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Chief Investment Officer's team, 25.08.2019
Last week started on a positive tone as markets were hoping for better US/China relations, and for the Fed Chairman to deliver a dovish speech on Friday. The latter actually happened, but not the former. China announced levies on US goods (including soybeans, autos and oil), and Mr. Trump retaliated (against this retaliation) with higher tariff rates on virtually every Chinese imports. Indeed, the all situation can be summarized in the following tweet from the US President, posted on Friday: “… My only question is, who is our bigger enemy, Jay Powell or Chairman Xi?”
This can be seen as more than energetic negotiation rhetoric: a shift in tone. The Chinese leader is an “enemy”, and the Fed has to prove it is in the right camp. Indeed, Chair Powell’s speech supported another easing in September, pointing the trade tensions as well as the market anticipations. As a result, there is a serious probability that risk assets anticipate higher tariffs and lower rates for the months to come.
Against this backdrop, we keep high levels of cash in our recommended positioning, a defensive turn initiated earlier. We however point-out that fundamentals, consumption in particular, are holding better than sentiment, and that at the G7 summit, Mr Trump didn’t point to any new “enemy”. Markets could react to a deteriorating situation, before potentially normalizing, should the scenario be a combination of slower, but still positive growth, with lower interest rates.
Markets do not like uncertainty. As predictability dwindles, so do the prospects of future corporate cash flows as perceived by investors, hence financial assets, in investors’ minds deemed riskier, are repriced accordingly. The protracted trade conflict between the US and China is a case in point of surging economic risk and diminished visibility about future outcomes. Should worse come to worst a recession would engulf the major economies, with global equities expected to lose 30% under such conditions. In case, this would be aptly labelled as the ‘Trump recession’, since absent the US-China stand-off there were no economic excesses warranting a contraction in business activity.
Developed market government bonds, the risk-free assets available to investors offering (theoretically) above-cash returns, are already discounting an Armageddon scenario, considering that the proportion of negative-yielding debt within the asset class has reached an unprecedented size and by now only US Treasuries guarantee a nominal yield significantly above zero. US 10-year real Treasury yields are at zero, which signifies that bond investors do not get paid for future inflation risk, by definition non-existent only under the by now priced-in deflationary scenario. If treasury markets in the largest and most resilient world economy point to deflation, in Europe they suggest a depression.
Trade conflicts have mounted against an already frail scenario of low earnings growth, falling investments and tumbling manufacturing confidence across the globe. This has occurred in spite of the exceptional stimulus effort of major central banks. The much-awaited Jackson Hole speech delivered by Fed chair Powell was overshadowed by Mr Trump vowing to react to China’s threat to increase tariffs on select US imports. And bearish investors looking for more drama must have been pleased by the European Council President’s claim that the EU would ‘respond in kind’ against US tariffs on European products.
Yet, investors should not throw in the towel in spite of a seemingly dismal outlook. The US consumer is keeping the domestic economy in expansion mode and positioning across equities and bonds is so extreme that markets could turn on a dime should trade conflicts recede even just slightly, or at least stop deteriorating. According to some insightful research recent rate movements were amplified by lack of market depth and are more a reflection of high-frequency flows than the views of long-term macro-investors. Although in the short term trade rhetoric is set to get worse, presidential elections must be at the forefront of Mr. Trump’s mind, even as China can ill afford tariffs on all of its products if it is still keen to avoid sub-6% growth.
Markets may be driven lower in the very immediate future by worsening investor perceptions, only to reverse course alongside improved sentiment if President Trump and President Xi do strive to avoid the next recession.
Fixed Income Update
The momentum on bond yields seems to be well supported by the recent heightened tiff between the US and China, as well as with the Federal Reserve dovish stance. The standoff on what President Trump wishes versus what the Fed policymakers are grappling with seems diverging, making it a complicated landscape to interpret. Inflation readings broadly remain benign, and economic activity is rolling-over while investors are wondering whether that the global monetary and fiscal stimulus could support asset prices. With corporate bonds, now benefitting from record-low benchmark yields, we find it challenging to find screaming opportunities. Within EM bond markets, the yield-hunt-appetite has been driven by long-duration high-grade bonds over the high-yield bond market. YTD, the yields on the global aggregate Sovereign bond index has fallen from 1.36% to the current reading of 0.69%.
The saga on negative yield continues. After the Swiss and German’s entire yield curve submerged zero-bound, investors are now anticipating Japanese long-dated bonds to follow suit. Japanese bond yields are already negative all the way out to debt maturing in 15 years, and investors have been positioning up longer-tenor maturities creating strong technical support. The drop in JGB yields makes it more likely the BOJ will lower its short-term negative interest rate (currently at -0.1%) should the yen strengthen to an uncomfortable level, according to Sayuri Shirai, a former Bank of Japan board member. The central bank has a trading range of about 0.2 percentage points either side of its zero percent target on 10-year government bond yields. Last week, the yield on the 10-year JGB dropped below the floor of the range to -0.255%, a three-year low.
Factory activity in the US contracted in August for the first time in over a decade as new orders declined, consistent with an ongoing global manufacturing downturn. The Purchasing Managers’ Index slipped to 49.9 from a final July reading of 50.4. The trend is even bleaker for Germany, where manufacturers are worried that slowing economic activity is pushing the Eurozone into a recessionary phase. The ECB has already planned to add monetary stimulus, and is expected to cut interest rates at its September meeting.
We remain conscious of the recent market gyrations, and heightened volatilities as investors flock to safe-haven assets pushing global yields to record low-levels. Our latest publication titled “Economic Cycles: Charting the uncharted” should provide readers with a good synopsis on how to navigate, and further understand the stages of economic cycles and our approach towards building sound bond portfolios.
Fitch Ratings downgrades Lebanon’s long-term foreign-currency issuer rating to CCC from B-citing that the country has the world’s highest debt ratios, high unemployment and little growth. S&P Global Ratings affirmed Lebanon’s rating at B-, six steps below investment grade, and one level higher than Moody’s Investors Service. The five-year credit default swap has surged from its February levels of 671bp to the current reading of 1125bp.
Equities remain vulnerable in the next few weeks with trade tensions and the next Fed meeting some time away i.e. mid-September. A possible scenario is the continuation of the roller coaster ride which started a year ago, as the US President could back-off the trade rhetoric and “the Trump Put” could come into effect. The “Fed Put” is well anticipated, and confirmed by the Fed Chair stating that if the trade battle heats up and pressures economic growth, a more dovish monetary policy is on the cards. The S&P 500 at 2847, is a little below our Year end fair value of 2900. Though we are neutral the US within our Developed Markets regional allocation, investors see it as a safe haven. Emerging Markets show upside potential to their fair value, but the strong Dollar continues to be a headwind. We are close to neutrality in EM equities and would add once we see better visibility on economic growth, which has come under a cloud as 2019 has progressed. Among the large economies, China could implement meaningful fiscal easing and a US$250 billion stimulus package including tax cuts has already been delivered. China could boost measures such as spend on infrastructure, if downward pressure on growth persists. India is struggling with lower consumption as evidenced by a sharp drop in auto sales and is looking at measures to boost tepid growth.
The Chinese announcement on Friday of additional tariffs on U.S. goods, with the first phase effective September 1st and 25% tariffs on U.S. autos effective December 15th, was followed by a retaliation tweet from Pres. Trump. This caused a sharp selloff in US markets on Friday c.2.5% reversing the week’s gains. Shares of toy makers, retailers and semiconductor companies that manufacture products in China were among the hardest hit. Healthcare has been a relative outperformer during the China US tariff exchange, given its defensive nature & domestic focus.
The 200-Day Moving average (2802) and the June lows (2728) will be the next key technical levels to watch for the S&P 500 Index. How much equities fall, will depend on the trade narrative, the message from the Fed and the economic data flow. Investors had been assuming that a trade deal with China would be reached sometime prior to the 2020 election but the uncertainty continues. The turbulence is having an impact on both consumers and corporations now evaluating spending commitments. As a result, earnings estimates for companies and GDP estimates for the economy are likely to be adjusted downward. Anxieties over trade relations with China has sparked fresh worries about global growth and the potential for a recession. Conflicting signals about the state of the economy are being generated as weak manufacturing data earlier last week around the world raised concerns about a possible recession as did the inversion of the 2-10 year treasury curve. On the other hand, strong earnings reports from retailers like Target and Lowe’s offer encouraging signs about the strength of the U.S. consumer.
The MSCI GCC is so far quite resilient with a YTD return of almost 10% as we write, outperforming Europe and China in US Dollar terms.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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