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Chief Investment Officer's team, 23.06.2019
When Central Banks talk, markets listen. Last week, every single asset class was propelled by the dovish shifts expressed by both the Fed and the ECB, making it clear that the next moves will be accommodative, and paving the way for virtually every Central Bank to follow. To some extent, even Facebook looked like a Central Bank as they announced the launch of an asset-backed cryptocurrency.
Global equities gained over 2%, led by Emerging Markets and China in particular, up 5%. The combination of lower government bond yields and renewed risk appetite supported all segments of fixed income. Gold and Oil also printed their best week of the year, the latter being also pushed higher by growing tensions in the Gulf.
In such a week, being defensively positioned hurts, even if our positive stance towards gold and Emerging Markets did well. Being fundamental investors, we can’t help highlighting that the reasons for Central Banks to be dovish are essentially downside risks to the economy. Should they materialize, only the safest assets would benefit, with dramatically compressed returns.
We are not there yet; so far absolute returns this year for our 3 recommended allocations are respectively +7, +9 and +10%, and we keep our positioning unchanged. We will focus our attention on the meeting between Mr Trump and Mr Xi later this week in Japan. For sure, the Fed will do the same.
Markets went on fire following the Fed’s policy meeting, with impressive moves across asset classes. Long-dated bond yields tumbled to historic lows in major G10 countries and to yearly lows in the US, US equities recorded new all-time highs, gold touched a 5-year high and the US dollar saw a significant loss of momentum. One might wonder why so much fuss if, after all, investors already had discounted a high probability of four cuts in the next 12 months for weeks and a looser policy stance starting from December 2018. Isn’t the market’s job to discount the news in advance, leaving room just for moderate price action when expectations materialize?
One could get a sense for what has happened by looking into the details of the Fed’s language in various FOMC-related communications and find after-the-fact justification for price swings. Indeed, Mr Powell lowered the bar further for rate cuts in the short term, came across as concerned about downside risks, especially from the intensifying trade conflict, and Fed’s forecasts suggest that a large number of officials favors cuts in 2019. Yet, this does not seem to go far enough explaining all of the explosive asset price reaction.
On a broader scale, one should consider also that Mario Draghi made a dovish turnaround as well, at the June ECB Forum in Portugal. He lost patience with persistently low inflation, signaled the prospect for rate cuts and maybe even renewed Quantitative Easing, absent any improvement in data. At the same time, looking further East, the People’s Bank of China has been moving along the same dovish lines for a while, and of late intensifying its policy efforts to fend off the negative economic effects of the China-US stand-off. EM Central Banks will be following suit and adopt an easing stance in order to adjust policy to a weakening external backdrop.
Investors are well aware that Central Banks have been playing the very same game since the end of the Great Recession, triggering mini economic cycles, which required renewed support when the effect of stimulus was fading. The bottom of the last mini-cycle was in early 2016, when policy was eased both in the US and China. Again, the US, Europe, Japan and China are fighting with sub-par growth and inflation. Wouldn’t a sharp investor look through the current cycle and come to the conclusion that policy rates will most likely be low on the forecast horizon?
This has strong implications for asset classes. Gold would be off to a bull market in such a scenario, which we failed to contemplate in the previous issue of this publication (the focus was on gold in the Cross Asset’ section). Under these conditions a bear market in government bonds would not be possible. Equities should be in a tight spot, supported by low rates, warranting higher multiples, but eventually threated by deteriorating earnings as the economy weakens. This looks very much like a disheartening new world of stagnating growth!
Fixed Income Update
Bond markets globally were driven by Central Bank’s dovish language. The FED, ECB and BOJ all attributed to the strong rally that pushed yields to multi-year lows. Within the fixed income asset class, Global high yield led the outperformance gaining over 1.30% over the week. DM Sovereign bond yields fell while the quantum of negative yielding debt instruments now crossing the record USD 13tn. The benchmark US Treasuries fell below the 2% mark and retraced to close at 2.05% while the ten-year Germany Bunds moved deeper into the negative territory to yield minus 28bps. On corporate credit, capital inflows have surged as investors add risk on investment-grade bonds together with higher-rated sub-investment grade bonds. The spread difference between corporate bonds rated BB (Sub-Investment Grade) and BBB (Investment Grade) has narrowed down to 57bps which is the lowest levels seen since 2007. Amidst the regional geopolitical tensions, GCC bond markets have been well supported with credit spreads tightening from this month’s wide of 190bp to 168bp to yield at 3.64%.
Asian Central Banks are increasingly likely to lower their respective policy rates following their DM counterpart’s (FED, ECB, BOJ) recent comments on their dovish stance. The Reserve Bank of India, BSP (Philippines), Bank of Indonesia, and Bank of Korea are some of the few to start the easing cycle. On India interest rates front, we expect the RBI to cut interest rates by as much as 50bps over the next six months.
On the primary issuance front, Sharjah Islamic Bank has begun meeting fixed income investors and are expected to close the offering of a capital-boosting instrument by this week. Sharjah Islamic Bank is rated A3 by Moody’s, A- by S&P, and BBB+ by Fitch (all with stable outlook). A benchmark fixed rate resettable USD Regulation S Additional Tier 1 perpetual non-call six year unrated Sukuk would follow, subject to market conditions.
Adani Ports and Special Economic Zone Limited (“APSEZ” ), rated Baa3 / BBB- / BBB- (Moody’s / S&P / Fitch) with a Stable outlook by all three agencies, has appointed several banks to arrange a series of fixed income investor meetings/calls across Asia, Europe and the United States commencing June 24, 2019. A benchmark size USD 144A/Regulation S senior unsecured notes offering may follow, subject to market conditions.
Equity markets particularly emerging markets (+3.8% last week) were boosted by dovish talks from Central Banks and talks of a possible de-escalation of China-US trade issues. A counter intuitive week with both risky (equity) and safe haven assets (gold and US treasuries) rallying. In the midst of Fed rhetoric and the start of the G20 summit, Facebook’s “Libra” took centre stage in the payment space.
Heading into the last week of June, the S&P 500 is on track to post the strongest June gain in over 60 years i.e. since 1955 and is up +7.3% month to date. The Dow Jones is on pace for its best June since 1938. With the S&P 500 moving to a new high last week, investors are building in a scenario of the Fed cutting rates with the economy staying stable rather than the end of an economic cycle with lower rates and lower economic activity. However, there are elements of caution with a shift this quarter to the more defensive sectors: utilities, consumer staples and real estate. The more cyclical areas of the market i.e. transport, semiconductors and the banks have lagged though technology still leads global returns. The yield curve, needs to be watched as an indicator of economic sentiment and as a guide to style and sector rotation. For the next leg up for equities, capital expenditure needs to kick in to boost growth, as it has remained stagnant last one year amidst caution on global trade growth. The global semiconductor sector reflects the slowdown in capex. The sector (+23% YTD) has recovered in June after falling sharply in May, due to the U.S. restrictions on sales to China and the embargo on Huawei. High valuations for chipmakers have to reconcile with the lowered demand picture in 2H. Prolonged negotiations without resolution for the U.S.-China trade war have led to companies in the tech supply chain to reduce component inventories. Semis have lowered guidance for 2H.
Asian markets gained as investors embraced the decisive shift by Central Banks back to stimulus mode with the MSCI Asia Pacific Index ex-Japan up 4.1% last week. Geopolitical tension did not affect global equity markets but led to a rally in oil prices. However, we don’t expect the GCC markets to rally in tandem with oil, post the strong run the KSA has already witnessed this year (+15.5%). The Tadawul Index traded high volumes but fell at the end of last week. Strong passive flows into KSA equities with positioning from foreign investors had accompanied the MSCI EM inclusion. Kuwait is on the review list for a potential upgrade to EM status in the next MSCI review end June and would join the UAE, Qatar and the KSA if included as an EM economy.
Facebook’s Libra is a secure blockchain-based payment system with a 100 institutional promoters expected. Users can make everyday purchases with the cryptocurrency, backed by central back assets and is the first effort to bring digital currencies to the mainstream and tap 1.7 billion people with no bank accounts. Libra’s fate rests with global policy makers, as Central Banks are demanding regulatory oversight. Facebook’s giant social network with 2.4 billion users provides a ready base for the crypto-based payments system. Institutional support for the cryptocurrency industry has helped boosted Bitcoin to a 13-month high, after a collapse last year. We do not advise on crypto currencies.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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