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Chief Investment Officer's team, 11.10.2020
2020 has been so far of an unprecedented intensity, and last week was no exception. It started with the world’s most powerful man being hospitalized for covid, with contradictory indications on his health, and it ended with the very same President Trump, more energetic than ever, asking for a bigger fiscal stimulus only days after having instructed his teams to stop negotiating with the Democratic party on the very same topic. At the same time, the virus resurgence in the West is alarming, especially in Europe.
To this chaotic backdrop we can add a clear rise in the number of new cases in Europe and an open Azeri-Armenian conflict. In spite of no new action from Central Banks or breaking news on an imminent vaccine, markets decided to make it simple: the probability of a clear victory of the Democrats is rising, which would both reduce the risk of contested results and open the prospects of a massive fiscal stimulus plan through 2021. The clock is ticking for defensively positioned institutional investors to put their cash to work, and so they started buying.
Following our TAA Committee last week, our own positioning is now close to full investment. We are slightly overweight stocks, due to the constructive medium term outlook combining recovery with low interest rates. We also own cash and gold, hedging market turbulence, but are underweight government bonds, for their low yield and currently poor diversification benefits, and hedge funds, which face unpredictable short-term markets. Our focus in the week ahead will be on Q3 earnings where we’ll look for resilience, a bit of growth, and hopefully forward guidance. Stay safe.
Judging from the latest cross-asset performance investors are front-running a big Biden win. It looks like that the expectation is for a Democratic sweep, whereby the Democrats would be holding control both of the presidency and Congress. This has turned from being a market-negative to representing a growth-friendly scenario. Initially investors were laying emphasis on the curbing effects of tax-cut rollbacks in Biden’s agenda on growth, while now they are focusing more on the increased public outlays and in particular on the infrastructure expenditure supported by the Democrats. Long-dated Treasury yields, discounting the risk of higher inflation, have been rising, material stocks, benefitting from infrastructure projects, have outperformed, while the US dollar, weighed by the prospect of larger deficits, has weakened.
The key question is how inflationary a Democratic sweep would be and what kind of effects it would ultimately exert on bond yields. The answer is: “It depends on the time frame”. Investor concern about the possibility of future higher inflation and Treasury yields is justified. If the combined effect of massive monetary and fiscal stimulus will not be enough to stoke inflation higher, then what is it that will? Yet, the shorter term effects of the Great Covid19 Crisis are deflationary, regaining pre-crisis activity levels will be a long drawn-out process and the Fed’s financial repression will exert downward pressure on yields. On the last point, it is worth taking notice that amongst the key drivers of long-dated yields are policy rates, expected to be stuck at zero for years in the United States, and central bank asset purchases, which should continue unabated. Actually, according to the September FOMC meeting minutes some Fed officials were open to altering or increasing the asset purchase program. In the absence of other effective policy instruments, the bias with little doubt is for Quantitative Easing programs to be stepped up. Against a backdrop of financial repression carried consistently out by global central banks it should take at least a couple of years for inflation to rear its head on expansive fiscal measures.
Long-dated yields are backing up, but won’t have a lot of room to grow further amidst a deflationary setting and central bank interventionism. We maintain a target of 1% on US 10-year Treasury yields for 2020 and for now hold the view that this level could be exceeded by 20 or 30bps at most even in 2021. Supportive financial conditions along the curve should be particularly favorable for high-yielding bonds. Monetary and fiscal support and low yields at the same time will remain formidable forces pushing income-seeking investors more and more into the asset class now that yields on IG have been crushed by the Covid-crisis Fed interventions. HY outperforming IG credit as the outlook brightens is a textbook occurrence and investors are advised to take advantage before spreads tighten further and they are left scrambling for the next source of income.
Fixed Income Update
What difference a couple of weeks make!! Almost all the sub-asset classes within Fixed Income rallied last week. The spreads of High Yield and Emerging Market credit indices now trade at the lowest levels post-pandemic. The U.S. Treasury yield curve has bear-steepened with 30-year yields rising by ~8bps and the 10-year yield approaching 0.80% as markets price in an outright "Blue Sweep" and the ever-increasing possibility of a monstrous fiscal stimulus. We will wait and watch to see if the markets will be disappointed. However, the road to the U.S. election outcomes will remain bumpy with occasional speed bumps representing geo-political tensions, virus concerns, and fiscal stimulus flip-flops.
The IG credit benchmark index registered its lowest OAS spread since 23rd March, closing at 118bps last Friday. Spreads on HY and EM indices traded at 516 and 329 respectively. We are currently neutral HY and would be looking to add to risk post-election. Within IG we maintain a preference for financials, including subordinated securities. In Emerging Markets, we prefer sovereigns versus corporates on their higher duration-adjusted returns and keep a bias towards the Asian and LatAm regions.
YTD defaults continued to inch higher, reaching 184 last week. According to an S&P report, the consumer products sector leads defaults in the U.S. with 26 so far in 2020, followed by Oil & Gas with 25. Among consumer products companies, both the impact of the COVID-19 pandemic and the road to recovery is mostly uneven, with sectors such as packaged food and household products and personal care benefiting from the epidemic with increased at-home food consumption and high hygiene standards. In contrast, other sectors, such as food service, durables, luxury, and apparel, were particularly hard hit by social distancing protocols put in place by governments. The 12-month trailing speculative-grade default rate for the US region is estimated to increase to 6.3% in September 2020 from 6.2% in August, whereas the same rate for Europe is estimated to increase to 4.3% from 3.8%.
Fixed income weekly fund flows rebounded reaching $26bn. HY funds received the highest net inflows of more than $5bn after two consecutive weeks of drawdowns. IG fund flows were also positive for the first time in a month. Emerging Market local currency funds attracted net flows of $1bn, pointing to expectations of a weaker dollar and possible EM rate cuts.
GCC Fixed income markets have had a great month so far, retracing the last two months' pull-back. MTD returns for the asset class are above 1.3%, which takes the YTD return to an astounding 6.64% for a region in the eye of the perfect storm due to an oil-price shock and a Covid-19-related shutdown coming together in March. Markets took a hiatus from primary market issuance last week, with the scene expected to heat up in the coming weeks.
Markets remain volatile on election and virus news but the week ended well as clear signs of an economic recovery are visible, with China in the lead. A holiday week had travel within mainland China just a little below 2019 levels, which is heartening for the rest of the world. Global equities gained 3.7% last week, EM slightly higher and the Nasdaq was +4.6%. Tech stocks rallied inspite of America’s House Antitrust Committee report on tech giants monopoly power and the rewriting of US antitrust law in order to force tech companies to break themselves up. Most major global indices are now positive year to date. Last week saw a broad-based rally with all 11 global sectors closing up and financials and materials outperforming. In the US indices are back to mid-September levels on renewed optimism that a deal can be reached on additional stimulus and US stocks also followed the dynamics of a full Democratic-House-plus-Senate win, with the three best performing thematic sectors being renewables (+9.5% w/w), infrastructure (+7.2% w/w) and China exposure (+5.2% w/w). We expect the U.S. market to follow election rhetoric in the short term, before shifting back to growth and valuation fundamentals. US rates ticking higher, has implications for the financial sector with bank net margins benefiting from any pick up in yields.
KSA markets are positive year to date, following a small rally last week, along with an uptick in oil prices. KSA equities have a higher beta to oil prices and retail companies, Almarai and Extra have published encouraging Q3 numbers. UAE markets saw a positive return from Abu Dhabi markets last week with the Dubai market lower following declining stock prices in the real estate sector, which makes up 23% of the Dubai Index.
CRISPR or gene editing stocks were up on the news with this year's Nobel Prize for chemistry awarded to the two discoverers of Crispr/Cas9, a defense mechanism in bacteria that's become the basis for gene-editing treatments. Emmanuelle Charpentier and Jennifer Doudna first proposed the idea of gene editing in 2012. The technology revolutionized biological research and led to the launch of a new generation of CRISPR companies. The gene editing strategy has been part of the recommendations in our healthcare portfolio.
M&A continues in the tech sector. With the planned acquisition of Arm Holdings, (licenses chip architecture to makers such as Apple and Samsung for smartphones and tablets) owned by Softbank, Nvidia’s transformation from niche maker (80% share of the graphics-card market) into the world’s most valuable chip company is underway. Nvidia’s emphasis on artificial intelligence seems to offer a good technical synergy with healthcare as it plans to build a supercomputer in Cambridge, England. Cambridge-1 is intended for AI research in tackling the world's most pressing challenges in critical healthcare and drug discovery.
We remain upbeat on equity direction in the medium term as we enter the Q3 earnings season. We have published a detailed note on our expectations for markets around and post US elections. Please ask your relationship manager for a copy, also available at the CIO Corner on our website.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Short-term uncertainty spikes
Known catalysts with an unknown timing
Momentum loss in markets continue
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