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Chief Investment Officer's team, 07.06.2020
We concluded our previous weekly publication by writing: “the positive macro scenario is fully priced-in, but the combination of pessimistic positioning and room for further rotation towards cyclical sectors could support markets further”. Last week’s sharp acceleration in markets’ rally proved us right.
It was actually more than an acceleration: risky assets boomed, with global equities gaining respectively 5.6% in Developed Markets and almost 8% in Emerging Markets, led by the most cyclical sectors such as Financials and Energy. The price of Brent Crude oil crossed $42 while interest rates rose, to 0.9% for the US 10 years, and Gold gave back 2.6% over the week.
As we write for long, we don’t think that markets are disconnected: the scenario of an economic recovery in a very supporting monetary backdrop is gaining traction, triggering panic buying from an overall way too defensive community. Last week alone, the European Central Bank and the PBOC both expanded their monetary support, Germany engaged in fiscal stimulus, PMIs came out better than expected and eventually the US Job reports on Friday revealed 2.5mn job creations while the consensus was for -7.5mn destructions. Markets typically look at only one thing at a time, which is why they simply ignored the US protests.
The rally is understandable, but it may not be sustainable: we won’t get incremental good news every week and at some point investors’ positioning will reach neutrality. We enjoy the great performances of our recommended asset allocation but remain vigilant.
Asset markets are showing an exuberance that cannot be defined as irrational, considering the positive surprises in economic data and fresh stimulus, in particular in Europe. Some investors, following the above-consensus US labor market report and Global Business Confidence readings, may be already entertaining renewed hopes of a V-shaped recovery, which would see the major economies soon regain pre-crisis activity levels. Indeed, the latest US unemployment numbers suggest a somewhat brighter outlook. Yet, sequentially impressive growth rates, to be expected in Q3 given the amount of policy support pushed through, would not imply the full healing of the economy. In this sense investors had better look into the details of the Fed’s first post-crisis Summary of Economic Projections to be released Wednesday, the next policy meeting, holding important information about future growth, inflation, unemployment and short-term rates. With chair Powell and Treasury Secretary Mnuchin painting a picture of post-COVID19 economic devastation not even a month ago, it would be pure wishful thinking to believe that the next Fed’s forecasts would be pointing to a sugar-coated outlook.
If neither the shape of the cycle, nor the valuations of overall US assets can be a great source of comfort nowadays, looking on the other side of the pond multiples come across as more appealing. Emerging market equities have been lagging in this rally with sentiment weighed down by collapsing oil prices. The crude market has more than doubled from the April’s lows and, although it is now expected to go through a consolidation phase with little upside in the next few months, it should no longer be a source of downside risk to the EM producing countries. Also, the US dollar has started to weaken, further loosening global liquidity conditions and boosting the case for EM assets, historically inversely correlated with the US currency. A rotation from dollar-based assets into other markets would improve the chances that the current rally continues, rather than relying on the magic of expensive multiples begetting even more expensive ones.
Although oil traders have recently been rewarded by positive economic surprises and diminishing tail risks, gold investors have been disappointed for the very same reasons. Burgeoning central bank balance sheets and a falling US dollar, otherwise supportive if looked at in isolation, this time have not unfolded their beneficial effects, at least since late April when gold has started to be range-bound. As already observed in this publication, equities are a competitive asset and stimulus translating into improving economic momentum, as it is the case now, plays rather in stocks’ favour. We are not so willing to buy into the story of sequentially strong economic improvements for many quarters ahead either, if anything because all is predicated on policy support which must be redeployed, yet with marginally diminishing returns. As investors gradually come to realize that the pace of the current recovery, however impressive in its early stages, is set to falter, gold will stage a strong comeback. Our clients are advised to buy the yellow metal on weakness and wield patience.
Fixed Income Update
The first week of June has surprised us with the aggressive rally across different sub-asset classes within the Fixed Income space. After returning more than 2% in the last week of May, Global HY posted another stellar performance with weekly returns of 3.23%, followed by EM Debt, which returned 1.40%. Corp IG spreads have tightened below 150 for the first time since March 2020 and could well be on their way to go below 100 bps if the current sentiments continue to prevail.
The only asset class with negative returns were DM Govt bonds with the US Treasury yield curve steepening significantly on the backdrop of stronger than expected data and massive high-quality corporate issuance. The 10-year US Treasury yield broke out of the 0.6%-0.7% range for the first time this week and sold off significantly to trade at 0.89% as of Friday. As we have mentioned in our recent weekly columns, the 30-year US Treasury crossed 1.60%, and the steepening of the yield curve is expected to continue until FED comes out with yield curve control measures to reduce volatility.
Looking East, Asian IG and HY benchmarks continue to outperform other sub-asset classes. We have reiterated our preference for Indian and Indonesian IG sovereign and Quasi sovereigns several times in the past weekly columns. The effective spreads for BBB names from the countries have tightened significantly from more than 400 levels a month ago to low 300s. Positive sentiment for oil and growth numbers would support the recent rally in the Asian credit market. The only risk to the current tightening of spreads on the horizon is the increase in US-China tensions, which could sour investors’ mood. In HY, we continue to be cautious with focus on credit selection and loss avoidance on the top of our minds.
The recent downgrade of India’s rating by Moody’s to Baa3 was along expected lines and was priced in as analysts believe Moody’s was too exuberant to upgrade the country to Baa2 even though macroeconomic stress was visible in 2017. Now, all three rating agencies have similar ratings on the country, and we don’t foresee the country being downgraded to the High-yield category in the short term. Moody’s has retained a negative outlook, and we think this could move to stable next year when the economy recovers from the COVID-19 shocks.
Closer home, GCC debt markets continue their strong performance. GCC is the only market that has posted positive YTD returns within the broader emerging market. While the IG sovereign spreads continue to rally, we have also seen significant outperformance in the HY sovereigns as the region seats at the intersection of improving oil price outlook and better investor sentiments. Govt of Sharjah issued $1 Bn 7-year USD Sukuk last week with significant investor demand as the Sukuk was issued with only a marginal new issue concession. In what can be termed as a piece of good news for the holders of regional bank perpetuals, FAB announced to call its only outstanding perpetual bond. This raises the stake for other large banks of GCC and should be a positive catalyst for the financial subordinated space.
The equity risk/reward ratio remains favorable though most global indices have met our fair values for year end 2020. Higher valuation multiples are not uncommon in low interest rate environments. Successful exits from lockdowns are allowing economies to re-open, boosting expectations of a v-shaped recovery. The latest move up in equities was accompanied by a broader risk-on cross asset move, with bond yields rising, credit spreads tightening and the weaker dollar helping the bounce in EM equities. However, while economies are opening, business costs may rise with the additional costs of sanitization measures. As of now, we don’t see any upward revisions to EPS numbers for 2020. Selection across themes and quality companies will continue to provide alpha to portfolios.
Global equities continued their May rally into June. All major global indices were up last week with outperformance from China in EM and the Eurozone in DM and the Nasdaq (+10%YTD) hitting a new intraday high on Friday. Global equities are now down just 4% in 2020. Markets are riding the stimulus wave. European equities are at a 3 month high boosted by a bold fiscal plan which is positive for Eurozone stability with banking stocks up 17% for the week, their strongest weekly performance since 2009. U.S. markets are flat year to date, with a third positive week, boosted by the May employment report with an unexpected increase in payrolls suggesting an economic recovery was occurring quicker than anticipated, though there is talk of a misclassification error. The hope for a cure / virus boosted markets in May and better than expected economic data in June is providing the next fillip. The cyclical sectors in line with improving economic data led last week’s rally. Airlines, automakers and bank stocks gained. The energy and financials sectors were up more than 10%. Defensive sectors: utilities and consumer staples took a back seat as did gold. The cyclical sector rally has been from a very low base and we don’t see it as sustainable but a summer event.
Oil had a sixth weekly gain with Brent now at $42.3. The OPEC+ meeting this weekend agreed to a one month extension of the cuts. Global oil demand fell by as much as a third in April but has started to recover along with resumption of road travel and flights. China has seen demand return almost to December levels. UAE markets should see renewed interest with the higher oil price supportive. Dubai retailers expect to get a clear feel of shopper sentiment now that malls in Dubai are back to full capacity. In the KSA markets may be slower to react as lockdowns have been reinforced with a resurgence of virus cases. This would affect consumer demand along with the increase in VAT to be implemented in 3 weeks.
The MSCI EM Index is now trading above 1000 and China equities are positive for the year though US China tensions persist and recovery in the Chinese economy is gradual. Some of China's most valuable U.S.-listed companies such as e-commerce giant JD.com and online-gaming group NetEase are proceeding with a secondary listing in Hong Kong, We are optimistic on further gains from Indian equities with continued inflows. Reliance’s Jio digital unit is now valued at about $65 bn having raised about $12 bn in six weeks from Facebook, KKR and Abu Dhabi’s wealth fund Mubadala.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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