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Chief Investment Officer's team, 07.11.2021
Last week saw positive returns across all major asset classes. Cyclical assets were supported by a combination of still strong Q3 corporate earnings, as well as by overall reassuring economic data. PMI releases confirmed that the global economy is regaining some momentum, and the monthly US job report was much better than forecast. Against this backdrop, falling interest rates were a surprise, but they did. The US 10-year treasury yield ended the week at 1.45, a meaningful drop. While the Fed confirmed the imminent start of the tapering, the general tone of the press conference was that rate hikes were a different story. They are less imminent for sure, and highly conditional to a full recovery in the job market. Other central banks, from the BoE to the RBA, also pushed back against the idea of a sharp increase in policy rates. The week was as a result positive for almost everything, with another record high for developed market stocks in particular, and a +2% gain in gold.
The precious metal was an important topic of our November tactical asset allocation committee, who decided last week to add 1% to gold across our three profiles, funded from cash. This is not a single, directional conviction, but the idea that gold brings an interesting hedge to a diversified portfolio, especially if/when stagflation concerns rise at some point. Don’t get us wrong: this is an optimization of the defensive part of our portfolios, but our positioning remains pro cyclical with an unchanged overweight in stocks and underweight in bonds.
The week ahead will see the completion of most of the Q3 earnings season. With regards to economic data, the most interesting will be inflation numbers, especially the US CPI on Wednesday. Stay safe.
Long-dated Treasury yields suffered one renewed setback, retracing almost half of the up leg put in since this past August, even as the labor market printed a strong payrolls number confirming that the US recovery is on track. The 10-year real yield is close to its all-time lows, deeply in negative territory and unable to send more encouraging signals about the longer-term health of the US economy. Markets seem to be unconvinced about the prospects for sustainable economic growth or persistent inflation, given the pronounced flattening of the yield curve, and at the same time to have run ahead of themselves in discounting future rate hikes. International developments, that is the BOE falling short of raising rates and disappointing investors positioned for that, poorer liquidity and other technical factors could be responsible for the unexpected drop in yields, which happened with US economic surprises improving since September this year. With yields rich versus fundamentals and the economy on track, it is our view that yields should rise again as the Fed starts the unwinding of its QE program.
In terms of asset class impact equities should stand to benefit the most, with a well-telegraphed QE which is now a non-event, depressed longer-dated yields rising ever so slowly and G5 central bank liquidity dropping to alarmingly low levels only in the second half of next year according to some projections. The healing of the US labor market is not that slow at all, with US growth projected well above trend and full employment in sight for 2022. So, positioning for a policy mistake, whereby central banks end up tightening too much on persistent inflation pressures to preserve credibility, seems to be too early now, assuming that the Fed will indeed tighten in 2022 as per consensus, which is really far from being a given. Actually, following the November FOMC Fed chair Powell made efforts to delink the end of tapering, which should be in June 2002, from the timing of lift-off, setting the bar high for tightening to start as per market expectations.
With so much central bank hawkishness already priced in, the possibility that no hikes occur next year would be a positive for long-duration assets, primarily gold and EM debt. Under the scenario of peaking, but persistent price pressures and delayed tightening gold could retest this year’s highs, and offer protection against the risk of sluggish growth and non-receding inflation. The yellow metal has so far been pretty resilient in spite of the Fed’s hawkish-leaning rhetoric, possibly pointing to excessive pessimism in the Treasury market.
It seems that central banks, and the Fed in particular with its reluctance to act, have boxed themselves in a situation where they will not be able to lift stimulus without derailing markets, thereby overly tightening monetary conditions. Gold resilience could actually reflect the lack of options of central banks.
Fixed Income Update
Finally, the wait is over for the Fed’s tapering, and Fed officials should receive kudos for their communication skills, at least over this particular area. They were able to avoid the repeat of "taper tantrums." Chairman Powell mentioned the Fed would be "flexible" in terms of the pace of the tapering and would review it at the end of the year. Moreover, they could let the inflation run hot until they see lesser slack in the employment numbers. The US Treasury yield curve has aggressively "bull-flattened" post the FOMC meeting as markets price in a more sedated growth in the future. The yield on the 10-year note dropped 15 bps in the last two days of trading. The 10-year break-even has fallen 14 bps from their high of 2.69% on October 26th. We believe these levels are fundamentally low in an environment where the growth next year is assumed to be higher than trend levels. We continue our bearish stand on long-duration assets at such yield levels.
The yield movements resulted in a positive week for the fixed income for a change. EM Sovereign and GCC Debt were the top performers. China's local currency Investment Grade bonds continue to show stability amidst the noise and have performed well. We believe investors should have an unhedged exposure to the asset class. Asia High Yield had another bad week on the backdrop of Kaisa defaulting on its onshore obligations. YTD, the asset class has lost 12.2%. Last week's drop for the asset class was 1.8%. The index has given up the gain of 3.4% it had in the second and third week of October. The Kaisa episode showcases that even the entities that announce enough liquidity and clear the three red lines instituted by the authorities aren't safe either. Defaulting on onshore liabilities should hasten authorities to take more steps to contain the fallouts. While we believe a 10% drop from current levels seems unlikely, the near-term waters will remain choppy, and investors should be careful about bottom-fishing. The market focus will likely be on tail risk concerns, especially with heavy RMB bond maturities in December this year and heavy USD bond maturities in January next year. Many strong property bonds on our recommended list offer a good risk-reward profile at current valuations, and funds on our focus list provide good diversification opportunities.
Flows into global fixed income funds were also roughly steady (+$8bn vs. +$9bn the previous week) and again mixed across market segments. Agg-type products and IG funds saw net inflows, while HY credit products experienced modest net outflows. According to S&P, the 2021 global corporate default tally remained at 63. So far, the fourth quarter of 2021 has recorded only three defaults, the lowest year-to-date quarterly default count since 2010. Most of the improvement in the defaults numbers is driven by the US issuers. This speaks to the sharp recovery, given ample liquidity available to the lowest-rated issuers, while economic activity recovers from the 2020 recession in the US.
No changes in equity positioning following our monthly asset allocation meeting. The equity overweight continues with a preference for DM and the US and within EM, we are neutral EM Asia, overweight EMEA and the UAE. It’s nice to get towards the end of the year on a positive note – global equities rallied 1.6% last week with DM equities gaining 1.8% and EM flat. Major movers last week were the Dubai Index +8.6% and the U.S. S&P 500 +2%. The S&P 500 logged its fifth straight week of gains and a fourth with +-1%. Fairly fundamental upswing and our overweight reinforced as central bank narrative is that the shift away from massive policy accommodation will be slow and policy overall will continue to support easy financial conditions. The infrastructure bill of $1 trillion was passed, but without corporate tax hikes (as of now), another positive. Buybacks are adding to returns. The healthy consumer and corporate demand backdrop is being highlighted in Q3 earnings. There are small signs that supply chain constraints, while more persistent than expected, may be starting to peak. For Q3 2021, with 89% of S&P 500 companies reporting, blended Earnings Growth is 39.1% and revenue growth is 17.3%, Earning growth is 10% above estimates. Key to inflation pressures is margins which are at a healthy 12.9%, indicative that consumers are bearing the higher costs. 70% of companies in Europe have reported with +50% earnings growth.
A rally for Dubai stocks last week was led by DFM stock +54, as higher trading volumes presage higher income for the exchange, Emaar Properties +18%, Emaar Malls +15%. Real estate gained as did banking. We have maintained our overweight positioning on the UAE for over a year now and whilst Abu Dhabi had rallied Dubai is now catching up. Year to date, total returns for the Dubai Index are 28.5% and the Abu Dhabi Index 65%. DEWA is to be listed on the Dubai bourse along with 9 other government entities as per reports in the coming year, adding to already successful IPOs. The market performance illustrates the UAE prowess in handling COVID. We still see further momentum. Expats are on the rise as well as visitors. The Expo is doing well and Dubai is targeting 25 mn visitors to the Emirates in 2025.
Lots of news on the individual stock front. Healthcare saw vaccine-linked names struggling after a very positive update from Pfizer on its oral antiviral Covid pill, which could lead to an 89% reduction in hospitalizations and deaths among high risk patients. Moderna shares were impacted by a hold up in its vaccine delivery, which is below the target. Apple and Amazon confirm that tight supply chains, a lack of components and wage pressures are costly, whilst McDonalds raises prices on higher wage and food costs. Tesla stock was up 48% in October and another 10% last week as Electric Vehicles finally come of age – fitting with the COP26 in progress, however Chevron with profits at pre pandemic levels indicates that fossil fuels remain a significant generator of energy. Facebook went “meta” to reflect growth opportunities beyond its social-media platform in online digital realms. Tesla has an over trillion-dollar value and looking to partly cash out is Elon Musk who asked the Twitter community, through a poll, whether he should sell 10% of his Tesla stock, and said he would abide by the results. The value at stake is around US$ 20bn.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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