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Chief Investment Officer's team, 06.09.2020
Last week started like a dream, with positive manufacturing indicators amplifying the Fed-ignited rally, but it ended with a sudden rout of technology stocks. A weekly 2% loss for global stocks is actually just erasing the previous week’s gains, which is not terrible. However, the 2-day turmoil was a psychological shock, with tech icons losing 10 to 20% from peak to trough.
We highlight for some time the retail investors’ frenzy, amplified by the massive use of derivatives. Actually, seeing Tesla shares (for example) losing 20% is not more irrational than seeing them gaining 80% in the previous 3 weeks just because a stock-split was announced. This could simply not last: a correction was meant to happen.
Is it the beginning of something bigger?
Last week was actually not a broad panic episode. The most defensive assets such as Gold and Government bonds did not rise, they were not even flat. Having said that, the conditions for turbulences are clearly met. Valuations multiples are elevated and price in a perfect earnings recovery. So far, it is not contradicted by both macro numbers and central banks’ generosity. However, the pace of the initial jump-start of reopening economies cannot be sustained, and many risks remain: the pandemic is still progressing, Washington hasn’t agreed on a much needed next round of fiscal stimulus, and geopolitical tensions are only escalating.
The US Presidential election in November is thus the next catalyst for visibility, assuming the results are not contested. In the meantime, volatility should remain but the medium-term picture looks ok to us: there is little alternative to risk-assets while many institutional investors are still underexposed. Stay safe.
Fed officials are taking turns at making claims that the US economy remains on a weak footing and more fiscal stimulus is needed. This year’s voting Fed member Loretta Mester mentioned Wednesday that “downside risks and uncertainty cloud the outlook“ and it will take a while for the Fed to reach the 2% inflation target, while chair Powell said Friday that the recovery will continue, but “it will get harder from here”. Investors in this sense are reassured that the so-called “monetary policy put” will continue to provide a floor to market prices, since rates will be kept low for years and asset purchases will be continued by the Federal Reserve. At the same time, the easy market gains related to central bank largesse could be behind us, with Treasury yields close to the lower bound and unable to sink further as Fed officials oppose the idea of negative rates. And with persistent inflation hard to come by anytime soon, as Ms Mester acknowledged, long-dated yields are going to be capped, hence stuck between, say, the lower bound and some upper threshold in keeping with the longer-term growth rate of the economy. With 10-year yields stuck in a tight range and inflation expectations at 1.7% already discounting a rosy scenario and showing little upside from current levels, the conclusion is that long-dated real yields should be in the process of bottoming.
Is this what may partially explain the tech rout? While IT stocks shed 3.2% for the week, 10-real real yields tested previous lows to close above -1% and gain almost 7bps. On a monthly chart since the pandemic lows the Nasdaq is a straight line up and real rates have moved straight down and with the latter hinting to a bottom, the former has just pulled back. Yet, IT investors have no reason to fret in this sense and should actually have found Ms Mester’s and Mr Powell’s message most reassuring, having both clearly spelt out the case for low-forever rates and expressed enough concerns about the outlook to justify seeking shelter in the haven of growth stocks for at least as long, so to speak. If the tailwinds of falling real rates are not going to blow as strongly as they previously have, it is gold investors who should be more concerned. Indeed, capped yields put a floor under gold’s prices, but upside for the time being seems to be limited as well, with the lower bound of 0% yield for now unsurmountable and higher inflation not round the corner. Also, in July central banks’ purchases of gold were the lowest since 2018 and bullion reserves rising at a slower pace would curtail an important source of demand for the yellow metal.
A more substantial threat both to the unchecked rerating of risk assets and to lofty gold prices could eventually come from what Ms Mester and Mr Powell have repeatedly wished for, that is more fiscal policy. Repeated rounds of fiscal support boosting the economy alongside plentiful liquidity would be conflicting with persistently low yields and force a higher risk premium across asset classes. Yet, with financial markets discounting a contested election outcome and the fiscal views of the contenders each sitting on opposite sides of the spectrum, visibility as to if and when this would happen remains minimal. Golden slumbers amidst easy money may well continue.
Fixed Income Update
Last week was peculiar in the sense that the typical flight-to-safety trades didn't happen when the risky assets had one of their worst weeks in months. US Treasury curve bear steepened aggressively with 30Y yields increasing by more than ten bps, and 10Y yields increased by eight bps in a single day on Friday in the backdrop of better than anticipated jobs data, including the unemployment rate and average hourly earnings. Moreover, this week's Treasury auction cycles are upsized by $4-6 Bn for various tenures putting further pressure on yields. Besides, the "September Supply Surge" should result in at least a $140b-$150b increase in IG corporate issuance, including a wave of jumbo trades that may weigh on Treasuries via hedging flows in the three weeks following Labor Day.
Three key factors continue to support the riskier sub-asset classes within Fixed Income. These are gradual economic recovery, improved news flow on the vaccine front, and broad policy support. Comparing HY and IG asset classes, HY spreads still are higher as compared to historical levels, and with the defaults rate stabilizing, the case for HY Vs. IG spread compression theme holds. The default pace slowed in August to 10, compared with the previous four-month average of 30.5 defaults per month. However, According to S&P, historically, August rates are low, and are expected to increase in the next few months. Also, the increasing volatility and tight spreads make us take a cautious look at our portfolios as higher risk is priced at such lofty valuations. We continue to prefer the barbell approach of portfolio building for single-lines, with long-duration IG exposure combined with short-duration HY holdings to optimize volatility, income, and capital appreciation possibility for the clients.
Last week net fund flow for fixed income stood at $22bn as compared to $16bn a week earlier. Aggregator type funds dominated the fund flows, pulling in more than $9.4bn. EM Hard currency funds saw a net inflow of $2.4bn, and YTD cumulative flows into EM Hard currency funds turned positive for the first time since early March, indicating the improved appetite for the asset class. This coincided with a record month of EM bond sales for August that notched up $33bn of primary market activity.
GCC bond markets saw large deals from Dubai Govt and SABIC last week. Dubai Govt approached the public markets for the first time since 2014 and issued $2bn equally split between a 10-year Sukuk and a 30-year bond. There was no new issue concession given, and the order books were 5x final tranche sizes. Local investors dominated the 10-year Sukuk while there was considerable demand from offshore investors for the longer duration bond. SABIC returned to the fixed income markets this week after a two-year absence to print a modestly sized dual-tranche $1bn bond. The deal was split between a $500m 10-year and a $500m 30-year Formosa bond. The new offering was well received, with books eight times over-subscribed. Both the tranche were priced with negative new-issue concessions indicating strong demand.
A spectacular run for equities since the March lows took a breather with developed markets -2.3% and emerging markets -2% last week. This doesn’t seem extreme, with most global regions still positive year to date, boosted by an expected economic recovery, with hope building on vaccines and therapies. However, the Nasdaq Index losing 5% on Thursday and Friday, raises questions about the sudden tech sell off, after an uninterrupted rally with the Nasdaq gaining 75% since 23rd March. We wrote a couple of weeks ago that 5 to 10% corrections are normal market movements and expect autumn volatility, with U.S. elections just 2 months away. The tech, healthcare and consumer sectors have led the global rally since March as their goods and services were in demand with the lockdowns across the world. However, some exuberance if not irrationality is apparent as a 80% year to date gain (till Sept 2nd) for Apple and a 400% gain for Tesla, cannot be attributed to just a pure increase in demand for their goods or services or their recent stock splits. Both stocks fell at the end of last week, in line with the broader tech sector. Tesla further traded down post market as it did not make the cut the S&P 500 index.
Softbank, now labeled the Nasdaq whale, is said to be a big player in the irrational performance of many big tech names, as it helped fuel the tech rally with an exponential increase in call option volume, buying billions of dollars of derivatives’ exposure. The overall nominal value of calls traded on individual US stocks averaged $335bn daily over the past two weeks, according to Goldman Sachs, more than triple the rolling average between 2017 and 2019. The recent retail trading boom and the liquidity created by the Fed, have also been a major contributor to the US equity rally, less so for other regions. On a more fundamental basis, investors flocked to equity sectors and companies with strong growth models however, this still does not justify the 50%+ year to date gains seen across many big tech names. Also in demand have been companies with resilient cash flows that support dividends, with government securities and investment grade debt yielding little or low income.
Valuations remain elevated even after the end of week dip, with the Nasdaq at 38X forward Price to earnings and the S&P 500 at 26X; and a wide divergence between EM and DM, with the former at 14X and the latter at 24X. We have a neutral to slight Overweight positioning for EM as China activity has resumed to almost normal pre COVID levels, however India has the highest daily cases of any country globally and Brazil is still in the middle of the pandemic. The GCC is seeing economic activity picking up and the UAE and KSA had a positive week, with both regions progressively reducing their 2020 losses. We have a slight underweight on DM stocks on account of the elevated valuations and the strong year to date run up and recommend a selective approach with a continued focus on not over valued companies in the healthcare, tech and consumer sectors and some resilient dividend payers for income, the latter providing a hedge against volatility, a usual feature around U.S. elections.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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