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Chief Investment Officer's team, 26.04.2020
Unstable equilibrium. On one hand, the economic shock is massive. On the other, markets want to look through the crisis, and trust policy action to bridge the gap. Last week oscillated between the two: April flash PMI numbers were terrible, but the US approved another $500bn aid package. A significant crack appeared in the Oil market: due to the combination of collapsing demand, storage saturation and speculation, the May contract on WTI traded below zero for the first time ever and Brent prices briefly fell into the teens. As we said before, we see this as a symptom of the current crisis rather than a new one. Having said that, we don’t recommend any direct speculation on the commodity – the only one we recommend is Gold, now our biggest overweight. It was up 3% last week while risk assets lost on average 2%.
The key question for investments remains whether markets have integrated that the easing of restrictions will cause a resurgence in infections: another duality of forces which will have to find an equilibrium. At least, the sovereign rating of Italy was not downgraded last Friday by S&P, still BBB with a negative outlook. In the meantime, EM Asia, our key overweight across asset classes, holds better. China’s factory PMI, due Thursday, could stay above 50, while US and Eurozone Q1 GDP due Thursday should crater. Major Central Banks will hold their monthly meetings next week. Technology titans will also release their earnings. So far, Q1 numbers are not that important for market direction, but Amazon or Microsoft could matter. Stay safe, and Ramadan Kareem.
Equities in the developed markets have outperformed emerging market stocks by a wide margin in the current recovery, although China, the leading economy in the pack, was the first country to suffer from the adverse economic impacts from the virus and the first one to lift lockdowns and resume activity. This can be partially put down to the liquidity-driven rally caused by the massive stimulus measures implemented in the United States which have dwarfed the steps taken by the Chinese authorities, constrained by past debt levels threatening financial stability; and also to the presence in the major US indices of larger shares of secular winners from the Great COVID19 Crisis, the technology and healthcare companies.
One should also notice that oil dynamics are particularly important for the emerging countries and historically capital flows into EM assets have followed the direction of crude prices and in general that of the broader commodity indices. This Great COVID19 Crisis has been no exception. Crude prices collapsed and capital flows came close to freezing, had it not been for unprecedented Fed interventions which restored global dollar liquidity to normal and avoided a sudden EM stop, an extreme situation where foreign inflows stop completely.
Intuitively, we have already laid the groundwork for understanding that a turn in oil prices, signaling a broader global economic recovery, and ample worldwide liquidity feeding into the major economic areas, would be needed to see a comeback of the emerging markets. This is what one would expect to happen sometime in the second half of the year, with a rotation from US- to EM-centric assets, provided that the reflationary efforts of the monetary and fiscal authorities translate into a strong enough global growth impulse. At that point, with large dollar flows leaving the defensive shores of the United States to chase cycle-sensitive assets, a renewed cycle of US dollar weakness would be started, in line with the debasement of the currency brought about by the huge liquidity injections of the US Federal Reserve. A drop in the value of the dollar would be consistent with EM outperformance and further contribute to the loosening of global financial conditions.
The above scenario seems pretty plausible, unless the whole world has already fallen into a gigantic liquidity trap, which would see it going down the Japanese deflationary route. The current DM-EM valuations gap would warrant a rerating of EM assets, with a value squeeze during the recovery phase being an opportunity for the sizeable EM discount to be reduced.
GMO, the investment house founded by the renowned value investor Jeremy Grantham, has recently published its long-term capital market assumptions and sees indeed value in the emerging economies. According to GMO, EM equities should see returns of 4.2% annualized in real terms over their 7-year forecast horizon, close to our projected nominal 9% when 4%+ inflation is added back. This contrasts with gains for US large caps projected to be barely positive. Of course, considering the long-term COVID19 winners in the US indices one may want to temper a bit this enthusiasm!
Fixed Income Update
Last week 10-year treasuries traded in a very tight range despite the large volume of issuance by the US Government and Fed reducing its treasury purchase limits. This was the pattern across most developed economies whereas European peripherals and LatAm benchmark yields went up. Mexico and PEMEX were downgraded by the big three rating agencies while Mexico did manage to price $6bn bonds in a three-tranche deal amid all the negative news.
Argentina came out with an exchange offer for its bonds, and depending on the discount rate, the value of the offers ranges between 35 cents to 40 cents, which gives little upside to the existing bondholders. There is a high likelihood of the proposal being rejected by the bondholders since little to no coupon payment may not be palatable to the investors. The four other critical features of the offer set out in the exchange prospectus, are (i) use of collective action clauses (CACs) to effect the exchange, (ii) the use of exit consents, (iii) a Rights Upon Future Offers (RUFO) clause, and (iv) limitation of cross-default. Moreover, Argentina did not pay the coupon on its $500mn bonds on 22nd April and invoked the 30-Day grace period.
Kingdom of Saudi Arabia is planning a record debt raising program this year to fight the dual shock of low oil price and COVID-19 related economic shutdown costs. The total debt issuance this year could hit $58bn. This is the biggest debt program since its debut in international bond markets in 2016. The Kingdom has already tapped the bond markets for $19bn issuance this year. Short duration A-rated senior papers of the Government related entities from the country currently trade at an attractive 250+ bps spread and offer decent risk-adjusted returns, in our opinion.
GCC investors came to terms with the first fallen angel of the year with S&P downgrading Kuwait Projects (KIPCO) to BB+ from its previous investment grade rating of BBB-. This change was initiated as a result of S&P taking higher haircuts on the OSN and UGH, which are subsidiaries of KIPCO. We do not think the bonds will default in the next twelve months as the company has adequate liquidity to cover repayment of its $500mn bond maturing in July this year. 40% of the company is owned by Al Futtooh Holdings, which is backed by the ruling family of Kuwait. Moreover, the company does not have any upcoming maturities until 2023 apart from the July bond.
Emerging Market HY sector continues to be under stress. Franklin Templeton’s closure of six short duration bond mutual funds with a total AUM of $4bn came as a shock to investors in the rupee-denominated market. These funds were holding very illiquid lower than AAA-rated papers. This was the culmination of a long time drawdown of cash by investors from the credit risk funds, which had been sold as cash alternatives. As we have mentioned several times recently, investors would do well to be “Up in quality” in all the fixed income sub-asset classes to avoid such negative surprises regardless of how lucrative the returns might look in the short term.
Equities had a bumpy week. Q1 earnings season saw a 25% y/y drop in earnings from the 20% of S&P 500 companies that reported and 16% drop in European earnings from the 17% that reported. Continued uncertainty surrounding the reopening of economies was countered by increased stimulus to aid small businesses and increased funding to the healthcare system. Economic and market data remains downbeat with lower PMIs in Europe, an increase in jobless claims in the U.S., a sharp fall in China growth, bankruptcy of a major airline in Australia and the gating of some debt funds in India. There is a divergence between the downward economic trajectory and the resilience of markets as the record stimulus (double the global financial crisis) remains supportive and as investors look through to 2021, setting aside current concerns on viability and profitability.
The volatility around WTI future contracts, did not impact the energy sector which was up last week, though year to date, the worst performer (-40%). Balance sheet strength remains key. BP and Shell, amongst the top 5 dividend payers in the UK, plan to continue scheduled dividends. Whilst debt for neither is low, they are the best placed amongst the oil majors with their diversified cash flows and cost synergies built up during times of higher oil prices. 40% of FTSE 100 companies have cut their dividends this year. UAE markets have rallied in April, recovering from an earlier deep sell off. Year to date, the telecom (good results from Etisalat) and financial sectors lead performance. The opening up of the economy should have a positive impact on investor sentiment.
Healthcare is the best performing sector, with the COVID 19 Pandemic disrupting people’s lives and economies and a cure and a vaccine, awaited eagerly. Trials are so far inconclusive on the efficacy of Gilead’s Remdesivir and Novartis’ Plaquenil. Service sectors such as airlines and hospitality can only resume full functioning once a vaccine or medicine to alleviate symptoms is widely available. Boeing is cutting 787 Dreamliner production in half whilst Alphabet will cut its marketing budget in H2. A paradigm shift in consumer preferences is evident. Procter and Gamble saw increased sales in Q1 as people bought more disinfectant and cleaning materials whilst Coca Cola gained from stocking in Q1 but saw sales fall by 25% in April, as demand for nonessential products fell. Unilever spoke of a fall in demand for personal grooming products, in its quarterly call, as people stay at home.
Netflix remains the streaming leader (+31% YTD) with a total of 183 mn paid subscribers. Other winners of the lockdown include Zoom Video Communication (+133% YTD), added to the Nasdaq Index last week. Zoom has 300 mn users, grown from just 10 mn in December and is competing in both the social (WhatsApp Video, Google Handouts) and office (Microsoft Teams, Slack) video communication space. Facebook, announced the launch of Messenger Rooms and also increased focus on Indian ecommerce with an investment in Jio, the digital platform of Reliance Industries. A beneficial alliance with WhatsApp’s 400 mn and Jio’s 388 mn users in India.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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