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Chief Investment Officer's team, 14.07.2019
For decades, “Don’t fight the Fed” has been an adage for investors. Last week gave the impression that symmetrically, the US Central Bank has no intention to “fight the market”. A tariff truce between the US and China, strong job creations in June, and a slightly higher than expected inflation were not enough to moderate the Fed’s dovish tone. One possible explanation is that given market expectations, not cutting rates would create a shock that could only be fixed by… cutting rates.
Wisdom or pragmatism? The beginning of a cycle, or a one-off? Supporting the economy, or inflating dangerous valuation bubbles? Only the future will tell, but we have to account for the very high probability that the Fed will imminently cut rates.
We had a fresh look at our year-end fair values for key markets, and adjusted some of them. We’ve screened for valuation opportunities, and didn’t find much conviction. Adjusting for risk, cash is probably the best defensive asset, better than gold after its recent rally. We have thus decided to cut our – successful – gold Overweight to Neutral and added to cash. Following our more aggressive stance at the beginning of the year, we are, gradually, turning more defensive. We do not see much upside potential, and our 3 profiles, Cautious, Moderate and Aggressive have done well this year delivering +7.5, +9.4 and +11.3 respectively. However, we are not outright defensive, as we trust our long-term allocation and monetary stimulus remains a powerful support.
Central banks have been concerned about muted inflation dynamics for a while, and rightly so. In a normally functioning economy, the general level of prices tends to increase alongside the amount of goods and services produced, a sign that healthy demand is supporting rising supply. The Japanese experience, which saw the country plagued by deflation for decades, has brought home the point that, once deflation sets in, it is very difficult to eradicate as expectations of lower prices drive even demand lower.
Core inflation has failed to stabilize above 2% annualized in the United States, has been stuck around 1% in Europe and has hovered just in positive territory in Japan since the financial crisis. Major central banks, in particular the Fed and the ECB, have often invoked disappointing inflation dynamics to justify persistently accommodative policies, and this time is no exception.
There might be a chance that inflation in 2020 could surprise to the upside. The latest reports show price pressures stabilizing at around 2% in the US and 1% in Europe, indicating little spill-over effects from the contracting manufacturing sectors. Hence, due to sheer base effects, price pressures in early 2020 could be higher, contrary to consensus projections. Also, asset markets are giving hints in this direction. Market-implied inflation measures seem to be bottoming in the lower end of their ranges. And gold is about to tell us that inflation next year will move higher.
Since 1968, as far back as our data history on US core prices goes for the US, core inflation has been higher 48% of the times. Yet, when conditioning on whether gold is at least 10% higher versus the previous year, the number rises to almost 60%. In this sense, gold is a good inflation gauge. Year-to-date gold is returning slightly more than 10%; should it manage to consolidate above current levels, it would be signaling higher price pressures to come with 60% probability.
We have decided to take profit on our gold overweight positioning, which we entered late last year. Although central bank dovishness should have us think twice before booking profit, we think that eventually easier credit conditions will lift the economy, and gold bulls will be temporarily disappointed. Gold swings have closely followed Fed policy, US real rates and the US yield curve quite closely in the last decade. Gold should have already discounted the greatest degree of policy accommodation, yield curve flattening and collapsing US real yields.
Of course, there is room for gold to be up less than 10% this year, and inflation to surprise to the upside in 2020. For now, we sit in this camp. It is also our view that, in the longer term, gold bulls will anyway have reason to be happy, since central bank monetary largesse won’t be able to support the economy forever and ever, and gold will most likely start a new bull market in the wake of most creative central banks and most stagnant economic growth. This justifies our neutral stance.
Fixed Income Update
The recent robust economic data out of the US supported corporate credit spreads particularly on the high yield sector while pushing benchmark yields higher from their recent lows. The big question remains how much it does take the FED to change their dovish stance based on a few data points. The FED in their last testimony has cited that slowing economic growth is one of the main concerns. Looking at some of the YTD returns, it seems that bond markets are at the cusp of some correction, particularly when valuations across the riskiest parts of the bond markets are assessed. The abundant and cheap cost of capital has been one of the main drivers for this year’s total returns.
We have revised our fair value estimates on the US benchmark Treasuries to 2.00%. The US Treasuries look attractive to us when compared to the rest of the DM Sovereign bond yields. While the FED prepares for policy responses, our views for a bull flattening of the yield curve remain intact. With global Sovereign yields now hitting the zero bound, the long-term trend for US bonds should move symmetrically lower in our view. For yield hunters, we reiterate our preferences on duration risk over credit risk in this late-cycle juncture.
On corporate bonds, we prefer investment-grade over high-yield with a strong bias towards defensive. Emerging Markets are our unchanged long-standing conviction, with overweight in local currency-denominated bonds. Our EM local currency bond conviction stems from the outlook on the US-dollar and the broader growth/consumption story. While idiosyncratic risks remain on the horizon driven by some geopolitics – in the case for Turkey and select LATAM sovereigns, we remain cognizant on credit selection and believe plenty of opportunities still exist for the discerning investors.
European benchmark sovereign bond yields rose last week due to the unwinding of some of the bets made on the possibility of ECB restarting the Quantitative easing sooner. Yield chasing by investors had led the peripheral sovereign bonds to record lows the previous week. Since Germany and France benchmark yields had gone below zero, investors had been focusing on the higher-yielding assets of Spain, Greece and Italy. In the coming week, Germany, France, U.K. and Spain are scheduled to sell bonds. Greece might also tap the market to take advantage of the market interest and positive post-election sentiment. On macro calendar front, the coming week is light with the market keeping track of UK CPI/ Jobless claims (Tuesday), UK retail sales (Thursday) and German ZEW Survey (Tuesday). UK CPI is broadly expected to track the BOE inflation target of 2% according to Bloomberg estimates.
Turkey’s credit rating was lowered further to sub-investment grade by Fitch reducing from BB to BB- (long-term foreign currency debt). TRY bonds widened by 41bp to 16.68% while Eurobond yields widened by 12bp to 7.43%. The cost of insuring against default rose to 410bp. Turkey’s real rates have reached the highest point in the last five years due to the easing of inflation. With new appointments in the central bank, the markets anticipate a rate cut sooner.
Equity-market downside is limited by the hope of easier monetary policy, but the upside is constrained by downward revisions to economic and earnings growth and we expect range bound trading in the near term.
We are neutral all Developed Market regions and maintain our neutral positioning for the US but have revised upwards our fair value for the S&P 500 for end 2019 from 2825 to 2900 (+2.6%). 2018 ended with a sharp sell down as trade tariff escalation created doubts about global growth and the impact on margins from higher input costs. Thus, at the beginning of 2019, a 15% total return for the S&P 500 for 2019 looked reasonable, on an estimated 5% 2019 EPS growth and a forward P/E of 16.5X. Last week, the 3 major US indices hit new all-time highs with the S&P 500 trading at 3013 (+21.5% TR YTD). With the Fed turning dovish and rates lower across the board, we have adjusted our PE for the S&P 500 (our estimate is 17X). We retain the 5% earnings growth target for 2019. Q1 saw flat earnings and estimates for Q2 growth are a decline of -2.6%. We expect Q2 earnings to beat estimates by 3 to 4%. Share buybacks are expected to contribute 2% to EPS growth in Q2. Last year saw a record USD 1tn buybacks, driven by the tax overhaul. Forward guidance from companies’ remains key for sentiment, with a focus on the trade war, with China being both a market and a critical part of supply chains.
We revise our underweight on the Eurozone to neutral and also revise the EuroStoxx Fair value for end ‘19 from 340 to 360 (+5.8%) as the accommodative ECB policy justifies a higher valuation. European markets have performed strongly in 2019. Though the global backdrop was challenging, the relative merits of European equities were attractive with emerging markets bearing the brunt of the selloff.
For Japan we take our Overweight position to Neutral as the implementation of Phase 2 of the consumption tax in October could impact economic growth and corporate revenues and as trade tariff escalation has shifted to Japan automakers.
In Emerging Markets we remain neutral Asia, retain our India overweight with a corresponding underweight in the LATAM and EMEA regions. We have revised up our year-end fair-value for the MSCI China (US$) from 80 to 84 (+5%). China companies’ profitability could improve as the trade tariff increases are currently on hold. We feel our estimates of a higher PE multiple from 11.5X to 12X and a higher 2019 EPS growth from 11% to 12% are reasonable. We remain overweight India as we see the government deliver the promised infra spend, though headwinds persist with banking woes and downgrades to corporate earnings.
GCC markets had a positive week, with oil rallying. We had recommended taking profits on our long KSA position, once the first phase of EM implementation in May was complete. In the UAE, we would add to the banking and logistics sectors as valuations remain attractive.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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