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Chief Investment Officer's team, 10.12.2018
The last two weeks have been a perfect illustration of the only clear theme of 2018: volatility. It seemed however that some of the market current concerns were developing positively: a more dovish speech from Fed chairman Powell, a temporary truce between US and China over trade, Oil prices rising after announced productions cuts, and even some signs of hope in Europe, from Italian budget to the legal possibility of no Brexit. Markets reacted positively, before questioning the reality of the relief in trade, especially as we learnt that a prominent Chinese business leader was arrested in North America. It thus didn’t take long for market participants to switch their focus to capital preservation (especially as the end of the calendar year approaches) and everything went red again.
As shown in the chart above, this leaves investors with a sea of red across assets, and as we wrote several times, the risk of total capitulation is always present.
Having said that, the lagging element in the picture is a tangible sign of fundamental deterioration. Yes there are fragilities, especially around the combination of strong US Dollar and tensions on trade, and yes the cycle is getting old, but it looks like markets are already pricing-in a down-turn which is factually not happening. While it is difficult to find a catalyst for the negative trend to reverse, especially as markets have ignored the recent good news, it is also difficult to see the current rout as an excess of pessimism – an undershoot. One week away from a dramatic decrease in trading volumes is certainly not the right time to take additional risk, but unless an imminent recession happens (which is not Emirates NBD’s scenario), it is time to show patience and resilience.
According to financial markets’ performance, the current state of affairs with the global economy is smelling of recession, although our, as well as the consensus, view, is that chances of a US recession in the next twelve months remain relatively low. Global equities are negative year-to-date and over a 12-month period, corporate spreads wider and safe-haven assets are in demand. This is reminiscent of early 2016, when concerns about US and China slowing down saw global equities plunge sharply in negative territory.
Economic forecasts currently see global growth still above trend, although barely, in 2019, which would be for a third consecutive year. To be sure, all is predicated on an orderly US slowdown and a benign China-US tariff scenario. Here comes to the rescue the very recent trade truce, to provide a window of opportunity for the next three months at least, and the November US business confidence report, as measured by the ISM Index, which shows that corporate sentiment is still pretty unscathed. Of course, as far as the macroeconomic picture is concerned, investors preferred to focus on rising US jobless claims, notwithstanding the widely held expectation that the unemployment rate is headed towards record-low levels by the end of 2019.
Should one look at Fed policy as a source of bearish inspiration, one would be disappointed as well. Mr Powell’s recent change of tack from forward guidance focused on lower future rates to data dependency, customary at cycle-end, implicitly portends a dovish shift, considering that US growth has peaked and the slowdown phase is in the offing. Last but not least, prior to recessionary periods, business profit margins tend to drop, whereas so far this year they have been rising to new cycle highs in developed markets.
The above signposts help us enter 2019 with a moderately cyclical view, overweight equities and EM assets versus government bonds, tempered by some portfolio hedges, specifically an overweight on gold and an underweight on high-yielding corporate bonds. Indeed, risks are aplenty, from unresolved trade conflicts to the delayed recovery outside of the US, to a Fed policy error or growing political tensions in Europe. At the same time, risk assets have already undershot their fundamentals and unless recession odds unexpectedly rise by a significant degree, we will adhere to a cautiously constructive view.
Crunch time is approaching on Brexit, as this week the UK Parliament is scheduled to vote on the Withdrawal Agreement signed by the Government and the European Commission. Although the vote remains highly uncertain, the base case discounted by markets is that the Agreement will not get the sufficient majority and that a second vote will be necessary further down the road to avoid a ‘no deal’ scenario. Hence, for investors the risk-reward currently embedded in UK asset prices is quite asymmetric to the upside. Unless uncertainty spikes because the deal is rejected by a very large margin , which according to most investment houses would be a margin of more than 70 to 75 votes, a small shortfall would still support hopes that a second round of voting would see the deal through. For instance, forecasts for the pound are relatively benign, muted reaction if the Agreement fails by a small margin, and become pessimistic, downside up to 1.20 against the US dollar, only in the case of a broad rejection. The unexpected ratification of the deal could see the pound spike towards 1.35. We hold the view that a ‘no deal’ scenario is not in the best interest of the UK people, hence even reluctant MPs in the end will coalesce round the most rational choice and accept a soft Brexit, in the second vote. The risk-reward is indeed skewed to the upside, unless adherence to ideology gains the upper hand.
Fixed income update
It was an eventful week for markets, driven by several macro-fundamental data and strong technical factors dominating sentiment and flows. The release of Fed’s Beige book last week provided some testimony towards the waning optimism on economic growth. The big question on every investor’s mind is what do we do on the fixed income asset class? Do we draw conclusions from the slope of the yield curve or wait to see what is the Fed’s “new neutral” policy rate?
We maintain our view that US Treasuries are appealing – as compared to other DM Sovereign bond yields. We also like corporate IG bonds. We see value within EM with green shoots of recovery on local currency bonds as real yields and lower oil prices strengthen the picture. GCC tops our regional preferences.
The flight to safety propelled by the equity selloff drove benchmark US Treasury yields towards 2.83% and retraced back to 2.88%. The much-awaited US payrolls missed forecasts. Although throughout the year, the narratives on labor market conditions and policy rates were underpinned by strong economic momentum, some are seeing signs of roll-over.
The five and ten-year breakeven rates, implied inflation over the next 5 to 10 years, has fallen to respectively 1.7% and 1.9%. These levels are questioning the Fed’s policy tightening for 2019 and beyond. Market participants have thus markedly revised their expectations on that front, now pricing-in just one hike for 2019, with some anticipations of a cut in 2020.
US trade balance has widened to $-55.5bn from $-54bn, and continues to remind us that such imbalances could potentially weaken the outlook on the US Dollar. China trade balance surged to $44.7bn from $34.4bn in US-Dollar terms. That said, the exports and imports have both sharply fallen. China’s foreign exchange reserves increased unexpectedly last month, ending 3 straight months of declines. The reserves rose by $8.6 billion in November from the previous month to $3.062 trillion, after dropping $33.93 billion in October. PBOC in recent months boosted its efforts to support the yuan exchange rate and stem renewed capital outflows.
The Reserve Bank of India released Q3 2018 balance of payments statistics. The current account deficit widened to $19.1bn from $15.9bn in Q2 2018, mostly due to merchandise deficit, which expanded to c$50bn during Q3 2018, close to the 2012 historic high of $58.4bn. On the positive side, the services balance surplus remained buoyant, at $20.3bn. Earlier this month RBI maintained their policy rates on hold. Inflation has been running much below the RBI’s 4% target for some time. The stable INR together with the benign backdrop on US policy rates should help RBI on their policy action for now. The real yields on Indian Government bonds are still at large and attractive as compared to their EM counterparts.
Peaking growth and less central banks liquidity are not a favorable backdrop for equities, but for investment decisions, backdrop has to be put in perspective with what’s priced in. Though a late cycle environment is not conducive to higher PE ratios, with US (S&P500) 2019 Price to Earnings at 14.8X and Emerging Markets (MSCI EM) at 10.5X, below long term averages, the downside from here looks limited. Earnings growth may have peaked in the US but is still robustly positive there and in the rest of the world. EPS growth remains key and EPS cuts may occur after the 4Q earnings season as is the norm every year. However, even if we don’t take for granted the 2019 consensus earnings growth rate of 9.3% for the US and 9.7% for the rest of the world, there is still plenty of growth in the pipeline. We continue to focus on ‘Quality’ in our strategy but with increasingly more emphasis on valuation.
U.S. stocks may stop outperforming global peers in the year ahead, driven by slower earnings growth and –at a point- a weakening dollar. Emerging-market currencies appear to be stabilizing with the prospect for less Fed tightening and potentially diminishing trade risks. The pace of the S&P 500 earnings growth, a key driver for performance, will slow in 2019. This contrasts with 2018, when S&P 500 earnings have advanced at twice the pace of global counterparts. Emerging markets whilst -13.4% year to date (MSCI EM total returns in USD), halted their decline post October as the path of Fed tightening looked less onerous. Last week emerging markets were down just 1.3% much less than Europe, the US or Japan.
US equities i.e the S&P 500 ended the week down -4.60% and the Nasdaq -4.9%, pushing the former into negative territory year to date (slightly positive on total returns). Euphoria from the G20 meeting has died down with disbelief that the US and China will work out differences in 90 days. A negative yield spread between the 2-year and 5- year treasuries, as well as the 3-year and 5-year treasuries led to financials being the worst performing sector -7.08% last week. Slowing growth concerns with negative tailwinds from trade tariff ramifications remains in the forefront. The IMF estimates that global GDP will decline 1 percent by 2020 if the US puts a tariff of 25% on $200 bn of Chinese goods. The US Jobs report was non impactful with non-farm payrolls coming in below expectations, while inflation remained contained.
A break of a critical technical support level (200 DMA) exacerbated the US sell off. For now, a trading range seems the most likely path. On Tuesday the S&P 500 posted a fifth 3% daily drop for 2018 and touched a 10% correction. Index valuations are oversold and inversions between two-year and five-year Treasury yields typically confirm the late economic cycle but not recession.
The GCC region saw some a broad based sell-off in the UAE last week, with the Dubai real estate sector developers seeing some pain. The focus in the region remains on high dividend yielders leading to the outperformance of UAE banking stocks and also the KSA petrochemical and banking stocks. The Tadawul banking Index is up 28% year to date, in contrast to global banks which have felt the impact of the lower 10 year Treasury yields. Whilst MSCI EM Index inclusion remains a catalyst for the KSA stock market, the Saudi SAIBOR is linked to the LIBOR hence may be time to partially book profits on KSA banks
Written By:Maurice Gravier Chief Investment Officer, Maurice G@EmiratesNBD.com
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