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Chief Investment Officer's team, 16.06.2019
Last week was not as spectacular as the previous one, but expectations for the Fed to cut rates retained some support for risky assets. Global equities were slightly up, with Emerging Markets leading, and the cyclical fixed income segments did better than the defensive ones.
Geopolitical risks kept on shaping markets: from tensions in the Gulf pushing oil prices higher to protests in Hong-Kong weighing on local assets, and including of course the main topic: trade between the US and China. There is unambiguous evidence that the trade war is impacting business confidence in the US, with declining job creation and ailing investments. This context, combined with low inflation, should trigger some response from the Fed.
It is however not a simple call. First, confidence is volatile, both ways, and one shouldn’t exclude the possibility of a trade deal, or that June economic data could be better than May, or even both. Another sensitive topic is the magnitude of the cut: market expectations, at -75bps for 2019, seems very aggressive. Markets could thus be disappointed, should the Fed decide to wait for more clarity, or should it be moderate in its easing. Aggressive cuts would also raise questions on the state of the economy, and limit the future ability to face a downturn.
We expect the Fed to adjust its verbal guidance this week, and will closely monitor the G20 (end of June) and the June monthly data. In the meantime, we keep our defensive positioning and our preference for EM assets.
Not all Fed meetings are created equal. Some meetings are considered to be business as usual, providing investors with little additional information about the business cycle and the future path of policy, while others can represent critical junctures for asset markets, recently more often than not supported by the Fed’s stance. The June 19 one definitely falls under the latter category, and so much so that investors already have discounted three cuts for this year and one for the next, in spite of chair’s Powell non-committal declaration that the Central Bank ‘will act as appropriate to sustain the expansion’.
On the surface, there seems not much to be excited about. After all, US unemployment, driven by a healthy labor market, is at multiyear lows and depressed bond yields make for easy financial conditions. Yet, markets move more in accordance with investors’ perceptions of the facts, than with the facts themselves dictating how they should. According to historical data preemptive Fed meetings, the ones where officials administered a positive shock to provide insurance against downside growth risks, have seen a much stronger equity performance than reactive policy cycles, when the Fed was falling behind the curve.
Recent US equity market action, +4.4% for large-caps in the week of the Powell speech, seems to validate the impression that investors are expecting a very proactive Fed. With the market biased so heavily in one direction, there seems to be meaningful upside left in risk assets only in the case that the ‘preparatory’ language in June is so dovish as to open the door for a July cut. Muddling waters further is the end-of-June G20 meeting, where Mr. Trump and Mr. Xi are expected to meet, but make little progress on trade tariffs, though at least keep the ball rolling for some more months, rather than go into full-blown hostilities.
Whether Mr. Powell will use this as a reason for switching to an accommodative, preemptive stance or not, is a close call. What we have little doubt about, is that global economic data will need to improve substantially to make up for a neutral-leaning Fed, in spite of a hyper-accommodative People’s Bank of China and the ECB unexpectedly joining the dovish chorus at its latest June meeting.
On longer time horizons, economies on perennial central bank support, as it has been the case since the 2007-2008 Great Recession, bring about increased talk amongst experts of Japanification. This term applied to today’s experience means historically low and still down trending bond yields in the face of nominal economic growth gradually dropping, in spite of consensus forecasts to the contrary. If loose policies have probably avoided a 1930’s-style depression, they have also forced investors to seek exposure in more cyclical assets within the fixed-income realm, hardly a recipe for avoiding the building up of financial imbalances in the later stages of the business cycle.
Uncertainty returned to markets as trade tensions resurfaced after Pres. Trump stated that he is personally delaying a trade deal with China unless Beijing returns to terms negotiated earlier this year. US markets were however cheered by an increasing conviction on rate cuts with the Fed Chair Powell talking about the impact of “trade negotiations” between the US and China and stating that the Fed was closely monitoring the implications of these developments for the US economic outlook. US equities eked out a small gain (+0.5%) last week on the back of a +4% gain the previous week bringing total returns for the year for the S&P 500 to 16.3%. Asian markets performed similarly last week with small gains however Hong Kong markets had a volatile week as street protests continued. The Extradition Bill has been put on hold and this could provide some stability. The Hang Seng Index is +7% for the year, but way below the 17% year to date advance reached in April. Q2 earnings season kicks off in a month and is important for the US and Europe where strong performance has led to valuations above the 10 year median. Emerging markets are more reasonably valued (barring India which has always traded at a premium) and valuations would become even more attractive if a strong beat and high teen’s earnings growth is achieved. However, we don’t expect a sustainable rally in Asia till tariffs are clarified.
Good economic data from the UAE and the KSA with high PMIs, should counteract the effect of lower oil prices on the regional indices. The KSA (+16% YTD) continues to lead performance, even post its -8.5% drop in May. The MSCI and FTSE EM index inclusion have buoyed trading volumes with daily levels close to USD 1.5bn. In the UAE, the Dubai Index is leading with total returns of 8.6% year to date with Abu Dhabi a little behind at +6%. Volumes are yet to pick up with combined daily trading volumes for both UAE exchanges at c. USD 100mn. Whilst banks are seen a s a defensive sector in the GCC, with high dividend pay-outs, they no longer have the advantage of rising rates to aid net interest margins. Valuations are stretched, as the GCC banking sector has gained 70% over the last two years. Time to book profits and add on dips.
The trade war effects are being felt across the global tech sector. The semiconductor index is down 15% from its peak. China companies that are listed in the US are also starting to worry about any restrictions that could be imposed on them. Alibaba valued at over USD 400bn is doing a second listing in Hong Kong. A poster boy for China’s ecommerce and payments industry, Alibaba has an enviable revenue growth of 50% p.a. over the last 3 years.
Data as an investable theme continues to gain traction. Following Apples launch of a credit card, Facebook will use its user base of 2.4 bn people to launch Libra a digital “safe” coin (backed by Central Bank currencies). Investing in this venture are Visa, MasterCard and PayPal amongst others. Whilst there are over 1000 cryptocurrencies’ with USD 270bn of traded value (Bitcoin has 50% of market share) it is the digital safe coins that are gaining traction as it is possible to regulate them.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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