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Chief Investment Officer's team, 21.04.2019
Last week was quiet for global financial markets. US 10y rates were slightly higher, acknowledging overall robust economic data, and weighing on listed real estate and gold. The riskier segments of fixed income were resilient with spreads tightening. Global equities were slightly positive in both Developed and Emerging Markets, and the GCC increased its Year-to-date outperformance.
2019 so far shows one of the best starts for financial assets in the last decade. The combination of reasonable valuations after the December capitulation, with a significant dovish turn from the Fed a couple of months later provided the first leg of the rally, correcting an excessive pessimism and aligning back to the fundamental backdrop. The second leg, and its sustainability, are conditioned to either an improvement in the fundamental backdrop, or an expansion in valuations linked to central banks actions. We don’t believe in the latter: valuations are already high given the medium term risks and another expansion would simply be unreasonable. As regards the backdrop however, recent numbers support the thesis of a global improvement taking place in the second half of 2019, especially if the US and China were to agree on a deal and if Europe confirms its recovery from what could have been a soft patch. We address the valuation issue by favoring cheaper Emerging Markets over Developed, and will closely monitor the tech earnings releases this week to assess the health of corporate profits.
Asset classes USD % total return, YTD 2019 and week
Let’s say it bluntly: the state of the global economy doesn’t deteriorate anymore. The strength of the US remains unabated, as demonstrated by the strong retail sales numbers (after a stellar job reports the previous week), and even a potentially tepid Q1 GDP number (to be released next week) wouldn’t break the trend as Q1 was affected by a long government shutdown.
In China, the economy grew by 6.4% annualized in Q1, which was clearly above expectations. The brightest spot was industrial production, followed by fixed income investments, and retail sales. These numbers can be read as the combination of the industrial sector digesting the disruptions from trade tariffs, synchronized with the positive impact of fiscal and monetary stimulus. Adding the increasing probability of a deal on trade bodes well for the picture in the world’s second largest economy.
An improvement of China would also have a positive impact on Germany, which suffers so far from its high export stance.
Finally Central Banks appear to be firmly anchored on their dovish stance. A confirmation of the improving backdrop should theoretically raise questions for the Fed (a last hike?) but realistically this looks very unlikely, given the pressure from both market expectations and multiple political agendas, as the last minutes show.
There is another positive, which is the fact that many investors didn’t cut their defensive stance at the beginning of the year (we fortunately did) and are missing out some of the rally. An objectively improving situation (including the extension of Brexit, which doesn’t solve anything but removes an imminent risk) could be the perfect excuse for them to buy, supporting momentum which has been the name of the game each time the Goldilocks context made a comeback.
Tactical Asset Allocation: simplified positioning
TAA – YTD indicative performance
Fixed Income Update
Stronger than expected US retail sales report for March across the various discretionary spending categories helped boost investor sentiment. The headline retail sales surged 1.6% in March fueled by gasoline (+3.5%). While the unemployment rate is at a five-decade low, and last Thursday’s jobless claims data came in at their lowest level since 1969 are mitigating factors for us to believe that yields are vulnerable to widen from current levels. The minutes of the March FOMC meeting showed policymakers are looking beyond the economic soft patch that has extended from the last quarter of 2018 till date. FED speakers mostly expect tepid consumer spending, business investment and even inflation to prove temporary. Nonetheless, the minutes also showed that the majority of policymakers are content to remain on hold for the rest of the year. US Treasuries have been in a tight trading range and currently at 2.56%. The 10-year yield is approaching a significant level of technical resistance at 2.62%. Should yields fail to break out and reverse, rates could fall back to a technical level of support at 2.3%. Furthermore, the relative strength index (RSI) is also suggesting that yields would fall in the future. The RSI topped out at an overbought level above 70 in late 2016 and had been trending lower despite yields continuing to rise, a bearish divergence. Now the RSI is trending even lower, suggesting yields will continue to fall.
In Emerging Markets, Turkey led the underperformance on the back of an FT article stating that “the Central Bank has bolstered its foreign currency reserves with billions of dollars of short-term borrowed money”. The article sparked a sell-off in the TRY from 5.71 to 5.84 before retracing to 5.81. The five-year credit default swaps surged to 436bps while cash prices on the Eurobonds reflecting the weak investor sentiment. Net international reserves as defined by the IMF stood at USD 28.4bn in the week through April 12. But the central bank says it’s misleading to focus on the net figures and instead urges investors to look at its gross reserves, which accounts to just under $98 billion. Turkey has close to USD 118bn of foreign-currency debt maturing within the next 12 months.
S&P revises the Sultanate of Oman Sovereign outlook to negative and affirmed BB/B long and short-term Sovereign rating. S&P highlighted “The negative outlook reflects the risk that in the absence of substantial fiscal measures to curtail the government deficit, or a more favorable external environment, fiscal and external buffers will continue to erode”. Moreover, the agency cited “our view of Oman's creditworthiness is constrained, however, by the concentrated nature of the economy. Oman derives about 35% of GDP, 60% of exports, and 70% of fiscal receipts from hydrocarbon products. Given this high reliance on the hydrocarbon sector, we view Oman's economy as undiversified. The current steep yield curve reflects the downside risks scenario when compared to similar rated Sovereign peer groups, in our view. We prefer the belly of the curve where valuations are compelling.
Fixed Income key convictions
Fixed Income valuations
Chart of the week: Oman Sovereign Yield Curve (USD)
The US and China remain engaged in trade talks and this along with improving economic momentum in China boosted most markets last week. The NASDAQ is at a record level, China markets are at a one year high, India and the US markets are close to their previous highs. The Dubai market is rallying from oversold positions and is double digit returns year to date. However, disinflationary pressures in the US remain a concern, as does Eurozone growth. For the MSCI World, equity multiples (15.5X Forward Price to Earnings) are now close to historical median levels, which is likely to give earnings outlook extra importance. The weaker Euro in Q1 should provide some respite to European earnings, though expectations are low, given the slowdown in macro conditions.
The Forward 12M Price to Earnings multiple is at 17.5X for the S&P 500, higher than the long term average. For the Index to rally beyond 2900, earnings need to grow faster than the current pace. Q1 2019 S&P 500 earnings are expected to decline 3.3% while revenues are expected to grow 4.8% as per consensus estimates. However, earnings usually outperform estimates and of the 77 S&P500 companies to have reported 80% beat on EPS by an average of 4.2%. Financials results have come in better than expected and industrials so far have delivered and this is positive for market sentiment given their sensitivity to underlying economic growth. Downward pressure on health-care stocks from proposed healthcare legislation led to the sector falling. This provides opportunities to buy and hold for the long term pharma companies that are spending billions on research and are now available at reasonable valuations.
Though technology has rallied and is trading at a higher multiple than the broader US market subsectors such as streaming and 5G continue to provide longer term opportunities. Disney and Netflix are the two top contenders in the streaming battle. Both have the advantage of pricing and the ability to scale up content and reach. Netflix continues to drive member growth and is expected to add another 30 mn subscribers in 2019 (international plays a large role) to its current base of 149 mn as well as increase it’s spend from the current USD 10 bn to double that by 2024. Disney is launching its streaming service with a compelling subscription price of USD 6.99 (half that of Netflix) and a target of 110-160 million subscribers by 2024. With the Marvel, Pixar and Star Wars properties, Disney+ has the perfect collection and balance of assets to be a successful family friendly offering. Most consumers subscribe to multiple services hence both Netflix and Disney can succeed concurrently, in a USD 500bn market and other incumbents i.e. Amazon and Apple will be able to grab market share too.
Dubai’s World Expo 2020 fair is expected to contribute AED 122.6bn (USD 33.4bn) to the economy from 2013 to 2031 and this should provide a continued fillip to the economy and the market. M&A continues in the banking sector with Dubai Islamic Bank, the UAE’s largest Islamic lender, considering acquiring its smaller rival Noor Bank.
Equity recommended regional positioning
Major indices performance (TR, US$) and 2019PE
Global sector performance (TR, US$) and 2019PE
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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