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Chief Investment Officer's team, 08.09.2019
Financial markets are currently driven by three deeply interlinked factors: political risk, leading to lower growth expectations, leading to hopes for policy response.
If anything, political risk has very modestly improved last week. The UK is far from having solved its Brexit headache, but should at least avoid the imminent chaos of exiting the EU without a deal at the end of October. On the trade front, the US and China have set-up another round of negotiations. We don’t expect any material improvement from the meetings in Washington but a dialogue is obviously better than a tweetstorm. As regards the economy, the latest data in the US confirmed a weak manufacturing sector, but also resilient services. Wage progression in America was steady enough to support consumption, the bedrock of its GDP, but job creation was below expectations, justifying another rate cut from the Fed. The rest of the world follows: China is cutting its Reserve Requirement Ratio and increasing government spending, and the ECB should announce a package or monetary easing on Wednesday.
Let us be clear: there is nothing to be excited about, but the 2% gain in global equities last week only demonstrates that investors are not positioned for any good news. Under a scenario of tepid but resilient growth with reasonable monetary easing, there might be downside risk in some of the most over-owned and over-priced defensive assets, and maybe some opportunities in carefully selected cyclical assets.
Jerome Powell delivered a remarkable speech Friday in Zurich. He stated both the expected, by saying that the Fed is ready to “act as appropriate to sustain this expansion”, and the unexpected, by touching upon a topic Fed chairs are usually keen to avoid and expressing the view that a recession is not in the offing.
We have already mentioned in this publication that policy stimulus and a strong US labor market still contain the damage inflicted by the manufacturing slump and while the current slowdown could spill over into a recession, business is unlikely to overreact given favorable credit conditions. The implicit assumption here is that the trade war won't blow out of proportion, although trade is not the only transmission channel which could tip the global economy in contraction territory.
Excessive US corporate leverage is another notable vulnerability in this regard, which has been growing steadily since the end of the Great Financial Crisis in keeping with expanding monetary support. Since what is important is the ability of companies to service their debt, the current ratio of financial interest expenses to profits, at about 30% as per Bloomberg data, is not worrying for US corporates, as compared to past peaks of above 50% which preceded some of the last recessions. Bloomberg economists reckon, by linearly extrapolating current indebtedness trends of US business, that a tipping point could be reached in 2022, thus identifying that year as a possible candidate for hosting a recession.
Economies and especially imbalances do not tend to operate in a linear fashion, hence it might as well be that worse comes to worst sometime earlier. Another leading indicator of such crunch times is the yield curve, which in the US tends to lead equity market volatility by roughly two years. The reasoning behind this is that the flattening of the curve, when longer-dated yields drop faster than shorter-dated ones, points to slowdown phases and historically it has taken more or less two years of flattening for the cumulative slowdown to trigger a recession-like spike in US equity volatility. This would leave us with the year 2021 as a potential US recession time.
If, as far as we can tell, we would tend to rule out major trouble in the next 12 months, what about the shorter term? Markets seem to be in risk-on mood again, celebrating the defusing of trade tensions represented by the expected meeting of President Trump and President Xi in Washington early in October. This, alongside the widely anticipated rate cut to be delivered by the Fed at the 18 September meeting, is good news and enough to keep the rebound going against the backdrop of lower summer liquidity and extremely defensive positioning. Upside should anyway be capped until the global economy turns and trade negotiations produce more than vague verbal commitments.
Fixed Income Update
September started with a better tone, with bond yields backing up to the upper-bound of the trading range to 1.59% supported by a risk-on sentiment backdrop. That said, economic data out of the US remains a worry with manufacturing confirming weakness, compared to a robust services sector.
The People's Bank of China lowered the reserve requirement ratio (RRR) by 50 basis points with effect from 16 September for all financial institutions (excluding financial leasing companies). An additional targeted reduction of 100 bps to support lending to small and micro-sized enterprises and private-sector firms is targeted for city commercial banks (CCBs) operating within their provincial-level administrative regions. This additional boost for CCBs will be accomplished in two steps; (1) 50bp on October 15th and another 50bp one month later. The cumulative effect of the cuts is expected to inject about RMB900bn in long-term funds as efforts to stimulate economic activity. The recent move is the third response by PBOC in a move to ensure liquidity ease as the economy slows.
The Institute for Supply Management’s manufacturing PMI index fell to 49.1 in August, below all major forecasts contracting and raising anxiety concerns on the underlying economy. Although manufacturing only makes up about 11% of the US economy, the macro backdrop remains on the helm of the ongoing trade spat with China, which could result in broader ramifications for the economy. That said, its equivalent for services, the ISM non-manufacturing index, printed an impressive 56.4 number in August, better than both the 53.7 of July and the consensus expectation of 54.
The Central Bank of Russia cut its benchmark interest rate by 25bp to 7.00%, as widely expected. The Bank also hinted that there could be more to come. The CBR noted that the downtrend in inflation remains well in place, despite high expectations, and lowered its forecast to 4.0%-4.5% (from 4.2%-4.7%). This compares with a policy target of 4.0%. The CBR also acknowledged that the economic activity is running below expectations and that uncertainty over global growth has increased. Against this backdrop, the CBR now sees the economy expanding 0.8%-1.3% in 2019 (from 1.0%-1.5%), and it did not rule out extra rate cuts in the upcoming meetings. Local currency 10Y bonds have enjoyed a good run YTD with yields losing 150bps to around 7% currently, while Eurobonds have strengthened by 168bp to yield 3.27% on the ten-year maturity.
On the primary issuance front, the borrowing binge continues globally. The US corporate bond market is expected to price over $74bn of new debt this week led by Apple. Asian bond markets had a busy start for September with several new transactions being priced successfully. Corporates now are by and large refinancing their debt due for redemption rather than using sale proceeds for new projects. In the GCC, Bank of Sharjah and Emaar Properties are expected to raise benchmark US-Dollar debt across five and 10-year maturities.
Global equities performed strongly last week with an average 2% gain in US Dollar for global indices. Emerging Markets outperformed their Developed peers with a 2.4% return in USD, led by China at +3.3%. Chinese equities benefitted from the combination of another round of stimulus measure, with an attractive valuation at 12.4 times forward 12 months PE. Developed Markets were up 1.9% in USD. Cyclicals led the rally in all regions. In Europe, Autos and Banks were interestingly the best performing sectors, from extreme oversold levels.
In the US, the S&P 500 ended the week within 2% of its all-time high. Defensive sectors lagged, reversing so far the trend of August, whilst weekly gains for Information Technology and Consumer Discretionary were strong at respectively +2.4% and +2.6%. In our sector model portfolio, we have started to reduce cyclical sectors to add to consumer and healthcare.
Within GCC, based on valuation, we prefer the UAE to Saudi Arabia where we are getting increasingly selective. By comparison, the 12 months forward P/E of the KSA market is at 16, while the Dubai DFM index is at 7.7. The Dubai Index rallied 5% last week, lifting its 2019 total return to +19%. Real Estate companies rebounded from oversold levels, and more recently, the decision from Emirates NBD to increase its Foreign Ownership Limit benefitted its stock price. In the UAE we continue to like the logistics, banks and healthcare sectors.
We currently await catalysts In Saudi Arabia to rethink positioning, as oil prices have fallen and the consumer sector has been under pressure on weak spending. As per media reports, Saudi Aramco has revived plans to sell 5% of its stock, aimed at funding Saudi Arabia’s efforts to diversify its economy beyond oil. Both domestic and international investors would have access to the stock in a domestic listing. Saudi Aramco is considering splitting its IPO into two stages, debuting a portion of its shares on the Saudi stock exchange (Tadawul) later this year and following up with an international offering in 2020 or 2021, and is even considering Tokyo as the venue for the second phase of its proposed plan. A number of options are being considered, and no final decisions have been made on the structure of the deal.
We have not been advocators of investing in the “gig” or shared economy companies as they have gone public at lofty valuations. Whist they hold value as they have large consumer bases and data on the spending patterns, which allows them to cross sell, they are years away from turning profitable. The exponential growth which was visible at the time of their IPOs, cannot continue forever as new regional incumbents pop up. Ride sharing companies Lyft and Uber are trading well below the levels they listed at IPO. They have been unable to penetrate the China market with Didi Chuxing, the leader and in India, Ola holds a large market share. In the shared hospitality space, an Indian company Oyo Rooms, a fast-growing hotel franchise, has raised more than $100 mn from Airbnb, and earlier from Softbank, Grab and Didi. Oyo has become the world’s most rapidly expanding hotel chain, adding more than 700 properties each month and is valued close to $10 bn.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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