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Chief Investment Officer's team, 16.08.2020
Compared to the previous one, with positive returns in all asset classes, last week was much more selective. As CPI and PPI reports highlighted some resurgence in prices, interest rates rose and defensive markets were overall negative. Gold was the most impressive with a -4.4% consolidation, crossing the $2000 line to close at $1945. Fixed income markets had a negative week, as the US 10-year Treasury yield ended the week at 0.71%. Developed Market stocks added 1.2%, as sales and profits are nominal and benefit from some inflation.
There is overall a feeling of transition in the recent data, from the easiest part of the rebound to a more delicate phase, with more and more divergence. Consumption is not far from pre-pandemic levels, but as inventories are low after the lockdown of factories, manufacturing activities should be the next one to catch-up. This is also why prices should keep on recovering after the collapse of inflation in H2. There is nothing to be excessively worried about, as we are far from the inflation levels which could reverse central bank actions. However, ultra-low interest rates are a very important factor justifying high equity multiples: stocks and bonds are pricing in very different scenarios.
Our view remains that the recovery will not stop, but that it is fully priced by stock markets, which should support volatility. A light positioning and a bearish overall sentiment from the investors’ community are the only reason why we are not more radically defensive. An agreement on a fiscal package in the US could be the next good news and it will be interesting to see if markets react, or if they already consider it done. We keep our positioning unchanged, including an overweight in Gold. Stay safe.
As we write and considering data as of Friday the 14th of August, the performance of our recommended asset allocation profiles is firmly positive so far in 2020. Our Cautious, Moderate and Aggressive profiles are up respectively 5.3%, 4.4% and 3%.
We are of course very happy with these numbers, which outperform both our Strategic Asset Allocations and our international competitors by a significant margin. For sure, cutting risk materially in February and massively adding in March helped a lot, and so did our largest overweight in the best performing asset of 2020, namely, Gold.
Having said that, and in full honesty, these numbers are also a surprise. They are actually already matching the forecast we elaborated for the full year, back in December, at a time when we –wrongly- thought that the coronavirus was going to be limited in both time and in space. This has been for sure our largest mistake of the year, and there is some irony in the fact that so far 2020 is one of our best years compared to the overall investors’ community. We have been fortunate enough to change our mind and adjust our allocation quickly, before the virus hit the shores of America which actually triggered the Q1 crash. We adjusted our year-end fair values to a different scenario, and it helped us realize that markets had turned from complacent to overly pessimistic in March, especially given the unprecedented policy responses to the situation.
This illustrates the fact that in current times, flexibility is paramount. And this leads us to our second mistake so far this year: we expected market turbulence in the summer, which so far has failed to materialize. The reason is simple: the current rally is happening against, and not because of, institutional investors who remain under-invested, and are challenged by an astonishing bullish enthusiasm from retail investors. This is the reason why we are only moderately underweight in stocks, and fortunately our performance didn’t suffer because we kept an overweight in Gold.
Looking forward, our level of conviction is nowhere near where it was in February (bearish) or in March (bullish). We believe in the recovery but most, if not all markets are trading at or above our year-end fair values. A perfect recovery is priced-in. On the other hand, we may still underestimate the power of behavioral factors: there are huge piles of cash in institutional portfolios and positive catalysts down the road. In August, a deal will be reached on the US fiscal stimulus package and manufacturing activity should mechanically rebound. Then in September, the Fed will come with a new (dovish) framework and November will remove the US election uncertainty. The probability of going from expensive to crazily expensive is actually not zero.
When the level of conviction is low, active positioning should be limited. This is why we are only moderately defensive and have carefully selected our overweight. In a bad scenario, the defensive power of Gold is stronger than DM Government bonds. In a good scenario, the upside potential of Emerging Market stocks is way better than their Developed peers – and it is also true in any scenario over the long-term.
Fixed Income Update
Welcome back to the “see-saw season.” U.S. Treasury 10-year yields rose to 0.71% last Friday after hitting 0.51% the previous week. The swings have been a result of markets moving from heightened geo-political and pandemic drama to improved inflation outlook. U.S. consumer prices rose in July more than expected on a jump in auto and apparel costs. However, we continue to believe there are macro headwinds, including slowing growth momentum, uncertainty about the Covid-19 outcomes, and U.S. fiscal deal. Moreover, supply dislocations have proven to be transitory historically. All of these factors should continue to put pressure on the yields to be low. This could also put downward pressure on other Developed market benchmark bond yields which have inched higher in the past couple of weeks.
The significant move in the Treasury yields has resulted in major credit indices posting negative returns last week even as Option Adjusted Spreads of the indices remain low. Bloomberg Barclays flagship Investment Grade yields have moved up slightly from the historic lows of 1.44% to end the week at 1.48%. The index spreads at 120 still are c.30 bps away from the historical lows achieved before the virus outbreak.
According to a recent data released by FED, the analysis of the first full month of corporate bond purchases in July indicates that FED has shifted its buying exclusively to corporate bonds from the early days of ETF purchases. According to Goldman Sachs Analysis, the largest deviation between the holding and index shares is 0.11%, within Consumer Non-Cyclicals, which make up 20.30% of current Fed holdings vs. 20.41% of the target index showcasing that FED has stuck to its intention of purchasing bonds in proportion to their index weight.
High-yield benchmark spreads closed last week at 556 less than half of the highest spreads achieved on Mar. 23 2020. According to S&P, the 2020 global corporate default tally reached 155 as of Aug. 12, with PizzaExpress and Transocean being the latest additions to the list. Globally, the oil and gas sector leads the 2020 default tally with 31, followed by consumer products with 26 and media and entertainment with 23. By region, the U.S. leads the default tally with 102, followed by emerging markets and Europe with 22 each. The trailing 12-month default rate has increased to 4.4% from 3.8% at the end of July. However, there has been a plateau in the increase in the number of cases of defaults.
Closer home GCC bond markets have been steady last week with YTD returns for the year at 6.55% and OAS at 200 bps. Fitch downgraded Bahrain’s Long-term rating to B+ from BB- last Friday. However, this may not have any material impact on the prices of the country’s bonds. S&P continues to maintain a B+ rating on the country with a stable outlook while Moody’s has a B2 rating on Bahrain. As expected earlier, Emirates NBD announced on Aug. 12 to call back its existing perpetual, which had a call date of Sept. 17. This should be positive news for the other bank perpetuals from the region.
The focus last week shifted from earnings to inflation and negative real yields. Markets saw a to and fro between value and growth. The impasse on the US stimulus deal did not deter the S&P 500 from trading briefly above its all-time high of 3386. The Index has gained 3.2% in the first 2 weeks of August and is up +5.7% for the year (total returns). The August equity rally has coincided with a rise in U.S. government bond yields, as there is more optimism on the economic outlook. Markets have also taken well Democratic presidential candidate Joe Biden’s announcement that Kamala Harris would be his running mate, seen as a moderate. A good month so far for DM, with the Europe and the UK in line with US returns and Japan up 7.5% so far in August. The UK’s FTSE 100 was boosted by the cyclical material and energy companies, despite second-quarter data showing the UK falling into its deepest recession on record. The Nasdaq had a flat week though select stocks continue to shine with stock splits on the cards. Apple is closer to a $2 trillion market value and Tesla made new highs post broker upgrades.
While technology firms remain this year’s star performers, there is a resurgence of sectors that are more sensitive to the economy and hit particularly hard during the pandemic’s early days. The S&P 500 departmental stores index is up 23% this month, hotels 16% and airlines 15%. Slowing virus cases in some parts of the world and mixed economic data have been viewed favourably, however, fresh travel and tourism restrictions continue and the rally in the leisure sector will be short lived unless virus cases see a significant decline. 90% of the companies in the S&P 500 have reported Q2 results , with a 10% beat in earnings, and we continue to see rotation into small caps/cyclical sectors as equity investors get convinced that a sustainable recovery is there. This recovery is wholly dependent on continued fiscal support, but the market is assuming that support will continue, especially in the run up to an election. Also, while the economic recession is unprecedented in terms of its depth, personal disposable income growth in 2Q is at its highest, a direct result of the massive fiscal stimulus. The term “unprecedented stimulus” is this year’s market mantra but also indicates that a policy-induced new-high is sustainable as seen with Japan in 2011 post the Fukushima explosion, where the market doubled by 2013, post Kuroda’s huge policy response.
To benefit from the cyclical rally, we reiterate our focus on EM equities, a laggard last week but a beneficiary of a weaker US Dollar and with still reasonable valuations and also select energy sector stocks with stronger balance sheets and more resilient cash flows. Some of the European E&P companies have been focusing on cost discipline which will benefit them long term and a focus on renewables. Even post dividend cuts, yield remains attractive at above 5% for BP, Total and Shell. Financials are however, a straight beta to economic growth and we would start adding slowly.
The positive market background could see listings from AirBnb, Ant Group i.e. the fintech arm of Alibaba and China's biggest mobile payments company, and Robinhood, the retail trading platform seen to motivate risky behavior with the "gamification" of trading.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Rising risks, rising markets
The “end of the beginning” of the recovery
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