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Chief Investment Officer's team, 09.08.2020
The summer so far is very positive for global markets, with a strong start to August. Almost all asset classes delivered positive weekly returns, with the only exception being government bonds: interest rates were slightly firmer due to positive economic data. Actually, most activity reports, from leading indicators (PMIs) to the US monthly job reports, were pointing to a firm global growth momentum. Stocks were up, as well as oil, and our Dubai market stood out with +2.8% last week. However, the relentless progression of gold prices, on which we are overweight, reminds us that risks remain.
Pushed by retail enthusiasm meeting institutional investors’ defensive positioning, markets are blurring the line between resilience and complacency. Risks are not only well known, they are rising: the virus is still not under control in the US, where negotiations to replace the expired weekly benefits for the unemployed haven’t succeeded yet. In addition, tensions between the world’s two largest economies are as high as ever, escalating above simple verbal rhetoric.
There is a dilemma for asset allocators: downside risk is significant, but momentum is strong. We were, and still are, expecting turbulences in the summer which have so far not materialized. However, as a dilemma means a low level of confidence, we had decided to have an only moderate underweight on risk assets, mostly DM stocks and Hedge Funds, and to keep an Overweight in Gold, which works fine so far. This combines with the benefits from our previously more convinced moves, especially cutting risk in February and adding in March: our three recommended asset allocations are so far firmly positive year to date at respectively +5%, +4% and +3%. We keep our positioning unchanged for now.
“Never say never“ the old saying goes. We see room to apply these popular words of wisdom to financial markets as well, in particular where investor psychology may have developed a set-in-stone view about future asset trends. Currently the foundations seem to be laid for a one-way bullish trade in gold and a bearish one in the US dollar, with the former up 34% and the latter down 3.1% year-to-date. The case for riding the trend in gold ‘forever’ is seemingly obvious, ranging from central-bank money printing to the potential for future inflation and the debasement of developed-market currencies where Quantitative Easing is rampant. In a similar fashion, one could argue against the dollar weakened by crushed policy rates, rising deficits and a flagging economy in the wake of the pandemic. In our view it is not as simple as this. While the US dollar is still overvalued according to longer-term pricing models, the case for considerable upside for gold from current levels is questionable. And for the dollar we would rather argue in favour of selective weakness rather than a broad-based bear market.
Falling yields and central-bank support guaranteed across the forecast horizon have been the main drivers of the bull market in gold. It is a well-known fact that gold tends to outperform at the end of the cycle, but also that equities become a competitive asset once the path out of the recession becomes clear and the recovery gains traction. A case in point is Friday’s US labor market report pointing to continued jobs recovery in spite of the resurgence in new virus cases, with gold losing 1.4% the same day on profit taking and Treasury yields rising. Unless the United States have already undergone a full Japanization process, repeated bouts of stimulus should eventually filter through every corner of the economy, boosting equities alongside long-dated yields and making gold less appealing. Also, Treasury issuance should reach record levels with the US fiscal deficit projected to be at 15% of GDP this year, leaving room for upward pressure on yields even taking into account Fed purchases.
Negative dollar sentiment is running so deep that unwarranted doubts about its role as a reserve currency are again resurfacing. Indeed, the yield differential with other currencies has decreased substantially, but the economic outlook has not been dented yet so much as to justify a disorderly fall. The European Recovery fund has removed tail risks associated with a possible break-up of the common area, but is no guarantee of structurally stronger growth in Europe versus the US, hence it does not imply uncapped euro upside. Covid-19 new cases, which were rising relatively faster in the US, have now peaked, while in Europe and Asia have started to rise again, removing the case for a so-called negative US exceptionalism marked by deteriorating virus dynamics and its adverse consequences on the economy.
Overall, we see the case for gold being close to peaking and the dollar to rebounding from current levels. Consensus view may well be different and we would be remaking to that: “Never say never”.
Fixed Income Update
Bond investors’ focus is shifting to the September policy meeting, when the Fed is expected to review its framework with emphasis on inflation targeting. Fed officials are keen to signal that they mean business about achieving their goal, proposing as per Fed watchers’ view to keep policy rates anchored until price pressures have been rising enough and unemployment has reached pre-crises levels. This would basically imply close to zero Fed funds rates on a multi-year basis, possibly raising inflation expectations and eventually inflation itself. Even though upward pressure would be exerted on bond yields, the Federal Reserve would continue its action of financial repression and cap the rise of Treasury yields in order to prevent a surge in the cost of servicing debt for the US government. Yet, for the time being bond yields will continue to fall, discounting low rates on the forecast horizon, until evidence of higher inflation or meaningful traction in the current recovery convince market participants that the Fed’s efforts are rewarded. Money markets are discounting zero rates for about 3 years from the policy meeting, which is no mean feat considering the current fiscal stimulus to the tune of x% of GDP.
It is obvious that the Treasury market is now finely balanced, on the one hand already pricing in ultra-loose conditions for the longer term, on the other on high alert for any signs of a pick up in price pressures. While sustained inflation is not our base case, higher yields from the currently depressed levels may well be possible, once the recovery becomes more robust, with material consequences both for bond and equity investors. The risk-reward for higher-quality bond holders has become particularly asymmetric now, hence the question remains open on how to hedge the potential for rising yields on a multi-year horizon. Within a pure bond portfolio, increasing cyclical bias to reduce duration risk would imply increasing exposure to high-yielding corporate bonds or to EM debt, both offering some buffer via larger coupons. In a multi-asset portfolio, we would advise to follow our Strategic Asset Allocation built to preserve clients’ capital on a 3 to 7 year basis depending on the client’s risk profile.
The Reserve Bank of India in retained the Repo Rate at 4%, maintaining its stance as “accommodative” to revive growth and mitigate the impact of COVID-19 on the economy. Ahead of the expiry of a blanket loan moratorium later this month, in order to support the stability of the banking sector where bad-debt is at a two-decade high, the RBI gave lenders power to restructure certain loans. Banks’ gross bad loan ratio could rise to 12.5% by March 2021, the highest in over two decades, from 8.5% a year earlier, the RBI predicted in a report last month. India’s economy remains affected by the virus outbreak, although foreign exchange reserves rose nearly $12 bn last week, its biggest increase on record, as the RBI mopped up foreign inflows and the dollar weakened. As at 31st July foreign reserves were at $534.6bn. The INR however, is relatively less changed against the US Dollar as compared to major peers.
Global equities were up 2.1% for the week, despite exacerbated U.S.-China tensions, the continuing rise in global COVID-19 cases and stalled talks in the US Congress around a new fiscal relief package. Some US investment houses are expecting a quicker economic turnaround with a vaccine expected by the end of the year, even as early as this autumn. We would await more data on broader testing before building up hope. However, encouraging July global PMI reports suggest a recovery in economic activity, supported by Friday's upbeat U.S. nonfarm payroll figures. Along with a rally in safe haven assets, the major markets had a positive week from Asia to Europe with Japan leading with a 3% gain and China lagging but still up a percent. In the GCC, the Dubai market stood out, up 2.8%. The S&P 500 and Nasdaq gained 2.5%. Industrials were the best performing sector last week along with the DJ Transportation index, seen as a precursor of broader market movement. A wide divergence remains with tech +23%, leading year to date global sector returns whilst energy remains a laggard at -32.5%. Growth as a strategy leads with the MSCI World Growth Index +15.4% year to date whilst the Value Index is -14.9%. This is reflected in the FAANGs outperformance +55% year to date. We recommend holding onto tech, whilst adding to healthcare. Some quality industrials (with a broader focus) and financials would be a good addition to the cyclical EM overweight we hold.
There are heightened tensions between the U.S and China with Pres. Trump signing executive orders banning Americans from doing business with Byte Dance's TikTok platform and Tencent Holdings WeChat messaging app and imposing sanctions on Chinese and Hong Kong officials. This led to a broad based tech sell off on Friday, starting with China and ending with the US. The Nasdaq however crossed 11,000 making a new high last week and is up 23% this year. Globalization is a key growth driver for China internet stocks, though the companies have a large domestic base with a billion mainland China users. The companies that have relatively higher exposure to the US are mainly the online entertainment apps (mobile games, streaming media) and messaging/social networking. However, US revenue exposure currently is below 10% for the large China tech companies. A possible retaliation on Apple, Qualcomm etc. that depend on China for growing sales led to the US tech sell off. The language of Pres. Trump’s order is vague hence it is too early to analyse the larger impact, as the US Commerce department has 45 days to interpret and enforce the rules.
Q2 earnings season in the US continues to beat a bar of low expectations. Almost 90% of the S&P 500 companies have reported and 66% have beaten revenue forecasts and 77% earnings forecasts. Revenue growth is c. -11% y/y and earnings growth -32%. BP rallied post earnings, as it announced a focus on renewables in spite of cutting dividends to half. With the exception of Total, most big European integrated oil companies have cut their dividends in recent months. Cutting dividend payments frees up capital to spend on low-carbon power. Saudi Aramco is expected to report today and dividend guidance will be closely watched.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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