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Chief Investment Officer's team, 29.09.2019
The third quarter is about to end. Our weekly publication dated 30th of June was titled “A strong first half of the year, many uncertainties ahead” and concluded with “There is thus little doubt that upcoming events will have to be analysed twice: for what they are, and for what they mean for Central Banks”. We also recommended to start turning more defensive in the Mid-Year update of our Global Investment Outlook.
Indeed and as we write, it was a mediocre quarter for investment returns: global equities were flat in developed markets, negative in emerging markets, Oil was down and only defensive assets such as US Treasuries and Gold appreciated. Last week mirrored this configuration, with risk assets suffering from a deluge of uncertainties, from geopolitics with trade tensions, to local politics in Washington, London, or Hong-Kong.
In such a backdrop, we keep on being impressed by markets’ resilience, which we explain by investor’s pessimism being already reflected in their portfolios. Next week, monthly macro data could confirm that the consensus has integrated the slowdown of industrial activity. We will closely watch the US job report, as well as speeches from Fed officials, to get confirmation of the current easing trend. When everyone is pessimistic, no deterioration could be good enough for a quiet start to Q4, especially if quarterly earnings meet expectations. We still hold important levels as we worry for long-term expectable returns, but are not outright defensive yet.
The almighty dollar is close to the highs of the year against major developed market peers and at its all-time highs according to a trade-weighted Federal Reserve gauge. It has taken the US currency 17 years to break above the previous peak, hence one might wonder whether a new bull market lies ahead in spite of the already impressive performance recorded in the past decade.
As per statistical records previous peaks in the Federal Reserve US Trade-Weighted Dollar sit roughly 8 years apart from each other. Extrapolating by considering that the previous top was in early 2017 is not going to take us very far, as past performance is no guarantee of future performance. Forecasting currencies in general is no mean feat, so we will abstain from trying to divine the future dollar path, but will anyway ponder the implications of the potential for non-negligible upside for the US currency.
Past periods of dollar strength, in trade-weighted terms, have coincided with DM real growth accelerating faster versus EM, as measured for instance by the Growth Forecast Revision Indices worked out by JP Morgan. Does this mean that Trump policies are going to hit global trade, hence the developing economies, more heavily that currently assessed? Or could it be that EM productivity gains are being overestimated? Or maybe is the negative impact of aging populations in the West overestimated? Nobody knows for sure, but the dollar suggests that EM ascendancy is not going to occur in straight line.
Periods of prolonged dollar strength have also coincided with higher equity market volatility. The pattern becomes more evident comparing the US Dollar Index with the VIX Index, a gauge of US stock volatility. The dollar advanced from 1995 till 2001 and volatility rose relentlessly to peak in 2002. Volatility rose again with the dollar in 2008 and then in 2014-2015. Fast-forwarding to the current days, it is our view that equity volatility is going to rise in the next few years as we approach the end of the business cycle in the US. The new all-time highs in the trade-weighted dollar reinforce that view and are a warning to investors who place all of their trust in the ability of central banks to avoid hiccups in the business cycle and asset markets.
Dollar over-performance has since 2016 reflected the dominating strength of the US economy and US assets as compared to a muted outlook and lower performance elsewhere. However we look at it, prolonged dollar exuberance portends no good news, either in terms of impact on global trade, flagging EM returns or higher market volatility. Should we be hoping that new all-time highs prove to be a head fake for the US currency?
Fixed Income Update
Concerns surrounding US Politics together with the ongoing trade saga with China, and the Federal Reserve trying to calm markets by pouring $100bn via repo markets, have supported the US benchmark yields. The ten-year Treasuries closed stronger at 1.68% while the market-implied probability for a 25bp policy cut by the Fed is under 45% for the October FOMC. That said, the bets are close to 75% for a cut during in December. The repo operation by the FED has helped ease the liquidity situation for now, and officials are fully engaged to ensure financial stability. The last day for third-quarter ends today, and $100bn repo operation would be repeated to ensure control over any bouts of volatility.
Japan’s 2-year/30-year yield curve has steepened by more than 20 bps in September with the pace intensifying post the Japan Central bank meeting where governor Kuroda hinted that ultra-long bond yields had fallen “ a bit too far.”
Germany plans to issue green bonds in the future as part of its 54 billion Euro package to fight climate change and reduce carbon emissions. If KFW debt is considered as a proxy, the sovereign green bonds are expected to be priced below the conventional bonds by about 4-5 bps for 5 to 10-year maturity issuance.
Dovish monetary policy continued in the emerging markets with central banks moving ahead to cut the policy rates to boost fledgling economies. Taking advantage of weak inflation and a stable currency, Egypt reduced its interest rates for the third time this year. Mexico had also reduced its benchmark rates by 25 bps, and the Philippines cut benchmark rates to 4%.
September marks an extraordinary month for new debt sales in Emerging Markets surpassing the monthly and Q3 volumes on a YoY basis. Total EM bond volumes for September doubled to $88bn as compared to September 2018 at $45bn. The quarterly trend follows suit at $168bn for Q3 sales. The Emirate of Abu Dhabi’s blockbuster transaction of $10Bn led the league table along with other GCC borrowers. From a pricing perspective, the transactions were issued at a lower yield compared to the initial guidance, which itself provides some color on investors’ appetite.
We look at some of the yield curves in the GCC region across Sovereign as well as select corporates and see significant term-premium as low hanging fruits. Such wide-spreads along the curve appears mispriced in our view when compared to broader EM peers. A good example is the recent pricing of the 30-year maturity of Abu Dhabi Sovereign, versus the Government-owned Abu Dhabi National Energy Co. Many of the regional Sovereign curves also face some steeper curves including the likes of the kingdom of Bahrain and the Sultanate of Oman. That said, a closer look at some of the arbitrages within the GCC bond markets could provide some compelling opportunities. Please contact our investment advisors for further details.
Global equities were down last week as trade news influenced market movements, along with political uncertainty in the US and UK. The exceptions were India, which benefited from the recent corporate tax cut (+1.6% on the week) and the KSA which bounced back after a steep decline which started in May (+1.3% on the week). The S&P 500 ended the week 1% lower, falling on news of impeachment proceedings in Congress. Eurozone equities fell in line with the US, on weak manufacturing data. Chinese listed stocks in the US, such as Alibaba, fell sharply on Friday on report of a possible de-listing of Chinese companies from U.S exchanges, later denied by U.S. Treasury officials.
Looking at equity performance from a year ago (end Sept 2018), we seem to be standing still. Global, developed and emerging market USD total return equity indices have moved barely 1-2%. However, when we look only at 2019, the picture is different. Developed market equities (+17%) have returned triple that of emerging markets (+6%), the latter suffering from a stronger dollar and trade rhetoric. Whilst the +27% year to date gain in 2019 in the global technology sector seems remarkable, there is no change from end Sept 2018 levels. This is the only cyclical sector we have retained an overweight, but selectively. There are key sub sectors, yet to realize their full potential. Electric vehicle technology is finally translating into production with continued pressure of countries, to lower carbon dioxide emissions.
We see a style shift, as value remained in favor over growth as a factor in September, with financials and energy the two best performing sectors. While growth stocks led during the first half of the year, they relinquished this lead in mid-July. The next quarters performance will be driven by the direction of the trade resolutions, the political fall out in the US and Q3 earnings. Central bank policy seems to be firmly in the dovish camp. We advocated to start shifting towards quality and yield in early September and recommend staying away from expensively valued stocks without growth prospects, amply illustrated by the lack of demand for WeWork’s overpriced IPO.
The impact of the attacks on Saudi Aramco facilities earlier this month has largely faded with Brent now only USD 1.69/b higher than it was prior to the events (In-house Research). The Tadawul Index is trading around the 8,000 level, +6% for the year. We await Q3 earnings for further direction, however growth seems stymied in the petrochemical sector with feedstock supply that was interrupted and in the banking sector by lower rates. The Aramco IPO continues to gather interest and we await more details on the proposed offering.
Climate change is in focus with increased activism and French President Macron urging world leaders to follow the Paris climate agreement. India moves to ban single use plastic from Oct 2nd, causing near term disruption, particularly in the fast growing food delivery services. The alternatives are more expensive, leading to higher operational costs. A number of initiatives to develop biodegradable plastic and alternate packaging are being explored by entrepreneurs.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Earlier this year, in our Global Investment Outlook, we expressed concerns on the investment landscape for the next decade, and highlighted the keys to successfully navigate it. We emphasised one in particular: the ability to quickly add or reduce risk, when volatility generates opportunity.Know More
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