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Chief Investment Officer's team, 21.06.2020
Last week partially reversed the risk-off mood of the previous one. On the economic side, data from the US consumer was upbeat in May, and China keeps on tracking a V-shaped recovery, just waiting for the rest of the world to add fuel to its tanker. Last week’s market volatility also triggered more action from policymakers: the Fed started to buy individual corporate bonds directly from the market, all other major central banks confirmed including credit support to their ample quantitative easing programs, and the US administration confirmed working on a $1trn infrastructure plan. The resurgence of geopolitical tensions, especially a deadly incident between India and China on the Himalayan border, was quickly forgotten, especially as some investors were still running after the rally before the end of the quarter.
No doubt, the recovery has started and we are confident that some kind of economic normality should be reached in 2021. Less restrictions means more infections locally but we are not overly concerned about a broad second wave of infection, in a much better prepared world. Having said that, the spectacular activity numbers from May should not be taken as an indication of a vertical trajectory. After the most brutal recession ever, it is indeed mathematically logical that the early stages of the rebound show a strong acceleration. Its pace in the West at least should fade, like the physics of a bouncing ball: its maximum speed is right after having hit the ground, and it’s close to zero when it reaches its peak.
As momentum could be fading, some consolidation would not surprise us, especially as the US Presidential campaign has now brutally begun. It’s time for a pause. and to prepare to seize some summer opportunities.
It seems likely that risk assets could be stuck in a holding pattern in the next few months. We may have to brace ourselves for more muted returns, at least until there is a better sense of the recovery ahead. Official economic releases and high frequency data are delivering hardly more than mixed signals, while Fed’s chair Powell urge for more stimulus offers little comfort that the economy is on a solid footing just yet. Real Treasury yields closed at a 2-month low last week, pointing to rising investor concerns about the outlook which saw gold close near the highs of the year.
US equities reacted very strongly to the better than expected May retail sales. That’s an indication of how sensitive markets are to growth-related news, now that lots of ammunition has already been spent on stimulus. Strong May sales reflect pent-up demand from the lockdowns, so it would be wrong to extrapolate similar readings into the future. US industrial production on the other hand disappointed. Asian exports, which give an early indication of global growth, painted an unclear picture as well, with strong divergences between economies. More timely data have us wonder whether the pick-up in business activity is fading already or rather we are just reading noise due to the higher frequency of alternative data. Restaurant bookings made available by Opentable showed some weakening, in particular in the US and Germany, while the Johnson Redbook Retail Sales Index has rolled over in the last two weeks after a strong reading for May, in keeping with official retail sales numbers.
At the Senate Banking Committee hearing chair Powell emphasised a “whatever it takes” approach to ensuring support for the recovery. The more pressing issue is the fiscal cliff looming shortly. Some fiscal packages are going to expire soon and must be renewed to ensure a smooth recovery. In general, the expectation is that the fiscal bill to be approved in late July, early August will ensure that the current measures will be rolled over until year-end. As for additional measures to the ones already in place, there is no agreement and for that it is likely that Republicans will want to see first how the economy reacts.
US real yields closed lower for the week, in spite of underwhelming CPI readings, on expectations for rising inflation. This suggests that markets do not see significant improvements in the economy in the immediate future, otherwise nominal yields should have been higher in tandem. These developments are positive for both gold and EM debt, as long as lower yields do not point to an economic slump, which in our view is unlikely amidst strong public support. Physical demand for gold in the emerging markets should pick up as growth stabilizes and the dollar remains weaker. Normalising inflation expectations should keep real yields depressed and boost gold prices. In turn, lower US yields would be adding to the relative appeal of EM dollar-debt. With the economy still struggling and more stimulus the only viable remedy for now, investors are advised to bet on currency debasement and buy gold or play it safe and allocate money to income-generating strategies.
Fixed Income Update
The FED is not running out of its gifts to the investors. It announced last week that it had started buying bonds directly from the secondary market, making it a regular participant in the market. Investment Grade bonds should get another leg of spread compression as a result and produce total returns of 5%-6% on an annualized basis by end-2020. These returns are much higher than what we were expecting at the start of June. We continue to maintain our overweight allocation to Corp IG across all the three TAA risk profiles. We are now more open to go long duration in the Corp IG market to take advantage of the spread tightening play. With Government bond yields at record lows, hunt for yield continues. We maintain our preference for Emerging Market Debt as a result of our base-case outlook, which considers gradual opening up of the economies and ample liquidity conditions in the second half of the year. We are cautious in HY while focusing on credit selection since corporate bankruptcy cases continue to rise.
This week’s credit benchmarks erased most of the widening that took place in the later parts of the second week of June. EM Debt outperformed the other benchmarks with spreads tightening to low 400s, and Global HY followed suit with OAS spreads closing at 630 for the benchmark index. US Treasury 10-year yields are back in the 0.6% to 0.7% range. They are expected to stay there unless we see a significant risk-on move. This scenario is highly unlikely given how jittery the investors are about a second wave and inflated valuations in the risk assets.
GCC markets continued their march north with YTD returns of the Bloomberg-Barclays regional credit index over 2.25%. Moody’s has recently revised the outlook of eight UAE-based banks to negative while reaffirming the ratings. Its rationale mentioned the action was taken due to “the potential material weakening in their standalone credit profiles, amid a challenging operating environment in the UAE due to the coronavirus outbreak, low oil prices and pre-existing economic challenges.” We don’t foresee any large sell-offs in the senior papers of the country’s banks. In contrast, AT1 securities of some of the smaller banks might come under pressure when international markets open on Monday.
The Sukuk primary market was very active last week, with three major deals hitting the market. Sharjah Islamic Bank followed DIB to sell $500 Mn of 5-year Senior Sukuks. Investors bid strongly for the Sukuks with order book coverage more than 7x times. AAA-rated Islamic Development Bank issued $1.5 Bn five year pandemic Sukuks to assist IsDB member countries in tackling the aftermath of the Covid-19 contagion. Indonesia issued a rare 30-year Sukuk, and despite the recent Garuda Sukuk restructuring, there was a decent investor appetite from the MENA region as the security gave an option of playing with duration in their portfolios.
Equities rebounded last week with more countries lifting lockdowns, though counteracted by news of rising coronavirus cases in the US, Brazil, India and a fresh outbreak in Beijing, China. Global equities gained 2% for the week led by DM. The Nasdaq is +11% year to date. Never too late to add to the COVID winners, as they surge week on week. If you had invested in an equally weighted broad basket of genomics, FAANG and gaming stocks at the beginning of 2020, you would have gained 33%. We don’t think the tech or healthcare sectors are overvalued and the high growth justifies any premium. Our third overweight sector remains consumer staples, with a focus on food sourcing and quality. As we said last month, we saw the cyclical rally as short lived and remain underweight energy and financials. Liking tech and healthcare implies an overweight to the US and we would continue systematically adding to Asian equities, the only region forecast to have positive economic growth in 2020, with a preference for India.
The fear of a second wave is ever present but governments look more prepared to handle it now, without the economy stalling to the extent seen in March/April. So overall, a much brighter outlook, than a couple of months ago (expect intermittent bursts of stormy weather) is driving a recovery in equities to almost December 2019 levels. Government stimulus has been a key feature of the global equities rally, despite soaring unemployment. More economic support is on the way with the Trump administration preparing a nearly USD 1 trillion infrastructure proposal as part of its push to spur the US economy. To keep the euphoria in balance we continue to watch elevated US-China tensions, the talks between India and China after their clash on the Himalayan border, the progress on Brexit negotiations and the US elections with Pres. Trump losing ground in the polls. Whilst both the health and political situations look ominous, central banks remain a key backstop for markets. The Fed is starting a new corporate bond-buying programme that has provided a boost to credit markets, which in turns helps equities. P/E multiples have re-rated supported by central banks’ liquidity measures. The next catalyst for equities is improving macro economic data with a favourable base already provided by lower rates for the foreseeable future.
Our region should benefit with Dubai businesses and the government now open and airlines and hotels opening in a phased manner. The IHS Markit Dubai purchasing managers' index increased to 46 in May, from 41.7 in April. Although the index registered a level below 50, which separates growth from contraction, the increase suggests that the easing of the lockdown and government support have aided business activity. In the KSA, Saudi Aramco will benefit from synergies in marketing & operations as it integrates with SABIC following the $69.1 billion takeover it completed last week wherein it acquired 70% of SABIC from the Public Investment Fund. It’s a decisive step in the company’s downstream expansion strategy, making it a global petrochemical powerhouse. The purchase of SABIC is a key part of Aramco’s strategy of expanding from oil production into chemicals, and also helps the PIF raise cash to fund its investment plans.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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