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Chief Investment Officer's team, 28.11.2021
“No doubt, the most important single driver of the current economic outlook remains the pandemic”: the first sentence of our weekly publication last Sunday was more timely than we thought. The new variant Omicron was named a “variant of concern” by the WHO on Friday. Early data suggest it may spread rapidly, due to a very high number of mutations which may limit the efficacy of current vaccines. However, we don’t know much more yet, including its virulence which is obviously crucial to assess whether the economy will be harmed again by lockdowns, or not. Countries have been quick to restrict travels from South Africa where it first emerged. Markets were even quicker. Global stocks lost more than -2% on Friday, and prices of oil tumbled to $72 for the Brent. Gold resisted and safe bonds were buoyed with the US 10-year Treasury yield losing an impressive 16 basis points to 1.47%. 2022 Fed rate hikes also almost evaporated from market-implied forecast.
The new variant is a concern. But volatility is not a surprise, as we write for months. Instant reactions are usually wrong, and we do not have enough data to form a new view. Our scenario has always been that we now live with the virus, not that we eradicate it. The worst-case scenario is that this variant is both highly contagious and highly virulent: this would impact the short-term outlook but also prolong support and trigger stronger responses. Investment implications are thus unclear, especially after Friday’s material move. The “risk-off” episode may even be a buying opportunity, depending on how data evolve, especially for the most affected assets – among which potentially our regional markets. We will closely monitor the situation and hopefully have more input for our asset allocation committee on December 7th. Stay safe.
The flight to quality witnessed last week across asset classes is reminiscent of the early days of the pandemic, when little was known about the virus and no remedy was at hand to fight it, other than lockdowns and other precautionary measures. Yet, a lot of progress has been made ever since, and we have already seen the playbook of restrictions being implemented following different virus variants, with subsequent waves being more infectious, but less deadly than the previous ones. So, if recent history is any guide, the market reaction should be temporary. With equity valuations high and investor sentiment bullish a shake-out could take place, a deeper retracement in the major indices which has failed to materialize year to date. Amongst non-traditional assets, bitcoin was no exception and recorded losses in the high-single digits as panic spread, countering the notion of it being able to play the role of a safe haven if need be. We repeatedly expressed doubts about that kind of bitcoin-good-for-everything view. Quite to the contrary, the yearly returns of the cryptocurrency tend to track global market sentiment, hence bitcoin is a cyclical macro asset, and as such cannot even offer great protection against runaway inflation. Gold, on the other hand, on Friday staged a mild rebound, as real rates tumbled.
And this takes us to our view that markets had priced in too much of central bank tightening, pricing which was partially undone following the news of the new virus variant on Friday. Pandemic twist and turns apart, we still think that the hurdle for the Fed to embark on a steep tightening cycle in 2022 is pretty high. Will the Fed dare tighten before the November mid-term elections, and even worse, stand in the way of the Biden spending bill aimed at supporting longer-term growth? Will the Fed hike so much as to eventually trigger a recession and undo mammoth monetary and fiscal efforts, to restart from scratch and then, what? Will the Fed raise the cost of money and make that of servicing government debt more onerous, if not unsustainable? In short, the political and economic costs of a steeply tighter policy are so big, that the Fed will stay put or just implement a token hike next year. Even though real policy rates are close to record-negative lows, rates will be capped to maintain real yields in negative territory, and reduce the real cost of debt without cutting it down.
In turn, negative real yields for a prolonged period of time would continue to make equities more appealing than government bonds, bring gold to the fore against currency debasement and usher in a bear market for the US dollar. But for now, a higher dollar will serve the Fed’s purpose of moderating inflationary pressures, gold will be treading water until it is clear that the Fed won’t be doing much after all, while equities remain the asset class of choice, virus-induced volatility notwithstanding.
Fixed Income Update
Strategists continuously talk about the benefits of diversification. But only during market turbulence do we really appreciate the value of well-diversified episodes. Last week after the new Covid-19 variant clobbered the risky assets, including the credit products within Fixed income such as EM Debt and High Yield, investors found out that US Treasury and Investment Grade exposures were the only asset classes that protected their portfolios. The two assets provided positive weekly returns of 0.9% and 0.3%, respectively. In our regular communication, we have also been touting the benefits of China's local Currency IG debt since May 2021. The asset class was flat, with spreads hardly widening. Most investors who have chased yield would not have enough exposure to any of the above three segments and would have High Yield and EM Debt in their portfolios which have lost -1.1% and -0.7% last week, according to Bloomberg Barclays indices. The OAS spreads of both the asset classes widened by 40 and 22 bps, respectively wiping out the effect of a significant Bull-flattening in the US Treasury yield curve. The 10-year US Treasury yield lost 16 bps in a single day, the largest daily movement post-March 2020.
2022 is going to be a year of many possibilities and few convictions. Under such a scenario, including a little bit of everything in the fixed income portfolio is the best course of action. If the growth story remains on course and inflation runs red, then HY and EM Debt exposure would give the much-needed yield. At the same time, in case of black swan events, the three asset classes US Treasury, developed market IG debt, and Chinese Government Bonds, would likely put a floor on the portfolio losses.
It is still early days for the new variant, and it may be "much ado about nothing." But markets have reacted in a risk-off manner to push back rate hike bets. We should get more clarity in the coming weeks, but most analysts agree that this wave might not be as severe as the previous delta wave due to the rise in the level of vaccinations. Only the countries that lag in vaccination and the reopening trade sectors should be impacted. We believe there could be opportunities for dip-buying at elevated spread levels. Global High Yield and EM Debt currently trade around 28 and 50 bps wider than where they started the year. We would be looking to buy if spreads widened by another 25 bps from current levels in either of the segments. High Yield defaults continue to be lower, with the segment having issued a record $455 Bn of bonds this year to push back maturity and short-term debt levels. Emerging Market sovereigns have received significant support from IMF and other organizations. We do not think credit risk would rise significantly from current levels even if we go through localized lockdowns.
The new COVID variant “Omicron”, with a number of cases recorded in South Africa, led to a wave of caution through global markets on Friday as concerns around the economic impact of the new travel restrictions and lockdowns rose. Global stocks fell -2.2%, a broad based geographic sell off, with the MSCI Asia Pacific Index -1.7%, the European Stoxx 600 -3.7% and the U.S. S&P 500 -2.3%, the last on a shortened day of trading. A sudden recalibration for markets that had been focused on inflation and monetary tightening, Friday saw US Treasuries gain and markets are now anticipating that the Fed will keep interest rates lower for longer. GCC markets (closed on Friday) had a mixed week with Dubai and KSA indices falling and Abu Dhabi gaining. We expect GCC equities, +39% YTD to react to a lower oil price. Oil fell on reduced mobility concerns with Brent trading down 11.5%.
Global equities followed a familiar Covid-era pattern and stay at home winners such as video conferencing companies Zoom, streaming and gaming companies and vaccine-makers Moderna and Pfizer rallied while reopening sectors i.e. airlines, leisure and online booking sites fell. All global sectors were in the red with energy the worst off and healthcare the least affected. The market drop was a reminder that Covid is still a powerful force for markets, and likely to drive sharper market action than inflation in the short term. Investors are worried about increasing lockdowns and uncertainty over how effective the vaccines will be, though mRNA vaccine makers such as Moderna are conducting clinical trials of booster candidates, and BioN Tech, Astra Zeneca and J&J are testing the efficacy of their vaccines against the new variant. It is premature to consider Friday’s slide a change in trends. The new variant is concerning, but it will create prolonged market jitters only if it evades the protection of vaccines and therapies. The economic fallout of the new variant should be contained as the world is better equipped with higher immunity, booster shots and antiviral drugs.
Many equity markets, barring China and Latin America, indices were at record highs a week ago, post very strong Q3 earnings and strong inflows with the higher valuations starting to be worrying,. Global stocks are up 15.5% year to date, the S&P 500 +24%. A 5 to 10% move down, seen usually once or twice a year, is a norm in markets, but not seen this past year. Last week we spoke of the three headwinds to markets- rising COVID infections, inflation and monetary policy tightening. The first now takes centre stage. Inflation has largely been demand driven and also a result of supply chain constraints, which had recently begun abating. Interest rate hike expectations are already taking a breather. We remain constructive on market returns but expect continued volatility. Many positives still in play – ample liquidity with record savings supporting consumption and a low interest rate environment. U.S. and U.K. Black Friday online sales beat expectations. In emerging markets, the India economic recovery has been rapid with strong consumer demand reflected in the +20% gains in equities, though China performance is lagging as it focuses on reducing dependence on monopolistic payment systems and data security and China listed firms in the U.S. such as Didi which have large user data bases have been told to delist from U.S. exchanges.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Digesting a more uncertain outlook
Inflation, infections, inflexion
An ideal start to November
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