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Chief Investment Officer's team, 08.03.2020
Last week was as eventful as it was volatile on global financial markets, with the coronavirus outbreak keeping centre stage. As we wrote one week ago, we were expecting Central Banks to respond, and it happened in a serious manner: the US Fed made an emergency 50bps rate cut on Tuesday. Let’s say it bluntly: we are not very convinced by this move. The rapidly spreading COVID-19 is posing a serious risk to the global economy in the short-term, threatening financial conditions and credit. But a rate cut doesn’t have an immediate macro effect. In addition, 50bps is a significant part of the Fed’s firepower, but it’s probably not enough to support the solvency of the most indebted companies.
A second shock is happening, after the OPEC+ Group failed to agree on Oil production cuts. Prices are collapsing. Our in-house expert has revised his assumption to $45/b for Brent (2020 average), but it could go much lower in the short-term, shocking markets. This prompts caution for GCC assets, stocks and high risk bonds, as well as for the energy-rich DM High Yield segment, on which we are underweight.
We’ll hold our monthly Tactical Asset Allocation Committee this week, with our current defensive positioning as a starting point. We still expect the health crisis to be resolved in months, and Oil prices could also revert – but the short-term is about more turbulences. It also means potential opportunities, especially as our current positioning is robust and conservative.
The spreading of the COVID-19 virus is challenging leaders across the globe in what has become the first pandemic since the so-called Spanish flu between 1918 and 1920. It killed as many people as the First World War did. We can so far say that the response of the Chinese authorities, although somewhat belated, has been drastic enough to bring the number of new infections down to a trickle. This is comforting, at least for the Chinese, though a little less for all of the others, considering that quarantines in Hubei were imposed starting January 23 when the number of cases was 549, while today three countries, Korea, Iran and Italy, have thousands of cases.
If growing inequality has seen the rise of populism and, with it, of demagogues, it is ironical that it will be some populist leaders who are called to tackle the virus threat in the Western World. They will have to take action and be judged by voters according to the effectiveness of the countermeasures taken. This stands in stark contrast to the chief qualities of a demagogue, “a politician skilled in oratory, flattery and invective: evasive in discussing vital issues …”, according to the definition given by the historian Reinhard Luthin. In a way, the virus will very subtly pit weak leadership against the necessity to act swiftly and decisively for the greater good.
In the United States, the last major developed country to have been infected, COVID-19 is still in the ramp-up phase and it is only a matter of time before we can compare how the US response stacks up against what has been so far achieved elsewhere. With the 2020 elections looming larger, the longer the virus-related disruptions last, the less inclined US voters may be to cast a ballot just depending on the state of the economy. So far the US Government is off to a mixed start, as one may well struggle to explain its weeks-long difficulty creating a diagnostic tool to contain the disease. Current conditions make telling who the next US president will be a closer call than ever. With regards to financial consequences, the good news is that last week saw the come-back of Mr Biden in the Democratic race, an undoubtedly more “market friendly” profile than Mr Sanders.
Virus-related developments will be decisive for the US being headed for a recession or not. We hold the view that the current massive stimulus efforts will survive the virus, eventually helping the recovery of risk assets. Not only is the Fed currently very pro-active, but also the BOE, ECB, and the BOJ have signaled that they have plans which go beyond interest rate cuts, the latter two central banks having no more monetary firepower left. Last week the IMF made $50bn of emergency funding available to stricken low and mid-income countries to cushion the virus impact. Yet, markets are likely to remain in turmoil until the COVID-19 daily-infection rates drop in the single digits both in the US and Europe.
The performance of our Cautious, Moderate and Aggressive profiles over the first two months of the year is -1%, -2.5% and -4% respectively. Absolute numbers are negative, after (+11%, 14%, and 18% in 2019), but our defensive positioning outperforms our strategic asset allocation and the majority of our competitors so far in 2020.
Fixed Income Update
We believe most of the fixed income investors might feel like the iconic dialogue from the TV Series Game of Thrones “You Know Nothing John Snow…” is directed towards them under the current circumstances. From a scenario of zero to one cuts at the start of the year, markets have come to price four rate cuts by June. This would require a lot of fair values and investment strategy rethink.
However, first, let’s get the records out of our way. US Treasury 2, 10 and 30-Year yields hit record lows almost every other day last week and finally settled at 0.50, 0.76 and 1.28 percent respectively as of Friday US close. 30-year Treasuries adjusted for inflation turned negative for the first time ever. These rates are pricing-in a recession, which is not our current base scenario. China’s 10-year yield at 2.62 hit the lowest level since 2002. German 10-year and 30-year bund yields hit record lows while UK short-dated benchmark yields approached zero.
It has been quite a balancing act for the benchmark bond indices. While rates continue their journey downwards, the credit spreads have widened. This has resulted in the Investment Grade indices posting positive gains over the week as they reaped the benefit of lower rates while HY indices lost out. US HY was the worst affected by a twin whammy of higher spreads and low oil prices inflicting pain on the energy sector, which has an 8% weightage on the index. For the first time this year Emerging Market Local currency Index posted positive return due to Dollar weakness.
GCC Debt markets have been quite resilient on the backdrop of local investor support and have beaten the broader Emerging Market Debt returns YTD. Real Estate and Retail sectors had taken the brunt of the worsening sentiment in the region. Hence, names such as MAF Perpetual and Dar al Arkan are among the issuers, which have seen a significant price drop. Moreover, long-duration HY sovereigns such as Oman 47s and Egypt 49s were affected before the Fed rate cut. However, the surprise Fed action resulted in a quick bounce back for the Egypt curve, while Oman bonds continue to struggle due to their high sensitivity to oil prices.
In terms of portfolio positioning, we would be cautious taking any fresh exposure to high beta oil names specially the HY sovereigns, private real estate players and Financials in the GCC due to the breakdown of OPEC+ talks last week. We continue to like Asia HY because of the improvement seen in the high-frequency data coming out of China along with the anticipated high liquidity support from PBOC to stressed firms. Asian HY also offers the highest Duration Turned Spread of 195. Selective credit pockets in Emerging Market continue to provide decent risk-adjusted-return, and the current sell-off has made them attractive. However, please bear in mind that we are not out of the woods yet, and the market will continue to be volatile for HY issues with rumours and noise affecting price movements. The key to sanity is to ignore short-term price actions and believe in long-term conviction unless the scenario changes drastically for the underlying credits.
U.S. and global equities ended a volatile week, higher overall, breaking a multi-week losing streak. (S&P 500: +0.6%, MSCI ACWI +0.5%). The impact of the coronavirus on the global economy remains uncertain and the S&P 500 whipsawed from +4.6% to -3.4% on daily moves last week. Friday avoided a close of -4%, as a Fed governor commented late afternoon on buying securities. Though US ISM numbers and the job reports for February were strong, they are backward looking. Both economic and earnings growth in the first half of 2020 remain at risk of further downgrades. The virus outbreak has disrupted global supply chain links, from raw materials and components to finished goods. Economies around the world are operating below capacity with manufacturing delays. Cash flows are impacted by lower production and this is being followed by a demand slowdown. People are traveling and shopping less and companies are forced to lay off workers. Highly leveraged companies could have problems servicing their debt. Lenders are being asked by the central banks to be lenient, to allow companies to overcome the short to medium term slowdown in sales. Central banks starting with the Fed last week are cutting interest rates to provide relief to corporates hurting from slowing business. Besides impacting public health, the coronavirus may mark a defining moment for economic policy as monetary action is no longer seen to be the panacea for boosting economic growth and fiscal measures will need to be brought in too.
The GCC markets with its large concentration of banks had a down week as margins and earnings are under strain after central banks followed the Fed’s decision to cut rates. The impact on bank earnings is estimated anywhere between 2-4%. Lower oil prices will also impact sentiment and the broader market revenue as businesses will feel the pressure of lower government spend.
We expect heightened volatility to continue and global equity markets to recover in line with resumption of supply and return of business to normal as illustrated by the performance of China equity indices. Semiconductors, transportation and homebuilders are key indicators for the pace of the recovery. UK’s Flybe has gone into bankruptcy administration and IATA stated that airlines could lose more than $100 bn in passenger traffic revenue in 2020. Semiconductors (SOXX -0.4% last week) should be the first to stabilize as China factories are back to at least 50% production. The primary risk to market performance is further degradation in the earnings outlook as multiples have no room for expansion and began the year at elevated levels. We began with a very conservative 4% earnings growth target for the US for 2020 compared to consensus at 9.6% and will look at bringing this down further. Consumer staples, Health care and Tech look better positioned, while Energy, Industrials, Materials and Financials appear more vulnerable to earning revisions. Healthcare has rallied, as Joe Biden is leading over Bernie Sanders as the Democratic candidate and hope builds up on select healthcare companies to find a cure for the virus (trials are on) and a vaccine (though still a year away, with tests starting now).
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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