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Chief Investment Officer's team, 17.11.2019
Last week was quite rich in terms of economic data and speeches from Central Banks officials. The numbers were overall not bright, with soft manufacturing indicators, but also some deceleration in the so far resilient consumer spending in the US. Consumer prices were also slightly higher, supporting the Fed’s stance to stay on hold on rates, which was confirmed by Mr Powell’s remarks before the congress, and should be more detailed in the minutes of the FOMC, to be released on Wednesday.
In a nutshell, there was nothing new, and if markets were overall positive last week, it was mostly due to the fear of missing out, from very defensive investors, as the end of the year is approaching. During our own tactical asset allocation meeting, we also decided to reduce our underweight on Global Listed Real Estate, which was a drag on our performance. 2019 remains excellent in terms of returns, with our three profiles delivering respectively +9, +12 and +14% as of last Friday.
We are working on our perspectives for 2020, and it’s not a simple exercise. The near term however looks quite binary, around the chances of US and China to reach a material “Phase 1” deal. This is why our current tactical asset allocation is not drastically divergent from our strategic asset allocation, with selected active positions: a slight overweight in cash, a long term conviction in Emerging Equities, funded by a slight underweight in fixed income and listed real estate.
Global markets have taken notice that economic conditions overall are stabilizing, especially in the manufacturing sector so far hardest hit by the loss of confidence driven by trade-war uncertainty. Sentiment indices and newsletter surveys, the latter yet another means of measuring investor sentiment, have not only turned undoubtedly positive, but are also pointing to a bit of ebullience, usually associated with a less favorable risk-return trade-off for risk assets in the short-term. This should not come as a surprise, considering that year-to-date equity returns are on average in the high teens, nor should this be a source of concern for the longer-run, provided that trade war headwinds continue to abate.
The medium-term outlook for markets seems to be more than ever predicated on successful US-China trade negotiations. Exacerbating trade conflicts would have dire consequences indeed, as per studies released by major investment houses. The details of the analysis conducted change, but the prognosis remains the same, that tariff escalation rather than roll-back would eventually weigh significantly on economic growth, hence cause risk assets to reverse course. Given sentiment and valuations levels, and that trade tariffs ranked amongst the top concerns in the last reporting season, investors will most likely sharpen their focus on the next slightest bit of US-China news-flow.
While the proposed Trump-Xi meeting seems to have been postponed to December this year, DM equities have in the meantime made new all-time highs also under the expectation that the latest round of import taxes would be lifted, and EM currencies have run ahead of the valuations justified by current Global PMI levels partly on the same premise. It seems that risk assets are to an extent already discounting a favorable outcome, making any disappointment in the ongoing negotiations all the more relevant. One would expect that the risk premium attached to the outcome of trade talks would be highest shortly before the event, and with that market volatility. Yet, this becomes indeed difficult to gauge, due to Mr Trump’s notorious unpredictability.
Barring any trade-war setbacks, under a recovery scenario one usually upgrades the outlook for risk assets, that we have done being overweight equities, and downgrades that for the dollar. As growth upgrades spread to more countries and the recovery gains breadth, the flow of funds tends to leave US assets to be directed towards higher-growth countries, more sensitive to the improving business cycle. This time around we would be more cautious before turning outright negative on the US currency, considering that growth upgrades outside of the US still lack sufficient impulse, the US services PMI surprised to the upside and as mentioned above Trump’s unpredictability can still play quite a role. If indeed, as we forecast, in 2020 the global economy heals and trade tensions abate, then a temporary but significant dollar setback should be expected.
Fixed Income Update
In a reversal of the last couple of weeks’ trends, the broader Developed Market bond indices staged a minor recovery this week. The Global HY index gave up some of the gains with European HY bonds being affected the most due to soft macro headline data. The reassurance by the Federal Reserve to maintain rates on hold kept US Treasury yields elevated. US benchmark Treasuries are now at 1.83% after briefly touching the 1.94% level. The US yield curve saw some modest flattening across the curve. The most-watched part, the 10-Year minus the 3-months, has edged higher to 26bp from the minus 51bp witnessed in summer this year. A Reuter’s poll of economists indicates the Fed will wait until Q3 2020 to make its next interest rate cut. The probability for the US economy to move into a recession has decreased to under 25% from 35% a month ago.
The Federal Reserve Bank of New York has released the schedule of repo operations for the monthly period from November 15, 2019, through December 12, 2019. Following the most recent FOMC directive, the FED will continue to offer at least $35 billion in two-week term repo operations twice per week and at least $120 billion in daily overnight repo operations.
Economic activity in China missed estimates broadly across some of the critical indicators. The downside surprises in investment and retail sales, together with weakness in official manufacturing PMI and credit growth, point to lackluster domestic demand. That said, liquidity in the domestic banking remains awash and has provided strong support for corporates. The average credit spreads on Asian high-grade USD bonds have compressed from 175bp to 131bp YTD, while sub-investment grade bond spreads have also tightened dramatically from 654bp to current 509bp.
Lower inflation driven by a sharp deceleration in food costs allowed the Egyptian Central Bank to reduce its policy rate by 100 bps last week. The deposit rate currently is 12.25%, and the lending rate is at 13.25%. The latest inflation measure is at 3.1% resulting in a real yield of 9.15%, which is one of the highest among the major emerging market economies. Resilient Egyptian pound, coupled with a high real rate, continues to make Egypt the most lucrative carry trade opportunity for fixed income investors. Egypt issued USD 2 Bn of 4-year/ long 12-year/ 40-Year bonds at 4.55%, 7.053%, and 8.150%, respectively, last Tuesday.
On the other hand, Indian CPI ticked up to 4.62% against the consensus estimate of 4.35%. The inflation is still within the RBI’s target range. The slowdown in economic growth continues with Industrial Production plunging to -4.3%, which is the lowest level since 2011. Similarly, Indian imports decreased sharply last month, highlighting the weakness in demand. The sluggishness in the economy would force RBI to continue easing the monetary policy. We expect Indian Rupee to come under downward pressure, especially since the FED has confirmed a pause to the rate cuts. The short duration Indian Govt and local currency corporate bonds should benefit from these anticipated rate cuts.
A good week and a good year (so far) for equity markets. Saudi Aramco has announced its pricing and will join the ranks of other trillion dollar companies – Apple and Microsoft. US equities continue to make new highs with several consecutive weeks of gains, with the S&P 500 at 3120, the Dow at 28004 and the Nasdaq at 8540. In trade, sentiment improved after economic advisor Larry Kudlow said that “both sides are close to an agreement”. Buybacks are at record highs in the US, the 6th highest week of buybacks on record. Earnings deceleration does not seem to be impacting the market, but 2020 revisions will be watched carefully. We have not revised our year end fair value for the S&P 500 upwards from 2900, though we expect supportive monetary policy and earnings stabilization to hold the Index steady.
At the global sector level, healthcare continues its breakout, +1.8% for the week and +17% year to date. Technology is now +40% year to date, almost double that of any other sector. The FAANG’s are making new records, backed by stellar earnings. Google announced a foray into financial services, following Apple’s foray into cards. Netflix is seeing strong competition from Apple TV+ and Disney+.
We confirm our overweight stance on emerging Asia, as we see signs of the trade tariff deescalating. Economic growth whilst slowing is still the highest contributor to world growth, with India and China the major contributors. The US Dollar should stabilize and the week ending 13 Nov saw EM equity funds (ex-China A) reporting inflows of US$2.88bn, driven by inflows into ETF funds of US$2.61bn. EM Asia valuations are attractive at 14.6 X Forward price/ Earnings compared to the US at 19.1X, historically almost the highest differential on record. Consumer growth remains strong – Alibaba’s China’s singles day recorded US$38 bn of sales +26% y/y. We see an emergence of strong regional Asian tech companies (Samsung and TSMC). Alibaba is scheduled for an IPO in Hong Kong in November, to reduce dependence on the US.
We move from an overweight stance on India to Neutral. This has been one of our favored geographies since PM Modi came to power in May 2014 and Indian equities have returned +44% (in USD) since then, double that of emerging markets. We are worried about Non-Banking Financial Corporations, after years of outgrowing banks on credit growth and profitability, defaults have risen. Our preferred consumer durables sector valuations is at all-time highs. Auto sector sales are facing a cyclical downturn. The long term secular story seems to be interspersed with volatility.
We shift from an Overweight position on the UAE to Neutral. Whilst UAE markets remain undervalued and are trading at 7.4 X Forward price/ Earnings compared to EM at 13.7x and GCC at 12X, the low volumes do not indicate a near term pick up.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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