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Chief Investment Officer's team, 17.05.2020
Last week was volatile and slightly negative on risk assets markets, with global stocks down 2%, commercial real estate tumbling, and Gold outperforming. The Fed delivered a downbeat assessment of the outlook but tried to close the door to the possibility of negative interest rates, while at the same time, influential figures from Wall Street warned about US stocks’ valuation. Some form of consolidation is not abnormal, especially as economic data remains depressed in the West. US Retail sales dropped more in April than during both the Great Depression and World War II.
In May however, economies are reopening in Europe and in many US states, except the most affected. Numbers from China keep on showing a spectacular rebound. April industrial production was 1.7% higher than a year ago, and retail sales were close to fill the gap versus December levels. This might explain why last week, Emerging Markets did overall better than Developed Markets. It also comforts our overweight position in Emerging Asia across asset classes. May is hopefully the beginning of the end of the economic paralysis, but some markets are already discounting it, creating vulnerability, especially as tensions between the US and China are escalating again. Volatility should not abate as US presidential elections are only 6 months away, and as relaxed containment policies may trigger more infections.
We keep our Tactical Asset Allocation unchanged, and will look for confirmation of better activity in the G4 May flash PMIs to be released next week. Stay safe.
The current pandemic, affecting our lives on many fronts, is likely to leave scars at a global level, both by accelerating trends already underway, for instance the curbing of globalization, and providing fertile soil for new ones. Fiscal policy is stepping in the foreground and governments are starting to play more relevant a role in society than neo-liberists might be wishing for. What is impressive is the suddenness and the scale of the changes, overwhelming societies and bringing about new trends which, though barely in play, already seem unstoppable.
Global trade is an obvious casualty of this crisis. The manufacturing sector will see the swapping of higher profits and global supply chains for wiser planning and some on-shoring of goods-producing activity, while services could witness long-lasting disruptions in sectors like tourism and education. Relocalization should come along with more inefficiencies, hence be on net inflationary. The flip side of the coin, and a much darker one at that, could be a tendency towards isolationism, populism and the weakening of international organizations, which unfortunately to an extent has already started and brings us back to the unfolding of very similar events following World War One.
The more relevant and immediate change pertaining to asset markets is the new role of fiscal versus monetary policy, with the latter becoming more subservient and yielding ground to the former, better suited to deal with the current economic challenges. The scale of the economic disruptions related to the pandemic is so large that the bills will have to be paid with money-printing. What was once considered as a taboo, namely that central banks should not print the money to meet government expenditure, to be funded instead with bonds sold to the public, is now being more broadly accepted given the gravity of the moment. The US Federal Reserve is already indirectly monetizing debt, by absorbing on the secondary market most of the Treasury issuance related to the latest fiscal measures. Many other countries are following along with their own forms of Quantitative Easing, with Japan further along the road to full debt monetization.
Common misgivings related to less globalization and more fiscal policy are about their potential for the rekindling of inflation, which would in turn be exerting upward pressure on yields, further straining government finances and upending any economic recovery. While these concerns are not unfounded in the medium to long term, in the immediate future investors are more likely to deal with the familiar problem of excessive deflationary pressures, given the higher worldwide unemployment levels.
For the next one to two years sluggish growth and depressed government yields should prolong the search for yield in credit markets and boost the performance of the secular equity winners from the Great COVID-19 Crisis, namely Technology and Healthcare stocks. On longer time horizons, the inflation genie out of the bottle might pose harder challenges than ever both for governments and investors.
Fixed Income Update
In the last weekly, we had mentioned that benchmark bond indices representing Global HY and EM debt had run ahead of their fundamentals. We were a little skeptical of the spread tightening that had happened despite signs of storm clouds on the horizon with US-China war of words increasing and looming corporate defaults in the High Yield sector. As if on cue, the HY indices were at the bottom of the return chart last week. EM Debt though continued to be robust, and the OAS spread came below 500 bps for the first time since March. We must add that EM Debt is not a very homogeneous collection of securities, and there are regional and rating dispersions in the index. While we continue to like investment-grade sovereigns and sovereign related entities from Emerging Markets, we are wary of taking single line exposures in the EM High Yield sovereigns as well as corporate securities.
US Treasury yields traded in a tight range last week. The 10-year yield closed at 0.62% on Friday. FED has continued to stick to an average duration of 7 for its treasury purchases in contrast to earlier quantitative easing periods, where it focused on keeping the long-end yields low with an average duration of purchases around nine years. With duration supply set to hit the market if the Treasury sticks to its funding commitment in Q2, we expect bear steepening of the rate curve. Unless credit spreads decrease proportionately, we may see an adverse effect on long-duration bonds and hence, advise clients to stick to bonds with a duration close to the treasury curve to benefit from FED’s generosity.
GCC benchmark index spreads were stable last week. YTD GCC bond index has outperformed the EM Debt index by more than 3.3%, indicating the support from the local investors to the region securities. There was a flurry of primary market issuance in the region. Equate Petrochem became the first Non-financial Corporate from the region to hit the primary market. The company issued a $1.6 Bn two tranche bond offering through its Canadian subsidiary MEGLOBAL. The 5-year and 10-year bonds were priced at 5% and 5.875%, respectively. Our preferred sub-asset class, IG Sovereign related entities from Asia, continued to tap the market. While Indonesian entities dominated the first week of May, REC Ltd from India issued a 3-year bond attractively priced at 4.86% that saw massive demand from investors.
However, the highlight of the week was a $ 4 Bn three-tranche issuance by Mamoura Diversified Global Holdings (previously known as Mubadala). The order books were oversubscribed by more than 5x times, and the surprise was that the orders were skewed towards the long duration 30-year maturity while investors continued to show interest in the front-end of the curve for other GCC sovereigns. This showcases the preference for stable quality for investors regardless of duration in the region, and the key to getting investor interest is to get pricing correct at the outset.
Despite the inflow of disappointing economic data, equity markets have rallied over the past six weeks. A recession is underway in the UK, Germany, the U.S. and other global economies. However, hopes centers around its length, with the reopening of economies and potential treatment/ prevention for the virus in progress. For the week, most global indices were down except the KSA, in line with a rally in oil prices. Also in the green are the healthcare and some select tech sub sectors. In the U.S. equities had a volatile week with dismal April retail sales and falling industrial production reports. The broad-based economic weakness is a representation of the adverse spending shock that has resulted from shutdown measures, pay cuts and the massive jump in unemployment. Semiconductor stocks fell as the Trump administration moved to block shipments to China's Huawei Technologies. Inspite of the friction, TSMC is setting up manufacturing in the US as companies want shorter, deglobalized and localized supply chains. This is critical for the supply of essential components but will lead to escalated input costs.
The S&P 500 is currently trading at a 22X 2020 EPS, with valuations supported by accommodative monetary policy from the Fed with low interest rates and favourable credit spreads. Looking beyond 2020, investors remain focused on how quickly lost earnings can be recouped. S&P 500 EPS declined by 14% in Q1 with technology and the defensive sectors i.e. consumer staples and healthcare growing earnings whilst financials, materials and industrials had sharp contractions. The steadier earnings trends of the former support their loftier valuations and hence our preference remains for these growth strategies. Negative earning revisions are strongest for the energy and materials sectors, the most affected by the fallout of the demand for commodities. Global technology sector quarter results continue to be upbeat. Tencent, Chinas leading social media company beat expectations led by Mobile games revenue +64% y/y. Cisco gave positive guidance as remote work and online activity is stoking demand for the company’s network equipment.
The UAE’s two-phase strategy to reopen the economy is backed by an USD 79 bn stimulus plan. The first stage includes the gradual reopening of businesses. The second phase is designed to accelerate recovery and advance growth, with a focus on the digital economy. Updates from Aramex focused on expected weakness in 2Q20 across International Express & Freight Forwarding whilst the Domestic express business is expected to continue doing well. Saudi Aramco retained its dividend despite a fall in profit and is on track to meet its full-year goal of USD 75 bn
EM had a better week than DM. India stands out with its fiscal-stimulus package of c. 10% of GDP supported by complementary fiscal and monetary policies placing it in a position of strength compared to emerging-market peers. There was a focus on small and midsized businesses and direct-benefit transfers to the bottom end of the income scale. Significant labor-law changes and eased business conditions are notable, as is a priority to capitalize on the supply-chain disruption. Digital consumption, with a focus on fintech remain key on the governments agenda.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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A strong start to the second quarter
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