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Chief Investment Officer's team, 12.01.2020
A quick look at the performances of financial markets so far in 2020 would give the impression of a smooth positive start, with all cyclical assets showing moderate gains. Gold however, which tops the list with a 3% appreciation, is the remaining indication that it wasn’t smooth at all, against the backdrop of brutal escalation between the US and Iran. The sequence seems to be over in the short-term, with what can be seen as a carefully calibrated response from Iran, prompting Mr. Trump to call for economic and political pressure rather than military action. This doesn’t obviously mean that tensions have disappeared, especially in a US electoral year and given Iran’s historical preference for asymmetric warfare through their proxies rather than direct confrontation. This will not necessarily affect all global markets, but at least oil, gold, and probably the GCC assets which are the most sensitive to international flows. The valuation discount on stocks might last a bit longer.
In the meantime, the focus switches back to fundamentals. Last week’s December job report in the US disappointed with less jobs being created than expected. The absolute +145.000 number was however not bad enough to change the current “on hold” stance from the Fed. A Chinese delegation is expected to sign a Phase 1 agreement on trade with the US later this week. This reinforces our current positive stance on Emerging Market assets, especially Asia.
Nobody seems to believe in inflation as a threat anymore. The times of high single-digit price gains are long gone and, after years of inflation fighting, major central banks are now in a conundrum which sees them struggle in the opposite direction, namely to push the general level of prices higher to avoid deflationary pressures. The rate of price growth expected 5 to 10 years ahead in the survey run by the University of Michigan has plumbed new historic lows; the crowd continues to expect muted inflation dynamics in the long run.
This week important macroeconomic releases are due, which are unlikely to deeply affect investor views in this sense. Although the US CPI is forecast to print well above its 10-year average, markets will want to see evidence of persistent positive trends before flirting with the idea that the inflation outlook may be about to change. The Fed has committed to a long period of stable yields signaling the willingness to tolerate significant overshoots of its 2% target level before shifting policy in the direction of tighter rates. And the fact that wage gains were below expectations in last week’s labor report will only reinforce Mr Powell’s resolve in this sense.
The above scenario has implications for bond yields. With shorter term rates anchored by the Fed and inflation expectations stuck at historic lows, not budging unless there is ample evidence of a different state of affairs taking hold, long-dated Treasury yields will continue to be stuck in a range. Brief spurts to the upside driven by the brightening outlook are going to be capped by income-seeking investors. The wave of liquidity unleashed by central banks is expected to drive improvements in business activity, eventually revive the ailing manufacturing sector and push Treasury yields higher. But upswings of US 10Yr yields much above the 2% mark are not likely to be sustainable.
Gold is taking notice. Capped yields and tolerance for inflation is a recipe for depressed real yields, or for gold prices to be under current conditions range bound. US economic growth in 2020 should not run above trend, given the fading effects of tax cuts acting as a drag, so upside economic surprises will only be able to do so much to discourage gold bulls. Bouts of gold weakness on particularly good macro releases should be seen as a buying opportunity.
Indeed, investors trying to divine market trends for 2020 are confronted with possibly receding geopolitical risks related to the US-China standoff, yet rising tensions in the Middle-East. The Middle-East shifting sands will provide fertile ground for flights to safety and brief gold spikes above $1,600/oz. We remain neutral the yellow metal, yet see upside risks as Mr Trump has defied the largely held expectation that he would show restraint in an election year.
Fixed Income Update
They say “morning shows the day” and if last week were any indicator of the year 2020, bond investors could expect a volatile year in terms of sharp shifts across yield-curves. The benchmark US Treasuries made intraday moves of 17 bps last Wednesday fueled by geopolitical tensions in the Middle East. Similarly and moreover, widespread shifts in the yields were noticed across the Emerging Markets and across the High-Yield indices. In times of such heightened uncertainties taking into consideration the dilemma of the current late-cycle context, it is imperative for investors to not panic at headline news-related sentiments, but to focus on hard-data facts on the underlying fundamentals to maintain a defensive-stance on their portfolio strategy.
US Treasuries were supported by the flight-to-safety and short-covering as US job reports for December 2019 painted a weaker outlook than what was priced-in. The US Yield-curve flattened with the 30-year yield dropping by five bps to 2.27%. The notable driver for such bull flattening was the outlook on wage growth, which helped long-dated bonds to outperform given its strong correlation with inflation pricing. The wages component on the unemployment report came in at 2.90% versus the consensus and prior readings of 3.10%.
China’s benchmark 10-year benchmark yields reached the lowest level in the last four months. Lesser concern over inflation and reserve ratio rate cut by PBOC fueled the bond rally for Chinese bonds. We maintain the view that the Chinese Sovereign bonds (CNY-local bonds) provide a robust technical play due to the benign inflationary outlook coupled with the inclusion in the global benchmark indices.
As the recent local tensions subside, investor flows to regional bonds and Sukuk have picked up. The average yield on the GCC benchmark index is at 3.19%, which translates to a risk premium of 145bps over the US risk-free benchmark Treasuries. The higher than above average premium as compared to the EM peers from ratings adjusted basis is one of the primary conviction we maintain. High yielding Sovereign bonds from Oman and Bahrain have provided a good source of income for investors and should continue to be supported in this low yield environment.
The year 2020 has begun with robust bond transactions across corporate and governments. Over USD 100 Billion of bonds have been priced so far, and last week’s activity was marked as one of the biggest weeks for primary bond issuance on record. While the GCC issuers have been relatively quiet in the primary issuance market, Chinese and Indian issuers have dominated the Emerging Market Debt issuance so far this year. Notable Indian issuers such as EXIM Bank and Shriram Transport tapped the markets last week while Gold-loan NBFC Manappuram Finance raised its maiden USD denominated debt. Indonesia’s first benchmark issuance this year saw strong demand. Chinese real-estate issuers dominated the Asian primary market last week. JD.com’s first primary issuance in four years saw robust bid from investors.
The broader market narrative at the start of the year is much the same as 2019, with optimism on trade resolution and easy Central Bank policy continuing to keep developed market equities near all-time highs. The Dow crossed the 29,000 milestone and the S&P 500 ended the week +1% with tech continuing its outperformance (Nasdaq +1.8% on the week) as global sentiment improved, amidst easing US-Iranian tensions and the imminent signing of phase 1 of the US-China trade deal. US margins have been feeling the impact of higher wages and tariffs and lower tariffs could boost earnings. Emerging markets continued their December rally led by China.
Post the strong performance of US equities in 2019, there still remains a case for staying invested, as we expect 5% returns for the S&P 500 in 2020 with select themes potentially adding alpha. US companies paid out nearly half a trillion dollars in dividend payments last year, +6.4% over 2018, the eighth consecutive year of record payments, providing investors with income alongside stellar returns. Tech which was responsible for the largest share of the US equity rally in 2019 was supported by strong FAANG performance. Just four companies account for half of the cap-weighted gains in the S&P 500 in 2019: Apple, Microsoft, Facebook and Alphabet, a concentrated rally. A strong consumer backdrop should continue to drive tech performance for companies that have high levels of engagement and stickiness of the user base (streaming and ecommerce).
We remain focused on growth and earnings, ahead of the start of the Q4 Earnings season which begins Tuesday in the US with the banks i.e. JPMorgan, Citi, and Wells Fargo. Consensus is expecting the banking sector to post 8%-plus EPS growth year/ year and the S&P 500 EPS to fall about 1.5% (as analysts revised down estimates after the 3Q season ended). We would add the usual 3-4% beat, taking earnings growth into positive territory. With price multiples at elevated levels in developed markets, earnings growth is the key to the next leg up. Emerging markets need to post significant acceleration in earnings growth to surpass current valuations at cycle-high levels. Though EM valuations at 13X forward earnings are low compared to DM, they haven’t exceeded this level in the past 5 years. Earnings forecasts favor a broadening global recovery in 2020 led by strong EPS growth in emerging markets. Our expectations for EM are at 11% and for China and India at 13% earnings growth.
The final size of Saudi Aramco’s IPO increased, as the Goldman Sachs Group Inc., one of the underwriters, exercised the over-allotment option and increased the offering to $29.4 bn. 450mn additional shares were placed at SAR 32 ($8.53) with investors, during the book-building process.
Airbus is set to displace Boeing as the world’s biggest plane maker when the latter reports production figures next week. Boeing will halt Max 737 production this month. The 737 was its top seller and a major source of profit. Airbus delivered a record 863 planes last year, above its target of about 860. Sales at Airbus last year were led by A321s.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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