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Chief Investment Officer's team, 16.02.2020
Last week was positive for both developed and emerging market equities, with US indices continuing to hit new highs whilst safe havens continued their upward march. Gold gained as did the real estate and utilities sector, both liked by investors for their yield. US Treasuries remain well bid with the 10 year yield at 1.58%.
We started the year fully invested, in line with our 2020 scenario: an improving global economy, combined with elevated valuation, should lead to positive but modest returns. We favour Emerging Markets, which feature faster growth at a cheaper price compared to their developed peers, across asset classes. We highlighted flexibility in our 2020 Investment Outlook, and we think that the time has come for action.
Last week, our year-end fair values were met on several DM equity indices. We haven’t changed our scenario but acknowledge that the coronavirus outbreak poses some potential downside risk, especially if China’s factories don’t reopen, which could add a supply disruption to the existing demand shock. Our TAA Committee took the decision to reduce DM equities by 3 percentage points across our 3 profiles, and to keep the proceeds in cash, for its flexibility, and even its yield. This is our most important risk reduction in more than a year, after having successfully added exposure in 2019. We might be wrong on the timing, but we will never compromise with our valuation based discipline. We are now significantly overweight cash, but also EM in both stocks and bonds.
The reaction of asset classes to soft global business activity and headwinds to growth from the corona virus outbreak has been mixed year-to-date. DM equities have been holding up well in spite of high valuations, underpinned by solid earnings releases and strong policy support; bond yields have tumbled amidst lack of inflation and dovish central banks; the US dollar, now a high-yielder against major DM currencies, has recorded a strong start to the year, up against all of its G-10 peers; DM credit spreads have lingered in the lower-end of their historical range, yet no longer tightened to new lows even as equities rose to all-time highs.
Whether it is going to be equities to pullback and trade more in line with depressed yields, or rather government bonds to fall and catch up with the more sanguine equity market sentiment, will most likely depend on the progression of the Wuhan epidemic and the extent of its damage to the economy. The DM flash Purchasing Manager Indices to be released at the end of this week will be very telling in this sense, by now incorporating concerns of the corporate world about demand and supply disruptions brought about by the virus, as against the January surveys run before the WHO declared the epidemic a global emergency.
For insights into Chinese business confidence readings investors will have to await the PMI release scheduled for the following week. Meantime, the day-to-day tracking of the Chinese cycle devised by some investment houses based on higher-frequency economic indicators reveals a discomfortingly sharp drop in business activity relative to its typical pattern during this time of the year. Although the February confidence reading can be expected to have taken a severe hit, the afore-mentioned higher frequency measures will have to pick up soon for the economic damage in China to be confined to 1Q, or the recovery risks being delayed further and becoming U-shaped.
Overall, while we maintain confidence in equity-versus-bond overperformance for the year, we would advocate against a fully pro-cyclical tilt in portfolios given the peculiar traits of this cycle. The recovery we would be expecting not before 2Q this year is peculiar enough to warrant at least a neutral allocation both to gold and absolute return strategies as a hedge against lingering headwinds to the cycle.
Fixed Income Update
Asian bond markets have bounced back with a surge in primary bond transactions and an active trading session in the secondary markets. Asian credit spreads have been well supported amidst the $10 bn of new supply hitting the market. In the GCC bond markets, new bonds are priced at record low yields proving to be resilient against the macro backdrop of tight valuations and the pandemic fears of the coronavirus.
The New York Federal Reserve released its liquidity agenda for next month and highlighted its plan to scale back the support in the overnight lending operations. The excess reserves have surged to $1.69tn (vs. Sep low $1.37tn), and funding spreads have compressed. The overnight repo facility was dropped from $120bn to $100bn, and the term operations were reduced from $30bn to $25bn for the rest of Feb, and then again in March from $25bn to $20bn. The Fed will continue to purchase $60 bn a month in short-term Treasury bills, which is best described as a technical adjustment aimed at increasing the level of reserves.
European peripheral bonds rallied last week. Greece's 10-year benchmark rates went below 1% for the first time, driven by a pro-growth government, large fiscal primary surplus, and speculation about being included in ECB's QE efforts. Italian BTPs also achieved lowest ever spreads against the German bunds post-May 2018 driven by relatively high yields on offer and greater political certainty.
Standard and Poor's reaffirmed India's long-term rating at ''BBB-'' with a stable outlook, citing the country's growth will stabilize and begin to recover from its current low ebb. Moreover, "Fiscal deficit will remain broadly in line with our forecasts over the next two years," the agency added. The rating agency, however, pointed out that India's fiscal position remains precarious, with elevated fiscal deficits and net government indebtedness. We remain constructive on the bond markets and see value in select BB-rated corporates over investment-grade rated bonds. The yields on INR Sovereign bonds, on a relative value basis, offer value. Meanwhile, RBI Governor had indicated last Saturday that the central bank is reviewing its practice of inflation-targeting policy framework as pressure mounts to cut rates to revive the economy.
Primary issuance activity picked up last week with EM Deals totalling USD 9.38 Bn almost twice that of the first week of February. Asian IG issuers dominated the space accounting for over 80% by volume. Notable issuers included Pertamina from Indonesia, Korea Development Bank from South Korea, Bharti Airtel, and IIFL Wealth from India. Pertamina's offering was launched in conjunction with a tender offer to buy back the company's current USD 1bn 5.25% 2021 issue at 104.40, which is set to close on 20 February. This week's line up looks healthy for the GCC issuers, with Riyad Bank expected to place their Tier 2 notes and Dar Al Arkan starting roadshows for a seven-year Sukuk issuance.
Though recent economic data and corporate results have been good, as our year-end fair values have been met, we have decided to take partial profits on developed market equities. Developed market equities have rallied in the first 6 weeks of 2020, a carry-over from their strong 2019 performance. It’s now 11 years into the rally and global market cap is up by $1 trillion in the last two weeks and we think the rally is due for a pause. A global health panic, has not restrained the S&P 500, which has been 15 of the last 19 weeks. The S&P 500 continues to set new records. Valuation multiples are above average (19.1X forward earnings) and whilst earning numbers continue to surprise to the upside, we think there could be opportunities to come back at a cheaper price. Within developed markets we retain our overweight on US markets and relative underweight on Europe. We view the S&P 500 as a safe haven because of its high quality defensive growth characteristics. It is the right geography to own as long as rates are low and we don't have a recession. Europe continues to see stagnant economic growth.
Emerging markets had a good week, with the growing view that the worse the economy gets, the more likely we will get fiscal stimulus from China. Europe and Japan too could look at reviving their economies, given the impact on growth from their strong trade relationship with China. The German and French Industrial Production numbers for December were disappointing and not in line with the global recovery signaled by the PMIs, yet, the German Dax and French CAC had a good week, as a fiscal response seems to be getting priced in.
The Nasdaq 100 is up 10% in 2020. For tech companies, we don’t see it as 1999 all over again, as this surge is backed by real earnings. The EPS of the tech sector has increased 350% since 2010, compared with a rise of 100% in the energy sector. We don’t think the growth run is over but advocate adding to defensive yield strategies. Last week saw high dividend companies outperforming as bond yields remain persistently low. The US 10 year Treasury is at 1.58%.
Whilst Brent oil rose above $57 a barrel, the energy sector remains the worst performing in 2020. The International Energy Agency (IEA) lowered its 1Q'20 oil demand outlook, the first y/y decline in over a decade.
The UAE real estate sector has announced Q4 and full year 2019 earnings and all eyes are now on the dividend payout. The sector is down year to date, though sales numbers were encouraging. The Emaar group has a consolidated sales backlog of AED 46 bn with off plan sales on target at AED 14.9 bn in 2019. Emaar Malls had a healthy footfall (Dubai Mall had 84 mn visits) and Namshi its ecommerce portal, recorded strong 2019 online sales of over AED 1 bn i.e. + 21% y/y. The Dubai Hills Mall is set to open in 2020, which will add up to 2mn sqft of leasable area. Aldar had off plan sales of AED 4 bn in 2019, in line with guidance and has announced its dividend (a yield of 6%). The latest to announce an increase in its Foreign Ownership Limit is Dubai Islamic Bank (subject to approval) from 25 to 40%, which would lead to increased weight in the EM indices and passive inflows.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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