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Chief Investment Officer's team, 19.07.2020
Last week basically provided more data on what we already knew. First, the virus is not under control, especially in the US, following a “first-in, first-out” pattern. Second, the recovery didn’t abate in June: after employment, retail sales were strong in the US, Europe confirms it restarts and Chinese GDP grew by an impressive 3.2% year-on-year in Q2. Third and finally, political risk is back: the US Presidential campaign accelerates as Mr Biden now leads Mr Trump in the polls by a spectacular 15 points margins; geopolitical tensions are rising especially between the US and China, but both of them are carefully calibrating their statements to avoid irreversible escalation; Europe and its unanimity-based governance failed to finalize its EUR 750bn stimulus package; last but not least, Central Banks have done so much, so quickly, that one should not expect incremental support unless things get worse.
In our view we are reaching the “end of the beginning” of the recovery, which was probably the best part from a market performance perspective. The next catalysts are not imminent: US elections in November, and a vaccine with an uncertain timing. The latter is the most important, as illustrated by the market impact of last week’s good news from Moderna and others.
In the meantime, we expect markets to be volatile and to show little direction. We decided to halve our overweight on Gold last week, which was our largest overweight on 2020’s best performing asset, and to raise our levels of cash. Our three profiles have returned respectively +3%, +1.5% and -0.3% so far in 2020, outperforming both our strategic allocations and our competitors; it doesn’t look silly to be a bit more defensive and ready for opportunities. Stay safe.
EM investors must have been cheered by China’s economic performance post-crisis, with the Q2 macro-release above expectations on many fronts. The GDP growth rate was an impressive 3.2%, a beacon of hope for countries that now cannot even think of thinking of their cycle being in positive territory. Industrial Production and Fixed Asset Investments printed above consensus, while Retail Sales trailed at -1.8% year-over-year. The recovery seems to be led by real estate, manufacturing and infrastructure, sectors historically supported by the government and sensitive to the flow of credit to the economy. Markets celebrated with an impressive rally in mainland China equities, with monthly performance reaching 15% at one point in July, to be cut as quickly in half as of last Friday on a 5% weekly loss driven by frantic profit-taking. Although valuations and sentiment must have not been favourable shorter-term due to speculative excesses, we would argue that the longer term picture remains supportive for Chinese, hence Asian, risky assets from a top-down point of view.
Corporate earnings can be boosted by an improving economic outlook and this in turn has been heavily dependent on government stimulus for decades in China. Although one may wonder why further support should be needed with positive growth rates, one should also take notice that official employment figures underestimate effective underemployment in the country and that, indeed, consumption is lagging production and no help can be expected from external demand as the developed economies struggle through this crisis. This leaves the Chinese authorities with limited options, other than to ease policy further and step up on the flow of credit, that is Total Social Financing. The restraint shown on this front in 2017-19 could give way to stimulus efforts exceeding the ones in 2012-13 and 2015-16, in order to fight deflationary pressures building eventually on lagging households demand. Historically this has translated into significant credit impulses boosting EM assets and global equities. The renewed Chinese liquidity wave should compound other forms of policy interventions elsewhere globally and bolster a reflationary phase. Not immediately, as consolidation is needed to work out the recent spike in sentiment and valuations.
Concerns will also mount that Total Social Financing growing faster than GDP could undermine financial stability and in the end be followed by new and bigger market corrections. This is our worry as well and the inevitable risk stemming from swapping economic growth for stimulus when the former proves exceedingly hard to come by without the latter, not only in China, but indeed globally.
Fixed Income Update
Fixed Income investors have wondered what it means that global banks continue to set aside record provisions for Non-Performing Loans. So we will focus on the trend of defaults, downgrades, and their effect on the H.Y. spreads in this weekly publication. The U.S. distress ratio -- the proportion of speculative-grade issues with spreads over 1,000 basis points (bps) relative to U.S. Treasuries -- decreased to 12.7% as of June 19 from 22.8% as of May 6, significantly lower than the March 2020 peak of 36%. However, as credit spreads remain elevated, the current distress ratio is still higher than its pre-crisis levels of 8%. S&P Global Ratings lowered 414 long-term issuer credit ratings in the second quarter, surpassing the prior peak of 331, which was set in the first-quarter of 2009. The number of monthly downgrades peaked at 268 in April before falling in June to around 50.
The number of U.S. corporate defaults nearly tripled in the quarter, rising to 60 from 21 in the first quarter. The 2020 global corporate default tally has reached 134. The U.S. leads the tally with 81 defaults in the first half of 2020 that outnumbers the 2019's full-year total of 77. The oil and gas, consumer products, and media and entertainment sectors lead the global default tally with 23, 21, and 20 defaults, respectively. The 12-month trailing default rate for the U.S. is expected to reach 12.5% by March 2021 from the current 7.5% for the U.S., while global 12-month trailing default rate hovers around 3.8%.
Credit quality is likely to recover alongside the economic recovery that has started this year in the second half. The time horizon for potential downgrades has shifted from the near term to the medium term. The share of companies with ratings on CreditWatch with negative implications declined at the end of the second quarter, even as the percentage of ratings with a negative outlook increased. A rating on CreditWatch indicates a one-in-two chance of a rating change within the next 90 days. A negative outlook indicates a one-in-three chance of downgrade for up to two years for investment-grade companies and generally up to one year for speculative-grade companies.
These data points indicate that a lot of downgrades and defaults are behind us, and going forward, we will see a moderation in the amount of distressed debt. Moreover, improved spreads and primary market conditions have resulted in many companies being able to tap the market for refinancing. As we have been saying, H.Y. spreads fairly price in the default rates expected by year-end. Any blowout in H.Y. spreads should be minimal and would be a good opportunity to accumulate positions as the central banks try to restrict "avoidable insolvencies."
Meanwhile, investment-grade corporate spreads continue to grind lower with I.G. yields reaching a record low of 1.73% after reaching an eight-year-high of 3.69% in March this year, reflecting investors’ continued preference for the asset-class. GCC spreads also ended the weak tighter with YTD returns above 4.2%. The government of Sharjah enjoyed improved risk appetite for the regional I.G. sovereigns, issuing a $1Bn 30-year Formosa bond last week with books coverage > 3.5x and a tight spread of 260 bps.
Global equities ended the week positively, amidst better than expected, US Q2 earnings (downward revisions have ensured a low expectation base) and encouraging growth in retail sales, along with good GDP numbers from China, which were measured against COVID flare ups and continuing geopolitical tension. The monthly rise in US spending has seen demand reignited for restaurants, autos, clothing, electronics, appliances and home furniture. An early-stage trial of a potential Covid-19 vaccine by Moderna produced antibodies in patients and gave the world hope on life getting back to normal. Airline and hospitality stocks had a good week. The S&P 500 was up 1.3% and is now positive for the year. In Asia, China’s CSI 300 index ended the week -4.4%, however still the best performing market this year. Strength in the industrial sector was weighed down by weakness in consumption. China US tensions remain escalated with curbs on Huawei’s 5G equipment and the possibility of Chinese video app TikTok being put on a blacklist.
Our broader positioning looking at both top down macro variables and corporate profitability along with valuations is a slight underweight for DM and OW EM. Within DM, we retain our US overweight and are close to neutral for Europe. Allocation is at broadly 75% DM and 25% EM in the equity asset class and for optimal returns the asset allocation grids should be followed. We have revised upwards our fair values for the major global indices for end 2020 as we see the huge stimulus, low interest rates and savings leading to consumption and demand returning to normal faster than we initially expected. For the S&P 500 we have raised our P/E multiple to 21.5X and expect earnings to contract by 15% giving us an 2020 year end index fair value of 3000. We did the same for the other geographies, which indicates upside for EM and China. DM ( US, Europe and Japan) are trading 4/5% above fair value. This supports our overweight stance on EM. India is trading at fair value and the pandemic is in full throes hence we have shifted our overweight position on India back to the broader Asia market. We maintain our underweight on LATAM as that is in the midst of the pandemic and affected by lower oil prices. GCC markets are trading at our current fair value of 480 for the MSCI GCC. Company earnings will be impacted by the virus and with oil below breakeven level for government budget balancing.
9% of S&P 500 companies have reported an average of -44% EPS growth. US bank earnings were as expected: higher provisioning and lower profits offset by higher trading revenue. Blackrock profits rose 21% y/y and assets now stand at $7.3 tn as it benefited from the increased market activity. The Nasdaq +18% this year had a down week -1.1%. The Fang+ index stands out at + 48% in 2020. Many US tech companies, Apple, Amazon and Netflix, have hit new highs in recent days, though the last fell after disappointing on guidance for Q3. We view the current EV stock rally as a bit of a bubble but highlight innovation in the EV industry and the capital inflows into the technology of the future. Tesla, Nio, Nikola have seen exponential gains as the shift to electric cars gains traction. We still see some of the established European large auto manufacturers, slow to move but with the scalability and product offering to fit all demand levels, eventually catching up.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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