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Chief Investment Officer's team, 22.03.2020
Let’s face it: the COVID-19 is pushing the world into recession, ending a multiyear expansion. China leads the way with a double-digit drop in activity in Q1, and the West should follow. Our in-house scenario is now for flat to negative growth in developed economies in 2020. Uncertainty prevails, as we don’t know when the pandemic will end, and how successful the policy measures to limit its impact will be. Policymakers have to fight the virus, but also provide enough liquidity to prevent a financial crisis, and limit the economic damage to preserve the ability of the economy to rebound.
Global financial markets tumbled last week with every single asset class in the red. Equities are down -30% for the year, High Yield -20%, and even Government Bonds and Gold are now negative, hit by the rush to preserve capital. The shock is immense, and might not be over. Our 3 profiles have given back their 2019 returns. They are more resilient than our competitors’, but deeply negative year-to-date with respectively -10%, -15% and -20%. In such a context we keep on urging our clients to avoid any short-term bet, and to be cautious with leverage.
Having said that, if it’s too early to expect markets to stabilize and if the short-term remains hazardous, investors with a long horizon should at least keep their positions. Both valuation and sentiment are in distressed territory, which supports long-term future returns. A robust and diversified asset allocation should stomach the volatility and deliver the expected results over time.
The pandemic-induced crash across risk assets has seen markets collapse at such a speed that one can only find similar episodes going as far back as 1987 or 1929. It seems that taken together the combined price action of equities, credit and US Treasuries is discounting one of the worst recessions of the last 50 years. Yet, given the absence of significant imbalances in the major developed market economies, even the projected once-in-a-100-year hit to global growth in the first half of this year might be absorbed relatively quickly provided sufficiently large fiscal packages are implemented soon.
Indeed, market recovery in the second half of 2020 is predicated both on resources being channeled to corporates and workers directly hit by the stop in economic activity and the peaking of the virus within the next month. In this sense Italy, the epicentre of the pandemic in Europe, serves as a template: should the number of active cases there stop growing in the next two to three weeks, as projected by some epidemiological models, investors would gain some comfort and be more willing to look through this health crisis.
In the shorter term it seems to be too soon to engage in the fruitless game of trying to call a market bottom. The forthcoming macroeconomic newsflow is going to be pretty negative, if not terrible, given the magnitude and number of lockdowns in different economic areas. The virus is expanding aggressively in North America and some time is still needed for fiscal packages to be agreed upon by lawmakers and implemented by governments. Although the Fed has provided liquidity backstops in all forms and fashions and alongside the ECB and the BOE has restarted QE, these measures are more aimed at ensuring the orderly functioning of money and Treasury markets, than able to tide families and corporates in distress over the bad times.
So far investors have been able to find some shelter only in dollar-centric assets, US Treasuries and the US dollar itself. Our 10-year Treasury yield model, based on some economic measures and market-implied changes in Fed Funds, suggests fair value just slightly above where yields are currently trading. Should a recovery phase eventually set in, being exposed from a duration point of view would be quite painful, considering the amount of deflationary pressures embedded in the current pricing. Likewise, once the worst of the crisis is behind us the dollar would be a zero-yielding currency with yawning twin deficits and likely to depreciate significantly in a more growth-friendly environment.
Some tightening of credit spreads and the bottoming out of gold would be two areas where we would be looking to get comforting cross-asset signals in relation to this crisis. With policy rates anchored for a while successful reflationary efforts would be translating into lower real yields, an obvious support for gold as a non-yielding commodity. Lower spreads would be signalling an inflection point in expected defaults, set to rise significantly until fiscal stimulus works its way through the system.
Fixed Income Update
How times have changed in the last two weeks! We can judge it by the fact that “Curve flattening” has come out of Rates Trading parlance into the common domain, and we can even see hashtags supporting the “Flatten the curve” movement. However, the US Treasuries yield curve alternated between Bear Steepening till Thursday to Bull Steepening on Friday. Liquidity in the bond markets was so inadequate that the US Treasury Bid-Ask spreads reached their highest ever levels in history. The broad-based sell-off is a cliché, and we saw it in action last week. For the first time in a year, all the sub-asset classes were in the red. Investors even sold US Treasuries to go into cash.
Against this backdrop, the Government bond markets prices look entirely haywire. Italian BTPs saw a wild ride with the 10-year yield reaching a high of 2.96% on 18th March and post ECB expanding its QE operations through the announcement of Euro 750 Bn bond-buying program, closed at 1.46% the same day. Greek government bonds were in the same boat as well.
As expected, the central banks have moved fast this time to become the “lender of last resort” and our last line of defense against the dislocated market. A wide array of tools were used, and some central banks went to uncharted territory. There were 39 rate cuts globally last week. FED unleashed its full might by unveiling GFC era measures such as Commercial Paper Funding Facility (CPFF), Primary Dealer Credit Facility (PDCF), and Money Market Mutual fund Liquidity Facility (MMLF). BOJ doubled its ETF buying target to 12 Trillion Yen. ECB expanded its QE to include Greek Government Bonds to support the Euro-peripheral yields. BOE cut its benchmark rate to 0.1% and restarted its Bond-purchase program. RBA cut its benchmark rates, started a QE program for the first time, and announced yield curve targeting simultaneously. All these emergency steps will eventually calm down the markets, support government bond yields, and ensure credit flow to needy corporates. But the time horizon is anyone’s guess.
Credit Markets meanwhile followed the rates market in lockstep. High Yield bond quotes ranged from bizarre to unbelievable, with investors trying to get rid of all risky securities. There was hardly any market-making with both bid and offer trades from clients taking days to be fulfilled. Global HY index OAS crossed 1000 Bps for the first time since 2009. EM Debt spreads were at 680 Bps as of Friday close. While being more resilient than the broader EM Debt, GCC credits were also not immune to the sell-off as the index OAS widened by 110 bps to reach 400 Bps last week.
Though credits look attractive by historical valuations, Government bonds market liquidity needs to return before the credit markets show any semblance of sanity. We still have our conviction on Emerging Market Debt and believe there is long term value in them; however, the short term volatility is not yet over, and unless forced to do so, investors would do well to keep holding the quality credits in the emerging markets.
What a difference a week and a month can make. The S&P 500 Index ended the week down 15% and 29% lower than its all time high, just a month ago . The index has erased all gains since Pres. Trump took office. The slowing down of many businesses with the lockdowns, will impact corporate revenue and earnings to a sizeable extent. Governments have to choose health over economics. Japan and Europe fell less last week c.5%. However, most of the main global indices have behaved in tandem and are -30% year to date, with only China a little better at -15% and the UK a lot worse at - 38% (USD).
Though GCC equities were down for the week, Abu Dhabi banks and telecom rallied, with banks closing limit up on Thursday. The UAE banks are seen to have strong balance sheets with adequate capital buffers and likely to maintain dividend payouts. This was in spite of oil prices declining 29% last week. Oil falling is a result of both the increase in production from the KSA, and demand hit with airlines globally operating at 25% capacity and other transportation at 50% capacity.
The economic and market outlook remains highly uncertain and dependant on the evolution of the virus, its containment and stimulus measures. Economic and corporate growth downgrades are severe for Q1 and Q2 and the recovery in H2 seems to shift further out. Governments, and central banks have used every tool possible: monetary policy, fiscal expansion, bond purchases and opening up of liquidity windows, on a scale never seen before. Our inhouse estimates for global growth have been revised down as have most global economists. JP Morgan expects US growth in 2020 to fall by 1.5% with a 7.5% fall in EPS. Consensus is still at a 2% EPS growth for 2020, as we are. However, with the protracted impact on corporate revenue we will need to revise down our estimates. We however expect lower cap ex and buy backs to help cash flows. Buybacks at the beginning of 2020 were estimated at $635 bn but this could fall by 60-70%.
Which sectors/ stocks will emerge the winners post the health crisis? Technology is holding up better as are consumer staples and healthcare. Worst affected are hotel groups, airlines, and energy (-53%). Marriot is already experiencing a 75% drop in occupancy. The new economy winners: online grocery and retail and streaming, have a favourable backdrop (Ocado / Amazon /Netflix/ Deliveroo), along with essential food (Nestle, Walmart) and healthcare companies leading on the vaccine or cure paradigm (Gilead, Roche) or diagnostics. However, amidst an unprecedented halt in demand & destruction of near-term earnings, balance sheet strength is paramount. Looking at value is not enough: autos/energy are trading at 50% book value but we do not see a quick reversal in demand when the economy recovers. Most automakers have shut plants in the US. Faith in the FAANGs has resumed as they have strong balance sheets and cash to survive the downturn. The long term winners will be companies with sustainable earnings growth and strong cash flows to service their debt and invest in growth opportunities.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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