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Chief Investment Officer's team, 19.05.2019
Even as the two conflicting parties in the ongoing trade confrontation appear to be nowhere near an agreement, the global recovery remains on a weak footing. Industrial production and retail sales both in the US and China were softer for the month of April, adding to concerns that slower earnings growth ahead and a firm dollar could further undermine business sentiment.
Until tariff concerns lift, equities are likely to trade in a holding pattern and safe-havens linger in overbought territory. The lofty US dollar, although expensive according to Real Effective Exchange Rate models, reflects a premium for resilient US growth and higher policy rates against major countries globally. US long-dated Treasuries, offering no protection against future inflation or a pickup in the growth rate of the economy, are underpinned by Fed dovishness and high geopolitical risks. Gold, still in the doldrums, should rebound to the upper end of its current range, as trade tensions, according to our base-case scenario, spike before eventually subsiding.
In spite of growing near term uncertainties, recessionary risks continue to be contained, with policy support and global unemployment near record lows providing strong offsets to the existing headwinds. The usual harbingers of a downturn, overinvestment and restrictive policy, remain notably absent in the current cycle. This favourable backdrop informs our medium-term constructive view on risk assets.
Major events on the global scene are pointing to an increasingly polarized world. Opposing blocks are engaged in clashes of historical memory, causing rising geopolitical uncertainty and in financial markets the continued outperformance of safer US-centric assets. The US-China stand-off marks a major turning point in the relationship between the two countries and in US trade policy, even as populist tendencies spread across Europe to affect the upcoming elections to the European Union’s parliament concluding on May 26.
Mr. Trump has broken with the multi-decade-long US tradition of supporting free global trade, which has boosted the rise of the emerging countries, the global integration of supply chains and the thriving of the open German economy. Research teams in investment houses are gradually coming round to the new reality that the increased US tariffs on USD 200bn worth of Chinese goods’ may well become permanent. It is interesting, and at the same time deeply concerning, to observe that global trade as a percentage of GDP in the last 60 years has moved in the opposite direction to the average US tariff rate on imports, which under Mr. Trump is rising by an unprecedented extent. Will the new protectionist order make a durable dent in the developing countries’ and Germany’s growth rates? While it is extremely difficult to make such forecasts, we can say with more confidence that in the short term we are unlikely to have seen the full disruptive effects of higher tariffs on the business cycle and asset markets.
Although according to different models the global economy should not be suffering too much unless a full-blown trade war breaks out, those same models last year underestimated the second-round effects on business confidence, which dropped more than expected and caused a marked slowdown in investments. The probability that the two leaders will agree to a deal at the G20 meeting has lowered somewhat, following the recent heightened brinkmanship. As a consequence, US markets should continue to outperform in the short term as uncertainty rises. While a deeper retracement should be expected, we do not see a double-digit crash either, since positioning across equities remains far from extreme, making the asset class less vulnerable than in Q4 last year.
As the Euro area parliamentary elections approach, tension between populist and the more traditional parties increases. Were populist parties to win big, they would be unlikely to build a cohesive enough front to disrupt legislative processes and jeopardize European values. Yet, the declarations of Matteo Salvini’s, the Italian populist PM following in Trump’s footsteps who advocates for a “fiscal shock” to boost growth, have been enough to see the spread between the Italian BTP and the German Bund widen and the euro weaken further against the US dollar.
Attempts to make America great again are likely to be depressing global growth in the end, attempts to shake the existing order in Europe could see it sink further.
TACTICAL ASSET ALLOCATION: SIMPLIFIED POSITIONING
TAA – YTD INDICATIVE PERFORMANCE
Fixed Income Update
US benchmark Treasuries in a tight trading pattern with yields below the 2.40% level underpinned by the safe haven bid while the German Bunds and UK Gilts also strengthening by over 3bps to 6bps to yield -0.10% and 1.03% respectively. The biggest gainers over the week were Portugal and Italian bonds strengthening by over 10bps in absolute yield terms to 1.04% and 2.65% respectively. Some gains on the Eurodollars futures pointing to market expectations of pricing in close to 30bps of cuts by the December FOMC meeting and two full cuts into July 2020 FOMC. The effective fed funds rate fell to 2.39% at last weeks close.
Capital outflows continue within emerging markets. EM Local-currency and Hard-currency debt funds faced their largest weekly outflows YTD. The scale of outflows from EM Local-currency debt funds has been large, and outflows are likely to continue. Almost 79% of inflows have been towards the EM local-currency debt and have been channeled through ETFs, and only 21% to active funds so far, this year. This positioning makes EM local currency debt more vulnerable and volatile during market stress, particularly with US-China impasse.
Chinese primary bond sales have surged totaling 3.6 trillion yuan or USD 522bn in April. The stock of Treasury bond issuance amounted to Yuan 465bn, while local government bond issuance was worth Yuan 226bn, according to a statement by the People's Bank of China. China will accelerate local government bond issuance this year to help the timely implementation of various projects. The debt balance of local governments stood at Yuan 18.39tn at the end of 2018, well below the official ceiling of Yuan 21tn. As of April-end, the size of the outstanding bond market debt was Yuan 90.1tn. Credit growth in China eased last month and remains accommodative for economic growth expansion, in our view. The aggregate social financing growth rose 10.3% (stock basis) YoY for April 2019 driven by RMB denominated bank loans, corporate bonds and local government debt. The Chinese industrial production rose by a modest 5.4% year-over-year in April, down from 8.5% in March, and below the consensus of 6.5%, slowed by manufacturing and mining.
On credit markets, Asian investment-grade outperformed Asian high-yield on the back of uncertainty over US-China trade rhetoric. On a total return basis, Asia IG delivered 30bps of positive returns compared to minus 32bps of returns in Asia HY. Sovereign and Quasi-Sovereign bonds dominated top performing sectors over the week while laggard were high yielding non-financial corporates. In GCC, regional geopolitics were the main drivers for widening credit spreads. The benchmark GCC broad aggregate credit index widened to 171bps (in spread terms) from this month’s lows of 153bps to yield at just 4% while the composite UAE investment-grade index has had a modest spread correction of 11bps MTD to 133bps at an index yield of 3.66% on an effective duration of 4.92 years.
FIXED INCOME VALUATIONS
The S&P 500 seems to be moving in a range, with support at 2800 and resistance at 2900. This is consistent with our year end fair value of 2825. The recent earnings season has been supportive, as have good numbers on consumer sentiment, both of which helped mitigate the concerns over US China trade Issues. The delay of auto tariffs and the lifting of Mexican/Canadian metals tariffs were also rays of hope in a week fraught with geopolitical concerns. Positive earnings reports from Wal-Mart & Cisco overshadowed a ratcheting up of trade tensions, as US companies were banned from doing business with Huawei, putting pressure on the supply-chain. Cisco gave a bullish sales and profit forecast for the current period, a positive sign on corporations infrastructure spending. Walmart remains focused on growing its ecommerce activities and forecast online sales growth to accelerate 35% in fiscal 2020. The retailer, however, warned that tariffs will translate into higher prices for shoppers.
Consumption has been and remains the bedrock of the mid to high single digits economic growth in China and India. Traction in China is maintained by the increasing spend on upmarket products such as luxury watches and apparel whilst in India white goods still have plenty of room to grow. The China market could however remain volatile till stimulus successfully counters the potential economic fallout of tariffs. For the MSCI India Index Year to date returns in Dollar terms are flat and we went overweight India last week. As we wrote earlier in the year, we expect the market to be agnostic as to the election outcome as long as there is a clear mandate. Exit polls are showing. PM Modi’s ruling coalition is poised for victory. The focus for the new government will have to remain on job creation, encouragement of the private sector investment and management of credit risk. An unhelpful global growth environment is creating its own quagmire.
Alibaba and Tencent make up c. 30% of the MSCI China Index and are also the poster stocks of China. However the exponential growth of Tencent is now slowing whilst at Alibaba margins look to be in jeopardy. Q1 Revenue rose 16% for Tencent however at the slowest pace since it went public in 2004. The FinTech division was a standout with revenues up 44%, driven by WeChat payments, insurance services and cloud computing. Sales at Alibaba increased 51% with 83% of sales from commerce activities, indicating shoppers are spending more but this was in contradiction to China retail sales for April, with growth decelerating to 7.2%, the slowest pace in 16 years.
The Tadawul Index (12.1% YTD, total returns) reversed direction at the end of last week, recovering from the selloff which began 10 days ago. With a total of 30 Tadawul stocks to be added to the MSCI EM index, this inclusion is expected to boost trading in the Kingdom’s stock exchange and attract foreign investment. The UAE indices however gave up some of their strong year to date gains, except for a mid-week rally on the real estate stocks that retained their MSCI EM status. Index rebalancing also led to some repositioning in the MSCI EM constituent names.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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