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Chief Investment Officer's team, 30.08.2021
Our weekly publication is back after a 2-week summer break. In the meantime, financial markets have been volatile, mostly due to concerns about the impact of the relentless Delta variant on the economic outlook. Indeed, recent activity indicators have confirmed a clear softening in the momentum of global growth. Additional uncertainty came from the East, with China’s regulatory reforms putting pressure on the private sector, while, paradoxically, the country’s leadership is increasingly signalling an intention to shift toward more stimulus.
As a result, markets sold off during the second week of August, but dip buyers came back last week. The improvement in sentiment accelerated after the most scrutinized event of the month: Mr Powell’s speech at the Jackson Hole symposium last Friday. There was simply no breaking news: inflation should be temporary and not require action, full employment remains the primary goal, and the Fed could start to slow down asset purchases this year, assuming that the US economy recovers. This was overall dovish enough to sustain the rally in risk assets and keep interest rates low.
Our positioning is unchanged, with a clear overweight on equities, and an underweight in bonds. This tactical positioning works, as it outperforms our strategic asset allocation. Having said that, our current year to date returns, around 3%, 4% and 7% respectively, are below our international peers, for two reasons. First, our SAA embeds a capital protection objective at a given horizon, which leads us to own more defensive assets than others. In addition, the strategic weight allocated to emerging market stocks is higher than peers. So far this year, they underperform the record-breaking developed markets. We remain confident that our positioning is right for the long-term. Stay safe.
Equities and Treasury yields have increasingly moved out of lockstep, with the yield on the 10-year note still low versus where it should be considering the strength of stock returns driven by the business cycle. Very strong stock returns and depressed yields can be partially explained by the composition of the US indices, where long-duration securities account for an overwhelming share of the market cap and technology stocks have been the investor darlings since the Great Covid Crisis. While this could last for longer, sustainability will eventually be put into question and it is fair to say that the odds of a market correction due to a rates shock should have increased. Also, peak growth was reached in the US and now in Europe as well, with euro area business confidence peaking for the first time since January, hence a growth shock would be a source of concern as well. Yet, both should remain just tail risks, rather than being base cases, given still plentiful policy support and above-trend growth rates projected for the forecast horizon.
The tapering of asset purchases was well telegraphed by the Federal Reserve and it should be carried out gradually, against the backdrop of low policy rates at least throughout 2022, as long as inflationary pressures remain transitory, of course a big if. Shorter-term the forthcoming August jobs report will be important, given Powell’s emphasis on incoming data at Jackson Hole and the possibility for outsized yield moves on lower liquidity ahead of the Labor Day holiday. It is also very relevant that, with the stronger economy, financing needs for the US Treasury should be lower, hence the tapering of bond purchases should not cause a tightening of financial conditions, as it happened in 2018 when the Federal financing needs doubled even as the Fed carried out Quantitative Tightening, which saw yields shoot sharply higher. Overall, yields should rise, though yield shocks do not seem to be in the offing for now, unless inflation stages a long-lasting comeback.
We hold the view that the novelty in the Fed’s policy lies not so much with Powell’s announcement at Jackson Hole that the tapering is now appropriate, a communication maybe overdue, as in the adoption of the Average Inflation Targeting regime last year. In the past the Fed substantially aimed for the stability of the dollar in order to support the financing needs of an over leveraged economy via overseas capital inflows, while the plan today seems to be indeed quite different. The Fed is minded to keep rates low for long even in the face of a strengthening economy, a recipe for dollar weakness against the backdrop of persistent trade deficits. Currency weakness would not be constituting a threat to US funding needs anymore, as the Fed is now committed to owning a considerable share of Treasury debt to keep rates from rising in an inordinate way. The tradable goods sector, the US export engine, should be expanding as a consequence, a goal Donald Trump himself was keen on with his reshoring efforts, and ultimately the trade deficit would be decreasing somewhat, commodity prices rising and the dollar tumbling, unless not so ‘temporary’ inflationary pressures put a spanner in the Fed’s carefully devised machinery.
Fixed Income Update
As we enter the home stretch of the current year, it would be great to recap our views and the current background for fixed-income investors. This has been indeed an extraordinary year for the asset class. It has been no less than a roller-coaster ride from the unprecedented bear market in the long-term US Treasuries to the pullback in the yields in the second quarter. As we take a look at the YTD returns, global High Yield and China IG Debt are at the top of the asset class returns. Emerging Market Debt has finally turned positive for the year with the relentless rally in treasuries. The laggards are global treasuries and Investment Grade debt. Finally, Asia High Yield has had an unsurprising turn of fate with Huarong and the Evergrande saga affecting investor sentiments after being in the top 3 segments till May.
Since mid-June, we advised clients to move from High Yield and add China IG to their portfolio to ride over the anticipated summer turbulence. The difference in performance between both the asset classes has been close to 2.5% during that period. We think this is a good opportunity to invest in Asia High Yield as the spreads are at their widest since June 2020, and with the Huarong saga settled, we should see a further decrease in spreads from the current levels. We are confident that this would generate capital appreciation for the investors. We had also cut our overweight in Global High Yield to neutral in the July TAA committee meeting and increased our overweight in Emerging Market Debt. However, High Yield has outperformed EM Debt by 0.34% in the same duration. We believe with the dovish tune from the FED chairman in the recently concluded Jackson Hole Symposium, the EM Debt, with its longer duration and higher spread headroom, could outperform the High Yield segment.
Flows into global fixed income funds remained positive and broadly steady (+$14bn vs. +$12bn in the prior week). DM flows remained positive across most categories, with the notable exception of High Yield. Money market fund assets increased by about $8bn. Emerging Market flows have remained negative for the last four weeks. The total default tally for the year has reached 59. So far in August, there have been five defaults--three of which are from the emerging markets. With 13 defaults so far is 2021, the region's default tally is still lower than at this point in 2020, when defaults totalled 22. Global 12 month default rate has fallen to a benign 3%.
The broad consensus is that the US Treasury yields should go up from current levels. We should have more information on the tapering timelines, probably in the September FOMC. We now believe it might be difficult to reach the March heights for the 10-year Treasury yield with growth peaking and inflation expectations moderating. We would be comfortable with long-duration assets once the 10-year treasury yields cross 1.5%. Till then, our advice to investors would be to be selective in credit within Emerging Market and avoid positioning in Global IG or increasing their bets on the global High Yield.
At almost the two third mark of 2021, we see a wide divergence in the performance of geographies, but less so across sectors. Emerging market performance seems to be turning a corner and the heavy weight in the EM Index, China had a very positive week +5%, though negative -3% in August month to date and -15% year to date. The recovery has been led by more fundamental stocks and not the education or gaming sector which continue to face restrictions and regulatory oversight. This has kept EM performance, flat so far in 2021. Within EM, India +21% YTD has benefited from China outflows, but the GCC stands out with the Abu Dhabi Index +58% and the Dubai Index +20% YTD and continues to show consistency in its uptrend, with weekly and monthly gains. DM +17.6% total returns, has performance led by the US and Europe in synch, with their strong vaccine rollout and strong economic rebound, whilst Japan’s markets lag at +1.3% YTD in line with the renewed lockdowns as the virus made a strong come back. On the global sector front all are positive year to date with the performance difference diminishing, indicative of a broad rally. Energy and financial sectors lead at +23% and the other sectors are close behind with high teen gains. Lagging are utilities and the consumer sector.
Our positioning is overweight equities with a stronger preference for DM. The US has not seen a 5 or 10% correction this year and it is impossible to time it, hence rather than sell out we would recommend remaining invested in fundamentally strong balance sheet companies and select sectors. There is still a lot of cash in savings making its way to stocks and earnings growth trending at +40% for 2021 is keeping valuation concerns at bay. Performance of sectors has shown a shift from recovery plays at the beginning of the year to quality stocks. Rates and yields remain favourable but tapering seems to around the corner, hence yields should rise, favouring financials which remains our strongest call this year. Higher yields and eventually higher rates implies lower PE multiples if the equity risk premium remains constant around 350 bps. Hence valuations remain important but we have always maintained that just low valuations are not enough for stock price gains it’s the future sustainable profit growth that drives returns. Technology can never be ignored as all consumer and industrial trends centre around digital transformation and Pres. Bidens recent conclave on cyber security highlights concerns around increased connectivity and the increasing ransomware attacks on corporations and governments. Healthcare is low valuation and defensive and in addition to financials which is a cyclical call, a preferred sector.
On the EM front, we continue advising a broader allocation to EM, with a neutral stance to China. Valuations are attractive but profit expectations have been lowered, unlike DM with the US and Europe continuing to see record profit growth and earning upgrades. Yes, DM economic and corporate profits are peaking but still growing. Our UAE overweight continues as the economy is showing clear signs of recovery on all fronts- PMI’s, real estate offtake, tourism and increased traffic on the road as many offices return to full capacity and schools reopen, with on-site learning.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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