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Chief Investment Officer's team, 05.09.2021
Last week was extremely rich in economic data, with activity indicators- PMI and ISM- in all major regions, as well as the US monthly job report, all for August.
The picture is unambiguous. In the developed world, leading indicators are not progressing anymore. Indices are at historically elevated levels, mostly above 55, but services are softer, and manufacturing activities are suffering from persistent bottlenecks. Meanwhile in China, activity contracted in August: the Caixin composite PMI fell below the 50 mark, at 47.2 after 53.1 in July. The week ended with a massive disappointment in terms of monthly job creations in the US: with 235k additions, it was less than a third of the median forecast.
This was however not a bad week at all for markets. The US S&P500 reached a new all-time high and even stocks in emerging markets had a significant rebound, up 3.4%. All asset classes were actually in the green, which as always means one thing: market participants are confident that the tepid news on the economy, on employment in particular, mean that the extraordinary monetary stimulus will not be brutally withdrawn. We are in a liquidity-driven environment, and there are reasons to believe that the current macro headwinds are transitory, paving the way for robust growth in 2022. Of course, at the current valuation levels, the risk of overconfidence is rising along with stock markets which seem invulnerable. They are not, but for the time being, there is no alternative to generate returns, which is why our positioning remains reasonably pro-risk for now. We closely watch signs of complacency as well as risks to the consensual outlook – which include regulatory and political uncertainty in Germany, Japan and China, as well as, of course, inflation. Stay safe.
Last week saw an impressive number of data points which continue to suggest that the slowdown of the major economies is in full swing, although markets still made new all-time highs and shrugged off the underwhelming news. Investors looked through softening activity and weaker surveys, against the backdrop of pandemic risks which are failing to translate into higher hospitalization rates. Supply constraints and labor shortages should by nature be temporary, although inflationary pressures are lingering longer than initially thought. The labor supply issues and the virus concerns which weighed on the disappointing US jobs report should wane by Q4, the drop in business confidence in Europe is for now a slight pullback from torrid levels, while the severe slowdown in China should soon be addressed by the authorities. Overall, a growth shock is far from being in the cards and global activity is expected to remain resilient into year-end.
The bad news seems to have been priced in already, with market measures of investor sentiment implying business confidence levels not far from the current ones and US long-dated yields actually rising on Friday, rather than falling, when the jobs report was released. Retail investors bought equities at record pace in the summer months, supporting markets, which are unlikely to drop significantly until inflows remain so strong. Also, the degree of investor participation remains very broad, as signified by some market breadth gauges making new all-time highs. The conclusion is that the slowdown in the economy, still showing strong growth in absolute levels, is not at all incompatible with bullish equities.
Long-dated Treasury yields rising on a disappointing US labor report was in our view a high-probability event, as at current levels, the yield on the 10-year note is basically discounting no growth for 2022, when actually the US economy should expand at above-trend rates throughout the year as per consensus estimates. The direction of travel of yields should be higher, as inflationary pressures linger and the tapering of asset purchases is announced. Yet, uncertainty surrounding our 1.75% year-end target is pretty high. The pace of the US recovery remains very uneven, the tone of the Fed’s message could shift more dovish in case of not-so-strong labor markets and investors seem to be looking through the tapering as reassured by Powell that the time of rate lift-off is nowhere near us. Overall, our judgment related to yields having bottomed out and subsequently moving higher is strongly supported by the Treasury-implied level of future growth, unrealistic versus projections.
Negative news on China regulatory interventions seems to be never ending, and it is actually overshadowing the positive fact that China policy is about to turn more expansive, which in turn should stabilize local equity markets. Government bond issuance rose to ¥951bn in August versus a monthly average of ¥387bn through July. Also, additional lending support is coming for SMEs and private enterprises. With global demand softening, it is clear to the central authorities that they can no longer afford that internal demand slips further.
Fixed Income Update
As we dive into the last month of Q3 2021, there are a few nagging questions at the back of the fixed-income investors. The foremost among them is the direction and the magnitude of the movement of the US Treasury yields and, secondly, the effect of the delta variant on the riskier segments of the asset class such as High Yield and EM Debt.
The answer to the first question from our side is that while we remain convinced about the direction of the yields, which is “up,” the magnitude of the move could be lower than earlier anticipated—especially looking at the stagnation of widely followed macro data and expectation of tapering to happen this year being priced in at current levels of the yield. Unless the FED does an unexpected hawkish turn, the yields could be range-bound or increase slightly, rather than a sharp upward movement similar to the first quarter. Our view about the second question is based on the tussle between valuation and fundamentals. The expensive valuation suggests that most of the capital gain from the High Yield sector is behind us. However, the improving fundamentals in plateauing default rates and record levels of cash to debt in the last two decades, along with structurally low beta to equities, means that the stress on this segment is relatively low. We are bullish on EM Debt as most nagging issues, such as the delta variant spread and economic growth concerns, are behind us. Moreover, with the yields expected to be stable, the long duration of this asset class should not hit the investors badly. Valuation wise EM Sovereign debt presents an excellent opportunity for fixed income investors.
Last week was very sedate, with US treasury movements across the yield curve remaining stable. Most of our preferred asset classes, such as China IG, EM Sovereign, and Global High Yield, gave weekly returns between 0.5% and 0.7%. Asia High Yield was the only segment which we like and gave a return of -0.6%. We continue to believe that this is because of repricing of the tail risk where markets expect more defaults from the weaker credits. However, systemic contagion risk remains low given that authorities are keen to avoid domino effects, especially in the property sector. Reinforcing our belief is that we anticipate the government is at the end of its credit tightening phase. There may be some positive intervention to increase liquidity in the system that would benefit the high yield sector. We remain positive on Asia HY, including on China HY, as we believe contagion risks can be managed and systemic worries will not emerge
MENA region has been silent in August with zero issuance from the region. However, the pipeline looks decent in the last quarter of the year. Recent reports by Refinitv suggest that the UAE held credit update meetings with investors last week. There is anticipation that the UAE may issue its first Federal Government bonds. The only Federal level issuance is from the Emirates Development Bank so far. This new issue would be a landmark and should see significant interest from institutional investors. The UAE is considered a solid credit from the region and has received the highest sovereign rating within GCC at Aa2.
After a very upbeat August with both emerging and developed market equities in synch, gaining around 2.5% for the month, last week saw gains of +1.2% for global equities, taking year to date gains to 17%. Many markets up close to 5% including China, Japan and India. India continues to gain as virus cases recede and as an alternate to China. Japan markets have taken well PM Suga’s departure. An encouraging start to September, statistically the worst performing month. There remain plenty of reasons for a pullback with the Jackson hole Central bank symposium where talks of tapering are being microscopically analysed and virus resurgence with vaccine boosters being touted (good news for stocks of companies approved for vaccine boosters). The marked difference between the Covid impact on vaccinated vs unvaccinated remains stark. U.S. equities, the leader in the DM space, headed into the long holiday weekend on a positive note with Fed Chair Powell’s balanced signals supportive and the Nasdaq was up 1.6% and the S&P 500 +0.6%, for the week. Tech back in favour with yields stable and the Nasdaq continues to make new highs as does the S&P 500.
UAE markets added to ytd gains and opening up of the country to vaccinated tourists bodes well for the hotel industry and real estate as more end users like the favourable living and working conditions with digitization and connectivity high on the UAE agenda.
Last week saw the MSCI China gain 4.2% following a flat August, stabilizing after the sharp fall in July. However, China remains the worst performer amongst large markets year to date, with regulatory oversight continuing on gaming hours for children, internet content and possible state investment and oversight on ride hailing companies listed overseas i.e. Didi. Tech giants are committing large contributions to “common prosperity” initiatives. Uncertainty on China policy with its strong push to a more equitable social framework, could continue to take its toll on its capital markets. Valuations are low relatively and absolutely but the impact on profit margins on the large tech companies is yet to be felt. Tencent, Alibaba, Meituan and JD.com are 30% of MSCI China. For positioning we maintain a broader EM overweight and are neutral EM Asia. Domestic China equities preferred over US listed enterprises. China is also strong on ESG initiatives so companies in renewables/ EV space should see continued outperformance. Europe also still looks interesting and a better proxy in some ways with China a major trading partner. The MSCI China has fallen 26% since February 14, while MSCI Europe is up 14% over the same period. Also, the recent Dax Index expansion announcement which includes more tech brings Germany to more contemporary Index weights.
There are several risks for the market: fading monetary and fiscal stimulus, peak earnings/economic growth rates and the Delta variant. However moderate growth upside remains supportive for cyclical assets – higher equities and higher bond yields. Cyclical sectors energy and financials continue to lead global equity returns along with real estate. But the year-to-date rally is broad based with tech and healthcare also with +20% year to date gains. We remain overweight equities with a stronger bias towards developed markets.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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