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Chief Investment Officer's team, 13.10.2019
In this very publication last week, rereading Sun Tzu, we wrote that the time could have come for a pause in the escalation between the US and China on trade.
This contrarian view gained credibility with the latest news. President Trump said Friday that US and China are about to reach an agreement on a “phase 1” deal, with the immediate consequence of suspending the scheduled implementation of additional tariffs. Over the week-end, a potential solution to the Brexit impasse also appeared, paving the way for either an orderly exit at the end of October, or, more probably, another extension for constructive discussions.
In both cases, nothing is finalized and the issues are serious. It is however steps in the right direction, combined with the Fed signalling an expansion of its balance-sheet to support markets. It was a “risk-on” week, with equities and oil outperforming defensive assets like bonds, gold and real estate, highlighting once again that investors are not positioned for good news. By contrast, our three allocations did well, matching their highest 2019 returns, helped by our overweight in EM Equities (which is much more than just playing a temporary trade truce).
Is this relief enough to allow the Fed to keep its rates unchanged in October, defying the 80% market-implied probability for a cut? It is not impossible. In the meantime, the week ahead will see numerous Q3 earnings publications, to be carefully monitored.
It is a well-known feature of financial markets that bouts of volatility tend to come in clusters, most probably because of the underlying drivers coming in clusters as well, falling in place in close sequence and causing sizable shifts across asset classes. A case in point is the possibility that both a no-deal Brexit is avoided and a temporary trade truce between the US and China is signed by year-end. Last week risk assets reacted promptly, with equities most sensitive to global trade rising sharply.
The current turn of events seems to be a promising one for the muted European economic outlook. The European bloc is exposed to the global cycle, being relatively open to trade flows and could at the same time benefit by avoiding the blow of a no deal Brexit to its exports directed to the UK. This would tie in nicely with the accommodative monetary conditions which have prevailed in the common area for the whole of Mario Draghi’s tenure at the ECB and are expected to continue under Ms. Lagarde. According to the latest ECB minutes, disagreements amongst Committee members were not about whether to act, but rather how to ease the Central Bank’s stance further. Money supply in the common area has been rising rapidly since the beginning of the year and this is usually followed with a lag by a positive turn in economic conditions. The FX market has also offered help in the same direction, with the euro weakening against the dollar since its January 2018 peak and representing increasingly favorable terms of trade.
The emerging market economies would stand to benefit the most from a temporary trade agreement and this would compound the positive effects of Chinese business confidence again on the rise, though from relatively low levels, in the last few months. In spite of mounting trade-conflict-related angst, EM equities, particularly inexpensive, found a bottom in August and have rebounded since. EM FX is sending the same encouraging signals, and by stabilizing it should help draw investor flows back to the emerging bloc. Even a small US-China deal should help put a floor under global manufacturing sentiment, hence the view that the cycle should gradually improve, rather than edge closer to recessionary territory. Investors are advised to continue to focus on cheap cyclical assets like EM equities.
Gold, on the other hand, is expected to be putting in place a top for the time being, becoming relatively expensive against the backdrop of subsiding macroeconomic strain. The steepening of the US yield curve since early September has weighed on the performance of the yellow metal. As euro area and EM business conditions improve, the allure of safe-havens will further lose its luster and investors should be finding the case for shifting allocations towards cyclical assets more compelling.
Fixed Income Update
The Federal Reserve announced buying treasury securities as a measure of their balance sheet exercise to maintain reserves at desirable levels. The Fed had been reducing its securities holdings as it unwound QE and in the last 12 months, the FED reduced its holdings of Treasury and agency mortgage-backed securities by more than $400 billion. Over the same period, some of the Fed’s liabilities increased, notably currency in circulation, up over $76 billion. The net result was a reduction in bank reserves, by over $330 billion.
Jerome Powell highlighted that “this shouldn’t be mistaken for quantitative easing (printing money to buy bonds). “I want to emphasize that growth of our balance sheet for reserve management purposes should in no way be confused with the large-scale asset purchase programs that we deployed after the financial crisis.”
For us, this exercise could result in the steepening of the US yield curve as short-term yields should fall. The recent inflation data across the producer and consumer prices also adds pressure for the mid-to-long end of the curve to stay flat, in our opinion. The Fed Funds futures are now pricing for an over 80% probability that the FED would cut rates by 25bp at their upcoming 29/30 October FOMC. The benchmark US Treasuries have weakened by 14bp over the week to 1.70%. The yield differential between the ten-year Treasury bond and three-month T-Bills are now above the zero mark at 1.6bp from their recent lows of -51bp seen in late August of this year.
In credit markets, Asian HY bonds (+0.3%) outperformed Investment Grade bonds (-0.1%) in absolute return terms over the past week on the back of a spike in US yields. Asian IG and HY have recorded year-to-date total returns of 11.2% and 10.8% respectively, making Asia IG the better performing asset class year-to-date. That said, across the Asian high-yield corporate bond markets, Indiabulls Housing Finance underperformed as bonds plunged after the Reserve Bank of India rejected a proposal to merge with Lakshmi Vilas Bank. Moreover, Yes Bank dollar bonds also saw renewed selling pressure. Yes Bank held a conference call to address several key issues, including its exposure to Indiabulls.
The EM primary bond sales remain well received by investors. Total volumes for October across emerging markets have topped $20.2Bn. Some of the Notable issuers included China Three Gorges ($850 mn), Bank of China ($959 mn), ICBC ($1 bn), Thaioil ($565 mn), Sritex ($225 mn) and Asian Development Bank ($3 bn).
In the GCC, Dar Al-Arkan successfully raised $600m of their new Long-five year USD Sukuk at a yield of 7.00%. Moreover, Aldar Investment Properties (Rated Baa1, wholly-owned subsidiary of Aldar Properties PJSC and 37.3% indirectly owned by Mubadala) has in the pipeline a potential 10-year Reg-S US$ Sukuk sale.
The week ended with gains in European, emerging Asian and US markets as US China trade negotiations reached some fruition. President Trump stated on Friday that the US and China had agreed to a “very substantial Phase One deal”. The US agreed not to implement tariffs set to go into effect this week and China agreed to buy more agricultural produce from the US. Many trade issues are yet to be resolved and US corporate margins have shrunk from the peak levels reached in 2018, as a result of wage inflation and higher input costs. Positive for margins is lower interest rates. There are little expectations from US Q3 earnings, making it an easy bar to cross with consensus estimating a 4% year on year fall in earnings, with the energy and tech sectors expected to be worst hit. The S&P 500 index has remained at near record levels since hitting an all-time high in July and we currently expect range bound performance.
Whilst the US consumer continues to drive the US and global economy, contributing close to 20% of global GDP, emerging Asia’s soaring consumption and its participation in global trade and innovation are gaining prominence. Asia has already gained considerable market share in luxury goods, as evidenced by the recent stellar results from LVMH (Asia is one third of its market). Asia is a diverse collection of demographics and culture, yet what is common is the strong economic growth. A recently McKinsey report analysed 71 developing economies and singled out 18 of them for consistently posting robust economic GDP growth. All seven long-term outperformers, and five out of 11 recent outperformers, are located in Asia. In 2000, Asia accounted for just less than one-third of global GDP (in terms of purchasing power parity), and it is on track to top 50% by 2040. By that point, it is expected to account for 40% of the world’s total consumption. Asian countries are increasingly less reliant on external supply chains and global demand, with their strong domestic consumption. Industrial and technological progress is leading to sophisticated goods being produced domestically. Asia accounts for half (2.2 billion) of the world’s Internet users with China and India alone accounting for one-third. This gigantic pool of digital consumers supports online consumption. So whilst, we have seen Asian market performance lagging so far this year, we expect a pick up: with historically low valuations and strong growth – the fundamentals speak for themselves.
The GCC markets had a mixed week. Abu Dhabi and Dubai gained, however the KSA Index fell -2.8% and is 18% from its peak in May. Whilst the most anticipated market event remains the Saudi Aramco IPO, all eyes are on earnings with the consumer sector seeing improved sentiment. In the KSA Q3 results kicked off with Jarir and Extra growing revenue +16% year on year. Whilst Jarir’s net income grew +6%, Extra disappointed. Margin compression was driven by marketing expenses/ promotional discounts/ ramp up costs of new ventures. We expect margins to be a key highlight for GCC banks’ earnings this quarter, following rate cuts and margin compression of 5-10bps vs 2Q19. KSA and UAE banks profitability will hinge upon their ability to manage rates and credit quality pressure. Consensus estimates are for KSA banks revenue to grow 4 to 5% and earnings by 6% Y-o-Y in 3Q19.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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