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Chief Investment Officer's team, 22.10.2018
After the aggressive correction of mid-October, markets remained uninspired last week. Developed Market equities were flat across regions, while EM stocks lost 0.9%, mostly due to China (-1.9%). Global bond markets were also slightly negative across all segments after the Fed minutes were considered as more hawkish than expected. Oil was down, especially in the US (WTI), and Gold was slightly up. The news-flow of the week was however not particularly bearish: the Fed is only responding to a vibrant economy, the US rates are still well below their recent highs, and more importantly, the Q3 earnings are so far very positive. For sure, the growth outside of the US is not as brilliant but still positive, Europe is stuck in its political issues (Brexit and Italy), and there is little hope of a trade deal between China and the US, but all these risks are well known. We were expecting volatility to be significant ahead of the US mid-term elections and as we enter the final weeks of the electoral campaign, markets should not find a clear direction before it happens. Patience is definitely required.
Asset Allocation: we add Gold versus High Yield
The month of August marked an important, although unnoticed milestone: for the first time since the Great Financial crisis the yield on the US Treasury Bill surpassed nominal inflation. Indeed, the Fed is achieving its dual mandate of maximum sustainable employment and price stability, and plans to continue to raise rates until the long-term equilibrium level is achieved. The cost of funding for Corporate America will go up and the companies which relied on cheap money to do business will have to strengthen their position as monetary conditions tighten. This begs the question of how the US and in general global, corporate high-yielding bonds will be affected. US junk paper has on average returned 12.6% annualized in the nine years from 2008 till 2017, as compared to a total return for the S&P500 of 15.3%. Investors who preferred to avoid equity risk and its 20-plus percent volatility and went for credit risk were rewarded nicely, benefitting from central bank’s ample liquidity since 2008
We are now in the late stages of the current economic cycle and investors may wonder if they should expect the same returns from high-yielding bonds. The rising yields on US Treasury Bills suggest that the answer is "no". Corporate credit tends to peak out before other asset classes, as credit quality deteriorates on rising debt levels and cash returns become more competitive with rising policy rates. Junk bond returns for this year are likely to be in the low single-digits, and the asset class is having a hard time trying to beat US dollar cash. Next year, it should still be able to do fine, supported by a macroeconomic backdrop neither too hot nor too cold, marked by the slowing of the US economy. Yet investors might have to rely more on coupon clipping that capital gains. In relative terms equities, although more volatile, should have more appeal and continue to outperform bonds and credit, usually delivering their strongest returns in the late stages of the cycle.
We have recently taken a tactically underweight position in global high-yielding bonds, in order to generate flexibility in the portfolio and focus our risk where it is the best rewarded. An overweight position on gold further enhances our portfolio hedges. In the case of gold, while short-term US rates are certainly not at their peak, we hold the view that US long-term rates, a more relevant driver of gold’s returns, should not be too far from long-term equilibrium levels.
Equity update: another upbeat earnings season
The continuing upbeat earnings season in the U.S. was not enough to generate positive performance for the S&P 500 but prevented it falling. Positive fundamentals around strong earnings growth, near-term resumption of buybacks and favorable seasonality should prevail into year-end. The economic backdrop continues to look strong in the US, with retail sales and industrial production beating forecasts, while job openings are hitting a fresh record high. Key areas of concern in the US continue to revolve around the tightening of financial conditions, global trade and peak growth (and profit margins). We expect volatility to remain high until the imminent mid-term elections. The major US indices are 5%, from their record highs, but still outperforming most of the other regions with more than 4% net return year to date, led by Healthcare and Tech (around +12% YTD). Valuation is not excessive with forward 12-month P/E at 15.9, which is not far from its 5 and 10-year average.
Eighty five S&P 500 companies have so far announced Q3 results, 65% have topped revenue estimates, and 80% have beaten profit projections. For the third quarter, companies are reporting earnings growth of 19.5% and revenue growth of 7.4%. Profit margins at 11.6% are healthy. Within healthcare, UnitedHealth Group and Johnson & Johnson have been particularly positive, as was Netflix within Technology with the expected addition of 27 million new subscribers in 2018. The major banks - Goldman Sachs, Citigroup, JP Morgan, Bank of America and Morgan Stanley- also had strong earnings growth. Analysts see double-digit earnings growth for S&P 500 companies for the fourth quarter at 17%. For 2019, analysts are projecting earnings growth of 10.3% and revenue growth of 5.4%.
Emerging markets were negative, with China the worst contributor. Q3 GDP was slightly lower than expected and some concerns about margin calls linked to leveraged equity investments were also a drag on indices. Expressed in US dollars, MSCI China is down -19% YTD and MSCI India -17%, the latter being hurt by weak currency as well as by concerns around liquidity and the banking sector.
GCC indices were positive last week and followed global cues with financials and energy stocks leading the gains. Despite the year to date rally, +28%, GCC banks appear reasonably priced. Sector consolidation in the UAE, KSA and Kuwait are helping, as is oil price.
China’s Q3 GDP growth slowed to 6.5% y/y from 6.7% in Q2. The authorities are articulating two very different sets of measures: on the one hand they target deleveraging and on the other they stimulate the economy to smoothen the impact of trade tariffs. So far this subtle action looks successful, as the steadiness of the bond market shows. The recent successful sale of the multi-tranche Sovereign bond transactions (including a first-ever thirty-year maturity) which fetched a staggering demand of over $13 billion is probably the best illustration. Looking forward, we believe that the authorities still have significant levers in their hand to adapt to the circumstances, especially on the monetary side with the Reserve Requirement Ratio, the medium-term lending facilities (MLF). The G-20 summit due next month could also provide some hope on trade.
The GCC bond markets have continued to fare slightly better than the broad EM universe at -1.50% vs -3.20% YTD, supported by the technical backdrop, higher oil prices and inclusion in international indices. Higher headline coupons on the newly issued shorter bond maturities, and the new style hybrid instruments (Tier-1 perpetual) have also attracted interest from investors. The region as a whole is developing its fixed income markets, as the recent decision to issue government bonds at the federal level in the UAE shows.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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