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Chief Investment Officer's Desk, 09.10.2017
Asset classes reacted to a strong data flow and renewed hopes for US tax reform, with global equities setting new record highs lead by the S&P500, bond yields rising and credit spreads tightening. Markets shrugged off resurging political risks in Europe and in the UK, focusing on the improving global outlook and signals of slowly mounting inflationary pressures. On a less positive note, President Trump was quoted to have said Saturday that “only one think will work” with North Korea, as new missile tests may be planned.
Strong economic momentum and easy policy eclipse risks in the short term
Business surveys as well as hard data continue to paint the picture of a solid global economy, boding well for the current quarter. At the same time, accommodative monetary conditions and higher odds of US fiscal stimulus make it hard to identify the risks to the outlook in the short term. We continue to hold the view that this bull market should run into the year end, supported by a confluence of cyclical and policy factors.
However, expect short spurts of volatility on renewed saber-rattling between the US and North Korea or any other geopolitical risks. The US markets are focusing on the tax reform and any negative news on this front would be a disappointment to investors. Pullbacks would provide an opportunity to add to risk. Safe-haven assets – gold, the Japanese yen and US long-dated Treasuries – are mildly oversold and quickly reversed losses Friday, preparing the ground for a minor bounce.
The global recovery in capital spending continues, as evidenced by the August factory orders reports for the US and the German economy. Business surveys hit multi-year highs in the US, were strong in Europe and Japan, and business confidence in China hit its highest level in 2017. Weakness in US non-farm payrolls was mostly hurricane related and, more importantly, both the US and Japan saw better than expected wage data, allaying concerns about the threats of a recovery with no inflation.
US equities and financials supported into year-end
The US economy has continued to perform above expectations since last June. The Citigroup US Economic Surprise Index has closed in positive territory for the first time since November 2016. This bodes well for the short-term performance of US equities and in particular for that of cyclically-biased sectors, which vindicates our overweight on the US market and our positive view on banks.
Expectations of US Treasury bear market misplaced
US bond holders, on the contrary, must be worried that the three-decade bull market may be close to an end, as upside pressures on Treasury yields keep on building. Should US 10-year yields rise above 2.4%, technical analysts would promptly observe that the downward-sloping trend line of the last thirty years has been breached to the upside, supposedly an ominous sign for Treasuries. With secular deflationary factors like excess debt, adverse demographics and technology disruption firmly in place, we would tend to dismiss calls for a new bear market in global bonds. We would rather see the current rise in yields as cyclical, hence temporary in nature, however painful it may prove to be for investors holding bonds which offer little protection against rising inflation. Tactically, we stick with our underweight positioning in global government bonds, supported by ongoing global reflation.
Risks of Catalonia’s separation from Spain currently limited
We would use the current sell-off in Spanish equities to buy quality companies which have recorded drops of up to 20% from their peaks, as well as to add some exposure to the better capitalized banks sensitive to the Eurozone economic recovery.
The Euro area has seen a resurgence in political risks. On Thursday the Spanish constitutional court suspended a session of the Catalan Parliament in which lawmakers were expected in the following week to make a unilateral declaration of independence. This is one of the worst political crisis hitting Spain since it embraced democracy in the ‘70s, following the referendum on independence held in Catalonia on October 1st. The Catalan economy accounts for quite a significant share of Spain’s GDP c. 20%. The fallout from this crisis has led to Banco de Sabadell, the country’s fifth-largest bank, to relocate its headquarters out of Catalonia. Eventually, we deem the odds of independence to be low, given the negative economic consequences of the region’s exclusion from the Euro area. Catalan banks would lose access to ECB funding in the case of a separation from Spain.
Sterling and euro short-term range-bound against US dollar
The UK’s separation process from the EU is becoming more entangled. The European authorities are taking a hard stance in relation to the UK’s due payments for its past EU membership and at the same time PM May’s leadership is further put into question after her unfortunate performance at the Conservative Party conference. The Pound Sterling is bearing the full brunt of increasing political uncertainty, with mixed economic data blurring the case for a November rate hike. A drop of the currency below 1.30, reversing policy-tightening-related gains, should provide a buying opportunity.
Although the US dollar should have only limited upside against the euro from current levels, we do not see a compelling case for a forthcoming resumption of euro strength either. The September ECB minutes and declarations by the chief economist Praet suggest that the ECB is likely to announce at its October meeting a lower for longer Quantitative Easing (QE). A sharper reduction in asset purchases in 2018 combined with an extended deadline for the end of QE would address the issue of the scarcity of bonds eligible for QE and at the same time take some steam off the euro bull-run.
Demand for GCC debt remains robust
Last week’s demand for over $30bn of Abu Dhabi’s $10bn sovereign bond issue was broadly driven by international investors. Interest in the 10- and 30-year maturities was 59% and 77% from the US and the European investor bases respectively. About two-thirds of it was accounted for by fund managers. We continue to hold the view that investment-grade GCC sovereigns remain attractive compared to their EM peers. This is still the case in spite of the year-to-date average compression of 37 bps in the credit spreads of UAE’s investment-grade bonds. Currently UAE IG bonds are trading at an 118bps premium over Treasuries, a level last seen in June 2014.
Standard and Poor’s rating agency affirmed the Kingdom of Saudi Arabia at ‘A-/A-2’ and expects authorities to take steps to consolidate public finances and maintain government liquid assets close to 100% of GDP over the next two years. The agency also affirmed the Kingdom of Morocco sovereign rating at BBB-, the lowest investment grade rating.
Growth expectations for Asia intact
The World Bank raised its economic growth forecasts for developing East Asia and Pacific for this year and 2018, but added that the generally positive outlook is clouded by rising risks of trade protectionism and growing geopolitical tensions. The World Bank expects China to grow at 6.7% in 2017 and 6.4% in 2018 versus previous forecasts of 6.5% and 6.3% respectively. China’s foreign exchange reserves ($3.1tn) are consistently growing at a stable pace this year, supporting the Chinese Yuan. While EM spreads are close to record-tight levels, our assessment is that fundamentals for the area warrant such valuations, with no evident signs of stress for the near term. Should the Chinese currency come under renewed pressure, authorities would allow for larger trading bands and closely monitor financial sector vulnerabilities as monetary policy would be tightened to safeguard the currency.
Don’t miss the boom in Video Gaming
The BI Global Video Games Valuation Peers Index is up 31.4% year–to-date, outperforming the World Technology Index and the Nasdaq Composite Index Sustained strong sale, earnings growth and margin expansion have led to the gains. Video gaming developers have shifted to a recurring revenue model from an in-game digital purchases and add-on model, thus reducing the hit-driven risk associated with large game launches.
The largest software providers in the world are racing towards AI, including Google, Amazon, Apple, IBM, Salesforce, Nvidia and Intel. The competitors continue to form partnerships and acquire small companies that are specialized in AI for competitive differentiation. The most prominent examples of partnerships for AI are Salesforce with IBM and SAP with Google. Some of the companies are speeding up the process of AI adoption by providing open source algorithms for gathering data and developing their AI strategy, whilst also encompassing an ecosystem of users.
Written By:Giorgio Borelli Head of Asset Allocation, GiorgioB@EmiratesNBD.com
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It's a Material World - 4 September 2017