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Chief Investment Officer's team, 26.05.2019
Last week’s picture was very clear: markets don’t like uncertainty. The best-performing asset classes were Gold and Government Bonds, while the worst were equities in both emerging and developed markets. Looking into more details, the only equity region with a materially positive performance was India (our recent overweight), where uncertainty was precisely lifted by the outcome of the elections. At the other end of the spectrum were tech stocks, with the looming perspective of a technological cold war, and oil prices, with their worst week of the year as trade war threatens the demand for crude oil. Finally, the British Pound was pressured by the heightened risk of a “no deal” Brexit as Mrs May announced her resignation.
After having been constructive at the beginning of the year, we had started reducing risk months ago and immediately increased cash after the unexpected re-escalation of the US/China trade tensions, by cutting our overweight in EM equities. We, however, stated that this was a temporary measure and are still looking for the right time, and price level, to come back on risk assets. The fundamental picture has clearly not improved, but it hasn’t either materially deteriorated, and if anything, valuations are getting more attractive every week. We remain on the cautious side as everything is not priced-in yet, and as seasonality is not particularly favourable. The trade situation could get worse but should eventually find a solution, and we stand ready for action.
The FOMC meeting minutes constitute the only silver lining to the previous week, marked by disappointing macro releases and increasing trade tensions between the US and China. The message from Fed officials conveys a patient approach in relation to future rate hikes and a more optimistic view on the growth outlook. This ‘Goldilocks’ scenario, which may sound a bit dated in light of the recent heightening of geopolitical risks, sits in stark contrast to the bleak mood on markets.
While global equities have so far been quite resilient, many cross-asset relationships are not sending the same reassuring signals. Different momentum measures of high-beta currencies, like the Australian dollar or the Asian crosses, against the US dollar, are becoming increasingly negative; in turn, the latter is close to the lows of the year versus the Japanese yen. US 10-year Treasury yields are consolidating below the 2.4% mark, ignoring the case for an improving economy made in the May Fed minutes. Gold is still in the doldrums, yet possibly consolidating, ready to move to the upper-end of its trading range.
Trump’s trade war is currently the epicenter of the shock waves rippling through markets and affecting global business sentiment, which in turn is depressing capital expenditure. EM Asia is the main victim of this tidal change. Growth in the area is highly sensitive to trends in global investment, with China itself showing as a top-ranking country in the list. As Chinese exports to the US get curtailed, local supply chains are affected, and the surrounding countries, providing China with intermediate inputs, see their exports heavily affected too. Only time will tell whether these countries will be able to redirect their supply to the US or other major markets. For now, the area is expected to see a net loss of wealth.
The new course of action traced by Washington on trade relations is causing pain to American companies too. Huawei, the Chinese telecommunications behemoth, will be unable to make purchases from suppliers reliant on US technology, following Mr Trump’s ban. US chip producers will see themselves forced to stop making business with a primary customer, suffering a “significant and immediate adverse impact”, as stated by John Neuffer, president of the Semiconductor Industry Association.
EM assets, the financial barometer of the current trade crisis, should remain volatile. EM stocks and hard currency bonds, in particular, seem to be still vulnerable, considering the crowded investor positioning across mutual funds, hedge funds and ETFs. Downward revisions to the outlook, as analysts gauge the second-round effects of trade conflict on growth, could be a catalyst for further weakness. This is why we have reduced our exposure to EM equities to neutral, but are still overweight in EM bonds for their favorable risk-adjusted yields. Both could be volatile, but the latter provides income.
Fixed Income Update
US Treasury yields have fallen at a much faster pace, touching the 2.3% mark, and interestingly below the fed funds effective rate (Inversion on the US curve). The ongoing US-China trade relationship, the recent developments on the Brexit front post-Theresa May’s resignation, and FED’s dovish minutes have supported safe assets across the board. While cash prices on corporate bonds remained relatively unchanged, the falling benchmark yields have widened credit spreads.
The biggest gainer over the week was of the Australian Sovereign bonds (10Y) with a -15bps move in absolute yield terms to 1.51%, on the back of increased expectations for RBA to lower policy rates in the coming months. Market consensus is now calling for a cumulative 75bps of cuts for this year. In the Eurozone, Italian BTP led the outperformance, with -14bps in yields followed by the UK Gilts at -10bps to 2.55% and 0.95% respectively. The GCC bond index holding well with yields and credit spreads at respectively 3.96% and 172bps.
The Eurodollar futures were marginally weaker throughout last week with the OIS pricing in around 30bps of cuts by the December FOMC meeting, and 50bps at June 2020 horizon, i.e. two full cuts. Minutes of the Federal Reserve’s last policy meeting showed the FED maintained their dovish stance and have cited “patience” on rates to be appropriate for “some time”. FED officials also raised their growth outlooks and sided with Chairman Jerome Powell that recent softness in prices was temporary and transitory.
Asset managers cut net long positions in the 10-year Treasury futures, while speculators added to the net shorts, according to CFTC data reported last week. Asset managers were also bearish the long end of the curve, while speculators were bullish. As uncertainty on trade talks remain heightened, we believe US Treasuries should be well supported and expect further bull flattening on the US yield curve.
Investor focus will turn to fiscal consolidation in India after PM Narendra Modi and his Bharatiya Janata Party’s decisive victory securing a second term. Markets would be keen to look further on any cues on policies from the comprehensive budget, which is expected in July. Domestic bonds and corporate Eurobonds should benefit from the positive momentum. We hope to see yields on IGB’s to fall alongside a stronger INR in the near term. The INR curve has room to shift lower (Bull flatten), in our view, with the short-end providing good value at current levels. While corporate IG spreads have been well supported, we see limited upside from current levels. We prefer corporate high-yield as domestic liquidity conditions should improve. We also assume policymakers (RBI) would add some stimulus measures to some sectors, particularly on the non-banking financial companies.
FIXED INCOME VALUATIONS
Global equity markets continue to feel the ramifications of the potential economic fallout from the US-China trade war. The S&P 500 finished the week down 1.2%. This marks the benchmark’s third straight week of decline and its longest weekly losing streak since December. This is even though President Trump said there remained a good possibility that negotiations with China could get back on track. The technology sector was under the most pressure as it is among the most exposed to global trade, and at the heart of the nascent “tech war”. The NASDAQ fell 2.3% last week. The CSI 300 - the benchmark index of Shanghai and Shenzhen-listed stocks has fallen 8% this month, on track for its steepest monthly drop in more than three years. According to EPFR Global, Emerging Markets equity saw strong outflows this week of USD 3.8bn.
Oil prices too declined as did the oil sector as it was felt that slowing global growth could impact demand. We remain buyers of some of the higher quality energy majors as they are not only investing in clean energy initiatives but also increasing cash flows ensuring dividend growth. In turbulent markets, we advocate adding companies with high and growing dividends. Defensive sectors have outperformed cyclical sectors in recent weeks, and until tariff talks come to a positive resolution, we will continue to see this shift. The healthcare and consumer sectors should provide some resilience as demand for their products is less elastic to the economic cycle.
The bright spot in a week fraught with trade tariff turmoil was India (+4.8% MSCI India USD last week) as the end of elections brought certainty as to policy direction. We increased allocation to Indian equities in early May and have an overweight position within our Emerging Market equity allocation. PM Modi’s BJP-led National Democratic Alliance (NDA) retained power in the Lower House of Parliament. In its latest term, the BJP government implemented several economic and banking reforms. However, physical and social infrastructure still needs fixing, and the government must focus on an accelerated agenda that ushers in a sustainable economic transformation over the next five years, setting the stage for continued growth. We favor domestically oriented businesses, especially in the Financials (private sector banks), Industrials (infra build) and Consumer sectors. Our fair value for the MSCI India Index for end 2019 indicates 5% upside from current levels with estimates of 16% earnings growth and at 19X 2019 Price to Earnings ratio. We are at the onset of a multi-year earnings growth cycle, hence the high valuation multiple is justified. India benefits from strong internal drivers which makes it’s market more immune to the trade war than other regions. Headwinds include slowing global growth and rising oil prices.
The GCC markets had a stable week after seeing a selloff in early May. They have lost some of their previously strong momentum, as lower oil prices and regional tension weighed on sentiment. MSCI WM inclusion has led to repositioning in portfolios. The Arabian Centres Company IPO added to the retail sector offerings in the KSA with a successful listing. This is expected to be followed by Saudi Arabia’s Public Investment Fund (PIF) listing its traffic management firm, Saher.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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