our DM Equity portfolio and the current pullback brings the indices closer to our fair values. Our level of 2825 predicated on a 16X earning multiple and 5% earnings growth rate for 2019, was reached in Q1. Earnings growth in Q1 has beaten expectations by 5% but concerns will be about their trajectory for the second half of the year. US retail/consumer companies could be the most impacted by tariffs, with a potential 5% hit on EPS. However, in the medium term margins will recover as the US will shift its supply chain to other countries. We would continue to remain invested in the US and retain our focus on quality and select tech and healthcare subsectors with higher margins and certainty of growth.
EM equities lost 4.5% last week and are now up only 7.5% year to date with valuations below their median historical forward P/E, thus leaving room for upside potential. The MSCI China closed the week down 6%, but year to date Dollar gains are still a healthy 14.2%. However, this index is not the best representative of China markets as just 2 companies, Alibaba and Tencent cumulate a 30% weighting. China plans supportive measures to support the economy and markets. The larger reforms and supply chain shifts will help keep up the pace of economic growth. We have shifted to a neutral stance on EM on a tactical basis and would add back once the immediate knee jerk volatility subsides.
European and Japanese stocks had a negative week, obviously impacted by both a risk-off mood and the risk of global trade being affected. In the GCC too, falling oil prices and a global risk off mood led to a c.3% drop in the Dubai and Abu Dhabi markets and more so in the KSA which has a higher beta to oil.
It wasn’t a good week for IPOs either. The much hyped listing of Uber had a lackluster take off (“Uber in reverse” as one media headline stated) and the stock price dipped by 7% on its 1st day of trading. Uber has broken private financing records with a $ 75 bn valuation, created a gig economy in transportation and is one of the most used apps globally. Quality matters as profitability around these new era tech companies remains a question mark. Uber is losing almost a billion Dollars a quarter.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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