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Chief Investment Officer's team, 05.07.2020
Risk markets had a great week, and a strong start to the third quarter. Global equities printed an impressive +3% weekly return, across developed and emerging markets. Macroeconomic leading indicators were overall positive in all geographies and economic segments. Among them, the US ISM Manufacturing Index and China’s Caixin equivalent gauge were both remarkably firm above 50, which signals expansion. At the end of the week, the US jobs report was spectacular, with 4.8 million jobs being created in June, and a 2 points drop in the unemployment rate. Promising developments on a potential vaccine and dovish FOMC minutes helped markets forget their concerns about the rising number of COVID-19 cases.
Getting more evidence that the economy is rebounding globally is undoubtedly a positive. It actually reinforces our constructive scenario of a complete recovery for the end of 2021. Having said that, we still think that markets are too optimistic in the shorter term, and that valuations leave no room for doubt. From the pandemic itself to US elections, the Brexit, geopolitics, and all the unknowns, we see many potential sources of uncertainty which could generate turbulence. This is why we reduced our exposure to risk assets earlier in June, before the quarterly rebalancing of our Strategic Asset Allocation, which leaves us now with a moderately defensive positioning allowing us to seize opportunities down the road.
After an avalanche of macro data last week, we will soon be entering the Q2 earnings season which will provide priceless data to fine tune valuation. Stay safe.
The minutes of the Federal Open Market Committee held in June revealed reluctance by Fed officials to adopt Yield Curve Control as a policy instrument for them to be able to further tighten their grip on Treasury yields. Instead of targeting specific low levels of yields to lock them in and ensure further easing of financial conditions, as YCC would imply, they still consider forward guidance and asset purchases as their preferred policy tools, with the intention of extending their use throughout 2022. On the one hand, markets were already discounting YCC implementation, with 5 year yields in a tight range below 0.4% and gold trying to breach $1,800/oz. On the other, the determination of the Fed to continue with ultra-loose policies for years is what really matters for the performance of financial markets.
Yields anchored at almost zero combined with quantitative easing for extended periods of time will continue to support both equities and credit. At the same time, expectations for future returns should be toned down versus historical averages. With yields anchored basically at zero future returns for stocks will come down to their equity risk premium, in the range of 4 to 5% historically. This will be quite a disappointment for investors used to thinking in terms of double digits. Likewise, in the case of credit duration benefits have basically disappeared owing to zero yields, with future returns driven only by the credit premium as measured by spreads. The Fed’s asset purchase program for credit securities, currently set to expire September 30, is heavily affecting the asset class by providing an implicit guarantee of more stable returns. Being unlikely that the Fed will suddenly take away support at a time when the system can ill afford a tightening of liquidity conditions, we would tend to view the credit facility as one more tool investors are very happy about, but Fed officials will scratch their heads on how to withdraw without causing unintended consequences.
Forward guidance and asset purchases maintained for years should convince investors of the merits of a persistently higher allocation to gold. It is the elevated stock of debt that, acting as a drag on future activity, will push central banks to grow stimulus at a rate much faster than that of the growth of the economy, causing currency devaluation versus gold itself. Real rates are expected to sink further into negative territory in the process, but with little room in the short run to fall significantly from current levels, we keep our year-end gold target at $1,800. Investors had better approach gold for the longer term, rather than fancying speculative trades with little appeal at today’s price levels.
The Fed’s message to keep rates low for long and carry on with QE should be very positive for the emerging markets as well. Excess global liquidity tends to find its way into higher yielding assets, EM bonds, or into higher growth assets, EM equities. Although EM outperformance should become more likely after the US elections, its foundations are being laid by today’s relentless stimulus.
Fixed Income Update
The tug-of-war between solid macroeconomic data and increasing Covid-19 cases continue as we write. The solid non-farm payrolls report last Friday is in stark contrast to the localized rising infection cases forcing various states in the USA to scale down reopening ambitions.
The latest FOMC minutes showcase dialogue on yield curve control (YCC), forward guidance and asset purchases. There is a lot of skepticism for the first option and even though we expected this to be the latest tool in the FED’s armory, it is unlikely to be the case. Even though, YCC doesn’t come into effect, we don’t see a large upside move in the yields due to the FED’s commitment to keep the rates low for at least next two years and soft underlying economic conditions. The 10-year treasury yields oscillated in a tight range of 0.62% to 0.67% over the last week.
We saw the everything-rally in action last week. All sub-asset classes except US Treasuries and EUR credit were up. The global HY benchmark was the leader of the pack with 0.75% weekly return followed by EM Debt which generated a 0.46% return. In the US, HY bond funds saw a $3.4bn withdrawal for the week ending July 1, according to data from EPFR Global. The redemptions broke a 13-week streak of inflows in which $54bn was added.
Within the broader HY market we continue to prefer Asia HY, which still has appealing valuations. Although increasing Covid-19 infections need to be closely monitored in the region, we believe that they will not be material to the sequential growth estimates for Q3. Moreover, the supportive liquidity conditions and low rates environment should entice investors to put money to work in the asset class. In terms of relative value in the Asian credit, we like long-dated Indian GREs and shorter-maturity Indian NBFCs, along with China property issuers.
Closer to home, GCC Debt had a strong week with yields printing below 3% for the first time since March-end and OAS spreads at 231 as of Friday. GCC Debt is the best performing credit benchmark with YTD returns of 3.46% edging out the global IG credit benchmark. The improving oil price outlook driven by the reopening of the economies and evidence that OPEC+ is sticking to its production cuts, reflected in lower US stockpiles, acted as a tailwind for the asset class.
Emirates NBD issued perpetual notes last Thursday. The final orderbook was $2.3 Bn excluding JLM interest and the issuance size was $750 mn. The pricing tightened by 37.5 bps from the IPTs of 6.50% and finally printed at 6.125% yield. This is the second perpetual issue in as many weeks by UAE based issuers. Investor appetite has improved for regional subordinated securities as hunt-for-yield continues.
A better than expected first half for global equities with China positive (MSCI China +3.5%) and the US following closely with the S&P 500 -3.1% and the Nasdaq +12.7% (as on June 30th). A brutal March sell off, was followed by the S&P 500 having the best second quarter in two decades +20.5% and the Nasdaq up +31%, its best quarter since 1999. Europe’s Stoxx 600 index also marked its best quarter since Q1 2015, up 13%. GCC markets were in line with global markets in Q2 with Dubai the best performer at +17.8%.
We start the second half of 2020 with a broad based equity rally (China +5.2% and the US +4.1% last week) and also on a statistically hopeful note as since 2008, July has generated positive returns for global equities and averaged the best monthly returns of the year for the Nasdaq. Looking back at over 60 years of data, quarters with returns of over 15% for the S&P 500 have always been followed by quarters of positive performance. But all this must be taken in the context of the current environment, as a pandemic is a once in a century event, with the virus still peaking in many parts of the world. We monitor the state of the economies reopening with businesses having to cope with supply chain constraints, lower productivity on account of social distancing between employees and the service industry, which is people centric, yet to open up meaningfully. Markets have begun July well as an early trial of an experimental vaccine from Pfizer and BioNtech showed patients produced a reasonable amount of antibodies. Other vaccine candidates from Oxford University and Moderna are also progressing well in trials. The economic recovery is so far surpassing most expectations : with a better than expected jobs report in the US last week, ISM new orders coming in very strong and China Caixin services PMI >58, vs the 53 expected. A key dynamic in DM, especially the US is for real rates to remain extremely accommodative. Corporate earnings data has followed the macro trend: earnings revisions across industries are positive in the US – and similar patterns have been seen in Europe and Asia and positioning remains light. We have been warming up to Europe though the performance of European equities through the second half of 2020 is likely to be dictated by the pace of the global macro recovery and size of the EU Recovery Fund.
India equities have rallied in Q2 reversing the sharp 35% drop seen at the end of Q1. With phased unlocking, economic activity is coming back to normalcy with rural demand: tractors, two wheelers, and power demand recovering. Urban discretionary consumption is still lagging. Consensus expectations are for a fall in earnings (flat to -5%) in FY 2021 followed by a rise in FY 2022 to a growth of 30 to 35%.
Tesla displaced Toyota as the world’s most valuable automaker, highlighting the shift to EVs. Tesla produced 103,000 vehicles in Q1, 4% of the 2.4 mn produced by Toyota. Shares of Tesla, are up 189% since the start of the year, lifting its market cap to USD 224 bn. Energy companies on the other hand are seeing the impact of lower demand for oil on account of the corona virus crisis (the shift to EVs is still nascent). Shell will write down between USD 15 bn and USD 22 bn in the second quarter, whilst Chesapeake has filed for bankruptcy.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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