Moment of truth

Chief Investment Officer's team
25 April 2021
Moment of truth
The week ahead will provide a clear picture on the economy and corporate earnings in Q1


  • The week ahead will provide a clear picture on the economy and corporate earnings in Q1
  • Q2 is expected to deliver better virus control and a strongly accelerating recovery
  • Our positioning is pro-cyclical but includes significant cash to deal with upcoming volatility

Asset class returns were overall positive yet relatively modest last week. Economic data releases were light but confirmed the current sequence in regional leadership. The US is booming, with flash PMIs and new home sales both above expectations. Europe and Japan are resilient, and dealing with rising infection numbers with more restrictions, along with a pick-up in vaccinations. China is slowing down under the double influence of a maturing rebound, and deliberate policy tightening. India is hit hard by the second wave of the virus, but trying to avoid another full lockdown. Bottom-line, the global economy remains on track to deliver a spectacular second quarter. At the same time, major western central banks seem to have convinced markets about their continuous support in the short to medium term. So far, the early birds from the Q1 earnings season are delivering way above expectations, with year-on-year growth in earnings as high as 50% for many of them. The week ahead will be extremely busy on that front, and will also provide Q1 GDP numbers for the US and Europe. We will have a clear picture on Q1, while Q2 is the pivotal moment which will validate, or not, the now consensually positive scenario on growth.

We believe in a constructive outcome: the US vitality should spill over, and virus control should improve, unlocking a rebound for services. But we also expect volatility. Valuations are elevated, and warning signs abound, the latest coming from the crypto currency world. Increased scrutiny from regulators is the catalyst for this not-totally-surprising convulsion in an ultra speculative markets, but the same retail hands are also active in stocks. We are overweight equities but own cash which we would consider deploying on any material dip. Stay safe.

Cross-asset Update

This year has been marked, as per the CIO-Office base-case scenario, by strong growth driven by exceptional stimulus, at least in the major developed market countries and in particular in the United States. China and some Asian economies are the exception being in a more advanced phase of the cycle versus the Western world. Being gold quite sensitive to US real Treasury yields, we were expecting that it would be struggling given the many cycle positives triggered by the Mother of all Public Interventions in America spurring growth, but also that eventually it would be putting in a bottom at peak optimism for the economy.

The yellow metal has for now bottomed at $1,700, the upper end of the $1,600-$1,700 range that we had identified as a potential buy area. What surprised us was the speed of the rebound, engendered by the quick pull-back in long-dated yields, also puzzling given recent strength in US data. We would have thought that gold would have had a hard time reversing course amidst the many headwinds. Markets must have begged to differ and we are tempted to conclude that investors will be looking through economic surprises, seen from now on as being noisier and harder to come by with peak growth momentum in the US being reached in Q2 and then fading gradually in Q3 and more sharply in Q4, as per consensus forecasts. Yes, expansion rates may be the highest in the last 35 years in 2021, but markets seem to be telling us that they do not see US growth clinging to peak levels for very long, actually maybe quite the opposite.

It is also true that we still see yields rising in the direction of 2%, more in line with the strength of the cycle and the possibility of higher inflation levels due to the Fed new laissez-faire attitude. To tie it all together, investors who missed out on the $1,700 bottom should be buying gold on weakness, ideally with a 10-year yield between 1.8% and 2%. The latest market reaction suggests that gold may have already bottomed or that anyway deeply lower levels are unlikely.

Similar considerations should hold for the dollar as well, supported by US exceptionalism as much as gold performance is undermined by it. The dollar should bounce again when yields resume their run, though we suspect that the rebound should be faded. Currently our gold and US dollar sentiment models point to the former being still oversold and the latter overbought, so in both cases recent lows or highs should not be exceeded significantly.

Fixed Income Update

While Treasuries took a break from the roller coaster ride, the investors breathed a sigh of relief. Few, if any, would expect any change in the FED's stance in the following Wednesday's FOMC meeting. We would most likely hear more of the same pledge to do whatever it takes. We don't expect very sharp moves in the Treasury yields post the FOMC meeting. Markets price in first-rate hikes in Q1 of 2023. Traders would look at more macro data to gauge the pace of recovery before changing camps on the treasury yield direction. Barring any black swan events, we expect the 10-year treasury yield to touch 1.7% earlier than 1.4%.

Meanwhile, there is a clear divergence between emerging and developed market economies. Emerging market central banks are less tolerant of inflation. According to a recent Bloomberg study, only six central banks are expected to hike rates this year, and all of them are emerging market economies. Russian Central banks came through with a 50 bps rate hike last week. Nigeria and Brazil are expected to follow soon. Turkey may be the only central bank to cut rates this year despite increased inflation following the unorthodox economic stance known as Ergonomics to pursue growth at any cost. Other large emerging market economies such as China and India are mostly anticipated to hold rates this year. At the same time, PBOC recently asked banks to curtail loan growth for the rest of 2021 to keep new advances at roughly the same level as last year.

The sub-asset classes were primarily positive last week. Long duration assets, including IG credit, developed market treasuries outperformed other sectors within the fixed income as the US yield curve bull flattened slightly. Concerns of tight spreads are reappearing in the riskiest of the junk bonds. CCC-rated entities have returned close to 4% YTD with economic growth and a tolerant funding market as a tailwind. However, with CCC-rated bond spreads trading at the lowest levels since 2007, we believe there is a lot of good news priced in, especially in the Energy and retail sectors. Any disappointment in data would lead to a blowout of spreads, and hence we advise aggressive clients to stick to solid BB and B names.

Fund Flows in the Fixed Income Asset class slowed down as compared to the previous couple of weeks. High Yield was the only asset class that saw a negative net flow while emerging market flows were a mere $570 Mn last week. This year's global corporate default tally jumped to 32 as per the latest S&P report. In 2020, 2019, and 2018, global corporate defaults totalled 40, 42, and 31, respectively.

GCC markets continue to show strength as US Treasury yields remain at a crossroads with a weekly return of +0.2% against broader emerging market return that was flat last week. The primary market remains robust with two deals from Equate Petrochem and Taqa. Equate petrochem issued a seven-year bond, while Taqa issued dual-tranche 7 and 30-year bonds. Govt of Malaysia issued the first sustainability 10-year Sukuk last week as well.

Equity Update

Markets this week were influenced by Pres. Bidens plans to double capital gains taxes for the wealthy in the US and surging virus cases, particularly in India. However many factors provide optimism that equity indices will hold these levels and eke out further gains gradually: the vaccine rollout is proving effective in reducing serious symptoms; strong earnings growth in the developed markets, though off a low base; 10 year US treasury yields in the 1.50 to 1.75 range; no new news on inflation or corporate tax rate hikes; profit margins on the up; falling volatility; continuing strong inflows into equities and $5.4 tn of additional savings i.e. 6% of GDP that will partially flow into equities and consumption. Global markets had a flat week, with US and Europe indices retaining close to all-time highs, though largely unchanged. EM equities were slightly up last week as China saw gains, though Indian markets were down. The India economic and corporate recovery will definitely see an impact, though more of a delay than a derailment. The UAE market had a flat week as the Dubai Index gained, with banks performing well. The Abu Dhabi Index lagged as the FOL on Etisalat is yet to be implemented. On the global sector front healthcare and real estate led last week’s returns, tech leads returns in April and year to date, energy remains the best performer. In terms of positioning, we favour recovery sectors such as financials and industrials though would always have tech and healthcare as integral holdings in all portfolios, as a second layer over the intrinsic geographical asset allocation.

US equities are trading above our year end fair value of 4000 but we would hold positions as earnings growth has been almost 10% above expectations and PMIs remain encouraging. Currently long-term capital gains and qualified dividends are taxed at a maximum rate of 20%, along with a separate 3.8% tax on investment income. The proposal is for taxing both of these as ordinary income for filers with more than $1 mn in annual income. This would roughly double the tax rate on capital gains and dividend income from 23.8% to 43.4%. But expectations are for a more modest increase, c.28%. US households represent the single largest owner of the US equity market, at 35%. The top 1% accounts for 53% of household equity ownership.

25% of S&P 500 companies have reported earnings for the last quarter and Q1 earnings are on track to rise 33.8%, y/y, with a base of weaker earnings in the year-ago quarter when the onset of the pandemic hurt many businesses. Revenue is on pace to increase 7.5%, y/y. Another third of S&P 500 companies report in the coming week, with Tech giants Apple, Microsoft, Alphabet and Amazon expected to record revenue growth north of 30%. The combined market cap of FAAMG stocks at $8.2 tn is now equal to EM market cap. Apple is planning to infiltrate the $350 bn digital ad landscape currently dominated by Alphabet and Facebook, also its iPhone 12, which can access the 5G network is boosting revenue. Microsoft continues to see growth in its cloud-computing and videogame business. Alphabet has seen recovery in ad spending as has Facebook. Amazon will probably have a second quarter with more than $100 bn in revenue, from increased online shopping and cloud-computing.

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