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Chief Investment Officer's team, 01.09.2019
The summer of financial markets has been almost exclusively driven by high frequency news on the trade war between US and China. Any negative development has instantly lowered growth forecasts, heightened expectations for monetary easing, pressured the prices of cyclical assets (equities, oil, EM currencies…) and supported the defensive ones (Government bonds, gold, US Dollar). Any positive news would provide a relief to cyclical assets, but interestingly wouldn’t weigh much on defensive assets, which have been remarkably steady. Last week was typical of this situation, with equities up 2% but govies and gold remaining stable.
As we enter September, the message from markets is ambiguous: defensive assets are increasingly pricing-in an imminent recession, with lower rates being a consequence, while cyclical assets are priced for the success of rate cuts to avoid an imminent recession.
We are currently in the latter camp, and believe it is premature to call for the end of the cycle. This is paradoxically not a comfortable situation: in this case, defensive assets are a bit expensive, but risk assets are simply fairly valued: there is no screaming investment opportunity. We enter September with an unchanged, cash-rich positioning, and will closely monitor the PMI and job reports released this week. Markets could remain relatively quiet before the major Central Banks meetings in a couple of weeks, but geopolitical tensions could then fuel more volatility.
The time horizon and reaction function of investors do matter. When market agents tend to react in a similar way to the same news flow and their time horizons get increasingly aligned, markets start to behave in a funny way and accelerate one way or another in a blow-off move, signaling what in technical terms is known as a capitulation: the end of a so-called crowded trade.
The US-China trade war has seen investors scramble for shelter across asset classes, and investment houses lower growth forecasts on a global scale. The reverberation of ever growing concerns about the economic outlook has triggered a growing bid for safer assets or investment styles, with traders of all sorts reacting in a similar way to heightened trade conflicts and in the process shortening their time horizon. Multiple crowded trades have ensued, with some of the sharpest rallies in gold and US long-dated Treasuries in a decade, high-quality and growth stocks surging against much disliked high-beta and value equities and DM stocks consistently preferred against their EM counterparts.
The collapse of US Treasury yields alongside the inversion of the curve smacks of markets discounting an impending recession with significant probability. Under this light one could also explain the defensive positioning across equity styles. Yet, we would refrain from this sort of reading of markets’ tea leaves. A US recession has never started with the consumer in such a strong shape and real Fed policy rates well below real growth. US Treasuries should have rather pulled off the spectacular rally based on a combination of the Fed dovish pivot, growing risk aversion and the rising appeal of the asset class on sizeable yield differential versus peers.
Although no capitulation with panic selling has yet occurred within risk assets, the extreme positioning across crowded trades could easily trigger a bounce following the Chinese decision to leave the door open to further negotiations, in spite of Mr Trump’s slapping more tariffs on their imports. Negative sentiment in our EM equity models is at oversold levels, which in the past coincided with relief rallies and credit spreads and equity indices both in EM and DM closed on a positive note Friday. US real yields are already discounting a deflationary scenario at current levels, which would imply an odd similarity between the US and the Japanese consumers’ mindset which we do not see at all.
We are not ready to signal the all-clear on risk assets yet. Markets continue to follow the ebb and flow of the war of words between the US and China, nowhere near an agreement. President Xi has just decided to set the stage for a quieter backdrop as the deadline for the 70th anniversary of the foundation of the People’s Republic approaches on October 1st. At the same time investors will be looking to the forthcoming September Fed meeting, when a cut is expected with an almost certain probability. We could see some calm before a new, trade-related storm starts to blows.
Fixed Income Update
Bond markets rejoiced a robust monthly performance with GCC debt and US Treasuries outperforming, with respective total returns of 3.5% and 3.5%. The flight to safety bid saw benchmark US yields fall from 1.89% to 1.47% during August. Moreover, the longest dated bond on the US curve has seen a record low of 1.90%. The real rates on UST, gauged by the yield on 10-year Treasury Inflation-Protected Securities, have turned negative for the first time in three years. The Fed’s main monitor on inflation remains well below its 2% target. Next Friday, the jobs report and Mr Powell’s statement will be essential. The market-implied expectations include a 25bp cut for the 17-18 September FOMC followed by at least two cuts in 2019. The macro backdrop in the US is split between strong consumption and slowing manufacturing activity, exacerbated by trade tensions. So far, data is steady. US economy grew 2% in Q2 (second revision from 2.1% initially). Personal consumption was 4.7% (revised up from 4.3%), with +13% in durable goods. Low-interest rates could provide another support to already very strong consumption. The investments was unchanged, still tepid (+0.7% for equipment). The July trade balance deficit was USD 72bn, showing little inflexion.
US Treasury Secretary Mnuchin is again raising the possibility of ultra-long bonds with maturities of 50 years or more. With US 30-year bonds yielding at record lows of sub-2%, it certainly seems like an excellent opportunity to lock in low funding costs for the long-term. The current demand across the outstanding century-bonds adds to the temptation for the Treasury Department. The yields on Austria’s (AAA rated) century bond have fallen from 1.77% to current 0.67% while lower-rated Investment-Grade Sovereign issuers such as Mexico also have followed suit with yields rallying from 4.5% to current 3.4% YTD. Optically, looking at the shape of the US yield curve and the existing term-structure, it seems reasonable to predict that yields around 2.20% and 2.50% would still attract investors for a 50 and/0r 100-year bonds respectively (our chart).
S&P cut Argentina’s foreign and local debt rating to “selective default” last week stating that the plan to unilaterally extend maturities on short-term bills “constitutes default under our criteria”. Argentina’s foreign-currency reserves have fallen $10 billion over the past month to less than $60 billion. Argentina’s Central Bank is trying to curtail capital flows and investor panic, and further stabilize the mutual fund industry after many of the country’s biggest funds suspended investor withdrawals last week. The Bank offered to buy local notes held by the funds, providing liquidity to face investor redemption requests. Investors withdrew more than 70 billion pesos ($1.2 billion) from money-market mutual funds on Thursday, equivalent to almost 10% of their assets under management, according to preliminary data compiled by local consulting firm 1816 Economia & Estrategia. Money-market funds were generally open to redemptions on Thursday, in contrast to those that focused on short-term notes that didn’t allow trading.
Global equities ended a very volatile August, down 2.4% (in USD), with both positive and negative market forces at play. Increasing signs of a global economic slowdown and uncertainty about trade policy, led to sharp down days. Emerging markets closed the month down 5% whilst developed markets fared relatively better down just 2% (TR in USD). The MSCI World (TR) Index is just 3.7% below its peak, in spite of sharp swings through the month. The S&P 500 closed down 1.8% for August, paring most of its early losses after hopes of easing trade tensions were reinvigorated. In August, the S&P 500 posted 11 daily moves of over 1% and 3 days on which the Index fell more than 2.5%. Big down days occurred on announcements of tariff increases, or flashing red macro indicators, while market positive days were triggered by positive Q2 earnings announcements and hopes of stimulus policy. S&P 500 earnings growth, while close to flat in H1, is 25% compared to 18 months ago, unemployment is at a low and consumer spending is stable. This is providing impetus to the market. U.S. GDP growing at 2% in the second quarter and lower interest rates —despite trade war uncertainty—have allayed investor fears for the time being. US growth looks good compared to stagnant peers in Europe and volatile Emerging Markets.
The Nasdaq finished the month down 2.5% but the tech sector still leads global returns (+26% year to date). Last month saw a rally in consumer staples and utilities both gaining over 2%. Investors flocked to defensive and high-yielding sectors to make up for declining income from the bond market. Financials were the losers as treasury yields compressed, causing fears about recessionary indicators and lower bank margins. Expect volatility to continue into September as new tariffs on Chinese goods kick in.
The GCC markets gave up some gains in August, with the KSA Index selling off the most (-7.9%) There were improved volumes overall with the KSA trading $7.6bln on the MSCI Quarterly rebalance day with inflows from passive MSCI trackers. The KSA sell off was expected post end May, the first tranche of the MSCI EM inclusion. We prefer the UAE, as valuations (forward P/E) are still in the single digits and yields are attractive.
India’s economy grew just 5% last quarter, the fifth consecutive quarter of deceleration, as companies and consumers suffering from an acute credit squeeze, lowered spending. This is down from 8 per cent in the same quarter last year. Over the past week the government has taken steps to boost growth and woo fresh foreign investment: a merger of public sector banks with weaker lenders to be absorbed by stronger, larger groups; foreign retailers such as Ikea and Apple being allowed to start ecommerce platforms; government agencies buying new vehicles; accelerating tax refunds to small businesses; a $25bn windfall from the Reserve Bank of India to bolster ailing banks and increase spend on infrastructure. However, large scale disinvestment of government assets and reforms need to speed up, to keep growth above 7%. The Indian market and the INR have both given up the gains achieved at election time (May ‘19) as growth worries dominate.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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