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Chief Investment Officer's team, 05.09.2021
Last week was not good for global markets, with almost all asset classes in the red. Cyclical assets were hit harder: the recent Delta-driven downshift in growth momentum meets historically elevated valuations. This is not new, but this was freshly highlighted by several influential Wall Street strategists in their “back to school” notes. Stocks and listed real estate were down, but very modestly, it’s not even a consolidation.
Defensive assets didn’t fare better, troubled by their own issues. Inflation keeps on rising, while central banks in developed regions keep on preparing to withdraw their now unwarranted and extraordinary level of support. Both the RBA and the ECB signaled steps in that direction. More inflation, and less liquidity: interest rates rose and gold fell over the week, unsurprisingly.
We have been writing for some time about the combination of a softer macro episode with elevated valuations and the imminent start of tapering, which is why we are positioned to stomach some volatility. This is not new, and we also see some reasons to remain reasonably constructive. First, the delta wave has started to fade, and vaccinations are on the rise where they need to. Second, everything is not dark: China’s trade numbers were better than expected, high level talks with the US resumed, and some cyclical assets are not signaling any softness, typically, oil prices or GCC stock markets. We have kept our reasonably pro-cyclical positioning unchanged, even if we expect volatility. Should risk-assets brutally go south on an episode of anxiety, we would certainly consider adding exposure.
The week ahead may actually fuel volatility, with potentially disturbing numbers on retail sales and inflation. We are prepared to stomach it. Stay safe.
Gold has been undershooting its fair value based on the level of the 10-year Treasury real yield for quite some months now, which is quite unusual, given the strict relationship between the real yield and the cost-opportunity of holding a non-yielding asset like gold. From mid-June to early August the 10-year real yield collapsed to reach all-time lows at -1.2%, consistent with gold trading round $2,000, which it failed to. Investors must have been looking through the current low yields, that are in no way discounting the tapering of asset purchases announced by the Fed and are depressed versus the above-trend rates of US economic growth forecast for 2022. Also, inflationary pressures due to supply constraints and labor shortages are proving less temporary than expected and should help lift yields, alongside the approval of Joe Biden’s Build Back Better stimulus package. A size north of USD2tn for the latter would be shoring up flagging consumption, while being inflationary as well. Since the US economy is past its growth peak and is slowing down, we should not be looking there for signs of weaker Treasuries, but rather turn our attention to the commodity markets. Indeed, the nominal yield on the 10-year Treasury note and the ratio of copper to gold, an indicator correlated with price pressures embedded in Treasury Inflation-Protected Securities, tend to follow common trends. Usually the ratio leads long-dated yields and now copper is again showing signs of life versus gold. The ratio, after range-trading since the spring of this year, is back at the July-August highs, an indication that commodity markets are awakening to the inflation theme again.
Since nominal yields are so depressed and yield-positive catalysts are plentiful in this second half of the year, from temporary supply-side bottlenecks to the tapering and fiscal stimulus, we still expect their direction of travel to remain higher. We maintain a fair value of 1.75% for the yield on the 10-year note, acknowledging that uncertainty round this level is high. We have little visibility on how ‘temporary’ supply-side constraints are. Companies are starting to warn more often on the worsening of those constraints in Q3, and some are even withdrawing guidance on related concerns. We do not know how markets will react to the winding down of asset purchases as the deadline for implementation draws closer. And, first and foremost, will the size of the Build Back Better package be closer to the lower-end or the upper-end of the expected range? Most likely, fiscal stimulus is going to be the main driver of yields in the next few weeks. Meantime, it is important to take notice that markets are awakening to the inflation theme and gold’s underperforming real yields is a clear message that markets are not underestimating price pressures.
If our scenario of higher US rates plays out, we should expect further weakness for gold. Although higher inflation would be one of the culprits for gold’s weakness, and gold is often touted as being an inflation hedge, with market-implied inflation already at elevated levels and yields very depressed real rates would be rising, a net negative for the non-yielding yellow metal. Investors should avoid buying gold above $1,800 and rather time entries on weakness.
Fixed Income Update
September historically has been the month when duration supply peaks and yields typically weaken. Last week, we saw two strong treasury auctions, and yields came down post the 10 and 30-year bond sales. Moreover, the U.S. investment-grade primary market completed its busiest week in history after 54 high-grade companies sold debt in just four days to take the weekly volume to $ 77.8 Bn. It is interesting to note how well the market has absorbed the supply. Issuers paid negative new issue concessions (-1bp) with deals tightening 25bps from IPT to launch driven by order books that were 3x oversubscribed. This week’s CPI report will throw more light on the direction of the yields.
Even though the Treasury volatility indicated by the MOVE Index reached a three-month low, there is anxiety that the debt ceiling debate would increase the volatility. The balance on Treasury General Account has plunged to $297 Bn at end-August. On Aug1, 2021, the amount of U.S. gross national debt outstanding of $28.43tn has become the “debt ceiling.” It cannot be breached unless Congress suspends it or raises it as it has been done 78 times since 1960. At the current rate of decline, the TGA balances will hit zero by mid-October. This could be extended to mid-November by “extraordinary measures”, which is when the U.S. Government could theoretically start defaulting on its bills.
Last week the asset classes behaved in line with treasury movements. China I.G. and Global High Yield continued to show resilience with +0.1% weekly returns. On the other hand, Developed Market Sovereign and corporate I.G. had a -0.1% return last week.
Asia High Yield topped the returns chart with +0.3% weekly performance. This was driven by positive news from the Evergrande bond complex, which has roughly 3% weightage in the benchmark. According to the latest updated on 9th September, China’s Financial Stability and Development Committee, the nation’s top financial regulator in Beijing, has signed off on a China Evergrande Group proposal to renegotiate payment deadlines with banks and other creditors, paving the way for a temporary reprieve. The issuer’s bonds closed the week on a new high after suspension of trading on Monday due to a sharp plunge. We have maintained our view that the asset class offers the best risk-adjusted returns to our clients and our belief that Chinese regulators would work to avoid systemic contagion from tail risks.
MENA primary markets kicked off a solid start to September after a no-show in August. Three issuers have sold $ 4.5 Bn bonds MTD. Emirate of Abu Dhabi was the largest issuer selling two-tranche $3 Bn bonds without any new issue concession pricing the bonds at par with the underlying sovereign curve. The bonds traded above issue price in the secondary market, indicating strong investor demand. We also liked the new Tier-2 Sukuk from Turkey’s largest Islamic Bank, Kuvyet Turk, which priced the Sukuk at 6.125% resulting in 50bps spread tightening from IPT to launch driven by 10x oversubscription.
Global markets are showing signs of lethargy, with developed market equity performance already having reached our year-end fair values. Both the U.S. and Europe are at +20% gains year to date gains. Asia, however, had a largely positive week with Japan markets +3.5%, as investors welcomed a change in Japan leadership. Also, Tokyo cases appear to have peaked, amid early signs of a roadmap to normalization tied to vaccination rates. China domestic shares rallied +5% but the MSCI China with a higher component of U.S. listings and tech was up only 1%. U.S. markets had a short negative week. Though the Nasdaq Index and Apple shares made new highs at the start of the week, gains were given back in line with the overall market. Supply chain warnings with rising inflation, stretched valuations, rising virus cases and stagnating growth and poor September seasonality played a role. Europe went through a similar down week, though the economic and fiscal outlook, supported by the Recovery fund, remains very constructive and bodes well for European outperformance. Europe is ahead on the vaccination rollout and cases are falling. New and continuing leadership across Germany, France and Italy also makes for good political support.
Going into the last third of 2021 no change in our equity positioning: a constructive outlook with economic growth, fiscal and monetary policy supportive. A continued higher overweight on developed markets and Europe within that space and also emerging markets with EMEA and the UAE preferred therein. Global ytd equity inflows at a record at $725 bn, just slightly lower than the cumulative inflow of prior 20 years, i.e., $0.8tn. Expectations for muted gains and higher volatility into end 2021, more so for DM, EM has some room.
The UAE saw weekly gains on the Abu Dhabi index. Our economic team sees many green shoots in the UAE’s economic outlook. Banks are the biggest contributor to gains in the Dubai and Abu Dhabi indices followed by real estate for Dubai and IHC and Alpha Dhabi for Abu Dhabi. Many factors are in place for continued upside as valuations are not stretched relative to global indices, oil trading over $70 is positive for government expenditure and the real estate sector offtake benefits both rentals and end users. UAE markets are amongst the top performers with the MSCI UAE index +34% ytd and could be further boosted by a slew of reforms and “green visas” to attract talent and prop up growth. 50 economic initiatives aimed at diversifying away from oil have been launched UAE public capital markets are dominated by banking and real estate and trading volumes and interest from international investors has been low. The UAE is just 0.76% of the MSCI EM index with 9 stocks participating. The ADNOC Drilling IPO is a welcome addition to the breadth of the market.
China's August trade data was better than expected and comes amid heightened volatility with China's regulatory crackdown on big businesses. The latest regulatory developments include new rules for gaming firms with a not for profitability bias and limiting hours for young adults and further crackdowns on the ride-hailing industry. The market may have seen the worst of it with the recent talks between the U.S. and China being encouraging. and we remain neutral, with no specific bias either way.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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