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Chief Investment Officer's team, 13.09.2020
After a glorious summer, the start of September is much more dramatic, with outsized declines for technology stocks in particular. The Nasdaq was down 5 of the last 6 sessions, but we shouldn’t forget that it was flying from record to record, almost every day, for months. A correction was simply due, and markets are actually just back to their mid-August levels. Last week’s returns on most asset classes were between -0.2% and +0.2%, stocks lost 1.4% in Developed Markets and less than 1% in EM. This isn’t a radical change in direction.
Last week was poor in fundamental news: scarce economic data release, no quarterly earnings, no big call from central banks. As a result, markets are mostly driven by sentiment, which hits markets as the elevated valuations still make them vulnerable.
Actually nothing has changed. The virus is progressing, with a clear resurgence of infections everywhere, but we have learnt to live with it and it shouldn’t derail the recovery. But again, it impacts sentiment. The US outlook and key geopolitical topics are now hostages to the US presidential campaign, with, in addition, a non-negligible risk of contested results in November. We probably won’t see positive breaking news in the coming weeks which also supports volatility. Having said that, reasons to be constructive are also unchanged. Elevated valuations are not just the result of retail frenzy and derivatives convexity: in a context of ultra low interest rates and fiscal stimulus, there is actually little alternative to risk assets to generate returns. This is why we haven’t changed our positioning as we are currently simply seeing the turbulence we were expecting earlier, in the summer. If anything, we may look to add risk on material weakness. Stay safe.
The recent flash crashes in US equities seem to be pointing to pent-up demand for a deeper correction which might not come to pass due to the plentiful central bank liquidity available. Since equity valuations are far from cheap, economic momentum is slowing and the US elections are looming larger, we might as well expect more volatility but no fully-fledged bear market, till key risks have been discounted and investors have decided that some healthy rotation is needed to push stocks decidedly higher. Money flowing into different themes and geographies would be also a testimony to investors’ confidence in the cycle, so far lacking given safe-haven purchases concentrated mostly in growth and US equities. The current macroeconomic backdrop is very much reminiscent of the post Great-Financial-Crisis period marked by low growth, muted inflation and ongoing monetary support, the big difference being that nowadays there is more uncertainty about growth and inflation, hence the necessary offset provided by huge stimulus.
Indeed, so far we have seen similar investment themes gain traction, with the search for income-generating assets still at the forefront of investors’ minds. Credit has stood out in the steady-state environment of low growth and little inflation and it is no surprise that year-to-date IG corporate bonds rank amongst the top performers within a multi-asset portfolio. High-yielding bonds have trailed behind, partly because direct Fed support has not been as significant as for IG, partly because investors still have some reservations about the outlook. During the latest market rout HY credit was remarkably resilient, with the Bloomberg Barclays US Corporate HY Index basically unchanged for the week in spite of widespread equity tremors. Given yield compression in IG and the scarcity of liquid assets yielding in the order of magnitude of 5%, investors are tempted to delve deeper in the asset class. The Federal Reserve has provided a cushion for the economic cycle and stabilised market liquidity. As long as the focus is on credit quality and pure passive exposure is avoided, we hold the view that one should reap the benefits of larger coupons. Credit selection would ensure that the risk attached to rising defaults in HY, should the Covid19 crisis turn out to be worse than expected, is minimised.
The former hedge fund manager Stanley Druckenmiller last week expressed the concern that excess liquidity provided by central banks is at the same time raising the tail risks of deflationary and inflationary scenarios. Deflationary from the bursting of asset bubbles inflated by stimulus, inflationary if the Fed succeeds in achieving the goals of its new Average Inflation Targeting regime. Since both scenarios would be adverse for risk assets, Druckenmiller made the case for subdued longer-term returns. Unfortunately, whatever the final outcome of this, for market participants it will once more be the case of dancing just until the music stops, to paraphrase Citigroup’s ex CEO Chuck Prince infamous remark in 2007.
Fixed Income Update
The Rates market is entering wait and watch mode this week with FED’s policy announcement on Wednesday. Analysts expect further details on the Average Inflation Targeting framework. Moreover, market participants also hope for more forward guidance from the meeting, including a new “dot plot” to show the median projection for policy rate at the end of 2023. This should be a new line of dots near zero. Treasury yield curve bull flattened over the week, with 30 Year tightening by c.6 bps to close around 1.41%. Benchmark 10-year yields closed c.5 bps down at 0.67%.
The FED’s balance sheet growth has plateaued significantly, after ramping up in Q2 2020 by $ 3 tn to $7 tn. There is lesser utilization of currency swaps and other emergency facilities. The FED has extended these emergency facilities till year-end to tide over any rise in volatility due to the delay in hammering out another fiscal package and November presidential elections.
Major benchmark bond indices were flat last week, with a slight biased towards safe-havens. IG and Developed Market Treasury indices were in the green, whereas Emerging Market and High yield indices generated slightly negative returns. IG primary market supply has been healthy this month with $68 Bn bond sales MTD as against a record-setting $151 Bn in an unusually active August. Fed policy and support and broader width of credit markets due to issuer level cappings in the indices have resulted in a lower beta of the asset class leading to MTD outperformance against equity. This characteristic further indicates that credit performance, even in the weaker sub-asset classes such as US HY, will continue to be less volatile during turbulence in the near term.
Global defaults have picked up last week after zero defaults in the previous weeks, with five new companies defaulting on their debt obligations, taking the total YTD tally to 171 as of 9th Sep. To put the numbers into context, at this point in 2019 and 2018, there were 77 and 59 defaults, respectively. The US continues to lead the tally with 115 defaults, followed by Europe with 25 companies. The trailing 12-months default rate for the US has reached 6.2%, with S&P expecting the year-end number to be as high as 12.5%.
GCC markets have seen breakneck issuance with issuers taking benefit of lower credit spreads and strong investor demand. Two critical characteristics this year have been large tranche sizes and extension of maturities. Kingdom of Bahrain and Saudi Electricity Company tapped the markets last week for bond sales. YTD 2020 benchmark debt sales have crossed $ 52 bn in GCC Ex-Qatar as compared to a full year number of $65 Bn in 2020. UAE based issuers have dominated the primary market resulting in 56% of the bonds sold this year. AS expected, IG issuers have issued 80% of the bonds this year. Looking at the issuance by sectors, sovereigns contributed 67% of the issuance this year as compared to 41% last year. The trend seems firm with a strong pipeline of issuers in Q4 and could lead to a record-setting year for the region.
Autumn usually brings volatility and whilst we had one of the best Augusts on record, September has started on a highly volatile note, beset with Tech retracement, potentially growing risks around the next US fiscal stimulus package and uncertainty on the Brexit deal. US election uncertainties are also top of the mind, along with continuing issues around US-China relations. On the economic data front, Q3 GDP and corporate earnings, remain key for year-end equity market direction. And threaten a market currently priced for perfection. Added to that is continuing COVID cases keeping tourism and travel at depressed levels, with no clear visibility on timelines of normalcy with vaccine dates being a moving target. The hotel sector remains a laggard, and continues to see occupancy waning and waxing depending on each country’s individual COVID situation. However, hopes persist for a vaccine by early/ mid 2020 and economic data points led by China are leading to positive sentiment. U.S. corporates too are talking of a visible recovery in demand, with Walmart saying back to school a little slow to start, but food remains resilient. Lowes is talking of DIY inventory in short supply and Mastercard said volume trends, excluding travel and entertainment are at 4Q19 levels. The data however, mainly illustrates COVID stay at home trends still gaining traction.
Market risk of high valuations is mitigated by Fed rates at the zero bound for the next few years. Financial conditions haven’t been this easy since 1999 and there is no other asset class that provides growth.The Nasdaq, has entered correction territory last week, down 10% from its peak but is still up 22% year to date. Apple, Microsoft, Amazon and Alphabet lost 7/8% last week, double that of the Nasdaq, however the FANG Index still leads global returns +63% year to date. These tech winners giving back more than the broader market and the tech sector, is recent over exuberance being tempered – and should provide entry points at more reasonable valuations - these are companies with strongly defined expanding business models and strong product lines, global leaders in every way.
China markets are also led by tech: Alibaba and Tencent constitute one third of the MSCI China Index and have been the major contributors for the Index performance this year, along with Meituan Dianping and JD.com. The MSCI India Index similarly, has seen retail and digital giant Reliance Industries as the largest contributor to performance, along with IT consulting firms, Infosys and TCS.
Energy was a laggard for last week, as Brent fell 6.6% to $39.8/bbl. on recent pricing and demand issues. The KSA market did not follow the drop in oil prices and was resilient, with strong trading volumes. The KSA Index is now flat for the year. The Abu Dhabi and Dubai indices lost half a percent, with trading volumes remaining a drag. In Dubai, investors stay focused on the strong dividend payouts expected from the banks, whilst real estate which has cut dividends is down 25% year to date, a reflection of demand falling for off plan properties and lower mall and hotel occupancy. Abu Dhabi markets are better year to date performers with telecom supportive.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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