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Chief Investment Officer's team, 10.05.2020
Two numbers released last week perfectly illustrate the current situation. On the one hand, China’s export numbers for April exceeded forecasts, showing a 3.5% growth while the consensus was expecting a -11% drop. The outbreak started in Asia, but countries who fought it effectively are recovering. We are not there yet in the West: the unemployment rate in the US released Friday was the highest since 1940 at 14.7%. It was by comparison 3.5% in February, the lowest in 5 decades.
This dichotomy explains why markets were positively oriented last week. Afterall, it is the same virus. Europe major economies are gradually re-opening (Germany, Italy, France) and the US is next. Global stocks added almost 3% and the price of Brent crude oil was up 5% to $31. The gap between sectors is only growing, with the technology-rich Nasdaq now positive year-to-date in 2020, after having printed a 40% gain in 2019.
The positive take is that selectivity and active management actually work, as illustrated by the resilience of our recommended asset allocation, down respectively less than 3, 6 and 9% so far in 2020. After having been very active in our allocation, we are now neutral. The negative, however, is that markets are taking for granted a recovery which might not happen smoothly: China’s current trajectory might be an optimistic benchmark for the West, and increasingly a target in the pre-electoral rhetoric. At least Emerging Asia has secular drivers, which is why we remain overweight.
Both laymen and investment professionals are amazed at the speed of the current market recovery, unable to reconcile the gap between the dramatic state of the economy and the buoyancy in risk assets. With the benefit of the hindsight it is clear that the massive monetary and fiscal interventions have contained the pandemic fallout and allowed investors to look through the short-term pain, providing confidence that economic conditions would return to normalcy relatively quickly. Failing these unprecedented liquidity and income measures the deepest and shortest downturn in history would have morphed into a depression without the faintest hue of visibility as to its own end.
Funding and liquidity stress have been removed, while infection rates have stabilised as more countries are going to restart activity. Looking into the folds of this forceful rebound it seems that markets appear to be more comfortable about systemic risk than economic growth. Indeed, US-centric assets continue to outperform, growth is still beating value and the same holds for developed versus emerging markets. According to investment styles or asset performance nothing suggests that investors are flirting with the idea of a strong recovery. Rays of hope in this direction are offered by the US yield curve, which has exited inversion territory and is now signalling growth ahead by steepening significantly, and US jobless claims, that by peaking, though at record-high levels, point to a bottom in equities in place.
Overall it seems that more of the same medicine, liquidity, this time combined with fiscal measures mostly aimed at smoothing household income, is going to keep markets going, support bank lending and eventually restart the economy. There is one caveat: if the large-scale and timely action of central banks and fiscal authorities is helping investors look through short-term disruptions and focus on the outlook in the next two years, markets’ rise is predicated on the expectation that bad news is going to reverse in the next few quarters. A slower than expected return to normal levels of activity or a second virus wave in autumn could be obvious stumbling blocks lying ahead. US personal savings as a percentage of disposable income recorded the largest rise ever in the month of March and for the recovery to match expectations it will be important that most of that is unwound quickly. Much of the confidence in being able to go back to past patterns relies on vaccines or treatments which are not yet in sight, but remain important to get the health crisis under control.
In the emerging countries, though stimulus has not been as outsized as in the West, economic forecasts for 2021 and 2022 point to upside left in financial assets, provided one writes off the current year completely. Equities, in the MSCI EM Index dominated by Asia which is well ahead in the management of the crisis, year-to-date have performed better in risk-adjusted terms than credit, skewed towards energy assets, or currencies, crushed by the US dollar. We continue to hold the view that investors can find quite some value in the emerging economies, as long as they maintain a selective approach.
Fixed Income Update
Investors may still wonder if the current situation can be termed as “calm after the storm” or the “lull in the eye of the tornado.” We tend to believe that the worst may be over for the investment-grade credits in the developed markets with the backstop provided by the Fed and other central banks. Moreover, we can also bet positively that investment-grade sovereigns in the emerging markets might have crossed the turbulent period propelled by the liquidity injection. So, the real question to ponder over is whether High Yield credit is over the wall yet. Our guess is probably not, as we can see the rising defaults in the USA and the lack of any significant deals in the high yield space. The liquidity in the emerging market credit space is still tight with bid-ask spreads for non-sovereign entities remaining wide by historical standards.
However, benchmark indices tell us a different story. Both Global HY and EM Debt Bloomberg-Barclays indices’ OAS spread tightened by more than 140 bps with EM Debt narrowly beating the Global HY index in weekly returns. At the same time, both Global sovereign bonds and investment-grade credit indices posted negative weekly performances for the first time since March. This “risk-on” sentiment is very similar to the moves in the equity indices. Only time will tell if this irrational exuberance will stand the test of cratering economic data and moral hazards being created in the monetary system to prop up zombie companies. But we advise clients to remain cautious in their single line exposures by staying up in quality and avoid credits that have a high beta to equities.
Fed Funds Futures have started to price in negative rates for the first time in history with future contracts pricing the prospect of negative rates by the end of 2020, while implied rates are now showing negative rates in the first half of 2021. We continue to hold our assumption that the FED will not go into negative rates territory and will tend to employ a host of other monetary tools to prop up the economy. US Treasury yield curve long-end continues to rise with investment-grade credit supply putting pressure amid the announcement of large issuance of bonds to support the unprecedented fiscal stimulus. The much-awaited 20-year bond will get introduced on May 20 with a $20bn supply. We expect it to be priced around 1.1%.
GCC bonds took a breather from the break-neck tightening that happened in the last week of April with OAS trading in a range. The Kingdom of Bahrain issued $2bn of bonds equally distributed between a 4.5-year Sukuk and a 10-year bond. The peak order book was more than $11bn indicating a healthy investor appetite for Bahrain risk. The pricing was attractive, with the final print leaving c. 25 bps on the table for investors. Investors thinking Oman can follow suit should be aware that with Oman bonds yielding close to 9%, the Sultanate has to be ready to pay around 10% to attract enough interest. Hence, we think Oman would wait for better sentiment to prevail before approaching the market.
A good week for developed markets but not so for emerging markets, with a shorter trading week for its primary constituent China. DM hope to follow the rapid opening up of Chinas economy, post the pandemic induced shut downs. The S&P 500 was up 3.5% last week and is now +30% from the 23rd March low. This can no longer be seen as a bear market rally. Should the March 23rd low hold, the 33-day, 34% decline from the February peak would mark the shortest bear market on record. The Nasdaq was up +6% last week, in positive territory for 2020, led by Amazon and Netflix at record highs. Whilst companies in the S&P 500 are expected to have EPS fall by 14% in Q1, majority of companies that have reported have exceeded analyst estimates, with technology and healthcare groups leading earnings and global sector returns. Investors are also looking ahead to 2021 with earnings for the S&P 500 expected to rise 13% in Q1 as per consensus. However, the resilience of the Nasdaq is not reflected in the broader markets, with the median US and Europe stock 30% below its 52 week high. The divide between the haves and have-nots has built up over the 11 year equity bull run with the mega technology companies, which are heavily weighted in the indexes, driving much of the gains. Five tech stocks Microsoft, Apple, Amazon Alphabet and Facebook constitute 20% of the S&P 500. Those companies have benefited from the working at home norm and distance learning, with increased use of social media and online purchases. Microsoft Teams now has 75Mn daily active users.
Oil rallied last week, along with the energy sector (+6%), but as it constitutes just 3% by market weight in global indices, has little effect on market direction. The energy sector is still down 35% this year, in line with the fall in oil prices. The UAE and KSA did not keep pace with last week’s oil gains, with UAE trading volumes still low. More UAE banks announced results with a focus on foreign ownership limit increase and building up of provisions to protect from any impact arising from the coronavirus pandemic, oil price volatility and the low interest rate environment.
There is a divergence between global market performance and economic data, with unemployment at record levels and increasing bankruptcies. Lower demand has been reflected in the drop in Q1 earnings, with many companies withdrawing 2020 guidance and with buybacks and dividends also off the table for several. Many FTSE 100, i.e. the UK’s biggest listed companies have cut payouts to shareholders by nearly GBP 24bn since the start of the pandemic, with BT the latest to suspend its dividend. It follows Shell which was the top dividend payer in the Index for seven of the past eight years. BT was also in the top 20 biggest payers.
India’s Reliance Jio was once more in the limelight as global investors added to Facebooks USD 5.7 bn investment in India’s digital leader. India’s 400 mn middle class is seen as resilient to global economic disruption and a route for growth by DM companies wishing to diversify from saturated markets with aging demographics. EM offer higher growth at reasonable valuations, however have lagged DM as barring a few megacap tech companies in China, there are no others to match the FAANGs.
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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