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Chief Investment Officer's team, 05.12.2021
The working week was shorter in the UAE but eventful on global markets. Shockwaves from the new variant continued to impact markets, with interest rates falling, and profits being taken in technology stocks and crypto assets in particular. The week also confirmed a more hawkish tone from the US Federal Reserve, and brought an avalanche of monthly economic data. November was not bad. Factory reopening continued in Asia, supporting global manufacturing activity and starting to ease the supply chain issues. Services were resilient, with the US ISM exceeding forecast. US job creations fell short of expectations, but the unemployment rate and wage progressions were net positives.
Of course, all that matters is Omicron, which is inevitably spreading with cases now reported everywhere. The situation from an investment perspective is both binary and frustrating. Binary: either the severity of Omicron illness is comparable to previous variants, especially for vaccinated people, in which case markets may have already overreacted, or it is worse, in which case the economic outlook will be materially affected. It is frustrating, because we don’t know yet. Early indications from South Africa support the thesis that the variant is highly transmissible but is not more severe than Delta. In the meantime, the principle of precaution leads to more travel bans and restrictions, which will affect the Northern hemisphere in particular. At this stage, we don’t change our scenario, especially as the world has proven it can provide effective responses to any adverse situation.
Developments of the pandemic will be the single most important driver for markets in the short term. Next week will provide important data, especially on US inflation and Chinese trade. Stay safe.
Ten days ago on Friday, news of the Omicron variant broke out, and panic spread to the point that investors saw one of the largest number of assets with moves exceeding the two standard deviations since the late 1990s. When moves are large enough, professionals subscribe to the notion that a repricing of growth must have happened, of course in this case towards more subdued growth. The pricing of Fed hikes in the Eurodollar futures, based off the 3-month Libor, also changed, with only five quarter point increases now discounted into 2024, which is about half of the total tightening implied by the Fed forecasts, followed by 2025 already reversing to cuts. Pricing changed first after Powell’s hawkish turn last Tuesday, as he mentioned accelerated tapering and markets obviously remained unconvinced about the Fed’s ability to stick to the plan, and then following the less strong than expected jobs report on Friday. Inflation scares or not, investors are making a call that ultimately the economy is still very much susceptible to deflationary winds, with full policy normalisation a distant dream in spite of the latest massive monetary and fiscal stimulus.
In this publication we have already expressed the view that the political and economic costs of steep tightening would be too much for the Fed to bear, so if anything markets have got somewhat closer to our viewpoint. If we have an opinion on rate hikes, what about inflation? Although uncertainty is high, some signs of easing supply constraints, from retreating RAM chip prices to peaking shipping and container rates, are showing up. Indeed, a new virus wave would be delaying the easing of inflation pressures, but each wave has proven to have less dramatic economic consequences than the previous ones, and this time should be no exception. Policy and inflation uncertainty are driving, via heightened rates volatility, the current spreads widening across IG and HY credit, as well as in USD EM bonds. More evidence is needed that in the end Mr Powell will be less hawkish than he is currently sounding, and that inflation is indeed abating, for credit spreads to settle down again. At the same time, we cannot fail to notice that rates volatility, since the Great Financial Crisis, was higher only during the so called 2013 ‘taper tantrum’, when Bernanke announced the removal of QE, if we count out the 2008 recession. Hence, we conjecture that maximum spreads widening should not be too far removed from current levels.
With limited visibility on policy and inflation and the new variant scare still fresh, we would think that US centric assets - equities, credit and the US dollar - for the time being will continue to outperform in relative terms. Once more, more trouble around should see more US exceptionalism.
Fixed Income Update
The year-end "Twist" is here. With everyone focused on inflation, Covid-19 and Chairman Powell seemed to have twisted the US Treasury curve. The hawkish comments from Powell about inflation not to be considered "Transitory" lifted the front-end of the curve. But the increasing closures due to the new Omicron variant and weaker than estimated US Jobs data have resulted in a quality bias in the minds of Fixed Income investors leading to a drop in long-end treasuries. As a result, the 10-year yield closed the week at 1.34%, hitting the lowest level in the last two and half months. This is also the biggest weekly drop in more than a year which makes us even more concerned about long-duration assets.
While these are very early days of this new wave, the first of the modified mRNA vaccines could hit the market next quarter, calming investors and leading to snap-up movement in the treasury yields. Moreover, the credit metrics of the majority of the issuers barring China HY remain strong. We have had close to 50 rating upgrades this year, the highest in the last five years. Issuers have built up a war chest of liquidity. Hence, we believe that any dip is a buying opportunity within Fixed Income. We would be happy to add to our High Yield position if spreads widen from current levels by another 25bps.
Last week was positive for most of the segments. Investment Grade Duration outperformed other credit segments due to the large movements in yields. Stabilization of spreads helped the riskier corners of credit as both High Yield and EM Debt provided +.45% and +0.85% respectively last week. The 2021 global corporate default tally remains at 67, with no defaults since Nov. 18. There have been just seven defaults so far in the fourth quarter, down from 13 in the third quarter. With the continued slowdown in the number of defaults, the 12-month trailing speculative-grade default rate for the US declined to 2.0% in October 2021 from 6.6% in January 2021, while the European default rate fell to 2.5% from 5.1% during the same period.
It was another bad week for China High Yield as Evergrande expressed its inability to honour $260 mn of guarantee, which could result in some creditors demanding to accelerate the payment of their debt obligations. However, on Friday, there was some good news as PBOC said they support the Guangdong govt's dispatch of experts to the company to oversee and improve the company's risk management and internal controls and help Evergrande maintain normal operations. The People's Bank of China said it would cooperate with the effort and work with other agencies and local governments to help lower Evergrande's risks and maintain stability in the country's property market. Moreover, the PBOC officials mentioned that the offshore funding market knows how to price risks, and one-off defaults would not undermine the fund-raising function of the market for the medium and long run. Therefore, the Asia HY market does offer interesting bottom fishing opportunities for aggressive investors who should be cognizant of extreme short-term volatility.
Equities had a volatile November, and the start of December has been even more so as markets face a double challenge from a renewed covid-driven growth scare and a tighter monetary policy shift. Magnifying these uncertainties, is the approach of year-end. Equity markets had been relatively immune to covid-related headlines this year; however, the emergence of a new variant has always been a key threat to markets that had begun looking at reopenings and increased mobility as a return to normal. At this stage we don't have enough data to predict the impact of the Omicron variant. Economists think the world economy should weather any impact easily as governments would step in with fiscal boosts and monetary policy tightening would get staggered, though Fed Chair Powell executed a hawkish pivot at the end of last week. On a global stock market perspective, policymaker and consumer responses will be key regarding the economic impact. Market volatility is unsettling, but not unusual, with 5 to 10% drops once or twice a year the norm and providing opportunities to buy cheaper. A diversified portfolio with relevant risk tolerance, should weather any temporary pullback. We expect markets to remain volatile near term as countries increasingly introduce mobility restrictions. We are cognizant of risks, but constructive on equity returns and would focus on quality companies with resilient margins from a bottom-up approach and asset allocation overall to balance risk and returns.
Global equities fell -2.4% in November and -0.3% in the first 3 days of December. There was a wide variance in performance across geographies and sectors with quality outperforming and over extended stocks falling sharply. Leading markets in November was the UAE +8%, with flat to mildly positive performance from the Nasdaq and China mainland indices. Most other markets saw a negative November performance with the Hang Seng Index -7.4% and the MSCI China -6%. The S&P 500 fell 0.7% in November and remains volatile but year to date gains at +22% are significant. The KSA Index fell 8% in November in line with the fall in oil prices, but capital issuance continues to be received well and the Tadawul Exchange IPO priced at the top of the range and was 121 times subscribed. China US relations remain strained and the Golden Dragon China Index fell 9% on Friday and 17% in the last one month as the announced delisting of Didi is impacting 240 Chinese companies with a market cap of over $ 2tn listed in the U.S. The only positive global sector in November was technology +3%, as Treasury yields fell and also as stay at home stocks were again the favourites. These gains were wiped out last week as tightening talks are again at the forefront.
Reopening stocks such as restaurants, department store, leisure and transportation have been amongst the biggest decliners since the discovery of the Omicron variant. The Bloomberg World Airline Index is down 14% in the last one month. Airlines face the uncertainty of mobility restrictions and increased testing (the U.K. has reintroduced tests on arrival). With vaccine advances mobility restrictions should reduce as vaccine makers have been quick to work on vaccines for the Omicron variant. Moderna is hopeful of a modified vaccine by early 2022, dependent on FDA approval and Pfizer has a similar timeline. Vaccine makers: Moderna stock is +193% YTD, +Pfizer 53%.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Digesting a more uncertain outlook
Inflation, infections, inflexion
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