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Chief Investment Officer's team, 02.02.2020
Last week, the Chinese coronavirus triggered a sell-off in all risk assets, starting with EM stocks and cyclical commodities, and strong support for defensive assets like Gold and Treasuries. This virus spreads at a very fast pace, affects primarily the world’s second-largest economy, and there is already an economic impact from the massive responses which have been put in place, from lock-downs to factory closures and flights restrictions. The good news, however, is that its fatality rate is not extreme, and that, at a point, it will peak. The size of its impact on business activity will hinge on how quickly the disease can be brought under control. In the 2003 SARS, outbreak business activity in China shrank significantly in Q3, though damage to the whole economy that year was limited. Today we hold a similar view of a sharp but limited impact. There will be more contagion, visibility is low -we might be wrong- and we will watch for the timing of Chinese factories reopening, to gauge the potential disruption on the global supply chain.
Overall we remain confident on the outlook, given the support provided by central banks, and given the fact that market reaction is already sharp, pricing-in, in our view, a pessimistic scenario. Volatility will remain. Should Emerging Markets discount the worst-case scenario, and assuming we don’t have evidence of global disruption, we would probably consider a buying opportunity. We keep our positioning unchanged. For January, our Cautious, Moderate and Aggressive performances were +0.6%, 0% and -0.6% respectively.
US 10-year Treasury yields accelerated their drop following Fed chair J. Powell’s press conference declaration on Wednesday that the Fed was ready to pull out all the stops to fight deflationary tendencies, hinting to an easy policy for longer. If the plan is to make up for past inflation undershoots, with the Fed consistently missing its target since 2012, investors should expect to see the CPI Index around 2% for a while or even slightly above, before any tightening would even be considered. The latest newsflow has not been auguring well for the outlook of US long-dated yields either, as the Personal Consumption Expenditure Price Index for December was standing at 1.6% and inflation expectations as surveyed by the University of Michigan have continued to trend downward.
Some investors may be tempted to put down the current fall in yields to concerns related to the coronavirus outbreak and its impact on the global economy. This would be temporary and limited to the time the epidemic spreads and eventually peaks, with no lasting effects as similar past episodes suggest, while deflationary pressures have haunted investors since the time of the Great Financial Crisis. ‘Bond King’ Jeffrey Gundlach described as ‘momentous’ Mr Powell’s decision to actively engage to boost inflation by keeping policy exceptionally loose.
If the plunging of US 10-year yields was a flight to quality, gold and the dollar should have both appreciated. Gold did, while the US currency weakened. An outlook marked by stable policy rates and the expectation of building price pressures speaks of negative real rates, a boon for gold and a curse for the dollar. The US Dollar Index lost 0.5% in a week when other safe havens gained consistently, hence we would be inclined to conclude that the Fed’s new stance towards inflation signifies a turning point not only in terms of monetary stance, but for the whole FX market as well.
With the fading of the negative impact of the coronavirus epidemic, a drag further delaying the global recovery most likely limited to 1Q this year, manufacturing confidence should further stabilize and then gain traction. Rest-of-world growth lifting would be the trigger for dollar weakness in 2020 following its 5%-plus gain to-date since the end of 2017 due to concerns related to the global outlook.
A weaker dollar would imply looser monetary conditions worldwide, hence provide further fuel to the fire of liquidity-driven markets and help compound asset bubbles fed by hyper-accommodative policies across the globe. It would also bode well for Emerging Markets.
Fixed Income Update
The US Treasury curve flattened over the course of last week in tandem with the sell-off across risky assets. The 3-month minus 10-year portion of the curve has inverted for the first time since last October as investors see elevated risk in the near-term stemming from the coronavirus scare. Moreover, the collapse of long-term bond yields is a function of what the Fed mentioned on their policy outlook and inflation. The weak macro data reported also added to the support for risk-free assets. The conundrum on the 30-year Treasuries is worth noting as it fell below the 2% level. Investors are now pricing for at least one rate cut of 25bp by July 2020.
While maintaining the policy rate unchanged, the Federal Reserve lifted the interest on excess reserves rate to 1.60% from 1.55% and said it would extend the overnight and term repo operations at least through April. We can expect a slowdown in the treasury asset purchase program as the central bank adjusts the size and pricing of the operations downwards.
The dramatic downward shift on global bond yields reaching to new 3-month lows has created uncertainty and vulnerabilities, particularly to other segments of asset prices. The UK 10-year Gilts were yielding 0.52%, and the same tenure German Bunds were trading at -0.44%. It was the best monthly performance for Gilts since May 2019. The Bank of England has kept its policy rate unchanged at 0.75% as the UK bowed out of the European Union last Friday.
Asian HY bond spreads have widened sharply following the virus outbreak reaching 516bps. The investment-grade bonds from the region have shown more resilience widening only by ten bps during the last week. The upgrade-to-downgrade ratio for Asia high-yield credit had plunged previous quarter driven by Chinese property issuers, while the measure surged for high-grade Asian credit. We believe this is quite early to speculate about the contagion effect in the Asian HY market, and still appreciate the risk-reward offered.
With Asian markets closed, issuers from Russia, Eastern Europe and Latam dominated the EM primary issuance market last week. A total of USD 7.68 Bn bonds were priced with Electrobas emerging as the largest issuer by selling USD 1.25 Bn of bonds across two tranches. Emerging Market players issued more than USD 100 Bn of securities in January, giving a solid start for 2020.
India’s budget presentation on February 1 made it clear that the government will resort to a record INR 7tn borrowing to fund the deficit. However, the bond markets have already priced this in, and we don’t expect any significant movement in local government bond yields. India increased the period of the concessional withholding tax rate of 5% for foreign portfolio investors in bonds issued by domestic companies and for government securities until June 30, 2023, that should help Indian companies raise offshore funds at lower costs.
The coronavirus outbreak has taken center stage for markets with DM equities giving up their year to date gains. The Hang Seng Index is -6.7% year to date, and EM equities had their biggest weekly decline -5.1% in almost two years. China mainland markets open on Monday after a 10-day Lunar holiday, and we expect performance in line with China-focused ETFs, listed in the US, which were down last week. The impact of the virus outbreak on global growth and the supply chain is too early to estimate but global airline, luxury goods, energy and mining stocks have been the most affected, as have companies with significant revenue from mainland China. Global tech and telecom companies are facing disruptions to their supply chains from the factory closures and labor shortage in China. Wuhan is under lockdown and is home to several component suppliers and is a key transportation hub.
Volatility has risen with a bid for safe-haven assets i.e. gold and US Treasuries. Low bond yields will push investors towards equities. A 3- 5% dip is a good buying opportunity in the relatively expensive high-quality DM growth stocks. Investors should also add to high yielding stocks with strong cash flows for sustainable yield. We would not time our entry to emerging markets as we cannot with certainty predict the length of the EM sell-off, however markets as per statistics have been quick to bounce back once the virus scare is over. Also, China will probably initiate stimulus measures to counteract any economic slowdown on account of the virus.
The only large Index positive for the year is the Nasdaq +2%, boosted by the tech titans posting strong Q4 revenue and earnings growth. EV market leader Tesla also declared a record cash balance, solid margins and guided that deliveries this year would exceed 500,000. Tesla shares have doubled over a year and it is now the second-largest auto company by market cap globally, higher than Volkswagen, which produces over ten mn vehicles annually. Microsoft’s Azure cloud business is now one-third of profits. Apple had all verticals delivering, led by iPhone sales and Wearables. Amazon revenue benefited from its one day deliveries with Prime users at 150 mn. Facebook however disappointed as growth slowed though daily monthly active people using one or more of the company’s social networks, Facebook, Instagram, Messenger and WhatsApp was 2.89 bn up 9% y/y.
In the GCC, the UAE banks have posted mixed results with impairments on consumer lending as they are adjusting to lower interest rates. The petrochemical companies in the KSA, Yansab and SABIC have disappointed on Q4 releases. SABICs CEO said he expects pressure to remain in 2020 amid a global slowdown in demand, especially from China and Europe.
India’s FY 21 budget focused on three main themes: an “aspirational India, economic development for all and caring society.” aimed to boost income, enhance domestic purchasing power and boost foreign investment in Indian Rupee debt. Personal income taxes were lowered and budget deficit targets were widened to help spur a slowing economy. The fiscal deficit target set at 3.8% of GDP for the current year disappointed investors, and the Sensex Index fell 2.4% on the day.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Another week, another rally
A geopolitical start to 2020
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