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Chief Investment Officer's team, 25.03.2019
Last week was quite different from the previous (bright) one. The major event was the Fed’s FOMC meeting, which delivered a very dovish outcome by simply removing any rate hike in 2019 from its “dot plot”. Markets immediately celebrated, both because rate hikes posed a risk to the economy, and because easy monetary conditions naturally support asset prices. The paradox however is that long-term bonds rallied so much that the US curve inverted last Friday, for the first time since 2007, which is widely considered as an early warning for a US recession. In a nutshell, good news for the economy (loose financial conditions) turns into a warning signal for the economy (curve inversion).
In such context, volatility should not come as a surprise, especially as there was negative news on the US/China negotiations, and still little hope on Brexit. The week ended Friday with a sharp sell-off in risky-assets.
In this context, our stance is unchanged. We don’t try to predict short-term movements, but adjust our exposure based on the fair values we derive from our scenario. Everything else being equal, the Fed dovish stance is a positive, but current valuation do not provide sufficient upside potential. We would consider acting in a contrarian way depending on the distance to our fair values, and are happy with our current positioning, which is slightly defensive overall with an emphasis on EM assets, but also Gold, and cash to seize opportunities.
Asset classes USD % total return, YTD 2019 and week
Investors witnessed a momentous week, as the Fed completed its dovish pivot, global business activity once more disappointed, the US yield curve inverted for the first time since 2007 and global bond yields plunged. After their spectacular 2019 performance, risk assets’ valuations are in line with a typical Fed pause context.
With most major asset classes now aligned with fundamentals, improvements in the global outlook would be needed for more upside. Although monetary policy cannot do much more in the short term, easier financial conditions should have the effect of avoiding a recession in the next 12 months. Under this assumption, equities could outperform government bonds one year out even if earnings were to grow just in line with nominal GDP, which would for instance translate in 4%- and 8%-plus gains for US and EM stocks respectively.
Our stance has not changed. We would be adding to risk on weakness in spite of the existing headwinds, based on our fair values, considering the amount of stimulus in the US, Europe, Japan and China. Also, softness in manufacturing is still offset by a resilient services sector and strong labor markets. Yet, asset markets seem to start thinking otherwise, and this takes us back to the ‘unnerving sequence of events’ mentioned above.
The global economy has quickly reverted to the pre-Trump period dubbed as ‘goldilocks’, where GDP was growing at a sub-par, yet neither too hot nor too cold rate, and Fed and PBOC support as well as the strong US growth-engine were keeping the rest of the world afloat. Today, as before, there is a distinct lack of investments and little inflation. YTD equity market internals have a defensive bias, with less cyclical, high-yielding sectors like utilities and real estate outperforming. Central banks and investors have become less sanguine about future prospects. The Fed and the ECB downgraded the growth outlook at their respective meetings and bond traders must now believe that the next interest rate move in the US will be a cut, since the US yield curve has inverted.
This is in certain respects reminiscent of the Japanese 1991-2000 ‘lost decade’, when the country’s economy stagnated in spite of massive monetary support. At the time corporate investment plunged and today it is ailing, in spite of Mr. Trump’s tax breaks. At the time defensive assets outperformed, and today bond yields are stuck at historically low levels globally. In Germany, which has one of the oldest populations in Europe, long-dated yields have entered negative territory again. While the jury is still out as to whether in the long run the developed economies will reflate, or rather follow the Japanese experience, in the more immediate future there still seems to be enough monetary firepower.
Gold has been perked up by the March FOMC meeting. The yellow metal would benefit from more inflation being tolerated by the Fed – but could be hammered by deflation concerns. We maintain our gold overweight, riding the Fed’s reflationary attempts.
Tactical Asset Allocation: simplified positioning
TAA – relative positioning – moderate profile
Fixed Income Update
In the aftermath of the FED’s FOMC statement and the forward guidance projected, global bond yields dropped dramatically to levels not seen in a while. US Treasuries touched 2.42%. Yields across the UST’s dropped 8bps to 9bps in absolute yield terms while the US yield curve partially inverted, especially 3 months vs 10 years, for the first time since 2007. This inversion, if it persists, has almost always preceded a recession, though it can take more than a year for it to happen. On average, an inverted spread of close to 1% or 100bps should provide for a higher probability of an economic recession.
Faltering global growth concerns resurfaced as policymaker’s narratives sparked a strong rally together benign inflationary outlook. The German Bunds have once again breached the zero bound levels with a -0.1% yield on the ten-year maturities, levels not seen since September 2016. Earlier this month, the ECB confirmed it would not raise policy rates for the rest of the year, and announced a new set of cheap bank loans to try and boost lending. The quantum of negative yielding debt globally is on the rise and currently at over USD 10tn.
Central banks in Asia have been alluding towards rate cuts on inflation and growth concerns. Bank Indonesia maintained policy rates unchanged at 6.00% last week. BI's stance on policy guidelines was dovish which translates to the beginning of policy easing via the RRR cuts, and lowering policy rates to the tune of 75bps to 100bps. Indonesia's inflation is below target, and real yields are trading close to 5.24%. The current-account deficit will be a key indicator in assessing the path for policy normalization while policymakers likely to maintain CAD within the 2.5-3.0% of GDP in 2019. The Central Bank of Russia kept policy rates on hold at 7.75%, but the accompanying statement was markedly dovish, with policymakers revising inflation forecasts down and suggesting that interest rate cuts could come already this year. FED's pause on their rates is a great catalyst for EM Local domestic bond markets as well as for capital flows in search of yield which underpins our overweight conviction and positioning on EM local currency debt.
Manufacturing survey data published by IHS Markit indicates that the Eurozone manufacturing activity contracted the most in nearly six years. Activity in Germany fell for a third straight month while France is also showing slack this month (48.7) as compared to the February reading of 50.4. Japanese factory activity also shrank while the US activity at the weakest pace since June 2017. US industrial production rose 0.1% in February, below consensus of 0.4% raising investor concerns on the broader outlook on the manufacturing sector which could dampen current benign growth expectations. The series of recent economic data releases have been below.
Fixed Income key convictions
Fixed Income valuations
Chart of the week: Negative Yielding Debt surges
The GCC markets had a good week with the KSA Index up +1.5% and both the UAE indices gaining over 2%. The Emaar group companies’ dividends were in focus with payouts in line with previous years. We recommend booking profits on the GCC banks, after their +60% rally over the last two years and as the dividend season is over. Net interest margins will also not get any further boost from interest rate hikes. Some select opportunities will always exist.
Giving up the previous week’s gains, developed market equities ended last week lower, as concerns over slowing global growth resurfaced post a negative outlook from the Fed and reinforced by disappointing economic data out of Europe and Japan. Stocks in Europe finished lower on weakening economic data and Brexit uncertainty with the German Dax taking the brunt. We retain our underweight stance on European equities. Trade worries too pressured sentiment, as the U.S. and China plan new rounds of talks. The Fed concluded its monetary policy meeting, and left the target range for its fed funds rate unchanged, with a more dovish stance. Treasuries moved higher and investors’ fears that U.S. economic growth is slowing was reinforced by the inversion of the 3-month/10-year yield curve.
Friday was only the third day of 2019 in which the US market declined over 1% and the third week with a decline. The Dow Jones was the worst performer last week amongst the major indices falling -1.3%, with Boeing and Nike shares contributing to its decline. The S&P 500 Index fell a little less and the Nasdaq Composite, after a strong mid-week rally managed to close the week with a decline of only -0.6%. The effects of tax cuts are fading, and earnings growth is expected to slow in the US. Strong 2018 earnings growth won’t be repeated in 2019, as last year’s earnings set a high bar: After rising more than 20% in 2018, year-over-year S&P 500 earnings growth is expected to be negative in the first quarter of 2019, and to grow by single digits in the remaining quarters. Profit margins forecast at 10.7% are still at a record high, but lower by 1% than last year with worries around labor costs, global trade and top line growth. Technology remains the best performer year to date, in the US and globally. The certainty that rates are not rising is a boon for this high growth sector and the reverse for banks. The US KBW Bank Index fell 8.3%, accompanying the sharp drop in bond yields.
The dovish Federal Reserve may prove a boon for emerging-market investors, as this would boost inflows into emerging-market currencies. China retains its lead as the best performing global market this year +17% (MSCI China USD), however India at +6.1% (MSCI USD total returns) is playing catch up. Please refer to our detailed note on India. Trade policy and global growth remain key for markets. Given late-cycle volatility, we recommend investors remain diversified and use volatility for adding to positions, however continue to maintain equity allocations in accordance with a longer term strategic view.
Equity recommended regional positioning
Major indices performance (TR, US$) and 2019PE
Global sector performance (TR, US$) and 2019PE
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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