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Chief Investment Officer's team, 23.02.2020
The latest developments over the coronavirus are not encouraging. The number of cases keeps on increasing globally, with Italy, for example, quarantining several cities and cancelling the Venice festival. The number of infections is still rising in China, and spiking in countries like Iran, Japan or South Korea, prompting travel restrictions and containment measures. After the benign economic indicators of January, more recent data reflects concerns, from energy consumption and manufacturing activity in China to US service (flash) PMI. Companies are also explicitly voicing concerns, with Apple being the most emblematic, warning about the virus’s impact on factories and stores.
No surprise, against such a backdrop, that markets took note last week. Gold rose to a seven-year high, while equities retreated and long-term rates fell lower, below 1.5% for the US 10 year.
The downside risk to the global economy is undoubtedly material, even if the worst is never certain. Deeper concerns will shake markets but also prompt stronger responses. We had reduced our exposure to developed market stocks earlier in February because of valuation concerns, but maintain our conviction on EM stocks. They are vulnerable to a negative turn of sentiment, but their long term prospects are second to none. Our significant positions in cash (our largest overweight) and gold should mitigate risk and provide flexibility to seize potential opportunities down the road.
Ever since negative newsflow on the corona virus has intensified safe-haven assets have gained consistently. In the last four weeks US 10-year Treasury yields have dropped by about 20 basis points plumbing new lows for the year and gold has recorded new multi-year highs putting in a 4%-plus performance. This stands in stark contrast to equities sitting close to all-time highs and seemingly unfazed about the outlook deteriorating in the short-term due to the economic disruptions brought about by the spreading of the epidemic.
A common factor driving both long-dated yields and gold is expectations about future policy rates. In a short time span markets have translated growing concerns about the economy into one more rate cut, with two currently being priced-in by Fed fund futures in the next 12 months versus one only anticipated as of January 24th. With real variables usually reported at monthly frequency and moving ever so slowly, projections of future policy rates should account for most of short-term volatility. So, the question is how many more rate cuts can markets discount when Fed officials are not inclined to loosening policy any further as per recent statements? According to the last FOMC minutes the Fed seems to be comfortably on hold, while markets keep on following the latest breaking news.
Research on high-frequency economic data in China, ranging from transportation to energy consumption, is not offering any relief, with activity still down up to 40% versus its seasonal pattern at this time of the year. Whoever envisages a V-shaped recovery from current disruptions cannot be certain about its timing. Should a third rate cut be priced in, which would be in our view extreme but cannot be entirely ruled out, yields would breach previous all-time lows at 1.3180 and gold could trade past $1,700/oz. At the same time as more companies report disruptions emanating from Chinese-related business activity equities should go through a pullback and catch up with safe-have assets.
Yet, the above analysis suggests that excessive pessimism is predicated on extreme views on the economy and rates. Fed funds discounted more than four cuts 12 month forward only during the Great Financial Crisis, so betting on looser policy from current levels seems to be quite a stretch. Safe-haven assets are richly priced in our view and with them bond proxies in the equity space. Investors should be better off looking to buy weakness in risk assets rather than chasing expensive safe-havens. Although the exact timing of recovery in the developing countries is uncertain, pent up demand can accelerate the process once disruptions subside. EM equities remain our favourite risk asset within this context.
Fixed Income Update
New records continue to dominate within the fixed income space. Be it US Treasuries, Euro-area peripheral benchmark yields, or participation levels at the primary bond issuance markets, it seems there is only one way for the yields to go – supported and fuelled by central bank policy stance, and the flight-to-quality on account of the virus contagion scare.
The US Treasuries bull-flattened with 30-year bonds, hitting a record low yield of 1.91%. The 10-year benchmark yields have stubbornly stayed below the 1.50%. The top debate among fixed-income participants is whether the 10-year yield breaches the 1.40% or 1.80% first. At the risk of being considered a daredevil under the existing circumstances, we believe the Treasuries might be overbought, and it is precarious to add any long position to the DM Government Bonds now. It might be a question of “when” rather than “if” for a pullback. For the time being, though, investors would have to put up with the crowd positioning to such safe-haven assets.
European bond yield moves were more modest with doubts being cast on the sustainable rate of growth amidst a disappointing ZEW Survey Expectations data report last week. There is bad news for optimists among us as Moody's Investors Service has revised France's outlook to stable from positive without upgrading the ratings. The rating agency, while reaffirming the rating, said the key driver behind not upgrading the rating was moderate than expected improvement in the country's fiscal metrics.
The extraordinary rally in the US Treasuries has resulted in the hard currency Emerging Debt, striking it rich for an 11th straight week. This performance is the longest positive streak for the asset class in the last eight years. Despite EM risky assets getting the stick, investors have put their faith in the fixed income counterparts for their higher risk-adjusted return. The option-adjusted spread for the EM Debt Index has come off from a high of 319bps in early February to current 310bps
The primary issuance market for high-grade issuers now looks more like a race-to-the-bottom. Singapore’s DBS set precedence last Thursday by selling USD 1 Bn Additional Tier-1 perpetual notes at a record low yield of 3.30%. This bond sale was Asia's first AT1 deal this year and may set a benchmark for new issues. In terms of regional names, we expect Dubai Islamic Bank to tap the capital markets for issuing a 5 to 7-year senior unsecured Sukuk this week.
With a flat yield curve and record-low Treasury yields, investors must rely on alpha generation strategies, which includes deep-dive on credit selection in often-overlooked markets by them. Two such markets that we like are the Indian NBFC sector and the GCC Debt complex. We see opportune tactical plays offer compelling propositions towards capital appreciation, and thereby higher total return for the discerning investors. The key to benefiting from these markets is to keep a close watch on the issuers entering the market and taking advantage of the new issue premiums.
For the week, US equities finished lower with the S&P 500 down 1.2% (+3.5% for the year) and the Nasdaq Index down 1.6% (+6.9% for the year), with the coronavirus outbreak and flash PMIs in focus. Cyclical sectors were the most impacted i.e. tech (semiconductors and software), consumer discretionary (travel and apparel) and communication services (entertainment), though the FAANG’s are still up 21% for the year. The defensive sectors held up better last week with utilities, REITs and consumer staples higher. The recent narrative for stocks has revolved around supportive central bank policy, a 2020 earnings rebound, a strong US consumer and expectations that the coronavirus impact will be limited to Q1.
However, we see downward earning revisions for the US emerging, though just a 1 % cut so far. The consensus for 2020 expects a 9% earnings growth, driven by a latter half recovery as analysts estimate growth of only 1.5% and 4.7% for Q1 and Q2. Our own estimate remains at 4% for 2020. It is widely expected that by end March, the virus should be under control limiting the impact on the global economy. What remains a bigger concern, are the stretched valuations, the longer-term supply chain disruptions and the headwinds from dollar strength. Asian markets, at the heart of the outbreak were the most affected last week, led by the Hang Seng Index. European markets, fell less, with automakers among the worst performers. GCC markets were fairly resilient, with oil prices dominating headlines.
Apple, lowering revenue guidance for March, was the catalyst for the downturn in US markets, which had hit an all-time high early last week. This raised concerns about the challenges of reopening businesses in China and the ramping up of production. South Korea has already highlighted the need for stimulus due to the coronavirus and the Bank of Japan has dialed back its inflation goal. A recent FactSet US Earnings report spoke about how companies are thinking about the coronavirus outbreak on Q4 earnings calls. 138 of the 364 that had reported up to the second week of Feb cited the term "coronavirus" during the call. Their average revenue exposure to China is 7.2%, which is not worrying, as the average for all S&P 500 companies is 4.8%. While many discussed headwinds, 34% said it was too early or too difficult to quantify the impact in guidance. Coke flagged coronavirus headwinds but still expects to hit full year guidance. Deere sees early signs of stabilization, in the farm sector. Some European companies such as Burberry, Pernod and Air France-KLM have warned about the impact of the virus, but others, such as Nestle and Valeo, have said it’s too early to gauge the effect.
Industries expected to benefit from the effects of the virus outbreak are those that are domestically oriented and not dependent on global trade for supplies or revenue and include online gaming, gene editing, food, utilities and real estate (bond proxies) and those with a defensive nature (quality yield). The most affected include luxury goods, hotels, cruise operators, airlines, logistics, shipping, materials, autos, energy and telecom. The last two on account of a shortage of supply of parts. This differs across regions and is just a bird’s eye view as the granularity offers some clear winners.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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