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Chief Investment Officer's team, 05.01.2020
Against many predictions, 2019 has been a fantastic year for financial markets, with all major asset classes delivering positive returns, often with double digits. This happened despite a considerable collection of geopolitical uncertainties, especially on trade. There were two reasons behind this apparent disconnect: valuations at the beginning of 2019 were attractive, investors were pessimistic, and crucially, global central banks provided massive monetary easing, with the Fed cutting interest rates three times in particular. The 2019 story went through 3 phases: as soon as January, the Fed signalled a dovish turn, triggering a sharp rally which was only interrupted in early May, when the US-China trade negotiations turned sour. This shocked both investors’ and business confidence, casting a shadow on the economy and generating volatility on markets. Under pressure, the Fed cut rates two times in September and October, just before visibility improved on both trade war and Brexit, opening the way to a sharp year-end rally.
2020 is only beginning, under the sign of volatility. A “phase 1” trade deal should be signed in January between the US and China, but the killing of a prominent Iranian General by the US in Iraq derailed stocks, while pushing defensive assets and Oil prices higher. The short-term will be dominated by this situation, and by the response from Iran in particular. We keep a positioning close to our long-term allocations, with an overweight in both Emerging Market stocks (Asia) and cash.
Although anxiety of a recession has taken hold of most investors throughout 2019, all major asset classes have posted returns significantly above historical averages. This is especially true for the most cyclical segments, with equities rallying 28% in developed markets, and 18% in emerging markets. Within fixed income, performances followed the risk hierarchy with EM Debt and High Yield delivering the best returns, followed by the most defensive segments. Finally, Gold, the iconic defensive asset, printed an exceptional year with a 18% gain.
Such a broad-based rally for all financial assets can of course be explained by monetary easing, which lifted valuations, combined with unanimous pessimism among investors. Indeed, there was no shortage of reasons to worry, and no lack of pundits predicting an imminent recession and a synchronized market crash. As regards our tactical asset allocation, we started the year with a constructive bias, reducing our positions in DM Government Bonds and adding to both Equities and Gold. This proved to be right as the Fed quickly signaled the end of the rate hikes, in January. At the beginning of the second quarter, we took profits on Developed Market equities, as our year-end fair values were reached, and kept the proceeds in cash. When the trade war between US and China re-started in early May, we tactically reduced Emerging Market equities as well. In July, when the Fed cut rates for the first time, we took profits on Gold, going back to neutral. As a result, we crossed the volatile summer with significant levels of cash in our allocations. Our latest changes happened after the summer, when we first bought back the EM stocks that we had sold in May, at a cheaper price, before reducing our underweight in global listed real estate.
At the end of the year, our Cautious, Moderate and Aggressive profiles have delivered returns of 11%, 14% and 17% respectively. Being constructive proved right, but to be honest, markets exceeded our own expectations. Compared to our long-term Strategic Asset Allocation, our recommended positioning slightly underperformed, the main reason being that we missed the rally in global listed real estate, on which we have been underweight all year long. Having said that, our performance is very close to our best international competitors in 2019, after having outperformed them by a wide margin in the more difficult 2018.
As regards our positioning, we start 2020 as we ended 2019. We overweight both cash, for flexibility and resilience, and Emerging Market equities, in Asia in particular, for their medium and long term potential. We underweight Fixed Income in Developed markets, as well as global listed real estate. As we write, we expect 2020 to deliver positive, low single digit returns across profiles, a performance close to our long term strategic asset allocation. This is credible, and probably the best we can expect from an eventful year, from geopolitical issues to US Presidential Elections. This is why cash and gold respectively combine 21%, 15% and 9% of our Cautious, Moderate and Aggressive profiles.
Fixed Income Update
While most of the market analysts have predicted a stable 10-year treasury yield close to 2% this year, black-swan type of events continue to threaten this narrative, at least in the short term. Last week's flare-up in geopolitical tension has turned the US Treasuries steepener theory on its head. Also, the unexpectedly weak US ISM manufacturing data helped the case for the bid on safe-haven assets. As a result, the week ended on a risk-off sentiment with most of the benchmark yields across the US and Europe dropping by circa 5bps to10 bps.
FOMC meeting minutes reiterated that the interest rates would likely stay stable in the first quarter for 2020 while the Federal Reserve keeps an eye on broader financial issues, including the effect of deglobalization and its ramifications on economic conditions.
GCC bond markets were affected due to headline sentiments. The YTD return was -0.25% for the Bloomberg GCC bond index, with the KSA long-term yields rising anywhere between by 6-8 bps and corresponding CDS widening by 5-10 bps.
In a relief to China's banking industry saddled with bad loans, the country's financial regulator CBIRC has announced that it will implement a slew of measures to reduce the burden on the troubled smaller banks while discouraging shadow financing and preventing a real estate meltdown by curbing property speculation. The steps would be an amalgamation of restructuring, capital injections and consolidations within the banking industry while improving risk management in the real estate sector. We hold a strong conviction on this segment.
China's central bank PBOC has pledged more financial support for the SME industry and is working on an incentive mechanism to make it easier for them to gain access to financing through targeted reserve cuts, re-lending and re-discounting, among other policy tools. The markets expect the PBOC to cut its policy rates by a token of 20 bps in the first quarter of 2020. This makes the local currency Chinese bonds an attractive bet for EM investors.
The Reserve bank of India’s operation twist has resulted in the 10-year INR bond yields dropping by more than 30 bps since mid-December. This week the RBI would purchase another round of INR 100 Billion bonds maturing between 2024 and 2029.
While primary market announcements are expected to remain muted this week, Malaysia's state-owned oil company, Petronas, could announce roadshows for Dollar-denominated global bonds taking advantage of the lower cost of funding. The company rated A2 by Moody's is set to hit the bond market after a gap of five years. The oil giant has six outstanding dollar bonds worth a total of USD 6.5 Billion, in which USD 1.25 billion of notes are set to mature on 18th March.
As we enter 2020 we remain optimistic about achieving positive (low single digit) returns from developed markets (the US and Japan) and low teen returns from Emerging Market equities. From current elevated valuations it is not rational to expect to repeat the outsized gains seen in 2019. However, economic growth and corporate profitability remain supportive and selective strategies will provide alpha. Whilst we see volatility around geopolitical events rising, relatively low bond yields should provide support to equities. Some of last year’s headline issues are moving down the risk ladder i.e. the trade war and Brexit however, they still remain a drag on global growth. Centre stage for investors in 2020 are issues around sustainability, climate change, volatility around the US elections and geopolitics in the Middle East.
We start the year with a neutral stance to developed markets (a relative overweight to the US continues) and remain overweight emerging Asia. We may not see the kind of multiple expansion that drove total returns for the S&P 500 to over 30% in 2019, but we expect upside driven by dividends, continued share buybacks, earnings growth (in the low single-digits), favorable monetary and fiscal policy and a strong consumer. Easing monetary policy and a completed phase one trade deal—could drive a near-term growth recovery in China and give the Chinese consumer more buying power.
2019 marks the end of a decade coming out of the global financial crisis. The S&P 500 has returned 256% whilst MSCI EM total returns (USD) are +49%. 2019 was a stellar year for global equities led by developed markets +26.9%. Whilst, emerging markets lagged, they ended the year with a sizable gain +18.9%. Technology has led sector returns through the year (+47%) and Apple and Microsoft have been stand out contributors not only in 2019 but over the past decade.
The GCC region lagged the broader emerging markets with the KSA reversing the strong gains seen in the run up to its inclusion the MSCI EM Index in May. Saudi Aramco was in focus with its $26 bn offering on the Tadawul exchange and is now the world’s most valuable company. The Dubai and the Abu Dhabi Index faced low trading volumes through the year. Returns were led by the consumer and banking sector. Real estate lagged on concerns of oversupply, though yields remain robust. Enhanced government budgets should flow through to the private sector along with spend on the Expo 2020.
While low-volatility and value stocks had their moments in 2019, looking back at the full year, higher-quality stocks with low debt levels and strong profitability, outperformed the broader market with stable performance through different macro backdrops. Growth and cyclical strategies outperformed value and defensive strategies. We enter 2020 on higher than average valuations and recommend to continue focusing on quality and companies with sustainable and growing dividend yield backed by strong cash flows.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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