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Chief Investment Officer's team, 21.01.2019
From the 2016 Brexit vote to the current yellow vests movement in France and including elections in the US or Italy, the Western world has been thrown into disarray by its social convulsions at a time when China is trying to take more space in the global arena.
Against this backdrop, the challenges to asset markets are becoming more geopolitical in nature, less easy to assess within a conventional framework, and more likely to produce binary outcomes. While these risks could be met with benign neglect when trumped by a stronger economy, they are now moving into the foreground as the business cycle ages. Rising uncertainty and abrupt market moves do not require unbalanced portfolios or, worse, short-termism, but rather robust allocations and a longer time horizon.
Our new strategic cautious, moderate and aggressive allocations have been built to minimize losses on a 3, 5 and 7-year time-frame respectively, taking into account longer-term valuations and a higher volatility scenario. The end result is that we have not maxed out on equities and found different sources of returns in alternative assets, specifically hedge funds and gold. Absolute return strategies should offer some shield against less directional markets, while gold fits quite well, as a safe-haven asset, in the geopolitical ‘new-normal’.
So far, 2019 starts on the sunny side of volatility. On a tactical basis we continue to hold the view that tailwinds should prevail for now, although new risks are rising to replace the fading ones, like the US government shutdown. Unless it is quickly resolved by Mr. Trump through his art of the deal with the Democrats by the end of February, it could intersect with the debt ceiling issue. Should this happen, not only would US growth be affected, it would also constitute evidence of the dysfunctional status of US institutions and be ground for concerns from rating agencies.
Progress is being made on the US-China stand-off. We believe that economic pressure is mounting for Mr. Trump and Mr. Xi to reach a partial agreement on tariffs, while more structural matters could be left unresolved and remain a source of conflict between the two superpowers further down the road. Brexit risks are also receding, in the sense that the most extreme scenario of ‘no deal’, with the UK crashing out of the EU, is disliked by all parties, although the path to a solution is still a long and winding one. The UK Parliament is likely to buy time, the same way the US and Chinese leaders would be doing with a quick trade agreement, by passing legislation to extend Article 50.
With geopolitical risks softening, the economy takes center stage as a potential support for risky assets, whose valuations still appear depressed. This week key business confidence metrics will be released in the large developed economies, alongside important Chinese data.
Inter-market relationships continue to be constructive. Credit spreads and equity volatility are normalizing, safe-haven assets - gold and the Japanese yen - seem to be short-term rich, while EM equities are close to clearing an important resistance level. Overall, markets are healing from the damage inflicted by the 2018-end tumble and EM assets in particular still look appealing.
Fixed Income Update
The Kingdom of Saudi Arabia along other four sovereign states are making their way to JP Morgan’s EM bond indices. As reported by a Bloomberg news article, the GCC would account for up to 12% on the indices by the month-end across the 15 benchmark borrowers in the region. The rebalancing across the broader EM allocation should have a slight impact on some of the larger constituents of the indices such as Mexico, China, Indonesia and Turkey. GCC debt has been a significant and long-standing overweight conviction for us. While the GCC bonds benefit from technical support, on a ratings-adjusted front, the valuations amongst their EM peers is also compelling. The recent demand on the GCC primary issuance is a good testimony, in our opinion.
Fiscal and monetary stimulus by the Chinese authorities alongside an improved macroeconomic backdrop has boosted bond performances so far this year. The general risk-on tone driven by the improved backdrop from the US-China trade impasse, a dovish FED which now translates to a weaker dollar have fueled the rally. Within the fixed income asset class, US High Yield has outperformed EM by almost 200 bps while US Treasuries have retraced some of the YTD gains hovering near the 2.8 percent level on the back of renewed risk appetite. Within EM, Asian local currency bonds are gaining traction and enjoying capital inflows in places like India and Indonesia on back of attractive real yields. The primary activity on EM debt is sustained. So far, EM has priced over USD 37 bn of new transactions as compared to the last five-years average of USD 57 bn. Asian led borrowers continue to lead with over USD 17 bn followed by GCC issuers at over USD 9 bn. January 2018 was an exceptional year for EM primary issuance recording over USD 85 bn in bond transactions.
2019 has begun as strongly as 2018 ended badly. After experiencing the worst December in the last 50 years, we’ve witnessed the best January yet; the MSCI All Country World Index is up 6.2 percent and every region globally participating in the rally – a significant step closer to our year-end fair values. All 10 global sectors are positive with growth and value performing similarly. Equities were also buoyed on optimism around trade. As Bloomberg reports, discussions are in place for China to reduce its trade deficit with the US to zero by 2024 (from USD 323 bn last year) by increasing imports with a combined market value of USD 1 tn over a six-year period. Also positive for markets is a planned meeting between Mr. Trump and North Korea’s Kim Jong Un.
The S&P 500 is up 3 percent last week, with solid earnings supporting performance. The government shut down doesn’t seem to have impacted equity markets as of now, but could affect Q1 growth and impact revenue for domestic companies. The US is leading returns for major markets globally, a continuation of 2018, but with much less dispersion within regions. Policy winds that plagued stocks in 2018 may be shifting, suggesting 2019 is unlikely to be a mirror image. Emerging-market currencies are stabilizing and so far earnings are beating expectations. A Fed on pause supports a brighter outlook for this year. The December weakness looks to be now, more likely a correction in the longer-term uptrend. However, economic and corporate earnings growth are both slowing so volatility will be the norm rather than the exception.
Financials were the top-performing sector in the US, up 6.1 percent for the week. Earnings reports this week indicate that US banks margins are reflecting higher interest rates while investors are shrugging off the weak trading revenue. Energy and financials, which were amongst the bottom performers in 2018 are leading with the energy sector as the best performing sector in the US year to date +11%. For Q4 2018 (with 11% of the companies in the S&P 500 reporting so far), the blended earnings growth rate for the S&P 500 is 10.6%, the fifth straight quarter of double-digit earnings growth. The blended, year-over-year revenue growth rate for Q4 is 6 percent. Looking at future quarters, analysts see low, single-digit earnings growth for the first three quarters of 2019. Our estimate is at 5 percent earnings growth, coming off a high base.
Other notable Q4 results include Netflix which has grown its subscriber base to 137 mn people, raised monthly rates and is spending USD 14 bn on creating content. Streaming is gaining traction with Disney making it a focus and Amazon already providing original content.
In Europe, the Stoxx 600 appeared to shrug off UK politics, ending the week up 2.3 percent (and up 5% YTD in USD terms, total return). The FTSE 100 lagged and was up only 0.7 percent (local currency) last week, affected by the Brexit turmoil. The Sterling’s volatility and any appreciation is seen to be a negative for UK companies that have two thirds of their revenue from overseas.
GCC markets continue to do well with the KSA up nearly +8 percent year-to-date, led once again as in 2018 by the banking sector, +12% year-to-date. Dubai real estate stocks continue to falter, counteracting the positive performance from the banks. The Dubai Index is flat year-to-date.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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