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Chief Investment Officer's team, 04.08.2019
Asset markets reacted sharply to president Trump’s threat of new tariffs on all Chinese imports, with S&P500 volatility fleetingly rising over the 20 mark, Brent crude tumbling 8% in one day and US 10-year Treasury yields recording a weekly close below 2% for the first time since November 2016.
It is not clear what is driving this new negative tariff surprise. The president might want to force the Chinese back to the negotiation table, even though it seems that so far the dragging of the conflict has had the opposite effect of hardening Mr Xi’s stance too.
As the tension between the resilient but softening global economy and the increasing burden it can take continues to grow, markets are unlikely to remain unscathed. Although recession risks still appear to be moderate, following the tariff tweet the US yield curve quickly reversed course into flattening mode.
The EM outlook is now exposed to increasing headwinds, with the US dollar stronger and trade conflicts once more in the foreground. Europe is not faring better either, stuck in its stagnant rut and equally exposed to the vagaries of the global economic cycle.
It seems that under these conditions US assets should continue to outperform until global activity takes a turn for the better. Meanwhile, investors will have to wield patience and be aware that Fed monetary support won’t be of any help against rising summer volatility.
Last week is a case in point that all that could go wrong sometimes indeed goes wrong. The first rate cut administered in a decade by the Fed, closely followed by President Trump’s announcement of more tariffs on Chinese imports and by the US job report release, saw stocks drop, the dollar rise and Treasury yields tumble alongside Brent crude. Investor reaction looks typical of a growth scare, considering the sharp losses across risk assets. And rightly so, as the longest US recovery on record comes with rich equity and credit markets and muted business activity outside of the US.
Although the Fed resuming an easing cycle is in and of itself an event of paramount relevance which in the past has been proven able of lifting growth and financial assets, investor expectations had run too high. Consensus was projecting four cuts before the FOMC in the subsequent 12 months, while Fed chair Powell made clear at the July meeting that this easing cycle would not be a long one, which should translate into one more cut by year-end with further Fed support remaining highly data-dependent. The dollar promptly reacted to this slightly hawkish delivery by recording new highs for the year.
Equity investors initially looked at the glass half full of Fed stimulus lying ahead, only to dump stocks when Mr Trump made the shock announcement of more tariffs on Chinese goods. While Powell’s message is a bit less benign than forecast, the words of the US president sound unequivocally troublesome for the outlook. Tariffs on all of Chinese goods will mean higher imported inflation and a further blow to business confidence. Once more facts have failed to live up to expectations, as the common assumption was that the trade truce would last into year-end.
With the earnings season 70% through in the US and Europe and monetary and trade policy surprises behind us, investor focus will turn back to the global economy, unlikely to come out of its soft patch before year-end. So, it seems that markets will be hostage to the thinner summer liquidity and the macroeconomic newflow, still dominated by the slump in manufacturing activity. This paints a somber picture for the short term, where volatility can rise quickly driven by investor emotions following the ups and downs traced by the noise accompanying economic data.
The renewed escalation of tariff risk does not appear to be priced in at current valuations levels, hence in the absence of positive catalysts at the shorter time horizons we maintain our underweight stance on equities and wait for better opportunities to add risk back to portfolios.
Fed support alongside ECB stimulus expected to kick in by the end of the year, as well as renewed Chinese fiscal measures should eventually gift investors with new highs in global equity markets. The path to those new highs still seems to be a long and winding one, though.
Fixed Income Update
The unexpected tariff shock administered by president Trump sent investors scrambling for safe-haven assets. A significant drop in US benchmark yields triggered similar moves across the major Sovereign markets, with the pool of negative-yielding bonds in the euro-area growing larger. Ten-year US Treasury bond yields are currently trading at 1.78%, while similar-maturity German Bunds are at the new record lows of -0.499%, below the European central bank’s key deposit rate of -0.40%. Germany’s entire yield-curve is sitting in negative territory.
The payrolls report for July showed a solid but slowing labor market with positive month-over-month earnings, slowing non-farm payrolls, and an unchanged 3.7% unemployment rate, while wage growth edged higher by one-tenths of a percentage to 3.2%. However, inflation expectations have continued to fall on demand concerns following tariff threats and mixed economic data. The 10-year breakeven rate, a market-implied inflation measure, is currently at 1.70%, as against the Fed’s 2% target. The persistent rally in global government bonds has seen investors venturing into riskier fixed income assets in their search for yield. Increased risk-taking in the late stages of the cycle is not boding well for future financial stability, should the outlook continue to worsen.
Investor sentiment towards primary bond sales is still resilient, in our view, in spite of the dragging trade-war and unabated geopolitical tensions. A testimony to this is the strong year-to-date primary bond sales of over $425bn. During July, central banks across Russia, South Africa and Turkey reduced their benchmark rates citing slowing global growth. India, Brazil and Vietnam’s central banks also commented that they would look to lower their rates in the upcoming monetary policy meetings. We expect India to cut its policy rate by 25 bps to 5.50% on Wednesday.
Central banks in Saudi Arabia, the United Arab Emirates, Qatar and Bahrain cut their benchmark interest rates by 25 basis points, following the Fed. However, Kuwait, bucked the trend and held its policy rate at 3%, still offering attractive real rate for investors.
Emerging market primary bond issuance has continued its strong streak in spite of growing concerns surrounding global trade wars. The volume of new issuance for last month was the third largest of 2019 at over USD68 bn and behind March and April volumes of USD75bn each. The July total EM volume was also the fifth highest since January 2018. Across the global EM, Asia led the issuance by almost half of the total EM volume printing $34.1bn of new bonds. Upcoming issuance in Asia this week includes ICBC Financials Leasing Co Ltd, Exim Bank of India and Renew power.
Last week equity-markets, after breaking records through July, gave back some of their gains following president Trump’s threats on new tariffs on Chinese imports. The developed market indices were trading 3-5% above our fair values, hence we see the current drop realigning market values with our models. Uncertainty will continue to run high as investors await China’s response to Mr Trump’s threats.
We remain neutral across the developed markets, including the US. Our fair value for the S&P 500 for end 2019 is 2900. Last week was an eventful one, with investors digesting newsflow related to the Fed, earnings, trade conflicts and economic releases. All major global indexes saw significant declines. US equities suffered the worst week of losses in 2019. After hitting an all-time high, the S&P 500 (+18.3% YTD) declined by around 3% in the past week. The Tech sector was a notable decliner led by losses in hardware and networking. Defensives fared better, supported by lower rates and the rotation out of growth and cyclicals. Energy was another notable decliner, following tumbling crude prices. Consumer discretionary saw some weakness in auto parts, travel and leisure stocks. REITs stood out as the best performer.
Over 75% of the S&P 500 companies have now reported earnings with 76% surpassing the consensus earnings expectations, in line with the one-year average. Companies reported earnings 6.0% above expectations, ahead of the 5.4% 1-year average. In aggregate, the Energy sector reported the largest difference between actual and estimated earnings, followed by the Information Tech sector. Notable surprises came from Intel (+5.0 YTD), Micron Technology (+38.9% YTD) and PayPal (+27.4% YTD). Companies strived to implement cost savings across sectors, guiding 2H estimates lower with negative revisions. Rising trade tariffs emerged as a recurrent concern. The full implementation of higher tariffs on all Chinese products would hurt consumers and dampen hiring. Buyback growth is losing momentum and is expected to decelerate from 2017-2018 levels as companies have to deal with a more difficult earnings backdrop and elevated trade concerns. Last year saw a record USD 1tn buybacks, driven by the tax overhaul.
GCC markets had a negative week as oil fell around 7%, the sharpest one-day decline in more than three years last Thursday. Central banks cut rates in the GCC in order to stimulate non-oil growth to reduce the risk of declines in the real estate sector and attract foreign investors. In July, the DFM Index climbed around 8%, the best monthly performance in more than four years and outperforming both the Tadawul index and the Abu Dhabi Index for the year. We expect market activity to remain subdued as the region celebrates Eid Holidays in the coming week. In the UAE, we would add to the banking and logistics sectors as valuations remain attractive.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Waiting for the Fed - 28 July 2019
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