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Chief Investment Officer's team, 05.04.2020
Last week was under the influence of two opposite forces. On the positive side, the Fed extended dollar liquidity to the world and hopes rose for a truce in the oil war, sparking a rally in Brent price to 30$. But March economic data revealed an economic disruption of unprecedented magnitude. The highly flexible US labor market crashed with 6 million initial jobless claims, and the loss of 700.000 jobs in March. As the US consumer alone represents almost 15% of the world GDP, dire economic implications loom large. Despite signs of inflexion in Italy, the peak of the pandemic is not yet in sight in the West and additional restrictions are being put in place in Asia, in areas which did well so far. The truce is also not certain on oil, with next week’s OPEC+ meeting being rescheduled and President Trump adding pressure by threatening to use tariffs to protect US energy jobs.
For the near term, we remain in the eye of the storm. April and the quarter which just starts will provide more depressing economic and earnings data and the pandemic should get worse before being defeated. Policy responses are proportionate and being progressively implemented, with the latest being another reduction in the reserve ratio from the PBOC, but everything depends on restrictions being relaxed in the coming months - with the risk of severe damage if they don’t. It is a crucial quarter. We keep on believing that medium to long term expected returns are positive, but we urge our clients to avoid any short-term bet and excessive leverage, as volatility should remain extreme.
The current pandemic, taking a heavy toll in terms of human lives and economic damage across the globe, has laid bare unpreparedness on the side of governments, facing for the first time a shock of such proportions to societies since the Spanish flu hit every continent about 100 years ago. Authorities in different countries have hesitated before implementing draconian measures aimed at stemming contagion, concerned by the unpalatable trade-off between mounting casualties and job losses due to lockdowns. Yet, the successful drastic social distancing actions taken by the city of St. Louis against the 1918 influenza pandemic, as against Philadelphia, only 900 miles away, where at the time a large parade was arranged and then deaths spiked, teach us a lesson that had already been learnt at a costly price during World War One.
The tale of those two cities which adopted opposite approaches to the same problem suggests that quarantines and stops to economic activity are inevitable, as economically costly as they are, at least until a cure for the virus is found. And these costs are becoming obvious in the repeated cuts to growth rates made by economists, now projecting US unemployment to hit new records highs quite soon.
Hopes of a V-shaped recovery could be sparked by the prompt rebound of Chinese business confidence, again above 50 in the month of March, hence pointing to expansionary conditions. Yet, this could be more a symptom of the depths plumbed in the previous months, than of substantial gains in absolute levels of activity. Also, in spite of most employees being back to work, consumption patterns in China still seem to be leaning towards essentials, with purchases of discretionary items all but languishing. Should this persist and become a template for other economies, a vicious feedback loop seen in previous recessions of lower demand begetting further retrenchment and layoffs would set in.
Massive public interventions in support of the economy will avoid though that the current crisis morphs into a depression. It must be of comfort that a fourth round of Quantitative Easing is being undertaken by the Federal Reserve and that QE1, QE2 and QE3 all managed to curb market volatility and reverse the negative momentum in equities. The Fed has adjusted the dose of the medicine to the gravity of the illness, being the daily purchases of QE4 tens of times the size of QE3’s. Also, tax relief reaching the pockets of the unemployed or incentivising companies to refrain from lay-offs should be able to cushion the blow to a considerable extent.
Against this backdrop we think it is still possible to take risk with the prospect of achieving appealing risk-adjusted returns, provided that in these early stages of the crisis investors are careful to navigate only those markets backstopped by the Fed. In particular, US IG corporate bonds represent quite an opportunity. They currently offer a yield of almost 3.5%, as per the Bloomberg-Barclays US Aggregate Corporate Index, which must be increased by the capital gains to be achieved as spreads tighten with more Fed liquidity injections, for an expected total return at least in the high single digits.
Fixed Income Update
Last week provided a much welcome relief from the wild volatility swings in the credit markets. The benchmark bond index returns were more subdued with all the indices returning less than 1% weekly absolute returns except for US High Yield, which saw a negative 1.4% return driven by spreads widening. Surprisingly European HY bagged the top spot in weekly gains due to less Energy beta of its constituents.
Benchmark rates, however, behaved differently, and were less volatile across regions than in March. Central bank actions have helped stabilize govt bond markets, and rates have been more range-bound. The Fed’s unlimited QE will ultimately decrease volatility and improve liquidity in the rates market. The ECB increased its bond purchases through the Public Sector Purchase Program (PSPP) and Pandemic Emergency Purchase Program (PEPP) to EUR 35 Bn last week.
There is a deluge of US Treasuries coming to support the Fiscal Stimulus announced last week. According to estimates, the total US Treasury issuance would reach USD 3 trillion in the next nine months. However, this is not expected to raise the US Treasury yields meaningfully due to FED’s unlimited commitment to provide liquidity and a large tranche of this supposed to be absorbed by Money Market Funds as well. 90-day commercial paper transactions continue to remain subdued despite FED’s CPFF indicating credit stress in the markets. Three-month USD Libor rates continue to remain elevated with LIBOR-OIS spreads at GFC levels.
US Investment Grade primary issuance notched another weekly record with forty-nine issuers pricing USD 117 Bn value of bonds last week. This unparalleled surge in issuance is a combination of the Fed’s backstop and the disjoint commercial paper market meeting pent-up demand. Putting the numbers into context the last 2.5 weeks saw USD 290bn of US IG issuance as compared to USD 260bn in the previous 2.5 months. That said, the larger sizes ensured that most of the deals were priced at a premium as compared to the outstanding securities in the secondary market, benefiting the investors.
GCC Bond index spreads remain elevated due to unresolved oil price issues. IG Sovereigns in the sector are trading stronger compared to the HY sovereigns. We still see value in the large A-rated D-SIB banks in the region and Sovereign related utilities. There might be some extension risks in the AT1 perpetuals issued with coupons resetting to lower levels and the bonds not being called this year due to a lack of access to the primary market by the issuers of the region.
In terms of investment positioning, we prefer global banks in the Developed Markets, which are trading lower on sentiment while underlying fundamentals remain robust. In the Emerging Market, we are more selective and like investment-grade sovereigns/ sovereign related entities in Asia. We are highly cautious in the HY sector and would add exposure only to EM sovereigns and high-quality companies in their respective industries and regions.
Q1 2020 saw global equities fall by c.20%, across DM and EM. The sell off has been unusual, because of the speed and the volatility. US stocks took just 16 days to tumble 20% from their record high, the swiftest fall on record into a bear market. The volatility gauge Vix soared to new highs in mid-March and remains at elevated levels, i.e. 46. Last week was lower, for most global equity indices and sectors, barring the KSA and Energy which rallied with WTI crude up 32% for the week and on hopes of a price war truce. Small and mid caps continue to underperform with the Russell 2000 –7.1%, last week. The smaller US domestic companies are the direct recipients of the shut down with less access to credit lines, which the large companies have been quick to draw on. The small business relief package saw Bank of America receive 60,000 applications c. $ 6 bn on day one. Continued lockdowns affect day-to-day functioning and the economic outlook. A record increase in jobless claims has added to downbeat investor sentiment.
Selectivity remains key. We continue to prefer US multinational companies in healthcare, technology and consumer staples sectors (with strong balance sheets and cash reserves) as they will be able to navigate the looming global recession better. Asian economies are also an attractive medium to long term investment as they would recover the fastest, on account of the high middle income cohort which has growing consumption power. We are seeing unprecedented levels of monetary and fiscal intervention led by the US, and the most attractive valuation since 2011. Therefore, current levels in equity markets should prove to be good entry points with a medium term horizon. As it is impossible to gauge the bottom of the market, systematically adding would yield the best returns. However, valuations whilst low, compared to long-term averages, should not be taken at face value: they are governed by changes in earnings which are estimated to fall between 5 and 10% for DM, flat for EM in 2020, in line with GDP growth.
Technology and consumer staples remain in favour with Ecommerce, local/ regional digital payment services, gaming, streaming and delivery logistics, amongst the few winners in the current lockdown as are essential goods: healthcare and food. Online food retailers are unable to deliver due to the backlog. Domino Pizza and Uber in India are utilizing their logistics network for essential food delivery. Noon (the Emaar group ecommerce venture) has expanded its product line in the UAE. Nintendo’s family friendly, Animal Crossing game launched last week had record sales and led to its switch console being sold out on Amazon in many countries. There are continued downgrades for the automakers, airline companies and banks. Analysts have cut forecasts for European and US banks as they don’t expect buybacks and dividends to resume anytime soon. Utilities can no longer be depended on as a yielding sector with Centrica, the UK based British gas player, cancelling its 2019 dividends. The Emaar Group in the UAE announced plans to not pay 2019 dividends. In the US markets are pricing in a one third reduction in payouts vs a month ago.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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