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Chief Investment Officer's team, 05.05.2019
We were about to publish our weekly document, talking about the patient Fed, quarterly earnings and vibrant US job markets, and considering the legendary strategy of “Sell in May and go away”. Then, Mr Trump sent 2 tweets, announcing that the 10% tariffs rate on USD 200bn of Chinese imports will be raised to 25% from Friday, and that tariffs on all Chinese imports will be applied “shortly” at the same rate. He added: “the Trade Deal with China continues but too slowly as they attempt to renegotiate.”
Let us be clear: that was not expected, and the relief in US/China trade war was part of the rally, and at least partially priced-in. As we write, Chinese equities are sharply down, as is the currency, and US S&P futures indicate a 1 to 2% fall.
We will closely monitor the short-term developments: will the Chinese delegation still travel to DC on Wednesday, and will the hike in tariffs rate be implemented on Friday? What is certain is that the face-off between the two super powers is here to stay, but also that China doesn’t accept to lose face and has a longer horizon that 2020 US presidential elections. We are currently overweight in Emerging Market assets, but within a reasonable positioning as we underweight DM riskiest assets (for their valuation) and hold cash and gold on the side. This will help us navigate the volatility ahead.
Following pages were redacted before, on May 4th
Central banks in the developed countries are becoming increasingly concerned about persistently low inflation, which threatens to depress expectations about the levels of future inflation and make subdued price pressures further entrenched, in a vicious circle which undermines the economy. Expected inflation has been consistently overestimated for years by the consensus, be it under the form of the Consumer Price Index or wage increases. The Japanese Central Bank has been grappling with the issue for decades and Japan represents a case, so far unique in the world, of stubborn deflation to be avoided at all costs. The US Federal Reserve has consistently undershot its 2% target since 2013, while the ECB is confronted with even worse deflationary risks.
Yet, insofar as low inflation comes alongside moderate growth, a duo called ‘Goldilocks’, both bond and equity markets remain supported and investors have reason to cheer. Following the so called Fed pivot, the shift from a potentially restrictive to outright accommodative policy made by the Fed early this year, a global balanced portfolio of government bonds and equities recorded through March, in dollar terms, its best quarter since the end of the financial crisis. Investors do not see price pressures building anytime soon, so much so that they are currently discounting a full Fed cut by mid-2020.
For how long could ‘Goldilocks’ persist? Although very hard to tell, the current state of the economy does not seem to be conducive to an inflationary regime anytime soon. Take for instance US productivity, which has been rebounding cyclically since mid-2016 from very depressed levels and surprised to the upside in the Q1 release. Higher output per hour will boost corporate profit margins and contain at the same time price pressures, since more can be produced with the same resources. Hence, in spite of wages gradually creeping higher, the cycle will be extended for longer and the Fed be able to afford to be patient as long as productivity normalizes.
Although Jerome Powell at the latest policy meeting expressed the view that subdued inflation is temporary, the real concern is that prices will remain low for too long. US growth is slowing down and the Fed pivot came purposefully to the rescue with a most welcome easing of the financial conditions. Above-trend Q1 growth won’t carry over in Q2. Temporary factors boosted GDP in the first quarter of the year and US manufacturing confidence for the month of April was below consensus forecasts, while in Europe business confidence pointed to no momentum in underlying activity.
The expectation is that the combined stimulus efforts of the Fed and the People’s Bank of China, alongside strong labor markets, will boost growth in the second half of the year. It that is enough to breathe some life into the price of goods and services, though, is still a moot point. Sustainable growth does not come without some inflationary pressures.
Fixed Income Update
US macroeconomic data supports the rich valuations on corporate spreads. US payrolls growth surged in April with non-farm payrolls increasing by 263,000 jobs. The unemployment rate dropped to a multi-decade low of 3.6%. The average hourly earnings growth held at 3.2% annually and the monthly gains missed expectations to 0.2% from 0.3% increase. US ISM headline declined to 52.8 from 55.3, lower than expected. Manufacturing activity continues to be depressed as production managers struggle to alleviate a substantial inventory overhang which developed over the past few quarters. Meanwhile, the survey comments point to a steady business outlook for the rest of the year. Corporate credit spreads across investment-grade and high-yield have been well supported at 112bp and 354bp respectively.
Last week, the Federal Reserve maintained the fed funds rate unchanged characterizing economic growth as solid even as inflation remains tepid. Fed Chairman Powell said current indications point to a prolonged period of holding pat on increases or decreases in rates despite President Donald Trump has said he wants the Fed to cut rates by a full percentage point. Benchmark US Treasury yields remained unchanged over the week at 2.52% while the US yield curve (30Y minus 5Y) flattened from 67bp to 59bp. Eurozone yields rose with the support of stronger-than-expected GDP growth (+0.4% QoQ) and a 10-year low in unemployment (7.7%). UK Gilts and German Bund yields rose to 1.21% and 0.023% respectively.
The maiden Sukuk issuance by Saudi Telecom earned a steady primary demand of $4.5 billion from global investors. Saudi Telecom issued $1.25 billion of senior unsecured US-Dollar denominated Sukuk with a ten-year tenor maturing in May 2029. Rated A1/A- by Moody’s and S&P, the Murabhaba structure was priced at MS+135bp which translates to a rate of 3.89%.
Eurobonds from India – holding well. India’s Eurobond issuance has already surpassed last year’s total in just the first four months of 2019, helped by easier global liquidity and the Reserve Bank of India’s stance to allow non-banking finance companies (NBFCs) to borrow from the international capital markets. So far YTD, Indian companies have issued $9.4 billion of dollar bonds led by diverse issuers such as State Bank of India ($1.25 billion), Shriram Transport Finance ($900 million), Vedanta ($1 billion), Indian Oil ($900 million), Bank of Baroda ($800 million) and JSW Steel ($500 million).
LIBOR, a radical transformation. The global benchmark is set to be phased out by 2022, to shift from being submission-based to transaction-based, an evolution triggered by the UK FCA back in 2017. The key alternative overnight (O/N) benchmark rates have already been selected across the five largest currency areas: 1) Secured overnight financing rate (SOFR) in the U.S.; 2) Sterling O/N index average (SONIA) in the UK; 3) euro short-term rate (ESTER); 4) Swiss average O/N rate (SARON); 5) Tokyo average O/N rate (TONA). Presently, there are close to $400 trillion of transactions linked to LIBOR.
Global equities had a volatile week. However, better than expected earnings contributed to a largely positive sentiment, also helped in the US by the Fed and job report. U.S. equities finished the week marginally higher (+0.2% for major indices), boosted by Friday session. There is no change in the outlook on trade talks and a deal seems to be priced-in so any disappointment would be negatively received. On the earnings front, 72% of S&P 500 companies have reported for the Q1 season and c. 78% of them have beaten estimates. Q1-2019 should now be at the same level as Q1-2018.
The Technology sector is still leading returns globally, but healthcare is recovering from the sharp sell-off seen last month. Merck boosted its forecasts for the year and approved a new restructuring program while Pfizer topped earnings estimates. Barring Alphabet, most mega-cap tech companies have also exceeded expectations. Google's ad sales rose 15% in Q1, the slowest pace since 2015. Amazon is being blamed for taking away market share. Apple had a good quarter with its continued focus on services revenue and a pickup in iPhone sales. There are now 2 companies flirting around the USD trillion dollar market cap Microsoft and Apple. Warren Buffett’s Berkshire Hathaway Inc. is buying shares of the e-commerce giant Amazon, an usual exception to their usual “value” principles given the current multiples.
Facebook CEO Mark Zuckerberg said the company was committed to building a "privacy-focused" social platform to ensure that conversations stay private and user data is secure across its products like Messenger, WhatsApp and Instagram. He acknowledged that there are privacy concerns related to its platforms, but committed to bringing in changes and "starting a new chapter". He outlined that the vision is based on six principles - private interactions, encryption, reducing permanence, safety, interoperability and secure data storage -across features like private messaging, groups, payments, and even location sharing.
Commodity and energy companies had mixed results. Glencore lowered its full-year copper output goal and trimmed production targets for other commodities from nickel to oil. BP matched expectations, avoiding the refining trap that snagged Exxon. In the aerospace sector, Boeing continues to be plagued by woes in contrast to Airbus whose earnings jumped as it churned out more A320s to plug the gap left by Boeing's 737 Max. In Asia, noteworthy results include China insurer Ping An which grew profits exponentially.
In an effort to achieve Vision 2030, The Saudi Arabian General Investment Authority (SAGIA) has reached nearly half of the 500 proposed regulatory changes proposed to boost Saudi’s business environment. The government has introduced 100% foreign ownership rights, enhanced legal infrastructure and offered greater protection for shareholders. The KSA market continues to do well. The Saudi Stock Exchange, Tadawul’s market capitalization reached SAR 2.2tn and total foreign investor ownership accounting for 5.7%. Tactically, we think it’s time to book partial profits as market valuations are getting stretched
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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A quiet week - 28 April 2019
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