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Chief Investment Officer's team, 03.11.2019
Last week was eventful, especially in the US. The Federal Reserve cut its key rate by another 25 basis points on Wednesday, for the third time this year. As we wrote last week, it was impossible to forecast anything else, and the Fed also confirmed our other expectation: this could be the last rate adjustment in a while. Indeed, three cuts this year is the exact opposite of the three hikes that the Fed was forecasting for 2019 a year ago. It thus makes sense to take a step back and observe the impact of such a swing. It is even more reasonable, as the latest macro data, released last week, confirmed some kind of controlled slowdown. US GDP for Q3 came at 1.9%, which is not spectacular but still beats the consensus (1.6%). Job creations for October were robust at 128.000, and the number for September was sharply revised upwards. Finally the October manufacturing ISM was weak, but slightly better than in September.
The bad news actually came from the trade front, with China expressing doubts about finding a long-term deal with Mr Trump, and being authorized by the World Trade Organization to retaliate on tariffs. This is not positive, but a “Phase 1” agreement is still possible, which could convince some investors to reduce their defensive bias when entering the seasonally strong end of year.
Our positioning is doing well, thanks to our contrarian overweight in equities re-initiated in September in particular. We keep this positioning unchanged and reiterate our conviction on EM stocks.
The message delivered by Fed chair J Powell at the October policy meeting suggests that the US Federal Reserve should have concluded its mid-cycle adjustment with three rate cuts. The reasoning is that enough insurance has been provided against the global slowdown and geopolitical risks, hence the bar is now set pretty high for further easing to be administered.
Some investors will be fretting that reduced stimulus could negatively impact risk assets, with markets by now grown accustomed to monetary easing in one form or the other. Yet, this concern is unfounded in our view, since equities in the long run are more sensitive to the economic cycle, e.g. business confidence, than bond yields. Actually, we anticipate that bond yields should rise slightly from current oversold levels alongside global equities, both signaling that the effects of plentiful central bank liquidity are translating in improved business activity.
Risk assets tend to perform best in the so-called recovery phase of business confidence, in particular when the Purchasing Manager Index rises from below to above 50, the threshold between expansion and contraction territory. If, as we expect, Global Manufacturing Confidence clears the 50 level by year-end or early next year, both global equities and government bond yields should be higher versus current levels. And, as already highlighted in a previous issue of this publication, if history is any is guide, it would be reasonable to assume that a cyclical portfolio should do well under these circumstances, up to 10%.
Yet, this time around there is going to be a marked difference versus previous recoveries following a slowdown phase, given that central banks are unlikely to raise rates in view of the muted inflation outlook. The absence of monetary tightening should provide some cushion for defensive assets and bond proxies in general. In other words, with yields anchored by low policy rates and capped to an extent by Quantitative Easing or quasi-QE activity, under the assumption of no tightening one cannot expect a bear market in government bonds, nor in other defensive assets sensitive to yields, like gold, nor should one expect that high-dividend-yielding stocks would be meaningfully impacted.
Hence, under the new normal of low nominal growth rates, depressed yields and the tendency towards Japanization in the Western economies, the massive USD15trn worth of negative yielding bonds is unlikely to be receding significantly anytime soon. Bond proxies and gold will continue to be supported by the search for safe-havens, amidst lingering uncertainty about the growth impulse driving business activity.
Fixed Income Update
Now that the Fed decision is known, focus should shift to crucial economic data and geopolitics, before entering a US presidential year. To remind our readers, the upcoming FOMC is scheduled for December 10-11. With three cuts of 25bps this year, global risk assets have broadly benefited with the low rates backdrop. To an extent, so did safe-haven assets such as the US Treasuries (aggregate index) with a total return of 7.5% YTD. Macroeconomic data out of the US remains mixed at large. While the US labor market remains strong, wage growth is still benign when compared to long-term levels. The manufacturing industry is undergoing a recession with a prolonged period of contraction. This week the focus would turn to gauge the underlying momentum on the US services sector, which accounts for a fair share of the economic activity.
This year's global tally of fallen angels (issuers rated 'BBB-' with negative outlooks or ratings on CreditWatch with negative implications) climbed to 14 as of Oct. 8, said S&P Global Ratings in an article "U.S. Utility Fallen Angels Are Rising." Meanwhile, the global tally of potential fallen angels decreased by one to 47 in October but remains elevated. The utilities sector dominates the count with 13 (seven from the U.S.) after the addition of Italy-based Atlantia SpA.
On the supply side, the treasury department is slated to auction almost $200bn of T-bills and T-bonds this week. The news on ultra-long dated bonds (maturities of 50-Year bonds) have resurfaced last week. The US Treasury Department highlighted in its quarterly refunding statement that "The Treasury is taking a proactive approach to prepare for prospective future financing needs." Currently, the longest duration US Treasury bond is thirty-years. The federal deficit topped $984 billion for the 2019 fiscal year, the highest in seven years. The United States has now over $23tn in national debt, with over $16.7tn held by the public.
Fitch revised Turkey's outlook to stable from negative and affirmed the credit rating at BB-. In a statement, Fitch cited, "Turkey has continued to make progress in rebalancing and stabilizing its economy, resulting in lower downside risks since our previous review in July. The current account balance has improved, FX reserves have edged up, economic growth has continued, inflation has fallen, and the lira has held up despite large cuts in interest rates, buoyed by more supportive global financing conditions and the recent US announcement on removal of Syria-related sanctions". Turkey's current account balance strengthened to a surplus of USD5.1 billion in the 12 months to August, from a deficit of USD57.9 billion in May 2018. The five-year CDS has tightened to 335bp from this May 2019 highs of 520bp. The yields on Turkey's Eurobonds have fallen 50bp to 6.45%, reflecting renewed investor appetite for return. We maintain our conviction bets selectively on the Turkish corporate USD bonds both from a fundamental and tactical standpoint.
Last week saw a robust 1.3% gain for both emerging and developed markets, lifting their 2019 total returns to respectively 10 and 20%. Cyclicals and growth factors are once again in the lead. India outperformed global markets last week, though banking woes remain dominant. The GCC was an exception with both trading volumes and markets down. The KSA has been in the news with Riyadh hosting the Future Investment Initiative with many global leaders attending. The Saudi Aramco IPO has been approved for listing on the Tadawul bourse in December by the Capital Markets Authority and should be the world’s largest listing in history.
US markets reached an all-time high after adding +1.5% last week, returning 23% year to date. A strong dollar is affecting revenues of the most globally exposed industries such as tech and consumer. This headwind was mentioned in earning calls by Amazon, Ford, Coca-Cola and McDonald’s. According to Factset, companies that generate over 50% of their revenue outside the US are expected to report an average 9.1% drop in earnings for Q3 compared to a 3.7% drop for the wider S&P 500 and 1% for domestically focused companies. However, the tech and consumer sectors remain amongst the top performers as the US consumer continues to spend and the products of these companies are global brand names with strong continuing demand. This week’s rate cut could however temper the strength of the dollar, as well as lower cost of debt. This would support margins, which had fallen in the US from the Q3 2018 highs as a result of higher wage costs.
The global tech sector is shining thanks to a slew of very strong numbers from the bellwethers and upbeat guidance. Facebook’s 3Q y/y revenues rose 29%, and income 19% driven by the addition of 35 million monthly global users. Capital spending remains high at $16bn for 2019 as Facebook continues to enhance its core app. For Google and Facebook advertising still makes up 60 to 70% of revenue driven by their dominant digital presence. Social media regulatory scrutiny is being largely ignored by investors as evidenced by their strong year to date performance. Apple continues to grow its services revenue and add-ons including wearables, and also forecast strong iPhone sales for Q4. Samsung projected a gradual recovery in the memory chip market in 2020 as 5G rolls out globally. Amazon, Microsoft and Alphabet all reported strong growth in their cloud services offerings and maintained their dominant global market share. In Asia, Alibaba leads the cloud services segment and benefits from the strong economic growth of the region. Revenues at Alibaba grew 40% YoY last quarter and profits tripled as China’s largest online retailer benefited from growing consumer spending.
The global healthcare sector has also been a standout with Q3 earnings reassuring, in a context depressed by increasing regulation concerns. United Health earnings benefited from cost synergies whilst Merck and Pfizer raised their financial forecasts. The biotech sector has been rising on recent discoveries and approvals.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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