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Chief Investment Officer's team, 23.08.2020
Last week’s market performances were as flat as you would expect from a normal late August week, with only 60 bps between the worst (Gold, down -0.2%) and the best (Developed Market stocks, up 0.4%).
There was however no lack of news. Tensions escalated again between the US and China with a focus on tech companies. The Fed expressed clear concerns on the growth outlook but confirmed that their long-term framework review should be communicated in September, and be followed by adjustments in the way they do forward guidance. Economic data was overall more tepid than alarming, showing divergences between a booming China, a solid US and a mixed Europe. The most spectacular part of the consumer rebound is certainly behind us but there are reasons to believe that businesses will be the next driving force.
There are however three unanswered questions. First, the virus is not under control, with a never-ending first wave in America and some risks of a second one in Europe. Second, in the US, failure to agree on the next phase of the fiscal stimulus would be a serious headwind on economic activity. Third, of course, the US elections are only 10 weeks away, and the imminent official start of the campaign may exacerbate postures on both domestic and geopolitical topics. In the meantime, market should focus on the Jackson Hole gathering of the world’s top Central Bankers next week.
As the summer ends, we also remain quiet on our positioning, which is slightly defensive and has delivered so far solid returns of respectively +5%, +4% and +3%. For markets and for our tactical allocations, September may be the time for more action. Stay safe.
Our asset allocation process classically includes two levels. The first one is the strategic asset allocation, which is the optimal static mix of assets for the three profiles we have defined: Cautious, Moderate and Aggressive. Based on long-term capital market assumptions and the rigorous, non emotional application of proven quantitative models, they are built to provide the best possible return over time, under the important objective of protecting our clients’ capital over respectively 3, 5 and 7 years. The result is three static portfolios combining cyclical and defensive assets chosen for their expected returns and differentiated behaviors in various market phases.
The second level of asset allocation is the tactical one, which aims at exploiting short-term inefficiencies to create additional performance over the strategic one, without of course compromising its risk/return profile too much. We identify inefficiencies by looking at three key market drivers. The first one is the macro and policy backdrop, which is a scenario on what happens. The second one is a valuation analysis: we built fundamental fair values for each asset class, reflecting our scenario, and this gives us a precious tool to see if an asset is currently under or overpriced compared to what we think it should be worth at the end of the year. These fundamental drivers are crucial in our thinking, but 2020 illustrates maybe more than ever than markets actually move much faster than fundamentals. This is why we add the analysis of a third category of drivers: the behavioral factors, which includes investors’s positioning, sentiment, risk sensitivity, to anticipate future flows, which drive markets in the short-term.
With regards to the two fundamental pillars, the situation is quite simple. We have a reasonably constructive scenario for months, but valuations of risk assets, equities in particular, are even more optimistic. Stock markets are priced for a perfect situation and may be a bit ahead of themselves given where we are in the recovery and the number of risks threatening its trajectory.
This is where behavioral factors matter, and have led us to be only slightly defensively positioned. We were and still are expecting turbulences on risk markets, but the analysis of positioning and future potential catalysts doesn’t exclude the surprising possibility of markets overshooting further, even maybe forming the next bubble. The key point is that many institutional investors are still very defensively positioned: money market funds have seen this year a record level of inflows, cumulating more than one trillion dollars, and stocks have seen net outflows. This cash, yielding nothing, will need to be put at work at some point, and the ever rising stock markets are putting pressure on professional money managers who are at risk at losing assets because they underperform. The near future could provide catalysts to do so: some form of agreement on US fiscal stimulus will be found, the Fed will reshuffle its framework in a probably dovish way, and the uncertainty of US Presidential Elections will be lifted in November. A new bubble formation is not our central scenario, but its probability is not zero, which is why our current positioning is not as defensive as fundamental factors would suggest.
Fixed Income Update
Last week was more sedate, compared to the previous week in terms of volatility. Benchmark 10-year Treasury yields decreased gradually from the previous week closing of 0.71 to 0.63 last week, indicating a drag on yields. Benchmark treasuries index was marginally down weekly while the investment-grade credit flagship benchmark was up slightly last week. Global HY and EM Bond index performance also diverged the previous week with the HY index down by seven bps while the EM index was up by 4bps.
July FED FOMC meetings did not spring any surprise with discussions on forward guidance, asset purchases, and yield caps. September meetings should give us more clarity on the renewed framework around formal adoption of Average Inflation Targeting. There has been a pause in the fiscal relief discussions with both Democrat and Republic conventions in consecutive weeks.
Primary issuance activity has picked up in August with $117 Bn of IG debt issuance in the month, which compares to an average of $95 Bn for the month in the last five years. YTD issuance for IG rated firms has reached $1.48 Tn, which is higher than full-year numbers for the last 10-years. A similar activity is observed in the USD HY market, with a YTD issuance size of $278 Bn beating full-year numbers for the previous five years.
Defaults are a crucial parameter to track during these times to understand the full impact of the Covid-19 related sudden stop on the weaker entities. Default rates have plateaued even though they remain elevated. Total YTD defaults have reached 159 with European defaults crossing the 2019 numbers last week. The week ending Aug. 14 saw only two additional defaults, which is the lowest tally in the previous four months.
GCC bond markets have maintained the strong YTD performance with returns crossing 6.50% that is second only to US Treasury YTD returns. There has been a slowdown in the primary market activities, with the last issuance being the Sharjah Govt 30-year Formosa bond. This lack of supply and overall improved sentiments have resulted in recent issues performing better than expected, squeezing out the value from these securities. FITCH downgraded Oman last week. This downgrade was expected as the other two rating agencies ranked Oman at BB- with Negative Outlook. Oman’s macro fundamentals remain shaky, with the fiscal deficit expected to cross 20% and funding requirements for the next three years in the range of $10-14 Bn. Debt to GDP has increased to over 60%, and Net Foreign Assets stand at -17%. However, with improving access to the debt market, we expect Oman to issue bonds in Q3 2020, which should ease immediate funding pressure. Moreover, last month Oman closed a $2 Bn Syndicated loan facility where FAB was involved, which gives us comfort that Oman will receive some form of support from its GCC neighbors.
2020 has so far been a volatile year for markets, with the sharpest fall and quickest recovery on record. We expect less volatility and more range bound behavior into the end of 2020, with the caveat of a possible 5 to 10% pullback, which is the norm rather than the exception for markets, typically twice a year. Global markets continue to drift upwards, though the momentum is slower. August has been an exciting month with Apple’s market cap crossing the two trillion dollar mark and Teslas’s share price up 870% from the same time last year. These two are now respectively, the world’s most valuable company and auto maker. Healthcare companies continue advances with FDA approval for a plasma therapy and on the vaccine front, though significant human testing (stage 3 with 30,000 candidates) remains key for faith in any vaccine and for mass adoption. We recommend remaining invested in tech and healthcare, but look increasingly at yielding equities with bond yields declining, a theme we have been promoting since last September and running concurrently with our primary growth strategy. Select energy stocks along with quality real estate can provide sustainable yields in excess of 5%. Many consumer and healthcare stocks provide yields +3%. On the energy front cash flows remain important and we don’t think the more diversified E&P players will further cut dividends. On the real estate front we would focus on companies with the potential of leasing warehousing to ecommerce companies.
GCC markets saw improved volumes with UAE indices gaining 3.6% last week, driven by ADCB rallying on possible merger talks and real estate across the board catching a bid. Aldar Properties was up 13% for the week with its entire hotel portfolio having been certified as safe following the adoption of protocols to help protect visitors from the coronavirus.
Developed markets had a positive week led by the US, with European equities however down c.1 %. The S&P 500 made a new high and was up (+0.7%) this past week, but fiscal stimulus remains key to support corporate earnings with a 26x P/E for the Index. Widening credit spreads, with higher unemployment claims than anticipated, led to a defensive bias last week with large caps outperforming small caps and tech outperforming cyclicals. Economic data points have stabilized with the re-openings but uncertainty around further fiscal support puts the stabilization and EPS at risk. Existing home sales in the US rose +24%, good for sentiment with demand driven by companies continuing to advocate Working From Home and years of under owning of property by the younger population cohort.
China equities had a good week as tensions decelerated with the U.S. though we expect the to and fro to continue. As per media news Pres. Trump’s team is privately seeking to reassure U.S. companies that they can still do business and Tencent shares rallied on the news. 46% of MSCI China and 19% of MSCI China A Onshore have reported 2Q results and have exceeded estimates. This marks a strong recovery from Q1. Entertainment and E-commerce leaders Tencent, Alibaba, JD.com and Baidu, one-third of MSCI China's index weight, delivered solid results, confirming their resilience under Covid-19 disruptions.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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