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Chief Investment Officer's team, 04.03.2019
There were a lot of information to digest for market participants last week, but overall asset prices didn’t react much. Mr Powell’s subtle testimony before the US Congress managed to reinsure markets on both the state of the US economy and the patience and flexibility of the Fed. The US/North-Korea summit ended without a conclusion, which shouldn’t come as a surprise as the negotiations between China and the US on trade are still ongoing. US GDP was higher than expected in Q4. As a result, US equities were slightly up as were US rates, weighing on gold (down 2.7%). Investors sentiment is improving across the board, and we believe that their positioning is now neutral on risky assets (up from very cautious at the beginning of the year). We stick to our fair-value based tactical asset allocation and thus to our recent and modest underweight in DM equities as well as on our overweight on Gold.
We might be able to see the first glimmers of hope regarding the global economic outlook in months. Although hard data is on average still disappointing, soft data for the month of February is starting to improve. The main gauge of US corporate sentiment remains at elevated levels, consistent with above-trend GDP growth, and the same measure in China is signaling a rebound in the manufacturing sector, thanks to ongoing stimulus measures. Although in Europe there is no reason for optimism yet, some gauges of business confidence are stabilizing.
The corporate sector is unlikely to come back strongly in the first half of this year, as excess stockpiles accumulated in the expectation of a prolonged US-China conflict will have to be worked out. But in the absence of further shocks, the combination of resilient US growth and easy Fed policy supports the view of an improving US outlook. The same should hold for the Chinese economy.
The leading components of business surveys rebounded in confidence measures. Credit creation, although at marginally higher costs, is once again having its intended positive effects on business. Also, the risk of an escalating trade war seems to have receded, with both parties likely to agree to a partial deal and Mr. Trump pushing forward the deadline for hiking tariffs on Chinese products.
Rate-sensitive assets have already started to discount an improving scenario with US 10-year yields grinding higher. The Fed pivot is expected to boost US growth and bolster some curve steepening, hence 10-year yields seem to be too rich at current levels. Although upside on US yields is somewhat capped, with 3% as the upper-end of the foreseeable range, long-dated yields appear to be currently too low for an economy growing well above 2% and at a faster clip than the trend rate.
Also, positioning on US 10-year Treasuries is quite bullish, even though not yet at extreme levels. Gold promptly recorded the envisaged state scenario by tumbling 2.7% for the week. We will let market commentators continue to argue about the fading geopolitical risks to justify the drop, while we prefer to stick with the view that expectations related to US rates, more specifically real rates, explain a good chunk of the swings of the yellow metal.
As the average correlation between US equities and US 10-year yields has consistently been positive since the Technology Bubble, bottoming yields bode well for future equity performance. Yet, until growth shows real signs of life, we prefer to have a bias towards IG credit. Higher quality credit has historically outperformed during slowdown phases. Gauges of economic surprises for the US are still dropping; we would rather wait and see a turn in economic surprises before sounding the all clear on DM equities.
Fixed Income Update
This week investors would watch carefully the biggest political meeting of the year in China, between the Chinese People’s Political Consultative Conference (CPPCC) and the National People’s Congress (NPC). Government advisors highlighted that China is set to announce further fiscal stimulus, with measures likely to include raising the budget deficit, increasing quotas for local government debt and further cutting taxes and fees. Policymakers and authorities have turned to ease through monetary policies in the past few months by relaxing some of the controls on credit and allowing banks to lend more freely through the RRR cuts. On the domestic bond markets, despite a few concerns on some of the corporate borrowers including a local government failing to meet timely coupon payments, performance has been steady relative to peers. The Bloomberg Barclays China index has delivered a total return of 3.4% YTD in USD, outperforming the EM local currency index (+2.4%).
India's real GDP growth came in at 6.6% y/y in Q4 18 versus the prior reporting at 7.1%. One of the main drivers for faltering growth could be predicated towards softening of government spending and a slow momentum on the private sector consumption. India’s retail inflation has also surprised investors to the downside and hovered closer to the lower band of RBI’s inflation target. The current ten-year real yield based on headline CPI at 5.2% provides us with ample conviction that policymakers could cut rates at their next April monetary policy committee meeting. Inflation trend remains the same for Indonesia as headline inflation continued to lose momentum (2.6% for February reading). Inflation readings have been benignly driven by lower food prices. That said, Bank Indonesia kept the reverse repo rate unchanged at its February meeting, with the governor saying the central bank may implement some macro-prudential measures to support economic activity, but rate cuts are unlikely given the state of their current account deficit. The government has taken necessary steps to address the nation’s wider trade deficit by promoting exports and has leaned towards a hawkish stance on monetary policy framework. The Indonesian real yield has fallen from the recent highs of 5.7% (October 2018) to 5.2%.
It remains a tale of two cities on what the Fed communicates through their macro-assessment versus what the market anticipates and prices-in. The US Treasury bond yields are range bound and supported close to the 2.75% levels. Thanks to the introduction of the magical word “Patience” by the Fed, the slope of the yield curve should begin to steepen, a sharp turn from late 2018 concerns on inversion. The spread between the five and 30-year yields climbed to the highest level in a year last week, briefly hitting 60bps before retracing at 56bps. That said, we remain cautious on the synchronized global growth that we got accustomed in the previous years. The divergence on global bond yields reminds us that structural issue persists and that bond investors need to remain cognizant on returns versus risk.
As the Fed reaches their neutral rate, we believe that shorter-term rates should fall faster than long-term rates. Investors with the appetite for hunting higher yields should focus and add duration as compared to going down the credit quality as the risk adjusted-returns no longer appeals.
The bullish momentum continues, despite valuations in most developed markets having shifted from cheap to fairly valued. As trade tensions have eased, global equity markets continue the rally, with the MSCI World now up 11% year -to-date. The UK however has underperformed, weighed down by a stronger pound. Further gains cannot be ruled out from global markets but we would prefer to not chase momentum. We would be selective in the US where we are close to our fair value of 2825 and underweight in Europe.
4Q earnings season in the US is coming to a close, with 97% of S&P 500 companies having reported results with an average EPS growth of 13% and sales growing close to 6%. The S&P 500 is up almost 12% this year.
China’s weighting in the MSCI’s emerging markets index, tracked by $1.9tn of funds, will rise to 3.3 per cent by November from the current level of 0.7 per cent. An estimated $75 -125bn of foreign inflows into China A shares is estimated in 2019. Chinese stocks listed offshore in Hong Kong and the US already have a 31% weight in the MSCI EM Index. By November this year, the total weighting for Chinese stocks in the MSCI EM index will be about 34%, the largest country weight. China's main equity indices have returned over 25% to investors in the 1st eight weeks of 2019 after having lost close to the same quantum in 2018 (CSI 300 Local currency) . Last year’s biggest concern trade tariffs seems to have been temporarily mitigated, as Pres. Trump has indefinitely delayed the levy of additional tariffs on imports from China.
A FactSet index of more than 3,000 stocks that represents the broader Chinese market trades at 14 times forward earnings, even post the recent rally. The MSCI China A Onshore Index has a price-to-earnings ratio of just 10.5 times. The Chinese market still looks reasonably priced compared to any other large global market.
China is the second largest equity market in the world. MSCI’s latest decision links the domestic Chinese stock market and the international markets and the corresponding inflow of capital into a large global market that is under represented with just 3 -4% owned by foreigners compared to 20% for India. MSCI is ultimately aiming for “full inclusion” of A-shares into the MSCI EM index, at which point the total weight of China in the index may reach about 40%. However, Chinese stocks are often troubled by poor governance and insufficient transparency and international investors may look to stricter governance and a reformed free-market mechanism before committing large funds to China, and definitely favor actively managed funds over ETF for any long-term investment, as the potential for selection alpha is arguably as significant as the beta.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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