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Chief Investment Officer's team, 15.12.2019
Two major geopolitical issues which have been plaguing markets for the last couple of years seem to be entering all of a sudden the rear-view mirror. The US and China agreed on a phase one deal with tariff rollback and at the general elections in the UK the Conservative party won an outstanding majority to get Brexit done.
Markets celebrated promptly, with the MSCI All-Country World Index hitting new all-time highs and US long-dated Treasury yields backing up significantly last Thursday. While the US dollar weakened for the week, gold remained surprisingly resilient, maybe a subtle sign that investor euphoria is running pretty high and risk assets are overbought in the short-term.
Both developments are quite impactful and bear consequences both for the macro scenario and tactical asset allocation choices. The lessening of trade tensions is expected to exert a positive effect on global business confidence and eventually boost capital expenditure and inventory rebuilding, while the dropping of the chance of a disorderly Brexit to basically zero should boost UK investments and have positive indirect effects for the Euro Area as well.
This latest turn of events reinforces our conviction about holding an overweight stance on equities. The non-US economies stand to benefit the most from the easing of trade tensions, in particular the emerging market countries. The US dollar should weaken as the recovery consolidates and risk taking gains hold.
The message put across by chair J. Powell at the last Fed meeting gives reason for optimism. The term ‘uncertainties’ with reference to the outlook was dropped off and Mr Powell communicated the intention to leave rates unchanged throughout 2020, no longer seeing the need for policy insurance given the expected state of the US economy. A stable outlook amidst low and steady rates constitutes a supportive backdrop for risk assets and calls for a bullish view. The easing of geopolitical risks both on the trade and Brexit front adds further fuel to the fire of the reflationary trade for 2020, with more investors beginning to warm up to this prospect.
Should investors blindly embrace this positive state of affairs and expect one more year of extraordinary returns after a surprising 2019? Not really. We advise that excessive optimism be tempered, although we subscribe to the view that 2020 should see at least mid-single-digit returns for risk assets and to some extent reflationary pressures gain ground. Yet, it is difficult to envisage a long and lasting bull market, considering starting valuations levels, late-cycle pressures on corporate margins and trade tensions receding but lurking in the background.
Our conclusion is that this fledgling recovery is not going to be prolonged in time nor is it likely to be outsize in magnitude. While market valuations are an obvious constraint, the focus should be on corporate margins, which limit valuations expansion by acting on the denominator of the price-to earnings ratio. Productivity trends in the US, and all the more so in the developed market economies, have been stagnant since the Great Financial Crisis, posing formidable supply-side challenges. As unemployment rates plumb new lows and slack is removed from the system, corporates will be unable to tackle demand resorting to productivity gains and will have to increase hiring constraining margins and fueling inflationary pressures in the process. At some point margin contraction is expected to drive a new downturn via layoffs.
At the same time, the stand-off between the US and China sees much more at stake than trade claims, implying a clash on structural issues ranging from intellectual property, to dominance of the China Sea and how the world order is structured. As suddenly as trade tensions have receded, they may well as quickly resurface with disruptive effects, especially once the US elections give the new White House occupant the full span of a mandate to tackle what the US sees as “unfair trade practices”.
It could also be the case that market gains are going to be front-loaded in 2020. The growth impulse coming from Chinese stimulus is likely to be more muted this time, since Beijing is minded to avoid financial excesses, the consequences of which are already showing up under the form of defaults of State-owned-Enterprises. Last week China suffered the largest state-firm, dollar-bond default in the last 20 years, as Tewoo Group forced investors to take sizeable losses on $1.25bn of its bonds.
Fixed Income Update
Last week high volatility on bond yields bore out our cautious stance with regards to macro events and market positioning. The gyrations on bond yields remind us that volatility is here to stay with so many unresolved issues carrying over to next year. The benchmark yield on the 10-year US Treasuries spiked to 1.95% last week before retracing to settle at 1.82% post headlines on the phase-one trade deal with China.
The US Federal Reserve left policy rates unchanged, as expected, with the funds rate target left at 1.50% - 1.75%. The communication highlighted that the "current stance of policy is appropriate," and that Fed officials will continue to monitor upcoming information to "assess the appropriate" path of policy, which suggests policy is on hold for the foreseeable future.
Most of the Central Banks across EM remain accommodative. The Central Bank of Russia (CBR) cut its benchmark interest rate by 25bp to 6.25%. The accompanying statement was very dovish. Policymakers have hinted that further rate reductions are likely but has given few hints about the size or the timing of the remaining easing cycle. Moreover, The Central bank of Turkey has opted for a front-loaded policy easing, cutting its one-week repo rate more than market expectations for the fourth consecutive time for the second half of this year. The Monetary Policy Committee (MPC) cut the one-week repo rate by 200bp to 12%.
YTD, bond returns have been driven mainly by the spread compression supported by a flattening of the US yield curve. Investment-grade bonds have outperformed high-yield by over 130bps, and within EM debt, credit has outperformed Sovereign bonds. The GCC bond performance has been outstanding and the region ranks just below the top performer within the sub-asset class category of Corporate IG at 14.22%. The EM primary bond supply has been close to the record levels of $687.15bn witnessed during 2017, and with two weeks remaining YTD EM bond supply is merely short of $5bn to ink as a record year for EM bond supply. Our thesis on the “hunt for yield” has been the main driver and the sponsorship for the fixed income asset class this year with double-digit returns.
The prevailing risk-on sentiment should support EM credit across Investment-grade and High-yielding sectors. With the US yield curve steepening, the positive tone for risk should prevail despite investor looming concerns over the US-China trade relationship front. We remain constructive on the fixed income asset class going into 2020 with a similar strategy bearing in mind our late-cycle positioning. While corporate defaults have picked up sporadically across EM, particularly in Asia, we see value on the current premiums offered against the current macro backdrop.
Saudi Aramco hit the $2 trillion valuation target, in line with our original assessment published before the IPO, on its second trading day (last Thursday). The Aramco listing is the centerpiece of the Crown Prince’s vision for diversifying KSA away from its oil dependence. The company’s market value crossed $ 2 trillion, several times during the day before ending slightly below at $1.96 trillion. Saudi Aramco is now the largest listed company in the world, dethroning US behemoths like Apple, Alphabet and Microsoft. Aramco is to be included in the MSCI EM and FTSE Russel Indices this week which is expected to fuel demand by passive investors. The proceeds of the IPO are expected to be channeled to the PIF, the Saudi Sovereign wealth fund with the aim of investing in mega domestic projects.
A clearer picture on China US trade relations and Brexit is supporting global markets, in what has already been a stellar year for world stocks. It is risk on, into the end of the year with the 10 year Treasury yield at 1.82%. The MSCI World, Nasdaq and S&P 500 indices all notched new highs last week. For the week, the S&P 500 finished 0.78% higher and though Value (+0.87%) outperformed Growth (+0.60%), the cyclical semiconductor sector outperformed, gaining 4.2%. Year to date the best performing global sector remains technology, with gains of 44% while Energy +10% is the worst performing sector. However, the week was positive for the energy sector as WTI crude gained +1.5%.
President Trump has agreed to a limited trade agreement with China. This will roll back existing tariff rates on Chinese goods. New levies set to take effect on 15th December will not be implemented as part of a deal to boost Chinese purchases of U.S. farm goods. This should lead to a pickup in capital investment as companies have been loath to invest as they were unsure of the global trade situation. There will also be lower cost input pressure on margins which should boost earnings, though the impact is fairly limited.
Also supportive of US markets was the Fed holding interest rates steady and signalling that it would keep policy on hold through 2020, as well as giving an upbeat assessment of the US economy.
A good end of the week for Europe with the FTSE 100 +1.6% on Brexit clarity after PM Boris Johnson’s Conservative party won a sizable majority, thus clearing the way for the UK to leave the European Union in January. Domestic UK sectors like banks, homebuilders, utilities and real estate are likely to be supported the most. The Euro Stoxx 600 also rose 1.2% last week supported by ECB President Lagarde’s increased confidence in the growth outlook for Europe and continuity on monetary policy, in spite of slow progress on inflation. Reducing UK uncertainty should also help the performance of European equities, though we remain underweight as US equities continue to generate better earning and free cash flow metrics.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Earlier this year, in our Global Investment Outlook, we expressed concerns on the investment landscape for the next decade, and highlighted the keys to successfully navigate it. We emphasised one in particular: the ability to quickly add or reduce risk, when volatility generates opportunity.Know More
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