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Chief Investment Officer's team, 30.06.2019
The first half of the year ends with spectacular performances so far. Every major asset class was positive, with double digit returns for equities, led by the US, with +5 to +10% across the fixed income sphere and almost 10% for Gold. Our regional markets also did very well, with GCC equities delivering +12% and a GCC Corporate index +8%. Against this supportive backdrop, our tactical asset allocation profiles delivered respectively +7%, +9% and +11% in H1-2019.
When everything is up, including the assets which usually don’t correlate positively together, it’s about the most single powerful force driving markets for a decade: accommodative monetary policy. The global dovish turn has been so far stronger than growth concerns, geopolitical tensions, and political uncertainties and have lifted valuations higher, sometimes unreasonably, as markets unanimously expect a rate cut cycle to begin in the US in July, followed by the entire world.
There is thus little doubt that upcoming events will have to be analysed twice: for what they are, and for what they mean for Central Banks. The truce between the US and China agreeing to continue negotiations without new tariffs being implemented is a positive for growth, and objectively reduces the probability of a large rate cut in July. Next week, we will closely monitor the OPEC meeting, as Oil price matters, as well as the monthly US economic data, especially the job report on Friday.
Geopolitical tensions in our region are significant and making headlines, but their impact on financial markets is not obvious, when looking into GCC credit spreads or the curve of crude futures prices.
Credit spreads, particularly sensitive to the economic cycle and liquidity conditions, during the Great Financial Crisis, blew up six-folds to a historical peak of about 700bps in the GCC, according to a JP Morgan gauge. Yet, nowadays, although headlines are rife with references to rising tensions, local credit spreads, at about 200bps, are not far removed from the lows touched in July 2014. Actually, spreads have been stable for a while, suggesting little anxiety at the forefront of investor minds.
Likewise, the crude futures curve is not sinking deeper in backwardation in spite of negative press news. When in backwardation, near-term contracts trade higher than longer-dated ones, pointing to tightening short-term supplies. Should investors expect a significant threat to existing crude supplies, backwardation should touch new highs, while it is retreating from recent highs.
Are markets failing to discount something, or are journalists discounting too much? We could say that the truth lies in between. One must look into the dynamics of the GCC economic cycle to find a tentative answer to the above question. As a measure of local economic activity - for simplicity UAE business activity - we could consider the Emirates NBD UAE PMI Index, which tracks business confidence, or the JPM gauge of GCC credit spreads, which captures concerns related to the corporate sector and is strongly correlated with the UAE PMI.
By studying GCC spreads, whose data history goes as far back as 2002, it is striking to see that the stand-out factors driving local corporate credit are the global business cycle and prevailing liquidity conditions, in turn, steered by Fed policy. As long as these factors remain supportive, it is hard to envisage something more than a transient drop in UAE business confidence, unless events take a more catastrophic, and in our view unlikely, turn.
Thus, while journalists do their job and continue to speculate about any possible turn of events, asset markets deliver a soberer message of relative resilience of GCC business conditions, subject to the world economy remaining in its current expansion phase. It is also true that one more unpleasant consequence of lasting frictions is lower market liquidity, which is already showing up in locally traded stocks. This is how so far, in our view, investors have expressed unease about GCC geopolitical dynamics.
Until tensions are dispelled, it is safer for GCC-biased investors to favor quality within stocks and bonds. Lower liquidity would be taken care of as well: whatever the quality of the underlying assets, escalating tensions will increase the difficulty of exiting a position quickly. Short-term trades don’t make sense in our markets, and excessive leverage is also dangerous as it can trigger forced selling.
Fixed Income Update
The temporary freeze on further tariffs on Chinese goods by the US is reviving risk appetite. A better tone in US-China trade talks, dovish central bankers and sound macroeconomic data are indeed good drivers, particularly for credit markets. High yield bonds together with emerging markets debt are now poised for their YTD stellar returns, and capital inflows continue to support asset prices creating a strong technical force –despite the combination of stretched valuations and a late-economic cycle environment. US benchmark yields are supported at 2% while German bunds have moved deeper into the negative territory at minus 33bps. The most observed segment of the US yield curve is the 10-year Treasury yield minus the three-month Treasury bill yield remains inverted at minus 9bps.
With the Federal Reserve’s dovish hinge towards a cut in interest rates at its next meeting, speculative-grade (High-Yield) and high-grade (Investment-Grade) debt have rallied alongside other risk assets. Oil prices have also surged supporting returns in oil-focused credits across broader emerging markets bonds. Major benchmark credit indices - CDX EM tightened significantly so far this year to 168bps. The spreads on GCC credit has held relatively supported at 170bps in spite of the heightened middle-eastern tensions. To be noted, the recent hybrid transaction by Sharjah Islamic Bank saw order books close to ten times oversubscribed, which remains a testimony towards the demand for higher-yielding assets in relation with the USD 13tn of global debt showing negative yields.
A token cut of 25bps on the Fed Funds rate on July FOMC is fully priced in, in our opinion. Whether the fed responses with a course of action or remain status quo, markets are already adjusting to the fact that the tightening cycle for the Federal Reserve is now over. This in fact now reflects on the short-term reference rates (LIBOR) as well as on the broader bond markets. We now foresee the US yield curve to “bull flatten” as long term yields need to adjust given the benign inflation expectations. This week several FED officials would be taking the podium.
US Payrolls data on Friday would be key as market participants would cautiously examine the prospects if the FED would use any softening data for policy action or wait till September for further rationalizing to lower the key benchmark interest rates. The median of economists surveyed by Bloomberg is for payrolls to gain 160,000 and average hourly earnings to accelerate by 3.2%.
Global equity markets have had a stellar H1, in spite of the flight to haven assets such as bonds, gold and a shift to defensive sectors. The principal worries for markets have been an increase in global tariffs, escalating geopolitical concerns and the expected end of a decade long economic growth cycle. Bloomberg economists estimate that tariffs at the current level will take 2021 GDP for the U.S., China, and the world, down by 0.2%, 0.4%, and 0.3% relative to a no-trade war scenario. U.S and China have now shaken hands at the G20, averting an immediate increase in U.S. tariffs on Chinese goods, though there's still Europe and Japan with which the US needs to agree on trade terms, especially on the auto sector. The easing of tensions is an immediate positive for global growth, and may also reduce some of the urgency in central banks’ easing policy. On Friday European exporters rallied, and Chinese stocks led by the tech and consumer discretionary sectors could see a near term rally once markets open on Monday. China equities trade cheaper compared to the rest of the EM at 12.2X forward price to earnings (MSCI China). The longer-term outlook depends on what kind of lasting trade deal can be struck. European equities have returned 16.9% in 1H 2019 poised for their best returns since 1998 (MSCI Europe USD), though they remain the most popular short trade. We have been in line with consensus, with an underweight stance on Europe.
Despite an end of the week rally, US equity indices closed marginally down last week. The S&P 500 finished just off record highs, up +7.0% for June recovering well from the “May Meltdown” thanks to a perceived shift in the Feds monetary policy. The index is up 18.2% (net return) this year, its best first-half performance since 1997. Technology continues to lead. The recent truce should provide further relief to the semiconductor sector, as profits tend to rely heavily on demand from China. US financials rallied on Friday post the Fed announcing the results of the recent stress-test on 18 major U.S. banks with all found in compliance with the Feds capital requirements. Share buybacks and dividends totaling USD 136bn over the next twelve months, are on the cards. Bank shares have underperformed the market, though they are cheap, with investors concerned about declining interest rates and slowing economic growth.
Geopolitical tensions have not as yet significantly impacted the performance of the GCC markets though liquidity concerns around trading volumes could emerge if any escalation were to take place as seen in previous cycles of economic or regional tension. The DFM Index is trading at 2626 around the 200-day moving average. It is supported by low valuations and a dividend yield of 5.1%. The main contributor to this year’s rally is the banking sector led by Emirates NBD and Dubai Islamic Bank and in the real estate sector Emaar Properties and Emaar Malls. Detractors include DAMAC, Amanat, Union Properties and Arabtec. Largest contributors to the Abu Dhabi Index include FAB, Aldar and UNB. The KSA continues its reforms. The Capital Markets Authority removed the Ownership Limit for Strategic Investors previously at 49%. The Tadawul Index at 8,770 is also trading around its 200-day moving average. Banks have led the year to date gains in the index.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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