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Chief Investment Officer's team, 19.04.2020
Let’s start with the good news: China’s recovery has started in March, with sharp rebounds in both industrial production and retail sales. The pandemic could be reaching a peak in Europe, and according to Mr Trump, “signs keep showing” that is also happening in the US. As a result, exit strategies are being discussed by all governments to follow the apparent Chinese “V” pattern. Korea, Austria and Germany will start relaxing social distancing soon, and Mr Trump hopes to follow.
In the meantime, March economic data, April surveys and even US banks Q1 numbers confirmed a historic cratering of the global economy, the most severe recession since World War II. However, policy response is also the broadest and biggest ever, and has so far shown success in stabilizing the financial system and avoid massive bankruptcies, preserving the ability to rebound.
Markets thus decided to look forward with positive returns last week, adding another 2% to one of the fastest, yet partial, recovery in history for equity markets.
Our own scenario is for restrictions being materially lifted by the summer, which is why we had significantly added to our previously underweight positions in equities from mid March. We had revised our year-end fair-values on that basis, and some of them are already reached. We don’t like to see valuations taking for granted a recovery which has not happened yet. For the time being, we keep our positioning unchanged, with preferences within asset classes rather than between them. Stay safe.
The global flood of central-bank liquidity, led by the Fed ensuring normal credit flow and market functioning, has seen an impressive rally in equities from the March lows. With financial assets more permeable to monetary stimulus than the economic system itself and record-breaking Fed interventions both in terms of speed and size, markets have discounted good news at lightning speed. The economy, that everybody is looking to for divining financial trends, is expected to adjust only further down the line, once the stimulus effort has reached all of its recesses. At the same time, as some major countries announce plans to gradually lift lockdowns, investors may be writing off 2020 earnings altogether to look through to 2021 growth.
We suggest that a view of the world with such rose-coloured glasses might be premature. It is unprecedented for markets to have found a bottom so early in a recession and this indeed may come down to the US Federal Reserve yet again successfully exercising its market put. Yet, unabated US dollar strength is pointing to relentless deflationary pressures and tight financial conditions, which are clashing with the current rush to recovery and the optimism embedded in the equity rally.
Demand for dollars, rather than stemming from speculative flows, is being driven by a global shortage of the reserve currency. In the United States it is the result of Treasury oversupply to finance the 2trn relief package, which forces Treasury dealers to exchange dollar reserves for Treasuries. The impact has been now cushioned by one more round of Quantitative Easing. Globally, excess demand is caused by the flight to quality, central banks increasing dollar reserves at times of crisis and EM countries with dollar debt having to deleverage, with foreign demand shrinking and capital inflows collapsing on risk aversion. US dollar strength is the bellwether of credit contraction and record low crude prices and only its weakness will signal that reflationary efforts have finally been successful.
Against this backdrop, we continue to suggest that investors focus on the safest credits until uncertainty has receded. Credit time to recovery, as measured by the number of months to clear pre-crisis highs, as compared to equity’s, was five times shorter in the last three major crashes. Credit’s degree of undervaluation across asset classes is also more pronounced, with spreads wider than current levels only during the Great Financial Crisis. Yet, high exposure to the equity factor within the asset class should be minimised. Our sensitivity analysis run on a wide range of relatively high-yielding credits sees EM subordinated financial securities, with AT1 perpetuals falling under this category, high-yielding corporate securities with ratings CCC or lower and contingent-convertible (COCO) bonds as the most vulnerable with beta to equities ranging from 60 to 50 percent. On the other side of the risk spectrum sit EM Asia high-yielding bonds and sovereign credit, both boasting a sensitivity to equity below 30%.
A proper selection of DM IG corporate bonds, backstopped by the Fed, and EM Asia credit still seems to come close to an optimal fixed-income portfolio with appealing carry, till crisis times are over and business confidence recovers.
Fixed Income Update
The Fed announced a reduction in its purchases operations to USD 15bn a day from about 30bn a day, indicating a lower demand for cash from the market. However, we think that the Fed may have to add T-bills again, as the Treasury’s pace of issuance would continue. This week’s auctions would take total Treasury sales to 1 Trillion year-to-date. US Treasury curve bear steepened with long end underperforming: the 10-year yield was at 0.64%. In a sign of easing liquidity conditions, three-month USD Libor traded down to 1.10%, and Libor-OIS spreads narrowed to 103 bps. The Alternative Reference Rates Committee released its objectives with potential impacts of COVID-19 while market participants remain divided between SOFR implementation and Libor extension idea.
The US and Global HY reaped benefits of investor positioning by tightening more than 40 bps last week. Investment Grade Credit OAS spreads traded below 200 bps for the first time in a month, indicating the continued strength in the asset class.
Primary issuance in the US IG market has come off its giddying highs, and last week the total IG issuance was just below USD 55bn taking the sum of issuance to USD 375bn since the third week of March. Fed’s backing for fallen angels resulted in Ford selling USD 8bn of bonds with an order book of more than USD 40bn after initially targeting only USD 3bn. EM issuance has been more muted with only sovereigns or GREs able to tap the market during the current window of opportunity. Last week, Petronas printed USD 7bn of three-tranche bonds, which was the largest ever issuance for an Asian Corporate.
KSA joined the other IG Sovereigns from the region to issue a three-tranche USD 7bn bonds. The new deal brings the total KSA issuance to USD 12bn this year. Investor demand was robust with peak order books over USD 50bn and skewed toward the 5-year tranche. This allowed the bonds to be priced in line with existing bonds without any significant new issue concession. This deal brings the total issuance from the sovereigns in GCC to USD 24bn with combined order books of more than USD 140bn showcasing healthy investor appetite for the quality names from the region.
Emerging market credits saw inflows, and the strong names rallied last week. GCC HY sovereigns moved up by 10-15% while Asian HY issuers were off their lows. However, we believe the HY sector outside the US remains under tremendous pressure in the absence of clearly defined support from respective central banks. Reserve Bank of India announced a range of measures last Friday including enabling banks to buy Investment Grade NBFC papers under targeted long term repo operations, extending bad loan resolution period by 90 days to manage stressed assets, reducing liquidity coverage ratios to 80% from 100% and a refinance facility for government finance agencies to meet liquidity requirements of housing, agriculture and small industry sectors. This should provide credit support to the Indian NBFCs that have accessed the dollar bond market recently.
Global equities rallied, on hopes of economies opening up, with news of progress for a cure for the virus (several therapies are under study including Gilead’s Remdesivir). Investor optimism in the US, outweighed news of COVID-19’s economic impact i.e. falling retail sales and record unemployment numbers (c.15%); the S&P 500 ended the week 3.1% higher. Whilst India’s lockdown continues, China is back to 80% production with demand gaining, as evidenced by data on retail and auto sales. The 6.8% fall in GDP for Q1 was severe, but in line with the economy’s shutdown. In spite of a historic OPEC+ agreement to cut production, oil prices were at lows, amidst a supply glut and demand-side shock. GCC markets are seeing low trading volumes, with petrochemical stocks affected by low product prices and banks expected to post lower Q1 earnings impacted by lower interest rates.
We expect a long lasting impact of the virus with governments spending more on preventative healthcare, tele-health and medical equipment. Testing, treatment and vaccination are the current focus to minimize the virus effects. Besides healthcare, with work and study from home, internet and connectivity are of prime importance for individuals and corporates, along with cloud services, social apps and home entertainment. Verizon recently acquired BlueJeans Networks as it taps into the booming demand for online meeting tools. Whilst Zoom, the popular choice for online teaching is ironing out security glitches, Microsoft’s Team and Skype Business remain popular with corporations. The demand for healthcare and technology products and services is evidenced, by these sectors leading performance in 2020. Big Tech‘s financial strength and the rise in digital demand places it in a better position to weather a slowing global economy. But it is not immune, and quarterly earnings calls over the next two weeks will give guidance. We see digital advertising at the biggest risk.
The recent market rally seems to be factoring in 2021 earnings, by which time economies are expected to be back to full functioning. Consensus EPS forecasts for 2020 have been drastically lowered, growing again in 2021. We are seeing multiple expansion across indices, with our year end 2020 fair values met for all major regional markets, barring India. In the near-term, we expect equities to trade in a volatile range on challenging economic, employment, and earnings data. The latest retail sales data from the US illustrates how the pandemic has hit spending habits. Purchases at grocery stores surged by 27% but there was a 27% drop in restaurant sale, 50% in apparel sales and 25% for car and furniture sales. America’s 5 biggest banks took a USD 25 bn provision in Q1, to deal with corporate and consumer loan risks. Demand for consumer staples was evidenced with Procter & Gamble’s biggest quarterly rise in US sales as consumers bought household essentials. A sustainable re-opening of economies requires adequate hospital capacity, public health infrastructure to support testing, contact tracing to identify hot spots and easily available testing to determine immunity levels. Companies who lead on these metrics would be potential outperformers in markets that are currently well valued.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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