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Chief Investment Officer's team, 27.10.2019
Last week was another positive one. Global equities gained around 1% across regions, and long-term rates grinded slightly higher, with the US 10y closing at 1.8%.
We write it for long, the starting point as regards investors' sentiment and positioning was, and still is, scepticism, which amplifies the market impact of good news. Economic data indicated some stabilization, should it be the US flash (preliminary) PMI numbers for October, or German IFO business climate, both slightly better than expected. Geopolitical issues are not solved at all, but at least the risk of a “no deal Brexit” is arguably low, and the odds for the US and China to agree on the “phase 1” of a trade deal in the next APEC Summit in Mid-November are reasonable. As regards bottom-up data, the beginning of the Q3 earnings season is also encouraging: expectations were not high, but they are exceeded across the board.
Our positioning is of course benefitting, with our 3 profiles printing their highest YTD return of 2019.
Looking forward, there is obviously one single imminent crucial event: the US Federal Reserve will hold its October meeting on Wednesday. The consensus expects the Fed to issue a “hawkish cut”: cutting short-term rates by 25 basis points but giving indications for a pause in the coming months. Market-implied probability is so high that it is difficult to forecast anything else. The ideal scenario would be to combine this “hawkish cut” with positive monthly macro data in the following days.
As far as US monetary policy is concerned, it would seem to be a matter of course to assume that the Fed is ahead of the game and markets just follow policy direction, which after all is a variable dictated from outside of the investment realm. Yet, financial market logic is never this straightforward and mutual expectations, on the investors' as well as the Fed's side, play an outsized role. Thus, at times the Fed leads and investors follow suit, while some other times investors discount scenarios way different that the one implied by the Fed's long term equilibrium rate and it is the Fed officials coming round to that.
For an example of the latter one should go back to what happened at the end of 2018, when equity market losses were in the low double digits in Q4 as the Fed tightening cycle was running into its third year. Although the Fed seemed committed to delivering two more hikes in 2019, markets were discounting almost no policy action, in complete disbelief that Fed officials would be able to deliver on their plan. Indeed, Mr Powell came round to the market's view that the excessive tightening of financial conditions could not be sustained by the economy and reversed policy course during 2019 in what has come to be known as the 'Fed pivot'.
Today the exact opposite is happening. Chair Powell has been saying for a while that the current cuts must be interpreted as a mid-cycle adjustment, implying that 'three and done' would be the most likely scenario. No sooner than April this year the probability of a December cut was almost a certainty, while now investors are falling in line with the Fed's view that in October the last one is going to be administered, with the probability of a December move currently extremely low.
In the process the US yield curve has steepened significantly, signaling that investors believe that the three cuts will manage to steer the US economy back close to trend growth. At the same time, global equity markets have come within a whiff of their all-time highs, another testimony to the trust investors have in the effectiveness of US monetary policy. No doubt that the increased possibility of a US-China trade truce and the potential for avoiding a no-deal Brexit have played quite a role in driving such a turnaround in investor sentiment.
It seems that any slight improvement in the macroeconomic outlook is what investors would be clutching at to push equities into a new bull-swing, given the degree to which tail risks have been receding of late. Although by and large the latest data releases confirm that the global slowdown is ongoing, looking into the folds of the data one may find reason to purchase EM equities, which we have advised clients for some time now, the latest being in September. The 'flash' estimate of the Global PMI New Orders, a leading indicator of global business confidence, has increased for a second month in a row, even as inventories reached a new low. This suggests that some restocking must lie ahead, which would be giving the global cycle a much needed nudge higher.
Fixed Income Update
All eyes will be on the Federal Reserve this Wednesday, together with the Bank of Canada and the Bank of Japan scheduled to make announcements. On the US monetary front, the markets are pricing-in 90% probability for a 25bp cut on the Fed Funds rate to the 1.50%-1.75% range, bringing it to three cuts so far, this year. The benchmark US Treasuries are at 1.8% while the gap between the 2 and 10-year yields has widened from 4 basis points at the start of October to 17 basis points, as the longer-dated benchmark has climbed from a low of 1.5% to 1.8% as of Friday.
The US budget deficit swelled by 26% to $984bn, according to data released by the Treasury Department on Friday, the biggest gap since 2012. Interest on the debt is the fastest growing category of the budget. In the three years since fiscal 2016, yearly interest has grown by 57%, or $136 billion, despite the low interest rates. This week (October 30) The Treasury Department will announce the fourth-Quarter refunding program.
Central Bankers have switched on the liquidity tap showing the willingness to ease further and aggressively if the economic conditions warrant. The New York Fed planned to increase its overnight repo offering to USD 120bn to ensure adequate liquidity when liabilities sharply increase and help mitigate any pressure on the money-market. The repo activity on Oct 24 and Oct 29 have been upsized to USD 45 Bn. There is mounting concern that the Federal Reserve's Treasury bill purchases will result in a scarcity of short-term investments and force money-market funds into the reverse repo facility.
Across Emerging Markets, many central banks have embarked on a series of easing measures. In an effort to stem any liquidity crunch in the banking system, the Peoples Bank of China has infused USD 79bn via reverse repo agreements. The injection has been the largest since January, and exceeded the amount the central bank granted this time last year. The coming week (Thursday) is a tax deadline for companies. PBOC has weighted on its cautious stance and we believe that during times of macro uncertainty it always remains prudent to err on the side of caution.
Indonesia central bank cut its policy rate for the fourth straight time while flagging deteriorating global outlook on US-China trade war. Markets interpret the guidance from the central bank to remain broadly dovish and expect further policy rate cuts. Indonesia's two-year yield, the most sensitive to the policy outlook, has dropped to the lowest since April 2018, signaling that markets may be pricing a lot of easing by the authorities. At 6%, the yield remains well above the benchmark rate but the gap has narrowed this year.
The Central Bank of Russia cut its benchmark interest rate by 50bp to 6.50%. Policymakers have also revised down their inflation forecasts which provides further evidence that another similar rate cut is highly likely in December this year. One of the driving forces for such a policy response is that inflation has continued to surprise on the downside. The CBR revised down its inflation projections, for the second month in a row, and now expects the headline rate at 3.2-3.7% y/y by year-end, down from September's forecast of 4.0-4.5% y/y. This is well below the Bank's 4% target.
It was a good week for the main GCC markets and for global markets overall. The year to date rally (+19% for global equities) has extended into October. Emerging markets are now almost at double digit returns (+9.7%) and Developed markets have gained 20% year to date (in USD). Growth may have disappointed, and recession fears have abounded with deteriorating leading economic indicators (including manufacturing data). However, equity investors have in the past few months received plenty of good news with the Fed cutting interest rates and expanding the balance sheet, the ECB restarting QE in November, progress on the US China trade talks and a no deal Brexit almost ruled out. The US consumer too remains resilient.
A discernible shift to quality (profitability and strong balance sheets) pervades global markets and investors will not pay for unprofitable businesses as illustrated by WeWork's failed IPO. We continue to recommend a more defensively oriented equity portfolio and whilst we stay convinced on the technology sector attractiveness and dominant weight in global equity indices, be wary of any elevated valuations in the equity asset class.
The main U.S. equity indices ended the second week of the quarterly earnings season with gains of +1%. Approximately 40% of S&P 500 companies have reported earnings with an average of -1.6% EPS growth and +3.5% sales growth. The deteriorating manufacturing outlook is having little impact on expected S&P 500 revenue growth. Positive surprises from the payment processors (Mastercard and Paypal), oil services companies (Schlumberger) and Semiconductors led to rallies for these stocks. A very cyclical bias is pervading October with defensive sectors underperforming. Amazon, however disappointed with its first earnings drop in more than a year. Year to date, Amazon is underperforming the S&P 500 but has returned more than 500% over the last 5 years, as its continued investment in new businesses has paid back. It is the undisputed leader of ecommerce in the US and cloud services globally and has recently begun making serious inroads into video streaming. Profits were affected by ramped up spending on its next-day delivery service. Cloud services growth continues with Microsoft announcing strong numbers on the back of large deals for its Azure service.
Earnings in the GCC have been a mixed bag. Banks continue to post flat to single digit growth, however KSA petrochemical companies have disappointed. Also worrisome is that feedstock prices (methane, ethane and propane) as per Saudi budget guidance were to be reviewed at the end of 2019, with an applied price ceiling.
Indian markets disappointed last week. Differentiation remains essential. For banks this is driven by asset quality. For 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.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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