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Chief Investment Officer's team, 24.01.2021
The COVID 19 global infection numbers are still rising, leading to more restrictions which should depress economic activity in Q1. Even China is affected to some degree. Fortunately, vaccination numbers are accelerating, despite some disruptions in the supply chain. The policy action however shows no weakness: President Biden issued a record number of executive orders, most of them to boost the COVID-19 response, and his new Treasury Secretary Janet Yellen unambiguously confirmed their intention for massive stimulus.
It’s not just a transition in Washington: the current quarter is expected to be the last depressed one, before infection numbers show a clear and unanimous inflexion thanks to the vaccination penetration hopefully reaching key thresholds. As a result, market participants’ focus also switches to consider the inflation risks and their consequence on central banks’ action. With high valuations and optimistic positioning, memories of the 2013 “taper tantrum” mix with parallels with the 2000 bubble and the usual predictions of apocalypse are back, including from some perma-bears warning about market apocalypse for a decade.
It didn’t happen last week. All asset classes were up, led by stocks from the emerging regions, including a strong performance of our very own local markets. Our positioning remains pro cyclical, overweight equities versus fixed income, but neutral cash and overweight gold as our preferred assets for risk mitigation.
The week ahead will be rich in Q4 corporate earnings, will see the first FOMC meeting of 2021, and will provide interesting economic data: German IFO, US consumer confidence and Q4 GDP. Stay safe.
Following Joe Biden’s inauguration day it is clear that both the new president and the nominee Treasury secretary support more public expenditure for shielding the economy from the deflationary effects of the pandemic crisis. According to consensus, Biden is likely to be able to push through Congress new fiscal measures to the tune of USD900bn, versus his ideal target of 1.2tn. Janet Yellen was also very vocal about more debt during her Senate confirmation hearing, since “the world has changed”, meaning that lower rates should allow for more outlays. Also, her dollar stance is one of so-called laissez faire, whereby the market should decide its value, which in the past was code language for longer term dollar weakness. On top of this, in about one month time a proposal for infrastructure expenditure boosting job creation in the United States should be in the cards. This wall of money, with the Fed now basically monetising government spending and dollar weakness possibly adding fuel to the fire of loose monetary conditions, is unlikely to leave bond investors indifferent. Market-implied inflation measures are already in line with the Fed’s inflation target level of 2% and 10-year Treasury yields are consolidating above 1%. There should be more to come in this sense and bondholders would be exposed to duration risk which must necessarily be managed.
From a multi-asset perspective neither gold nor TIPS, Treasury-Inflation-Protected Securities, would be the best way to hedge a fixed income portfolio against the possibility of rising yields. Real rates, at record low levels, are expected to rise, market-implied inflation already close to 2%, acting as a drag on gold and TIPS returns. Both would tend to outperform early or late in the inflation cycle, not now when more cyclical commodities or commodity-related equities should benefit the most from inflationary pressures. The returns of basic resources stocks are positively correlated with inflation and at the same time the sector offers appealing dividend yields. In particular, oil stocks are not yet discounting particularly elevated crude price levels and have a dividend yield in the mid single-digits. In the case of rising inflationary pressures driven by more fiscal stimulus and a pickup in the real growth rate of the economy investors would be standing to benefit both from capital gains and accrued dividends. Also, our clients could invest in a basket of high-dividend-yielding EM stocks, as EM equities tend to follow commodity cycles. Both EM equities and commodities show a strong positive correlation to global growth, a common driver dictating their same direction of travel.
In the end, a portfolio built out of cash, bonds and commodity-related securities could ensure better inflation-protection qualities than a pure fixed-income one, or than the typical 60-40 bond-equity allocation. As the policy backdrop changes, shifting from monetary to fiscal dominance, so should allocations.
Fixed Income Update
Compression themes continued in the fixed income markets. The government benchmark yields have remained stable following the recent spike. Most of the indices have moved sideways except European high yield, which has seen decent spread compression. The only exception has been peripheral euro bonds from Italy, where the 10-year yield has increased by 12 bps following increased restrictions in Europe. Meanwhile, USD HY issuance has been off to a bullish start for the year, with volumes up by 35% compared to last year. More than 75% of these are bondholder friendly as the proceeds would be utilized for bond repayment/refinancing.
According to S&P, global corporate defaults in 2021 remain at four, with no defaults this week. Although still early in the year, defaults are lower than at this time last year. Moreover, there were six defaults at this point in each of the prior three years. The trailing-12-month speculative-grade default rate increased slightly for the U.S. to 6.6% in December 2020 from 6.4% in November 2020, while Europe remained at 5.3% in the same period. Emerging Markets are slightly better off, with the trailing 12-month default rate at 3.1%.
Weekly Fund flows into the fixed income asset class has remained robust as per the recent trends, with Agg funds again dominating most of the flow. Net inflows into EM fixed income products accelerated to their highest level in almost two years, reaching $4.3 Bn, led by local currency funds, which attracted $ 2.4 Bn. Despite third consecutive net outflows from Government Bond funds, the massive Q1 2020 flows have kept the net LTM inflows positive the asset class. Money market funds lost another $13 Bn after the $9 Bn outflows last week. But the previous four-week total for the Money Market asset class remains positive due to the massive inflows received in the last week of December 2020.
GCC fixed income markets had another blockbuster week with two primary issuances dominating the scene. The National Commercial Bank issued the Kingdom of Saudi Arabia’s first USD denominated Tier 1 Sukuk. Opportunities for geographical diversification and strong credit metrics of the bank generated massive investor appetite. The spreads tightened by more than 60 bps as NCB launched the region’s lowest ever priced Tier 1 Sukuk. The Kingdom of Bahrain followed Oman to launch a three-tranche issuance. The 12-year had the widest IPTs relative to the existing sovereign yield curve. However, massive investor demand again resulted in the 7-year pricing within the sovereign curve and 12-year pricing inline. Both these transactions showcased immense opportunity for the local issuers to raise funding at record low yields.
Optimism prevails in spite of the third wave of the virus, with strong year to date returns for most major global indices with some already above the 10% mark (China, UAE). A fairly fundamental rebound, with EM equities continuing to seeing strong inflows and out performance. Also supporting EM equities is a weaker Dollar. China equities continue to build on their strong 2020 performance as Q4 GDP numbers indicate an economy well back on track. China tech saw a rebound as Alibaba shares rose (the founder made an appearance after a gap, reassuring investors) as did other China tech, though regulatory issues around the monopolistic nature of the ecommerce, social media and digital payment businesses of these monolithic China tech companies, remains very much in focus. The Indian Sensex Index crossed the magical 50,000 level intraday, keeping pace with the Indian cricket team’s momentous victory in Australia. All hopes on a stimulus driven budget and a rollout of a vaccine to a population of 1.38 bn people. Foreign inflows have been good $8.4 bn into India equities in December. Auto sales were surprisingly robust in December.
On the sector front Tech is once again in favour, though we expect a yoyo between growth and cyclical plays to continue. Last week’s rotation back into growth stocks, specifically large-cap Technology, Communication Services, and Consumer Discretionary names brought the Growth segment in line with Value year to date following recent weakness in Energy, Financials and Materials. Year to date energy +8% still leads sector performance.
UAE equities have had a strong January so far and last week saw the Telecom companies Etisalat and Du boards approve raising of their FOLs. This would lead to increased participation from international investors and boost trading volumes on UAE exchanges. First Abu Dhabi Bank changed its ownership disclosure and this could lead to an increase in weight in the MSCI EM Index. Banks in the UAE are seen as strong and consistent dividend payers and remain our top call. We also like the telecom companies for their dividend yield.
U.S. Indices were higher for the week with Pres Biden’s inauguration boosting sentiment along with Treasury Sec Yellen’s push for higher stimulus and spend on infrastructure. Nasdaq Index +4.2% and S&P 500 +2%. After a c.10% drop in 4Q earning y/y we expect 2021 earnings in the US to grow 21%. The earning season is now in full swing. Approximately 13% of S&P 500 constituents (mainly financials) have reported an average EPS growth of -5.02% and Sales growth of +0.74% (Factset). The banks announced large write backs of loan loss reserves created to deal with the economic fall out of the pandemic. Their well capitalized balance sheets, resumption of buy backs and an economic recovery bode well for performance in 2021.
Our key calls for 2021: We see high single (DM) to mid teen (EM) returns for equities. We are currently neutral between the sub regions but favour the US in DM and Asia in EM for the medium to longer term. For growth we like selective tech and healthcare and for value and cyclical play financials. For income, plenty of consumer and healthcare companies yield more than 3%.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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