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Chief Investment Officer's team, 12.07.2020
Last week was another good one for global markets. Their performance hierarchy followed the virus developments and consequences. First in, first out: China outperformed Europe which outperformed the US. Sector-wise, tech and consumption did better than energy and real estate, illustrated by the Nasdaq printing new all-time record highs almost every day.
The virus shows no respite in the US with a record level of infections. We however reiterate the view that based on what we see in Asia and Europe, not even mentioning the remarkable handling of the crisis by the UAE, the global economy will not be stopped again. We are learning to live with the pandemic: local outbreaks are inevitable but manageable. They will however impact consumer confidence and generate turbulences in the trajectory of the recovery, with replications on expensive risk assets. Political risk also supports volatility, through the US Presidential campaign and rising geopolitical tensions, as illustrated by President Trump mentioning “severely damaged” relations with China, and North Korea looking as unpredictable as ever. But again, Mr Biden’s program is not disruptively market adverse, and we don’t think that any country can afford more than verbal escalation given the context. The recovery is on track but markets might not be ready for uncertainty and for the fading momentum which will naturally follow the initial surge from the bottom. This is why our positioning is more defensive than a month ago, but we are ready to seize opportunities.
The current “First-In, First-Out” dynamic of data should be confirmed by China’s GDP, Europe Industrial Production and US Retail sales this week, and the earnings season will start with US financials. Stay safe.
Markets tend to move in line with fundamentals as well as crowd psychology, with the former driving longer term returns and the latter usually playing out at higher frequencies. Few expected in the darkest moment, at the late-march lows, that equities would soon be posting one of their best quarters ever. That moment marked an instance of crowd psychology at work, with investors caught short stocks or underinvested when the Fed announced one alphabet soup of stimulus measures after the other, driving a very forceful rebound across risky markets. After engineering the rally, one of the many which can be ascribed to the Fed’s largesse since Alan Greenspan started serving as chair in 1987, Fed officials are still unconvinced about the sustainability of the recovery. A number of them last week expressed concerns that economic improvements are in danger of stalling on rising new virus cases. On top of this, enhanced unemployment benefits, which have been key to replacing spendable income amidst rising joblessness, are set to expire at the end of this month. Congress should extend the benefits till year-end, although Treasury secretary Mnuchin said that they will be adjusted so that they will no longer exceed work compensation.
One may wonder whether investors, once more bending to the overwhelming power of US Federal Reserve’s liquidity, will now be caught off guard with some headwinds possibly looming larger. Dissecting the rally in risk assets reveals elements of rationality to it and indeed little in terms of crowd psychology, bringing market-implied beliefs much closer to Fed’s views than one would at first sight expect. The list of year-to-date best performers reflects trends already familiar since the Great Financial Crisis, mostly clustered around dollar-centric and growth assets. Gold comes on top, driven by sinking real rates on exceptional stimulus, while MSCI China equities, on a par with the Nasdaq, represent an exception born out of the benefits of a domestic V-shaped recovery. GFC winners, from Technology stocks, to US Treasuries to S&P500 growth or US High-Grade Credit, follow in the list. Which is highly unusual, as in the aftermath of a recession the usual playbook is that cyclical assets, more sensitive to the vagaries of underlying economic activity, tend to outperform, with defensives and growth trailing. This has not happened this time as Covid turmoil has exacerbated trends already in place since the Great Recession of 2008, from deflation to low government bond yields to muted growth and economies unable to gain escape velocity in spite of durable, rather than temporary, stimulus measures being in place.
With Fed policies firmly entrenched, yields expected to remain low for longer and economies in need of support throughout the forecast horizon, it is difficult to see dollar-centric, growth or higher-yielding assets handing the baton over to market segments leaning cyclical. That is more likely to happen temporarily, relieving overbought conditions for the secular winners, rather than becoming structural. A more durable shift would occur in the case of deflation giving in to an inflationary outlook, not the base case until the detrimental effects of the current crisis continue to play out.
Fixed Income Update
As economic forecasts and reopening schedules get adjusted, we see the effect of the investor sentiments on both the benchmark yields and the broader benchmark bond indices. US 10-year Treasury yields have been oscillating between 0.6%-0.7% range for the last three weeks. While we do not foresee any rally in the yields unless FED opens up directions for negative rates which could in themselves open up several Pandora's boxes, we also do not see any reason for the yields to move materially higher on the backdrop of uncertain economic recovery and increased localized infection cases.
The weekly returns showed a clear bifurcation between high-grade index returns led by the Developed Market treasury index topping the charts in terms of bond benchmarks. While the riskier sub-asset classes within the fixed income space, such as emerging market debt and global high yield indices, posted negative weekly returns.
The primary issuance after notching record levels by both IG and HY sectors are expected to moderate in the second half. Net issuance by IG issuers at $380 bn has surpassed both 2018 and 2019 levels fueled by $550 Bn net issuance, which is the highest since 2014. We are aware of the fact that around $175 Bn of bonds have moved to HY by way of fallen angels. Similar results are observed in the High yield space as well. Moreover, Net fund flows have been positive in markets with direct policy support with maximum flows into USD IG funds, followed by USD HY and EUR IG funds.
GCC spreads have been more range-bound after the recent rally. Front-end of the IG credits, including the sovereigns, has tightened considerably. We believe they seem stretched in terms of valuation compared to other similar rated Global IG credit, while long-end of the curve is pricing in geopolitical uncertainties. In contrast, the front-end of HY sovereign curves incorporates a lot more risk, which may not manifest due to expectation of support from GCC neighbors to avoid domino effect on the currency pegs and the region's overall investor sentiment.
S&P has downgraded three Dubai based real estate players Emaar Properties, Emaar Malls, and DIFC Investments from Investment Grade to High Yield on the backdrop of soft sector conditions on 9th July 2020, increasing the fallen angel issuers from the GCC to four including Kuwait Projects which was downgraded earlier. The rating agency had earlier placed Emaar Properties, and Emaar Malls under credit watch negative and had changed the outlook on DIFC to negative in March 2020. The current outlook is stable for DIFC Investments while negative for Emaar Properties and Emaar Malls. We believe all three issuers have sufficient cash balances and bank credit lines to avoid any distress scenario even though the credit metrics look stretched in the medium term.
A spectacular Q2 for global equities, sustained into July, with some volatility. A pattern we expect will continue, as the pace of the economic recovery is weighed against new flare-ups in coronavirus cases across the world. The week ended well, on news that Gilead’s COVID-19 drug remdesivir reduces mortality. Vaccine trials also continue to progress satisfactorily. The S&P 500 ended the week +1.8% and the Nasdaq +4%. The leaderboard remains the same: Apple, Amazon, Microsoft, Facebook and Alphabet have strong YTD gains and made new highs in July. Oil E&P stocks had a rough week - 5% (XOP US). In Europe, financial and mining stocks have somewhat recovered from their deep sell off along with the auto sector, industrial groups and luxury makers exposed to China.
The US Q2 earnings season starts Tuesday, with the banks. What will be watched closely is the guidance. The estimated earnings decline for the S&P 500 for Q2 is -44.6%, according to FactSet. With earnings surprises, this could be closer to 40%. It will mark the largest y/y decline by the index since Q4 2008 (-69.1%). All S&P 500 sectors are expected to see negative earnings growth, led by energy, at -151.5% and cons. disc. at -118%. Tech earnings are estd. at -9.5% and comm. services at -30.7%. The least fall is the utilities sector, -3.3%. Estimates for the S&P 500 for Q3 are at -24.9% and for Q4 -12.4% with a return to earnings growth in Q1 2021 (12.2%).The outlook for Q2 sales is much better, with an 11% decline overall and health care and utilities projected to see y/y sales growth. The forward 12-month S&P 500 P/E ratio is 22X, above the 5-year and 10-year average.
The UAE in a remarkable drive to create an even more agile government has set up a single Government Digital Services portal with a focus on Economy, Technology and Cybersecurity. The start of July has seen an uptick in the Dubai Equity Index with Abu Dhabi flat. Businesses seem to be recovering with the UAE headline June PMI, in expansion territory.
Crises tend to accelerate macro trends already in place and internet, cloud, video conferencing and enterprise technology companies which can support remote working have benefited in 2020 as have big pharma, genomics and biotech companies. Another trend that’s been gaining is ESG and winners include Electric Vehicles companies Tesla and Nio, both up c. 270% this year. Tesla’s market cap of $276 bn make it to the top 20 most valuable companies in the U.S. and it is now turning a profit. Whilst China is supporting the move to EVs, the spectacular run up of companies such as Nio, yet to make a profit need to be treated with caution. We remain focused on quality names.
The MSCI China (USD) is up 13% month to date in July accounting for the majority of the 2020 Index gains. The rally, has echoes of 2015 at the back of investors’ minds when the market came down as quickly as it had gone up. For now momentum, trading volumes and margin lending are supporting the China rally. The government-backed China Securities Journal emphasized the need for a “healthy” bull market to support the recovery. Analysts said Chinese authorities could be seeking to boost markets in the hope that this would boost consumer spending. We remain neutral China.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Time to be cautious, but not too pessimistic
Preparing for a volatile summer
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