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Chief Investment Officer's team, 07.07.2019
Looking at weekly performance numbers gives a simple “risk-on” picture, with global equities up, led by Developed Markets, and global fixed income slightly down. There was however a sequence, especially as the US markets were closed on Thursday. The start of the week was positive across markets, as the tepid ISM numbers didn’t threaten the consensus for a Fed cut in July. Friday, however, the Non-Farm Payroll number was out: 224,000 jobs were created in June, much more than expected and almost 3 times more than in May. This was strong enough to question the July rate cut, and certainly excludes a 50bps cut. Market reaction was unequivocal: everything was down, except the US dollar.
As a bank, we keep on believing that the Fed shouldn’t waste its ammunition in “pre-emptive” rate cuts and keep them for when it will have to fight a pronounced downturn. But as investors, we acknowledge that doing nothing in July would probably shock markets, prompting them to cut later to fix the situation. The probability for a -25bps cut with carefully worded guidance is thus very high. We will know more this week as chairman Powell will testify before the congress later this week.
Monetary support can be strong enough to propel markets to unreasonable levels, on one hand, but unanimous positioning and expensive valuations also create vulnerabilities. As our YTD returns are excellent so far this year, we stay slightly defensive looking forward.
Following the year-to-date outsize performance across risk assets, we do not find compelling evidence of strong upside in any asset class, either considering the macro outlook or valuations. The increasing tension between the deteriorating fundamentals and the growing wall of money thrown at the system keeps us wondering when a tipping point will be reached.
Although eventually easier financial conditions are likely to positively affect the economy and justify current valuations, negative repercussions on earnings from existing trade tariffs and ongoing uncertainty might come first and hit investments further.
In the very short term, though, we see a cyclical window of opportunity for non-US assets to outperform into the July 31 FOMC meeting, where Fed officials are expected to deliver at least one rate cut, given the intersection with the trade truce agreed to at the G20 meeting. In this respect EM assets, hard-currency credit and equities, look appealing and can be further boosted by a temporary loss of momentum in the dollar, more dovish EM central banks and hopes for a less-dark-than-initially-thought outlook for trade tariffs.
Yet, the balance of factors between what must go right for markets to continue to rise and what might go wrong for volatility to persist seems to be strongly skewed towards the latter. A high-single digit rally in equities from current levels would require almost all the stars to be aligned, from a plan for the rolling back of tariffs to global economic surprises moving into positive territory, while the stalling of the rally would just need the current state of affairs to continue.
We continue to maintain a prudent allocation skewed towards defensive assets and EM bonds, with an equity underweight that we are looking to reverse at more favorable valuations. Duration is not offering sufficient protection against a positive turn in the cycle, hence the overweight in dollar cash against government bonds, reinforced by the inverted US yield curve. EM hard-currency debt still offers an appealing yield pick-up with less exposure to the global cycle versus equities.
Full valuations, correlated assets lifted by monetary stimulus and trend- or sub-par growth can be better navigated leveraging the higher degrees of freedom offered by absolute return strategies, to which investors are advised to allocate at least a benchmark-weight share of the portfolio.
Our approach implies only an opportunistic overweight exposure to equities, with focus on growth-substitutes like credit, or on alternative assets offering a more favorable risk-return profile. As we still do not see a recession occurring on our forecast horizon, market weakness should be seen as an opportunity to add to risk to the portfolio and reverse the currently light equity positioning.
Fixed Income Update
US payrolls data pushed bonds lower, causing a widespread sell-off across most of the DM Sovereign bonds. The June unemployment report was better than expected on the hiring front, although wage growth still needs careful interpretation towards positioning within the fixed income asset class. Notable job gains occurred in professional and business services, in health care, transportation and warehousing. With all the downward revisions on the total non-farm payrolls job gains have averaged 171,000 per month in Q3. Wage growth has been a bit less impressive though, losing momentum in recent months and remaining just above the 3% mark—not enough to generate significant inflationary pressure. The big question remains as to the timing and the quantum of the move that the Federal Reserve is expected to respond with. We still hold the house view for one rate cut of 25bps later in the year, but probability for July is also significant. The Wednesday release of the Fed’s FOMC minutes would be key for investors to assess further on the macro backdrop and to provide for their assessment about the prolonged softness on inflation.
Global Bond yields edged higher post-payrolls. US Treasury yields spiked higher by almost 9bps to 2.04% while their European counterparts also saw yields edge higher between 3bps to 10bps in absolute. The Germany Bund yields have moved higher by 3.5bps after touching its record lows of -40bps. Moreover, the dovish remarks by ECB have also distorted corporate credit spreads. About 2% of the euro high-yield universe is now negative yielding and is expected to rise. Some of the high-yield bonds that offer negative returns are either short-dated bullet maturities or have upcoming calls. It is now widely expected that the ECB’s stimulus would come in through the corporate sector purchase program.
The recent maiden Euro-denominated bond issuance by a GCC Sovereign was well received showcasing a strong demand. The Kingdom of Saudi Arabia raised 3 billion euros from over 14.5 billion worth of orders across eight and twenty years of maturities. The bonds were priced with a fixed coupon of 0.75% and 2.0% respectively.
Indian Budget was presented in the backdrop of soft global macro data, declining GDP expectations of the country, late cycle worries such as slower earnings growth in conjunction with inventory buildup as a result of slowing consumption and limited fiscal maneuverability. As the country aims to double its GDP to USD 5tn from the current USD 2.7tn in the next 5 years, the budget focuses on increasing investments through FDI route, banking sector reforms to improve investor confidence, development of infrastructure and tapping the dollar bond market to take advantage of the current low yield environment. With the market expecting RBI to cut rates in August (Emirates NBD expects a 25bps cut in the coming months), we expect a bull steepening of the Indian yield curve with short term bond yields to fall swiftly.
Now aptly titled the “Rally of Everything”, risk assets and safe haven assets were moving in the same direction till last week, when oil and gold faltered. Equities however, have continued on their upward trajectory, with the US maintaining its momentum and lead. The S&P 500 Index gained 1.7%, and is 10 points shy of the 3000 mark, with similar gains from the Dow and Nasdaq indices. All three narrowly missed finishing the week at record highs. The week earlier, stocks had benefited from a more dovish Fed and a trade truce at the G20 meeting that included no new tariffs, an agreement to restart negotiations, and a reprieve for Huawei. The stronger-than-expected reading from the June payrolls brought the market lower on Friday but didn’t reverse the weekly gains, despite raising questions on the Fed’s July decision.
Valuations are at the higher end of long term averages for US equities and year to date returns from US markets are already +20%. It would take a significant catalyst for the market to move any higher. Just a Fed rate cut itself is not enough, economic and earnings growth both need to remain resilient with wage inflation supporting consumption. Manufacturing data hasn’t been encouraging though the US economic cycle is in its 121st month of expansion, the longest in history. 10-year Treasuries continue to trade at a lower yield than the three-month: historically a reliable recession predictor. Capex growth projections for US companies are lower for 2019 at 3%, as per S&P Global, from 11% in 2018. Earnings season begins next week with expectations of a 2.6% decline in EPS for S&P 500 companies according to FactSet, though a 3 to 4% beat is usual. We expect sideways consolidation for US equities near term.
The KSA markets are gaining participation from global investors on account of the EM index inclusion and the high yield offered by many of the companies in the banking, petrochemical and cement sectors. The last has begun a late rally with many cement companies at a 52 week high. As oil prices go up and the KSA government starts to focus on infrastructure spend, cement companies should continue to benefit. Within this context, KSA has revived discussions for an IPO of Aramco (as per media reports). Last year a USD 2tn valuation was under consideration. Aramco inclusion could take Saudi stocks up to 4.6% of the MSCI EM Index.
We see the Indian budget as a non-event for the market. India’s better collection of taxes, accelerated infrastructure creation, increased use of savings in the financial system and a possible healing of corporate India’s balance sheets continues to keep us constructive on equities. Though large corporates and high net worth individuals have higher income tax surcharges the vast majority of the middle income earners will benefit and we see the surplus savings going towards consumption. The government has toned down the Goods Services tax while raising spend in agriculture and rural areas as well as “social spends” – education and health.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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