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Chief Investment Officer's team, 20.10.2019
Investor’s appetite for risk was better last week, leading to positive performance for equities and for the most cyclical segments of fixed income. This outcome is the combination of defensive positioning, meeting some relatively good news coming from both bottom-up (US corporate earnings) and top-down drivers.
As regards the latter, we had written for weeks that we were expecting the tensions between the US and China to mark a pause, and the recent declarations by Vice-Premier Liu confirmed the positive mood. Last week’s Brexit breakthrough was a welcome addition. Our stance was that the EU wouldn’t close the door to an agreement, and it is unchanged: predicting the outcome of next week’s vote in UK Parliament is impossible, but at least we can assign a very low probability on a “no-deal” Brexit, which is what really matters for the economy and for the British Pound. The deal might pass in October, there might be general elections or even a referendum, there will be volatility ahead, but the situation has improved.
Another top-down headline was the 3Q GDP of China which, at 6% year-on-year, was “the weakest since 1992”. It is factually true, but it’s good to remember that the total size of the Chinese economy is US Dollars was around 500bn in 1992, compared to c14.000 today. Indeed, it is the equivalent of 2 Chinese economies from 1992, which has been created in the last 12 months. The Emerging Markets story is far from being over, and it’s the only place where valuation is still compelling.
Some clouds are lifting on the horizon in the form of reduced risks related to a no-deal Brexit and the escalation of the US-China trade war.
It would be obvious to expect that cyclical assets should stand to benefit the most since the dim macroeconomic outlook so far has mainly been predicated on adverse geopolitical factors.
This is in principle true, although time will be required for the large and intensifying damage inflicted to business sentiment to be repaired. The latest releases confirm that the global slowdown continues and it is actually entering a phase where consumption and services are starting to be adversely impacted. US retail sales were softer than expected, and the Services PMI in the euro area took a tumble in September. At the same time, the Chinese authorities continue to show a bias towards avoiding excessive leverage in the system at the expense of growth, which in real terms touched the lowest point since 1992.
Looking at past occurrences of recoveries following a hiccup in growth when a recession was avoided, equities tended to be up in the low double digits, with stronger EM performance, and safe-haven assets like Treasuries and gold were weaker until the effects of the economic impulse faded. This time around markets should be following the same script once PMIs start to rise again, with the difference that current valuations are not as cheap as they usually were during past economic troughs, since investors have started to discount a reflationary phase owing to widespread central bank stimulus. Also, gold and US Treasuries are unlikely to enter a bear market when things start looking up since central banks are expected to remain market-friendly.
In a nutshell, expectations for outsized returns should be tempered indeed given the current peculiar backdrop. If history is any guide, buying on weakness with the objective of targeting a pre-defined risk budget, which will be again reduced once optimism once more starts to be widespread, most likely in the next 12 to 18 months, should be a rewarding strategy.
The US dollar should follow along the lines of this same narrative. A lower gap in the growth differential between the US and the rest of the world, so far markedly in favor of the former, is all that is required for risk-on sentiment to come back to the FX markets and dollar weakness to start to set in. Yet, the road to stronger DM or EM currencies versus the dollar is going to be a long and winding one as well, since investors have been accustomed to witnessing the impressive resilience of the US economy in the face of multiple headwinds for quite some time now. A high hurdle has been set for markets to be convinced that as global recovery this time is for real.
Fixed Income Update
The "risk-on" sentiment fueled by the positive macro backdrop, including the progress on the US-China trade front and Brexit developments kept bond yields towards the upper band of the recent trading ranges. Global Credit outperformed Sovereign bonds led by high-yield, returning 0.48%. Euro-Area aggregate, which returned -0.35% last week, was the worst performer as investors looked for higher returns by moving into other asset classes.
The Sovereign bond market weakened as a result of the investors' positioning. The only exception was Greece, which benefited from the sell-off of core Eurozone bonds, rallying 12 bps over the past week. However, the volatility of bond yields stays elevated as investors remain skeptical of the global economic growth outlook. Surprisingly low US retail sales and the slowest Chinese GDP growth since the 1990s weighed on investor sentiment. The market will closely observe the US Market PMI indices due this Thursday, and the University of Michigan sentiment index, due this Friday.
The Federal Reserve initiated its Treasury-Bill purchase program by buying securities worth USD 7.125Bn with dealers offering USD 32.55Bn of T-Bills. This considerable response removed previous concerns of limited supply. Short-end treasury rally has also been supported by the increasing probability of the FED delivering a rat-cut hat-trick in its October FOMC.
In the Eurozone, apart from Brexit developments, the markets will look forward to the Oct. 24 policy decision by the European Central Bank. No policy change is expected.
The Peoples Bank of China grapples with a classic EM central Bank dilemma of whether to control inflation or support growth. The Chinese Q3 2019 GDP growth figure hit a multi-decade low of 6%. The September PPI reading came in at -1.2%, adding to woes on corporate earnings. On the contrary, inflation has been ticking up with the Sep 2019 consumer prices at 3%. A total of 26 corporates have defaulted this year, which include one SOE State Owned Enterprise), and translates to a cumulative of RMB100 Bn (USD 14 Bn). The PBOC has ensured adequate liquidity in the system by injecting RMB 200bn through the medium-term loan facility and RMB 30bn through open market operations last week.
GCC credit markets returned 0.22% last week. Investors’ appetite for GCC credit remains strong as witnessed by the large order books for Aldar Investment Properties' USD 500 Mn and Government of Sharjah's USD 750Mn 10-Year Sukuk issues. Both the issuers witnessed significant spread tightening to the initial price guidance. This week, Kuwait Projects (KIPCO) is expected to hit the market for a 7 to 10-year USD denominated bond issue. Moreover, India's largest gold loan NBFC Muthoot Finance concluded the investor roadshows for its maiden USD bond issuance and is expected to issue a 10-Year bond this week.
Global equities had a positive week on better than expected Q3 earnings and as a tentative EU Brexit agreement emerged. The S&P 500’s 0.5% increase for the week marked the second consecutive week of gains. Upbeat quarterly earnings reports from US banks i.e. JP Morgan, Morgan Stanley and Citigroup, in spite of lower rates, indicated the strength of the US consumer with an uptick in credit card spending and strong growth in consumer finance. The three main US indexes are within 3% of July’s all-time highs, showing the resilience of the US stock market despite concerns about slowing global growth. It’s been a mixed month with cyclical sectors such as communication services in the lead and defensive sectors such as healthcare gaining traction.
According to Bloomberg, Saudi Aramco’s initial public offering has been delayed to allow incorporation of third-quarter results into pre-IPO assessments of the company. GCC markets saw the Dubai Index and the KSA lose c.1% last week whilst Abu Dhabi gained +0.4%. Banks in the UAE have begun publishing Q3 results with net interest margins not as yet showing declines as there is always a lead and lag effect of the lower interest rate implementation. The logistics sector continues to show growth: Air Arabia announced that it had signed a JV with Etihad Aviation Group, Abu Dhabi’s flagship carrier, to launch the first low-cost carrier in the UAE capital “Air Arabia Abu Dhabi”. Complementing Etihad Airways’ services, the new airline will further serve the growing low-cost travel segment.
Our overweight call on emerging markets is working so far with a 1.3% rally last week (MSCI EM TR USD) in spite of China reporting its slowest GDP growth in three decades at only 6.0% (below consensus of 6.1%). However, China industrial production was up 5.8% y/y and ahead of consensus of 5.0%. The expected US-China trade deal between President Trump and Xi Jinping when they meet next month remains an important potential catalyst. A good week for India +3.2%, though annual returns are lagging EM and global markets with finance sector worries weighing on market performance.
Of the 73 companies in the S&P 500 that have reported earnings, more than four-fifths topped analysts’ expectations. On the consumer front Coca-Cola rallied post results and on increased sales of healthier drinks with less sugar: a theme we have been watching for the last few years with Nestle, Pepsi and Danone. In the healthcare sector, Johnson and Johnson and United Health Group posted strong growth, though the former is beset with legal issues. The American consumer has been supported by strong wage growth, offsetting weakness in corporate profits and capital spending. Some of the headwinds around concerns of a slowing U.S. economy and trade tensions seem to have abated.
The streaming war is on internationally with Netflix, Disney+, Apple and Amazon providing subscription-based video on-demand services, through which viewers watch what they want when they want. Content is key to survival but less important for Amazon and Apple, as this is not their primary business. Netflix added 6.7 mn subscribers last quarter, slightly below consensus and largely outside the US, indicating that new markets were the key to growth.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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