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Chief Investment Officer's team, 28.04.2019
Last week, the superheroes from “Avengers: Endgame” broke all previous box office records, and so did their financial equivalents, the S&P500 and the Nasdaq, printing fresh all-time highs. The weekly performance numbers were not that epic, but the Year-to-date numbers are impressive: +12 to 16% for equities and real estate, +4 to 7% for the riskiest segments of fixed income, and every single major asset class in the green.
There have been three phases in the rally. The first one was a normalization of excessive pessimism. The second one was an immediate reaction to the US Fed turning explicitly dovish. The third one, which we currently enjoy, is the combination of an overall light positioning from investors, with a stream of converging facts and hopes. Facts: the US and China are doing well, lifting the global economy, and there is no pick-up in core inflation globally. Hopes: the same US and China will reach a deal on trade, and the rest of the world might recover from the recent economic soft patch.
This context would support other weeks of low volatility and gentle positive returns. The only issue is valuation. It is fundamentally a very serious one, but the near term consequence appears to be a cap on potential upside rather than an outright risk of imminent correction. We solve the dilemma between momentum and valuation by staying invested, but favoring more than ever Emerging Markets and keeping cash and gold on the side.
‘Stable, or somewhat higher’, this could be a quick but effective way to put across how we feel about the upside left in some asset classes in the short term. It applies in particular to the US dollar, crude oil and gold prices for very different reasons.
The US dollar has continued to defy gravity and traded close to its highs for the year on a broad trade-weighted basis. Our expectations that stabilizing growth in Europe would help the common area currency strengthen at least modestly were disappointed after the release of a below-consensus IFO in Germany and weaker consumer confidence. EM currencies have also made new lows for the year against the dollar, in general due to a dovish feedback to global central banks from the recent Fed pivot, which saw EM policy rates trend lower.
Yet, upside for the dollar should be modest, as the combined effect of China stimulus and supportive policy rates across developing countries drive the EM-DM growth differential wider. Also, in the second half of the year the bounce in the European economy should gain some momentum and breathe a bit of life in the euro. For the time being, Q1 growth rates in Europe forecast at above 1.5% appear unsustainable, as the latest business surveys point to a more modest 1% for the current quarter. Concerns about a pause in the stimulus drive in China are also constraining EM Forex upside. So, the dollar has still room to move somewhat higher before pulling back as non-US growth consolidates.
Crude prices traded close to 6-month highs to retreat and close around $72/bbl for the week. Geopolitical tensions in Venezuela, Libya and Iran played a role, alongside OPEC’s determination to limit production and possibly lock prices in the $70-80/bbl range. This could represent ‘Goldilocks’ levels, both globally and for the major GCC producers. According to some studies, crude prices up to $80/bbl should not be stoking inflation in the US above consensus forecasts, causing little reason for concern about consumer demand disruption. At the same time, the lifting of US waivers on crude imports from Iran on May 2nd would bring about tighter market conditions, leaving room for Saudi Arabia to increase output and stave off excessive price pressures. ‘Stable, or somewhat higher’, seems to apply to the crude market too.
The next Fed meeting is slated for May 1st and, although no interest rate decision is expected, Mr Powell is likely to be questioned about a possible rate cut following Friday’s disappointing inflation release. Real rates are close to this years’ lows and could grind even lower as investors discount a market-friendlier Fed. Gold should react positively, continuing the rebound which started late last week. Yet, upside seems to be capped, since one full rate cut in the next 12 months cut is priced-in by futures. We think that Mr Powell will rather stay on hold to keep some powder dry for rainy days.
Tactical Asset Allocation: simplified positioning
TAA – relative positioning – moderate profile
TAA – YTD indicative performance
Fixed Income Update
Growth momentum is supportive. The US GDP came in stronger than expected with a 3.2% annualized growth rate in Q1. The strong reading supports the continuity of one of the longest economic expansions on record. Dissecting the report, one key inflation measure (PCE) dropped to 1.30% in the quarter, from 1.80% which prompted a sharp rally on the US Treasuries. This week would remain key for financial markets as the Fed’s policy decision and press conference is due on Wednesday. Moreover, investors would also pay a close watch to the Treasury’s refunding announcement as well as payrolls report which is due on Friday.
EM worries resurfaces. Deja vu…
Emerging markets debt performance was mixed on the back of concerns surrounding Argentina and Turkey. The five-year credit default swaps on Argentina and Turkey soared to new YTD highs of 1214bp and 460bp respectively. On the broader EM index, the longer-dated and lower rated credits performed well, but underperformance in Argentina and volatility in Turkey capped overall return. Broadly EM high-yielding corporates and Sovereigns outperformed those on the investment-grade sector. EM credit indices have also widened to 194bp (CDX EM).
The higher the S&P, the tighter credit spreads. The S&P 500 is at all times high, which has supported a strong spread compression on the US corporate bond markets. Both IG and HY have staged a strong comeback with spreads now at 110bp and 359bp respectively. We keep a close watch on the volatility front (VIX) given the nudge higher in the last few trading sessions to 13.25 for any early signs towards investor risk appetite. The Fed funds futures are now pointing that the central bank’s benchmark will fall to 2.18% by the end of 2019, more than a quarter point below the current fed effective rate. The US 10-year Treasuries has rallied pushing yields below the 2.50% - a strong reflection from the recent quarterly change in the price of Personal Consumption Expenditures (PCE).
Russian policymakers hold their dovish stance – policy rate cut imminent. The Central Bank of Russia kept its key interest rate on hold at 7.75% at its April MPC meeting, with a dovish message, backed by inflation numbers consistently surprising on the downside and driving expectations lower. Policymakers state that “short-term pro-inflationary risks have abated” but also acknowledges the risks stemming from unanchored inflation expectations and geopolitical factors. CBR now “admits the possibility of turning to cutting the key rate in Q2-Q3 2019”.
The Bank of Japan cut bond purchases for the first time in two months. Last Friday, the BOJ offered to buy 160 billion yen ($1.4 billion) of 10-25 years duration bonds, versus 180 billion yen previously. It also lowered purchases of longer duration bonds to 40 billion yen, from 50 billion yen at the last operation. The BOJ’s board is scheduled to meet April 24-25 for their MPC.
Fixed Income key convictions
Fixed Income valuations
Chart of the week: Five-year credit default swaps of Argentina and Turkey
UAE markets are catching up with global performance, with the Dubai Index (total return) up 13.7% and the Abu Dhabi Index up 14.5% year to date. Banking consolidation has boosted the UAE financial sector, as have the high dividend yields of 5-6%. The recent move to 100% freehold in some Abu Dhabi developments have given a fillip to the real estate companies there. The Tadawul (Saudi) index is +20.4% year to date. MSCI will add Saudi stocks to its Emerging Markets Index at the end of May, and in August. Other indices have already started, but MSCI is the most important with c. $14 trillion of assets tracking it. Saudi stocks will be bought by passive funds but also potentially by the 115 actively managed mutual funds that use the index as a benchmark. This should boost foreign participation in the KSA. MSCI will add 69 stocks with a total market capitalization of $84 billion—roughly 15% of the $530 billion Saudi market. The KSA will make up almost 3% of the MSCI EM Index, on par with Malaysia and Indonesia. The KSA market is heavily skewed towards two sectors— banks and petrochemicals. New listings in the retail and consumer sector will help diversify it.
The S&P500 and NASDAQ made new all-time highs this week, with the US markets marginally outperforming other key global markets. This week’s record levels leave the S&P up 18% for the year, and the NASDAQ up nearly 23% (total return). Earnings are strong, buybacks are growing, economic growth is improving, auto tariffs are not on the cards right now and a China US trade deal seems imminent. The Q1 US GDP printed strong on growth but soft on inflation. Within sectors, tech and healthcare were the key outperformers in the US while semis, cap goods, energy and transport under performed. Healthcare was helped in part by Mr Biden’s entry into the US presidential race, alleviating to some part the concerns around increased regulation. The major Eurozone indices ended unchanged with underperformance in the cyclical sectors while defensive sectors fared better. Mainland China markets had negative returns last week on worries the government will begin dialing back stimulus in light of improved growth. However, there is clear improvement in Chinese activity momentum reflected in the strong PMI prints and better credit data.
Positioning levels aren’t elevated. The Q1 season in aggregate can be classified as strong and is unfolding better than expected though 2019 consensus hasn’t been rerated upwards. Initial results point to a positive earnings surprise in both the US and in Europe, to the tune of 5% and 2%, respectively. Almost 50% (230) of the companies in the SPX have reported earnings and 77% are beating EPS expectations by an average of 5%. Stellar results included Facebook, which grew users and advertising revenue, Microsoft, which grew its Azure cloud services and hit the $ 1 trillion mark on market cap and Amazon which doubled profits. The qualitative tone from the banks has also generally been encouraging. Our year-end fair values are admittedly tame relative to current levels given this year’s extraordinary moves.
Equity recommended regional positioning
Major indices performance (TR, US$) and 2019PE
Global sector performance (TR, US$) and 2019PE
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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