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Chief Investment Officer's team, 28.07.2019
Two recently released data give a fair summary of the situation: the US GDP grew faster than expected in Q2, with an annual rate of 2.1%, thanks to strong consumer spending. By contrast, the German IFO Business Climate index declined (again), due to low expectations from the industrial segments for the immediate future.
In such a context, there is little doubt that the European Central Bank will provide additional support, and potentially “new answers”, as expressed by Mr Draghi last week. He mentioned low inflation, geopolitical concerns and the heighted risk of a “hard Brexit” after Mr Johnson was appointed Prime Minister of the UK.
In the US however, it was a different story, and expectations for a rate cut from the Fed next week are progressively turning more reasonable (25 bps). Last week also saw an unexpected agreement from the US Congress to lift the debt ceiling for 2 years. The US Dollar was stronger, rates were marginally higher, and US equities printed new record highs, supported by an overall very robust earnings season so far.
Economic and geopolitical risks haven’t evaporated –we don’t expect much from the US/China discussions this week- and high valuations justify being defensive. But we are not radically so: in the thinner trading volumes of the summer, having better than expected corporate earnings, and Central Banks on the accommodating side, could sustain the current positive trend in risk assets, until it becomes really unreasonable.
US exceptionalism is reemerging, considering the outstanding performance of the US economy and asset markets versus peers year-to-date. This has been the case across the post financial crisis period, which has seen the US business cycle lead, with very few and far exceptions in between. The MSCI US Index has outperformed the MSCI Index ex US, and indeed in 2019 as well, as concerns related to the trade conflict with China have resurfaced. The US dollar has been strong too, mainly driven by relative monetary policy trends.
Yet, year-to-date, in spite of the largely held expectation that the Federal Reserve is very soon about to embark on a new easing cycle, the dollar, on a trade-weighted-basis, is close to its 2002 highs, recording gains against all major currencies. It doesn’t appear to be fading, unless non-US growth is going to take a substantial turn for the better, reversing the widening gap between the resilient American economy and its lagging peers. It looks like that President Trump, while happy with the idea of ‘America first’, is much less enthusiastic of a ‘US dollar first’, complaining either about too low policy rates, or currency manipulation elsewhere in the world.
The US dollar is not in the least pricing in the possibility of market intervention aimed at curtailing its exuberance, an idea the President must have entertained after he said to reporters on the currency: “I didn’t say I’m not going to do something”. The Administration is split about the consequences of such a move, and rightly so, with history showing that forex interventions work only if they are concerted, given the size of the currency market, and in line with monetary policy differentials.
Mr Trump should also be very careful about what he wishes for. A strong signal that the Administration is bent on a weaker dollar could precipitate higher import prices and negatively compound the effect of higher trade tariffs, pushing inflation higher and denting US consumers’ purchasing power. Also, at a time of rising trade conflicts, the weakening of the currency can easily be interpreted as an act of economic war, far from a conciliatory move for striking a deal in a pre-election year.
According to some studies, given the firepower Washington would be able to deploy via the USD100bn-strong Exchange Stabilization Fund, and currency sensitivity to market positioning, the dollar would be incurring nothing more than low-single digit losses, should investors shift overweight dollar allocations back to neutral. In our view, the Administration will not have to resort to these extreme measures. Sitting it out and waiting for the positive impact of the gigantic monetary stimulus underway across the globe will play the trick. The flood of stimulus money will eventually rekindle risk appetite, boost non-US assets and weaken the US currency.
Fixed Income Update
All eyes are on global Central Banks this week as market participants would observe closely the first policy rate cut by the Federal Reserve. A quarter percentage point would be the first cut seen in over a decade. The market implied cuts for the rest of the year are within a range of a cumulative 50bp to 75bp. During the past couple of weeks, many global central banks have lowered policy rates citing concerns on most of the common pending issues on the economic growth front and the ongoing global trade tensions. ECB’s comments on their stance on monetary policy did push yields lower across the board. Bond yields across the Sovereign curves dropped. For example, bond maturities on Switzerland are negative across the totality of the curve. The German Bund yield fell to a new record low of -0.41% on news of a potential rate cut in September by the ECB. The Italian BTPs outperformed DM counterparts as yields dropped close to 9bp over the week followed by Swedish and Greek bonds. US benchmark Treasuries closed a tad wider and continue to hold at 2.07% on the back of encouraging economic data.
Benchmark yields on global corporate Investment Grade debt are now at 2.27% whereas over 25% of all outstanding global investment-grade bonds yield negative. This phenomenon has challenged investors’ hunt for yield to venture out to take excessive credit risk. In our opinion, credit selection remains our top priority within our long-standing conviction on corporate IG debt. For the discerning investors’ searching for higher yield within the IG bracket, we advocate on taking on capital structure risk in the form of hybrid instruments (sub-debt). These subordinated debts which are also mostly under the IG domain offer a better risk-adjusted returns.
The market witnessed “Erdonomics” last week. The Turkish central bank delivered higher than anticipated policy rate cuts (Actual 425 bps Vs Est 250 bps) and, surprisingly, the TRY held better than one could have expected. Central Bank Governor Uysal’s first MPC policy response was underpinned by the fact that the real rates in Turkey remains relatively high as compared to EM peers. However, President Erdogan mentioned he was the rate cuts were not enough. That said, we remain concern on the after-effects of the quantum and magnitude of lowering policy rates which in turn heighten FX volatility. While our view on Turkish bonds remains constructive, we remain cognizant on the fact that investors need to pick sound credits that are resilient to liquidity shocks, and those that can withstand any unforeseeable market duress.
The Sultanate of Oman returned to the international capital markets with a dual-tranche offerings across the 5.5-years and 10-year tenors, raising a total of USD 3bn from the market. The issue saw an overwhelming response from investors with a total order book exceeding multi-folds. The first half 2019 budget deficit came in at 2%, which came in better than expected. However, according to FITCH rating agency, this is expected to widen to 10% by year-end as most of the spending traditionally has been concentrated towards the latter half of the year. Oman’s debt to GDP ratio has already crossed the previously appointed ceiling of 50% and is expected to increase further in 2020 and 2021.
Globally equity markets benefited from better-than-expected corporate earnings and expectations on central-bank easing, putting aside IMF’s downward revisions to global growth estimates.
This month has seen strong performance from the UAE market. The Dubai Index is +17.5% year to date having gained 7.2% in July (month to date). The Abu Dhabi Index is +14.4% year to date and has gained 8.2% this month. Both have seen improved trading volumes. A possible removal of foreign ownership limit cap as proposed by some corporates will result in a substantial increase in the UAE’s weight in the EM Indices, which can drive significant inflows from passive index trackers. The real estate sector rally continues with Emaar +29%, Emaar Development +12% and Aldar +56% year to date. The rally is driven by a recovery from very low valuations; a rotation into the UAE from more expensive GCC markets; MSCI maintaining Emaar Malls and Emaar Development in the EM index; attractive dividend yields and the award of new projects. Concerns around increasing real estate supply remain. Our preference for the banking and logistics sector in the UAE is unchanged with good results from the former and increase of ecommerce positive for the latter.
The major U.S. indexes saw new records with the S&P 500 up 1.7% and the Nasdaq up 2.3% last week. The bug bears which caused the market downturn in December i.e. slowing economic growth exacerbated by trade tariff issues and slowing consumer demand, have been currently put aside. The strength of the U.S. consumer was evident from Q2 earnings and economic data. GDP growth at 2.1% in Q2 was boosted by U.S. shoppers, as consumer spending, which makes up more than two-thirds of the economy, posted the strongest pace of growth since late 2017. To date, approximately 44% of US companies have reported with average EPS growth of 0.65% on 4.53% sales growth, according to FactSet Research. The low bar for S&P 500 2Q earnings leaves room for upside. Also supportive of US markets are expectations that the Fed will cut interest rates.
Tech companies are the winners of 2019 as investors look for growth. The S&P 500 tech sector has risen 34%, outpacing the S&P 500’s 22% gain. Between them Microsoft, Apple, Facebook and Amazon have contributed to 20% of the S&P 500’s total return this year. The communication-services sector performance which has lagged technology, was lifted last week by Disney, Twitter and Alphabet. Twitter rallied on subscriber growth and Alphabet on a sales rebound (higher ad revenue) and a $25bn share buyback program. Amazon disappointed with earnings below forecasts, but maintained its year to date gains of 30%.
The second best performing sector this year is consumer discretionary, a theme that’s been gaining ground this year. Stable consumer companies are seen as a good hedge if markets were to become volatile. Starbucks is up +54% in 2019, rising almost 10% post its Q2 release with talk of growth in China. Industrials i.e. Caterpillar and Boeing have disappointed on Q2 announcements but the defense sector has been strong on new orders and rallied accordingly.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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More data, less certainty - 07 July 2019
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