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Chief Investment Officer's team, 06.10.2019
The relatively flat returns of last week across markets don’t reflect their significant volatility. Weak US economic data was the key reason, on top of political uncertainty, from Washington to London.
In the US, both ISM indices missed the consensus, fuelling recession fears and depressing risk assets. Job creations and wages, released Friday, were good enough to reinsure, but weak enough to support expectations for the Fed to cut rate as soon as October. The perspective of monetary support, meeting investors’ very defensive positioning, explains the overall flattish returns of most assets, which is also the reason why our positioning is only moderately defensive. Yes, this is the end of the cycle, but massive monetary support could lift valuations across all asset-classes, especially if the global economy stagnates instead of collapsing. Investment conclusions are definitely not obvious, and the imminent start of the Q3 earnings season will give precious insight.
Another unknown is the trade war. To some extent, the context creates an incentive for Mr Trump to make some concessions to China, which would relieve markets and business sentiment. From a Chinese perspective, dealing with Mr Trump now could make more sense than waiting for his unknown successor. As Sun Tzu wrote thousands of years ago in the Art of War, “the way is to avoid what is strong and to strike at what is weak.” We are not expecting a comprehensive deal, but both parties, and markets, could benefit from a partial de-escalation.
Manufacturing business confidence matters a lot to global stocks, since their yearly returns are highly correlated with this sentiment measure. The accelerated selling which hit equity markets when US manufacturing was reported early last week way below expectations and deeper in contraction territory is understandable. Yet, performance in the industrial sector is not highly correlated with US economic growth and details in the report suggest that there should not be too much room for further deterioration. At the same time, uncertainty about trade war developments have hit animal spirits heavily, hence investments are unlikely to recover until at least a truce is agreed upon between the two sides.
Although further hiccups in business confidence are likely to buffet risk assets and intersperse their performance this year with more drawdowns, we do not see recessionary conditions as being imminent. Typically, in the five years leading to past recessions the cumulative leverage in the US private sector reached specific tipping points which are nowhere near the current relatively more subdued levels of corporate and household indebtedness combined.
Market bears might be looking to the rapidly mounting momentum in president Trump’s impeachment as a major source of uncertainty, to justify protracted market weakness. Yet, historical records on past impeachments do not bear this kind of conclusion out. Indeed, each event unfolded against the backdrop of specific macroeconomic conditions which mattered more than each single presidential drama. Impeachment this time could be positive, if it forced Mr Trump to reach a trade deal sooner for the purpose of regaining popularity, or rather be negative, if China decided to sit on the fence under the expectation that Donald Trump will lose the 2020 elections.
Looking into what accounted for past returns is a better course of action to get insights into future market direction than relying on the latest big headlines. Since late January 2018, when the US-China trade war broke out, global bonds, with low double-digit returns, have outperformed global equities, with losses in the mid single-digits. Only large-cap US equities have managed to stand out and boasted some gains, which have anyway not been significantly above those of US dollar cash to justify taking equity risk. Risk assets have been the major casualty of the worst trade war since the ‘30’s and they might have fared much worse had it not been for continued monetary support and the late-cycle US fiscal stimulus. We are thus inclined to conclude that a policy surprise, from the US Federal Reserve or in the form of tax cuts in Germany, or a durable trade truce between the US and China could constitute a turn of events significant enough to boost global equities to new all-time highs. In the meantime, range-trading seems to remain the most likely outcome.
Fixed Income Update
Weak economic data, heightened trade tensions, Brexit woes, and headlines on impeachment talks provided a strong backdrop for safe-haven bonds. The US Treasury yields have moved towards 1.50%. The market-implied probability for a 25bp cut had risen swiftly considering the recent macro-related events for the 29-30th October FOMC. While the global manufacturing slowdown had been priced-in by the bond markets, the recent incoming consumer-related data out of the US had also begun to show weakness causing broad-based concerns for the economy.
The US payrolls report for September was weaker than expected across jobs creation and wage growth. The headline jobless rate in September dropped 0.2% to 3.5%, the lowest since December 1969. The US economy added 136,000, marginally below consensus (145,000). The job gains were concentrated in sectors such as health care and professional and business services while retail and construction sector showed weakness. The wage-component of the unemployment report was a disappointment, with no change on the average hourly earnings for September at just 2.9% for the year.
The Reserve Bank of India cut its benchmark repo rate by 25bp to 5.15%. This is the fifth policy rate cut (cumulatively 135bp) by policymaker’s in a move to stimulate economic growth. The RBI also reduced their growth forecast for the fiscal year to 6.1% from 6.9%. The benchmark Government bonds are attractive in our view, and we expect the yield curve to flatten. We favor the short-end of the yield-curve and anticipate the real-yields to reflect the current inflation levels. Within the corporate bond markets, we maintain our cautious stance given the stress across certain sectors that have been influenced by the NBFC. We remain opportunistic buyers on the Steel and Airport-services sector.
The World Trade Organization cut its global trade growth forecast for this year to the weakest level in a decade, warning on further rounds of tariffs in an environment of heightened uncertainty. The volume of merchandise trade will increase by 1.2% this year and 2.7% next year, after a 3% advance in 2018. The recent outlook marks a sharp downgrade from the WTO’s previous projections in April this year.
On the new issuance front, Dar Al-Arkan (KSA real estate company) is expected to raise a USD-benchmark sized, Long-5 year fixed-rate senior unsecured Sukuk.
The Kingdom of Saudi Arabia is also expected to return to capital markets with a Sukuk issuance.
In EM Asia, HPCL-Mittal Energy (India) and Thai Oil (Thailand) are expected to issue benchmark size Eurobonds.
The start of October saw most global equity indices fall c. 3 to 4% as unexpectedly poor data on U.S. manufacturing and payrolls stoked worries about economic growth. Manufacturers' sentiment has been weak since H2 2018, due to the ongoing issues around US-China trade tariffs, with a perceptible slowdown on capex spending and a strong dollar. US markets recovered at the end of the week, as the US September jobs report helped ease fears about an economic slowdown. Other global markets didn’t fare so well. The S&P 500 ended last week -0.3%. Tech and Healthcare finished the week stronger, up +1.1% and +0.9% respectively while Energy sold off 3.8%. European equities fell -2.3% and Japan -2.1%. EMs fared better than DMs with China in the green, however the GCC and Indian equity markets fell c.2% last week.
While the ISM manufacturing survey accurately represents industrial activity, it's not necessarily a great predictor of earnings on the S&P 500, with shrinking exposure to manufacturers. Goods-producing industries in the index are 49% of the market cap, down from a peak of 60% in December 2009 (Bloomberg data). What is affected most, are the sectors most sensitive to manufacturing activity i.e. industrials, energy and materials (which we underweight). These are 16.5% of the market cap, down from a high of 28.2%, and below the five-year average of 20%.
Global equities have had a stellar run this last decade, with the MSCI All Country World Index almost tripling from its March 2009 low. While the recent run of bad data has led to doubts as to whether Q4 may be a repeat of 2018, easing monetary policy evidenced in the US, Europe and Asia, should continue to be supportive. We reiterate our preference for U.S. equities in the developed market space and for India and the UAE within emerging-markets. As regards sectors, we favor information technology and health-care, while being underweight financials, despite their low valuations, and also industrials, on the back of slowing global growth and lower capital expenditure.
We see Q3 earnings, as the most important catalyst for the near term path of equities. Expectations are low for S&P 500 companies, with EPS projected to decline 3% y/y, a substantial lowering from the 5.3% Q3 growth estimated at the start of 2019. The 2.5% earnings growth estimated for 2019 is also lower than the 8% initially estimated in Jan 19. Analysts haven’t yet changed earnings expectations for 2020, at +10% growth, unchanged from the 10.2% at the start of 2019. Revenue is likewise expected to climb 4.9% in 2020, unchanged from the 5% forecast at the beginning of 2019 and much above the 3.9% revenue growth forecast for 2019.
GCC equities were downbeat last week, partly reflecting the fall in oil prices. Volumes have fallen to less than $50 mn of daily traded value on the Dubai and Abu Dhabi bourses. As per report, the Saudi Aramco IPO is going ahead, with estimated valuation ranging from $1.6 to $2 tn. This is at the core of efforts to modernize the KSA economy and diversify the revenue from oil and also increase foreign participation in the KSA bourse. Currently the UAE has the highest foreign participation amongst all GCC bourses, with Dubai at 18%.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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