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Chief Investment Officer's team, 27.09.2020
Everything was negative last week. Not just stocks: gold was the worst performer, and fixed income was in the red. The reason? A widening pandemic, a decelerating recovery, and rising political uncertainty, but no additional help from the Federal Reserve.
No doubt, the virus is still expanding, and we have to live with it until a credible vaccine is widely available. The timing is unknown, but this is unquestionably the most important catalyst: it will unleash the rebound of the services sector and boost confidence. Seeing growth decelerating is logical as the post-reopening pace was unsustainable. But it’s worth noting that the goods sector is fine, and that China is booming. The examples of the UAE or Japan, with their proportionally very low number of deaths without full lockdown lead the way in demonstrating that yes, we can deal with the virus
The US elections are less important, but more complex. First, the campaign is intense, which paralyzes Washington at a time when fiscal stimulus is needed. The political opportunity of blaming the other party for doing nothing is apparently too appealing. Another issue is that with a historical proportion of vote-by-mail, the results may not be known on election night, which doesn’t mean that no one will claim victory, prompting the other to engage in a legal fight. The real deadline is December 8th for the Supreme Court to issue results, and volatility could remain elevated until then.
In such a context, we are more neutral than outright defensive: the medium term outlook combines growth with low interest rates, which is not adverse. We are seeing now the turbulence we were expecting for the summer. Like the virus, we have to live with them.
It is tempting to account for recent market weakness with the usual raft of factors ranging from increased Covid19 cases globally, to disappointing business confidence in Europe and the looming risk of contested US elections. We hold the view that, although each of those variables has some explanatory power, the ebb and flow of central bank liquidity has played a major role in dictating market direction. It has been no coincidence that global stocks peaked in early September as US long-dated real rates bottomed and got a second blow when chair Powell failed to add to market-supporting measures at the September FOMC meeting, implying that peak stimulus for the time being was reached. Equities have rerated massively from the March lows, with price-to-earnings multiples expanding in line with the swelling of the Fed’s balance sheet. A peak in liquidity compounded with other kinds of risks clouding the outlook could see multiples deflate somewhat and in general risk assets struggle into the US elections.
In the good old days investors could have hedged portfolios via government bonds, offering a unique combination of steady income and price appreciation during turbulent times. Unfortunately, this is no longer a viable option, considering that both US 10-year and global Treasuries have failed to score any gains in the last four weeks with yields already close to the lower bound. Other common hedges in the forex market, be it for instance the Japanese yen against the US dollar or gold, have not performed any better. Gold should continue by and large to follow equity direction since both asset classes are currently sensitive to financial conditions. The US dollar has on the other hand played once more the role of safe haven, and rightly so, being inversely correlated to domestic real rates which are creeping higher. One may wonder if portfolio managers might be tempted to continue to hoard above-average cash piles in spite of yields being at record-low levels now that equities have become more difficult to hedge and valuations over on the expensive side.
Investors leaning more conservative in their risk-taking approach should welcome the news that DM credit has become less sensitive to market shocks since the Fed’s direct intervention to support IG and the higher quality HY corporate bonds. Spreads of the Bloomberg Barclays US Corporate HY Index did not follow S&P500 volatility higher in the worst moments of the sell-off, pointing to some resilience. Reduced beta to the downside would translate also in reduced outperformance once the bull market resumes. Overall for now credit seems to be in a sweet spot in terms of risk-adjusted returns it can offer.
Market participants will be looking forward to an eventful week, punctuated by the first presidential debate, the release of manufacturing confidence in China and the jobs report in the US.
Fixed Income Update
When technical factors get squeezed out of the markets, investors turn to fundamentals. With most of the capital appreciation in the asset classes behind us since the March mayhem, it seems the YTD returns race is more of a marathon than a 100-meter sprint with only strong fundamentals supporting the asset classes from now on. Last week we saw a broad-based sell-off across sub-asset classes within Fixed Income. We can ascertain the sell-off breadth since only FED backed assets U.S. Treasury and MBS gave positive returns. High-beta assets such as E.M. Debt and High Yield indices saw significant spread widening with H.Y. spreads increasing by c.30 bps and E.M. spreads higher by 15 bps. U.S. 10-year Treasury oscillated between 0.64% and 0.69% last week, closing at 0.65% last Friday. The curve steepened slightly.
We expect volatility to continue in the coming weeks, leading up to the U.S. Elections. We continue to like BBB-rated IG names with duration less than 10-year and G-Spread of more than 250 bps. Even though hunt-for-yield and supply-demand technical support longer duration, we would avoid taking new position in any security with more than a 10-year maturity to minimize volatility in the portfolio. H.Y. spreads above 600 bps would present a fresh buying opportunity, and the same goes for E.M. Assets above 375 bps.
As of Sep 25, the total number of defaults has reached 177, which is more than double that of 2019, similar duration numbers. The oil and gas sector leads the overall corporate default tally so far in 2020, with 37 out of which nearly 70% are from the U.S. The U.S. H.Y. last 12-months default rate is 6.2%, and the global default rate is currently 4.8%. The number of vulnerable companies, according to S&P, is at a historic high of 589, indicating that the default rate could remain high for some time to come.
Fund flows reversed last week's risk-on tone, as the equity-based funds saw a net outflow of $21 Bn. F.I. asset classes saw a Net inflow of $1.2 Bn with the demand for D.M. Govt focused funds stable while High Yield funds saw a net outflow of $5.3 Bn on volatility concerns. Interestingly, EM Local currency bond funds saw the highest inflows since January this year of $1.5 Bn.
GCC markets saw sell-offs in the High yield names. Both Bahrain and Oman's long-dated bond yields widened by more than 50 and 100 bps, respectively. Oman's underperformance is due to the anticipation of a 10-year bond supply. I.G. curves performed better last week with the curve's belly for most of the sovereigns outperforming the long-ends. Market volatility put a pause on the primary market issuance with the most anticipated FAB PNC6 Dollar AT1 sale being postponed as investors observing the developed markets before finalizing the spread
Global equities are down 5% in September so far, wiping out their yearly gains. Developed market equities are close to flat for the year, whilst emerging markets are down 3%. Last week was negative across the board, barring tech. Eurozone equities fell 5% and were the worst off, with European banks selling off post reports of FinCEN money laundering accusations. US banks haven’t performed much better– and are now at 50% of the broader market valuations. Energy stocks lost the most globally 7% last week, along with materials.
When will it be time to rotate into cyclicals? We await renewed growth optimism, a pick-up in yields and any shift in future inflation expectations. Commodity and banks are well valued but need a pick up in global growth, which is again seeing downward revisions. Although the market has built in the possibility of one or more viable vaccines by 2Q, it would still represent a significant moment for markets as any vaccine progress is received positively, including the latest from Johnson & Johnson's experimental single-dose COVID-19 vaccine which has entered the final stage of testing. This is increasing confidence around the path of economy 'normalisation' and would likely lift equity markets, put upward pressure on government bond yields and lead to a rally in cyclical stocks. For now we remain with our preferred sectors tech, healthcare and consumer but reiterate select themes and quality companies. The shift to a more online world continue to provide major demand for digital services. At the same time, worries have increased that this year’s tech rally may have stretched valuations. We shy away from the heady rise of non-profitable EV companies such as Nikola.
September was expected to be a tricky month for equities with uncertainty around more US fiscal stimulus, Brexit and the spread of covid cases. Election and virus uncertainties remain a focus and overshadow the upbeat global reports on September manufacturing and services sector activity. Fed Chair Powell in his Congressional testimony, reiterated the Fed's commitment to supporting the economy, but noted that additional fiscal support will be needed as economic uncertainty remains. With these issues in the forefront, we expect markets to remain irregular for a bit longer. U.S. equities inspite of the sharp daily movements lost only 0.6% on the week, but as we draw closer to the elections, could see even sharper daily movements. This could create buying opportunities, and our medium-term outlook remains positive. Next week remains key given Biden’s lead in national & key state polls. It’s far too early, to be making predictions – but next week’s debate will be closely watched.
Emerging markets had a broad based sell off, down 4.4% last week. The stronger Dollar did not help. We remain over weight Asia and see continued investment into the digital and retail space in India with global players investing in Reliance’s retail and digital arms, seeing India as the blank canvas for consumer growth. The fintech space remains in focus and China’s Ant Group could be the world’s largest IPO, at a valuation of about $250 bn. GCC markets fell last week, but less so than global markets. Retail remains important and KSA’s BinDawood Holding IPO is reportedly receiving strong investor interest, though delayed by a week.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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