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Chief Investment Officer's team, 07.10.2018
The past week was not devoid of significant market moves, as US 10-year Treasury yields and crude oil recorded 7- and 4-year highs respectively, while both EM equities and FX dropped to new lows. What some investment houses have labeled as ‘US exceptionalism’ continues, with US economic growth roaring ahead and translating into higher yields and in general over-performing assets versus the rest of the world. The non-manufacturing ISM index exceeded all expectations at 61,6, and the explainable weakness in September job creations (with hurricanes) was offset by the upward revision of August numbers. But as rates are one of the key concern for markets, “good news” can be “bad news” for them.
What springs to investors’ mind is whether weaker Treasuries are going to impair equity performance via higher costs of funding. Our short answer is “not for now”. Our impression is that the US market is vulnerable to higher yields in the short term, since a general sense of euphoria is starting to prevail, given unabated positive US economics news flows and consistent recovery of the main indices since the February lows. Yet, strong momentum in activity combined with Fed policy still far from restrictive provide strong support to equities, hence very little room for large downside risks. Indeed, historically equities have recovered from significant up-moves in yields, as long as they were indicative of strong future growth. We gauge this to be the case under the current market circumstances.
One more source of legitimate concern is higher oil prices, as Brent crude briefly surpassed the $85/bbl mark in the past week. Rising crude prices will boost headline inflation, curtail purchasing power and dent consumption. Although this makes for rising volatility in the short term, eventually the shock should be absorbed by markets. Wage growth in the main developed nations remains close to cycle highs, providing some cushion against crude pressures.
Overall, in spite of the latest headline-catching moves, we maintain our overweight stance on US equities and EM assets. We must at the same time acknowledge that the rally in stocks remains pretty narrow and is mainly US-led, with rest-of-world growth failing to catch up. Investors will have to wield patience. It will take time for Chinese stimulus to kick in and lift Asian equities first, and EM assets alongside. It will also take time for exceptional US growth to benefit the developing nations via stronger imports.
It is well worth mentioning the good news on the tariff side too. The US administration over the weekend struck a deal with Canada to renew the NAFTA agreement, meanwhile continuing constructive talks with the EU and Japan, pledging not to impose auto tariffs until negotiations proceed. A US war on global trade would have significantly impaired business confidence and raised the risks to the global outlook.
Fixed income update
The benchmark US 10-year Treasury yield hit its highest level (3.23%) since 2011 after the Labor Department's monthly jobs report showed another month of rising wages and a sharp upward revision to August's nonfarm payrolls. The unemployment rate dropped to 3.7 percent, a level not seen in nearly 50 years. August job creation was revised up to 270,000 from 201,000. The yield on the 30-year Treasury bond was up at 3.4 percent, its highest level since 2014. That said, the recent bond sell-off is closely watched by bond investors as they prepare to digest the $230bn of Treasury sales (Bills and Bonds) this week. The Treasury Department would auction $156bn of Treasury bills followed by $36bn of three-year bonds, and $23bn of ten-year and $15bn of thirty-year securities.
The U.S. trade deficit widened in August, as the strong domestic economy boosted imports. The foreign-trade gap in goods and services expanded by 6.4% from the prior month to a seasonally adjusted $53.2bn in August. That was slightly narrower than consensus. A wider overall trade deficit in August was broadly expected, after data on goods released last week showed the deficit climbed for the third month in a row.
The Kingdom of Bahrain should receive financial aid via a $10bn support program by their Gulf allies (Saudi Arabia, United Arab Emirates and Kuwait) helping it avoid defaulting on loans as it tries to restructure its finances. The support comes after the Governments agreed to underpin Bahrain's financing plan and stimulate economic growth in a five-year aid program. Bahrain issued a 33-page financial program aimed at eliminating its budget deficit by 2022, reducing public spending overseen by six task forces, introducing a voluntary retirement scheme for government employees, improving efficiency in state expenditure and streamlining cash subsidies to its citizens. Bahrain has several upcoming debt obligations both across Sukuk and bonds from 2018. The current pricing reflects the strong support from the neighboring states.
The People’s Bank of China lowered the required reserve ratio by 1 percentage point, effective from Oct. 15. After this fourth cut, the ratio currently stands at 15.5 percent for large commercial lenders and 13.5 percent for smaller banks. Policymakers have stepped up liquidity support across the financial system this year and focused on calming fears of capital outflows and sought to soothe battered markets in a US-China trade war context. China's yuan currency has fallen this year, losing over 8 percent between March and August at the height of market worries, though it has since cut losses as authorities stepped up support. The RRR cut will bring in a total of 1.2 trillion yuan ($175 billion), of which 450 billion yuan is to be used to repay existing medium-term funding facilities which are maturing. The PBOC has continued to demonstrate a prudent, neutral monetary policy and this reserve ratio cut should curtail the recent yuan weakness. The cut will apply to large commercial banks, joint-stock commercial banks, city commercial banks, non-county rural commercial banks and foreign banks.
US markets ended the week with the S&P 500 down 1%, troubled by rising yields, wage growth numbers potentially weighing on margins (we mentioned both in our Q2/Q3 quarterly) and a reported increase in tensions with China on the alleged planting of tiny spy chips on computer motherboards. Inflationary pressures too are rising with oil prices.
Yields above 3.1% has been calculated as the threshold beyond which US companies and those companies in countries pegged to the USD, would find interest costs hurting profits. Corporates have become used to low cost debt and their absolute levels of debt have risen dramatically in the last decade. Rates have not been fully normalized as yet as per Fed officials. More rate hikes imply higher yields. Corporate America did not use the windfall from tax cuts to reduce debt, but to improve returns to shareholders. Wage growth is another area of concern as the unemployment rate is at 3.7%. Amazon has recently increased its hourly wage to $15, along with a number of companies stating they are in the process of doing so. These potential headwinds generate volatility at a time when investors also question the valuation of US equities. We are cautious on some interest-rate-sensitive sectors such as telecoms and utilities.
Elsewhere in the world, Emerging Markets have materially been impacted with a -4,5% weekly fall, despite the fact that Chinese markets were closed. We were expecting volatility and will still be looking for opportunities to add further to our current modest overweight, as the cheap EM valuations do not reflect the long-term fundamentals.
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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10 years later - 10 September 2018
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