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Chief Investment Officer's team, 10.11.2019
Last week was interesting, with a clear differentiation between cyclical and defensive markets. Equities were up across the board, with Developed Markets reaching an impressive +22% YTD, the US at a new all-time high, and Emerging Markets confirming their come-back. Oil was also well oriented. By contrast, Gold lost 3.7%, and every other defensive asset, from government bond to real estate, was negative. This was not the typical liquidity-driven “rally of everything,” but market participants starting to take into account the possibility of stabilization, if not a pick-up, in global growth.
As we write for long now, the fact that most investors were, and still are, very defensively positioned, amplifies the market impact. We should not take for granted the current signs of hopes, should it be from fading geopolitical risks or from “less bad than expected” economic data. As the end of the year is historically seasonally strong, with the possibility of a significant “phase 1” trade deal between the US and China, pessimists neutralize their positioning.
The key question obviously is whether this acceleration of a rally we indeed welcome (we are overweight equities and have reduced both govies and gold) is sustainable. We keep our current positioning but will carefully build our views for 2020 without any complacency. The spectacular returns of 2019 might have borrowed from the future, unless the economy re-accelerates materially – more than just a “risk-on” week.
There is gathering evidence that the tide is slowly turning in the manufacturing sector, where weakness in activity data has been concentrated during the global slowdown phase which is still ongoing. New orders in manufacturing survey indices have turned higher even as inventories dropped further, a development which usually precedes an upturn in business confidence and eventually hard data. Also, the US labor market continues to be strong, which should be reassuring about the resilience of the US consumer. To be sure, weakness in manufacturing tends to manifest in the services sector with a lag, hence in Q4 this year, there is still room for some negative economic surprises coming from services. But this should not be enough to dent the bottoming process in the economy, which could potentially lead us into a 2020 recovery.
Cyclical assets, that is to say global equities, credit and EM assets, are tracking the typical path followed during recoveries after slowdown phases, whereby a cyclical portfolio tends to rise in the mid-single digits in the first half year of the recovery. Investors are looking through the current lingering weakness, hence DM equities are recording new all-time highs. This vindicates our stance expressed on past issues of this publication which saw us very skeptical about the largely-held view of an impending US recession. Since risk assets tend to rally until growth continues to improve, we still see some support, in spite of expensive valuations. Also, improving economic conditions, eventually reflected in higher earnings, could moderate equity multiples, even if 2020 consensus expectations already look quite high.
Investors are also coming round to the view that the amount of monetary easing baked in market prices can be excessive. The probability of a fourth rate hike this year by the Fed has dropped very sharply recently to sit now below 10%. Long-dated US Treasury yields have responded promptly to this new state of affairs by rebounding quickly and surprising the flock of recession believers or the ever-green bond bulls. As the very loose financial conditions brought about by central banks in repeated rounds of easing work their way through the system, the real economy should continue to heal and eventually be in full recovery mode.
The main casualty of the improving outlook is gold, which is finally breaking below key support levels after range-trading around $1,500/oz for longer than two months. The discounting of no more Fed cuts in the near future, the steepening of the US yield curve and the green shoots of normalization in business activity all work against buying gold, which, as a non-yielding asset, requires some degree of uncertainty in the outlook to be held in place of, say, equities or credit in a portfolio. Although we would not foresee any bear market in the yellow metal, unless central banks embark on some unexpected tightening, the deteriorating risk-return trade-off attached to holding gold suggests that further weakness should be in the offing, most likely in the direction of $1,400/oz, a round-number level where one may think of starting to reposition on the long side for rainy days.
Fixed Income Update
Global Fixed Income markets around the world witnessed another week of sell-offs primarily driven by investor appetite to take on more risk due to positive headline news on the US and China developments as well as some macroeconomic data points. The US Treasury bond index was the worst performer returning -1.38% over the course of the last week. European HY Index was the only index posting a marginally positive weekly return of 0.19%.
US benchmark Treasury yields are higher at 1.94% while the Germany Bunds and UK Gilts were also higher at -0.25% and 0.78%, respectively. Sovereign bonds across Emerging Markets also followed the broad-based sell-off with yields higher by 10bp to 15bp. Philippines and Chile were the biggest losers with bond yields higher by almost 15bp at 2.49% and 2.47%, respectively. The Japanese benchmark yield climbed the most in six years and climbed 4.5bp on Friday to minus 0.045%, taking its total increase last week to 14bp, the most since April 2013. Emerging Markets still allure investors due to the high average real yields of 2%, whereas developed markets continue to offer negative real yields.
Primary bond issuance in Euro currency has a set a new annual record crossing EUR 1.28tn with seven weeks to spare in 2019. This is a jump of 13.4% over the previous year's volumes. With the European Central Bank pumping billions of additional euros into bond markets in an effort to stimulate the economy, borrowing costs are hovering around all-time lows. The average yield on a European high-grade corporate bond is less than 0.5%, compared with 2.9% for its U.S. counterpart.
The U.K.’s sovereign credit rating was placed on negative outlook (Ratings affirmed at Aa2) by Moody’s Investors Service, which said the country’s ability to set policy has weakened in the Brexit era along with its commitment to fiscal discipline.
Arabian Centre Company (Ba1/-/BB+), Saudi Arabia's largest mall operator, will start its road shows for its maiden USD bond issuance. The company is expected to raise USD 500mn of 5-year notes to refinance a part of its existing secured loan obligations. Dubai Islamic Bank has also mandated banks for a potential Sukuk offering.
Two years after Moody's upgraded India's foreign currency LT obligation rating to Baa2, the rating agency has assigned a negative-outlook to the country. The rationale behind the outlook change is low prospects of economic growth due to the lower fiscal and monetary policy effectiveness at addressing long-standing economic and institutional weaknesses. Fitch Ratings and S&P still maintain India's rating at BBB- with a stable outlook. We keep our cautious stance on the Indian corporate debt front both across domestic and Eurobond issuance. That said, we still maintain our conviction on the “rate-cycle” and expect the Indian Government bonds to perform from current levels. We also have niche convictions on some selected corporates in the USD denominated segment.
Last week saw a rally in European banks from oversold conditions, cyclical sectors such as semiconductors gaining and Japan outperforming other developed markets. Rally was broad: most major markets gained c1%. In spite of lackluster earnings growth and demanding valuations, developed-market equities have added 20% so far this year, supported by cautious investor positioning and meeting relatively supportive news on trade and Brexit. U.S. equities finished the week with another record close. Emerging-market equities had another positive week and continue to recover from their earlier underperformance this year. While value stocks did well in October, healthcare and technology were the best-performing sectors, supported by relatively strong Q3 results. Consumer discretionary was also strong, with luxury stocks outperforming. This supports faith in continued consumer demand, especially from the still emerging yet strong middle class from Asia. Singles day in China and Black Friday in the US will be closely watched to assess continuing consumer strength.
Companies have highlighted ongoing risks/pressures from macro uncertainty, trade and lower economic growth, but the tone hasn’t been too negative. The current bullish sentiment reflects the faith that falling profit margins will abate, as growth picks up. Hope on a rollback of trade tariffs has been good for investor sentiment. Macro news has also been supportive, the Michigan Consumer Sentiment for November improved, as well as China import and export data for October.
80% of companies have reported Q3 results, and earnings are estimated to have contracted 0.7 percent. US analysts have significantly scaled back their expectations for Q4. Consensus analyst forecasts are for S&P 500 earnings growth for 2019 as a whole at 1.3 percent, the slowest rate since it rose 0.2 percent in 2015. An interesting example: Caterpillar cut its earnings guidance for the year, citing trade tensions weighing on demand for construction equipment. Yet investors are looking at a shift in global demand and the stock is up 25% over the past month. Caterpillar is seen as a barometer of the global industrial economy and has recently registered a 52 week high. On the other hand Honeywell said that sales expanded by double digits over the past 12 months. Honeywell’s digital software strategy is working and the stock is up 96% in the past five years, almost double that of major US equity indices. Texas Instruments caused a sell-off in chipmaker shares when it announced earnings by saying demand was weak.
Saudi Aramco remains the focus in the region and internationally. The company plans to list on the Saudi bourse Tadawul in December. Scale, profitability and dividends are keeping investors interested. The company is a strong quality “yield play” and thus attractive in a low-interest rate environment. The 650-page long prospectus has just been released, and the book-building process should start on November 17th.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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