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Chief Investment Officer's team, 22.09.2019
Last week started with a shock on oil, continued with panic in US money markets, and ended with re-escalation of trade tensions. The responses were also impressive. Saudi Aramco recovered a significant part of its capacity and indicated it was “stronger than ever”. The Federal Reserve calmed monetary markets with massive repo operations and cut rates Wednesday, in a widely expected move. India aggressively cut the corporate tax rate to 25%, from nearly 30%.
In such a context, one could have expected to see extreme volatility in financial markets. They, of course, reacted to the day-to-day news, but the weekly numbers point to a modest “risk-off” mood. Gold and bonds gained, and equities were down, but only marginally.
For sure, the macro and geopolitical backdrop is not bright, and valuations are not cheap. But investors positioning is extremely defensive, which is the key factor explaining this resilience. This is also the reason why we haven’t turned outright bearish yet. As of last Friday, our cautious, moderate and aggressive profiles are delivering +9, +10 and +11% in 2019, their highest return this year.
The combination of central bank liquidity, fiscal stimulus, and investor pessimism might provide fuel for the current rally. However, our fundamental framework leads us to keep significant levels of cash, and to be very selective about the assets we overweight (among which Indian equities). Should bearish investors capitulate, we would consider reducing risk.
The statistics tell us that all but one of the 11 post-WWII oil price spikes have been followed by a recession. The recent rising of tensions in the Middle East begs the question whether the higher risk premium markets are likely to attach to oil prices will eventually tip the global economic balance for the worse. We are inclined to believe that the world economy will once more give proof of its resilience.
Although last Monday Brent crude closed more than 14% higher, recording one of its largest one-day spikes in decades, it has since retreated to trade within its June-July range. Saudi officials have reassured markets about a relatively fast production recovery and according to major studies even a 3-month production outage would not manage to cause a global recession, assuming both the Kingdom and the OECD draw on their reserves to cushion the impact of the missing barrels. Also, both shale oil supply and the global slowdown reduce the odds of an overly tight crude market.
Yet, supply will in the short run be limited, hence some temporary upside to oil prices should be expected. According to Emirates NBD Research, near-term upside risk should not exceed the high-single digits from current price levels. We would expect that some investors will be looking to capitalize on pricing inefficiencies of oil-related assets, like oil stocks or high-yielding energy bonds. The former seems to be trading cheap to the underlying commodity, while the latter has an appealing carry given relatively wide credit spreads.
It is worth noting, especially for the investors who believe in the efficient market hypothesis and in the discounting mechanism embedded in the price of financial assets, that gold barely budged the day when oil surged dramatically. Since gold is more often than not touted as being sensitive to geopolitical tensions, it is pretty odd that when oil investors were fretting about those risks and sending crude prices flying, gold speculators were not losing their cool. One interpretation would be that the crude market was just discounting a production shortage, even as the gold market was projecting no meaningful rise in geopolitical risks. So far, gold investors have been right.
The bull-run in gold has so far exceeded our expectations. At current levels, we see limited upside, considering that the US yield curve is starting to tighten and global economic surprises are no longer in negative territory. Should anyway gold continue to rise, it would be pointing to unexpected inflationary pressures lying ahead from the relentless easing efforts of major central banks. The inflation information carried by gold prices is lost in crude plagued by a long-term glut.
Fixed Income Update
US Treasury bond yields strengthened by 17bp to 1.72% mainly driven by technicalities over the recent repo market operations. The 25bp cut by the FED and the following press conference provided some color on the economy as well as the risks on the horizon. The saga on the repo market had seen overnight rates surge dramatically. The New York Federal Reserve opened a series of daily repo operations to curtail the squeeze. Moreover, a series of overnight and term operations for the next three weeks were also announced. The FED cited that it has a control in maintaining financial stability for such dynamics and would support as and when required. The New York Fed said it will conduct overnight repurchase agreement operations daily Monday through Friday until the 10th of October. They also highlighted that they would conduct three 14-day term operations for an aggregate amount of at least $30 billion starting today, according to a statement.
The OECD downgraded its outlook for global growth. OECD now projects the global economy to grow at 2.90% this year and 3.00% in 2020. OECD’s chief economist Laurence Boone said "The global economy is facing increasingly serious headwinds and slow growth is becoming worryingly entrenched. Governments need to seize the opportunity afforded by today’s low-interest rates to renew investment in infrastructure and promote the economy of the future."
Post announcement of negative mortgage rates last month, Jyske Bank A/S, the second largest Danish commercial bank, has imposed negative rates on all clients with savings of USD 110K or more after the latest rate cut by the Danish central bank. Passing on negative rates to individual clients with assets below USD 1Mio had been a taboo till now. This backdrop could become a compelling test case to study the pattern of savings in the era of record-low zero-bound yields.
India has unleashed a wave a fiscal stimulus in the last couple of weeks. The latest has been a surprise corporate tax cut, which would boost profitability but widen the fiscal deficit by potentially 0.3% in FY20. The loss is expected to be partly mitigated by the onetime USD 24Bn windfall from the RBI. The RBI governor in a separate meeting last Thursday has hinted at the possibility of additional rate cuts in the October 2019 MPC meeting, on top of the 110 bps cuts so far this year. The 10-year yield widened by 15 bps to 6.79% as a result. Moody’s said the move is credit positive for companies because it will enable them to generate higher post-tax incomes. However, it is symmetrically credit negative for the sovereign.
The primary bond supply continued across the board. The 25bp cut by the Fed supporting US benchmark Treasuries supported confidence particularly for the investment-grade borrowers. The hunt for yield has been a predominant factor for the stellar YTD bond performance resulting in a deluge of new supply.
In the GCC region, National Bank of Fujairah is on the final leg of meeting investors in London after meeting regional investors in the UAE on Sunday for a potential additional tier-1 perpetual bond. The Kingdom of Bahrain has also mandated banks for a possible long 7-year Sukuk and a 12-year bond transaction. Both are expected to price this week.
A turbulent week on many fronts did not seem to affect the equity markets greatly, with global equities down 0.4% on the week across emerging and developed markets. Oil (Brent) soared 7%, as KSA oil production was curtailed following an attack on the oilfields. The Fed had to step in to relieve funding pressure in money markets. Another 25 bps rate cut in the US, left investors guessing as to the future path of monetary easing. Global markets took these events in their stride, and we continue to see a range-bound performance near term.
GCC markets were a mixed bag with Abu Dhabi and the KSA gaining but the Dubai Index falling 2.4% last week. Year to date, Dubai still leads in the region at +16% total returns. KSA is now flat in 2019, down from +18% at its peak in May 2019 (time of MSCI EM inclusion). We had recommended to take profits and switch to the UAE, which is overweight within our EM regional strategy.
US equities are just 1% below all-time highs, including last week’s negative -0.5%. A report that the Chinese delegation to the US returned home early fueled renewed worries at the end of last week about the progress on trade negotiations. It was not a good week for cyclicals, with the PHLX Semiconductor Index down -2.7%, but still returning +36% year to date. Semi stocks are viewed as a proxy for growth, as demand for chips are linked to industrial capital expenditure. Defensive sectors like healthcare gained 1% last week, on the hope that the Senate will not endorse a plan to lower drug prices. Year to Date the Nasdaq is +23%, the S&P 500 +21% and the Russell 2000 +16% illustrating technology’s and large caps’ leadership in this US rally. Another style angle: growth is still outperforming value this year but the last weeks have seen a rotation into cheaper stocks.
Our overweight call on India saw some traction last week with the Indian market (MSCI India in USD) gaining 5.2% on Friday, back in positive territory in 2019. The Indian government lowered the corporate tax rate for domestic companies, by 8% to 22% (with the effective tax rate lowered from 34.9% to 25.2%). The tax cuts should boost earnings for companies by a corresponding number, improving valuation multiples and return on equity. Indian equities valuation premium (18.9X forward P/E) over the broader emerging markets (13.2X) is justified, only by strong earnings growth, backed by long-term macro development. New companies that start manufacturing in the next four years will be subject to a tax rate of only 17%, to boost production. The government has also removed the additional surcharge on capital gains for all classes of investors to boost the capital markets. These measures will cost the government an estimated revenue loss of $20 billion a year and doubts are being raised as to how a fiscal deficit target of 3.3 % will be achieved. However, the tax cuts put India at par with other large economies. India aims to become a $5 trillion economy by 2025, but a slowing manufacturing sector and sluggish consumer demand have lowered economic growth to just 5% year on year. (June quarter). India needs its economy to grow 8% every year to employ the burgeoning young workforce. This economic growth should translate into earnings growth and equity upside over the long-run.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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