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Chief Investment Officer's team, 21.07.2019
Last week was rich in news-flow, from both Central Banks and companies releasing their Q2 results, but reasonably quiet on markets. Some profit taking took place on the best performing asset classes of the year, with DM equities down 0.8% and global listed real estate down 1.3%. Fixed income continues to be supported by dovish comments from Fed officials, which also helped Emerging Market equities. As a result, so far 2019 is still a fantastic year for financial returns.
We have just released the Mid-Year update to our Global Investment Outlook, and at a time when key data is expected, we have more questions than certainties. For US equities for example, we need both earnings growth, and dovish central banks, to justify the current valuation. To find fundamental upside potential, more stars have to be aligned: an improvement in the growth outlook, which would be strong enough to sustain earnings, but not inflationary enough to threaten rate cuts.
When level of confidence is not high, it is wise not to take strong active positions. This is why our positioning is not radical. It is however explicit: with cash our largest overweight, and Emerging Markets our preferred region across asset classes, we are slightly defensive and favour fundamental valuation over market momentum. We preserve flexibility and intend to use it, probably in a contrarian way, should the markets deviate again from their fair values.
When it comes to tactical asset allocation, having an estimation of the fair value of an asset on a relatively short-term horizon is equally important, and difficult. For equities, a short-term metric of market value is the Price-To-Earnings ratio, or PE. Our own approach estimates the level of earnings growth first, then the multiple that we think should apply at the end of the year. This fair-value is a necessary tool, but it’s of course not perfect. The actual PE of the market can undershoot or overshoot our measure, based on analysts’ projections, but also the rates environment and of course risk appetite.
Robert Shiller came up with a different gauge, whereby earnings are smoothed across ten years, to avoid shorter-term fluctuations, and then divided into an equity price index. The so-called ‘Shiller PE’ has sparked controversy, since it has consistently pointed to overvaluation of US equities for quite a while, having recorded higher levels than the current ones only in 1929 and 2000, respectively the pre-depression and the dot-com bubble peaks.
We have successfully made the Shiller PE, also called Cycle-Adjusted-Price-to-Earnings, or CAPE, the bedrock of our analysis framework for estimating long-term equity returns. The detractors of this metric are trivially associating high or low values of the index with equity over- or under-valuation. That is simplistic, and, we agree, it does not work that much. What about going a bit deeper, rather than throwing the water with the baby? Levels of the CAPE for US equities correlate well with the 10-year average future total returns of the asset class, hence today’s CAPE between 29 and 30, as of June 2019, would justify average yearly returns below 5% for the next 10 years. That is pretty bleak, considering that this includes a dividend yield of, say, 2%.
CAPE detractors have a point, though. Why are longer term metrics consistently in the high-end of their historical range? Is there some factor boosting cyclically-adjusted equity multiples? In our view it is the ever-rising tide of monetary policy. The Shiller PE skyrocketed higher after 1990, with Fed policy rates stable or on net falling until 1998. And it has been rising quickly following the Great Financial Crisis, with Fed Funds basically stuck at zero and repeated rounds of Quantitative Easing supporting markets.
Equities are supposed to deliver returns which reflect a premium over risk-free assets paying for the uncertainty related to economic growth. Why should that risk premium not be historically low if the so-called Fed put, the tendency of the Fed to avoid tumbles in equities by feeding loose enough financial conditions to the system, is always operative? A world made safer by constant monetary stimulus defies the notion of market risk and aligns valuations across all asset classes to the lofty levels reflecting lower uncertainty than warranted under no stimulus. The monetary trick will continue to work, insofar as markets do not hit the recession snag. We are not there yet, so investors can still enjoy lofty PEs.
Fixed Income Update
The ongoing rally across the bond markets is all about headlines. On one side, President Trump’s trade policy keeps on threatening business sentiment, and thus global growth. On the other, FED policymakers debate over the case for deeper policy rate cuts for next week. The recent comments by New York’s Fed President John Williams and Fed Vice Chair Richard Clarida suggested that a higher cuts (50bps) was not off the table: "it's better to take preventative measures than to wait for disaster to unfold" and "You don't have to wait until things get so bad to have a dramatic series of rate cuts. You don't want to wait until data turns decisively if you can afford to." After initial euphoria however, there was a sharp pullback in the probability of 50 bps cut as NY Fed clarified that Williams was not talking about potential policy action but about academic research.
US benchmarks have been oscillating around our year-end fair value estimates of 2% at 2.05%, with most of the other DM sovereign bonds equally stable at high valuations. High-beta EM sovereign bonds are benefitting from the overall search of yield while domestic bonds are supported by the perspective of rate cuts, fueled by low inflation. South Korea’s central bank lowered its benchmark interest rate by 25 basis points to 1.75%, while Indonesia cut its rate to 5.75% followed by South Africa. Turkey Central bank is widely expected to cut rates this week. Markets anticipates a 200 bps cut with the policy rate coming down to 22% which could have an impact on the currency.
The debate on the debt ceiling in the US has once again resurfaced. The short-term securities (Treasury bills) are reflecting some concerns with small pricing dislocations appearing around securities maturing close to the months of September and October. Treasury Secretary Steven Mnuchin has said that under one of the department’s most conservative estimates, there will be a risk of default on payment obligations in early September before lawmakers are scheduled to return (Sept. 9th). This week, $205 billion of bills and bonds would be auctioned by the US Treasury Department.
Outgoing ECB chief Mario Draghi will lead an ECB policy meeting this week which is widely anticipated to lay out the plans for a September rate cut and a possible resumption of quantitative easing through CSPP II. Market anticipates that ECB will focus on corporate bonds rather than financial sector bonds. Draghi was the only ECB Chief to not have a single rate hike during his 8 year tenure.
Greek Prime Minister Kyriako Mitsotakis seeks to cut taxes and initiate privatization of public sector undertakings in an effort to spur the economy. Corporate tax rate is expected to be cut from the current 28% to 20% by 2020 in two steps.
We are expecting a maiden Sukuk issuance from Emirates Strategic Investments Company. This multi sector investment holding company owns a diversified portfolio in the UAE, and is controlled by H.H. Sheikh Mansour Bin Zayed Al Nahyan, Deputy Prime Minister and Minister of Presidential Affairs of the UAE.
In markets that are trading close to or above fair value, outperformance rests on selectivity and quality (sustainable businesses, high ROE, low leverage). As communicated last week we have revised upwards our fair values for the US, Europe and China equity indices, with dovish Central bank policy justifying higher valuations in the former two, and a combination of higher EPS and multiple for the latter. Both US and Europe are currently trading above our revised fair values but Emerging Markets still show some upside. Most Asian markets ended the week up, but U.S. equities finished the week lower (a percent below their all-time high).
The last leg of the US rally was aided by more certainty on rate cuts by the Fed. The focus is now on earnings growth. We had expected Q2 earnings to beat estimates by 3 to 4% and this seems to happen so far. In the first week of the Q2 season, 16% of the S&P 500 Companies have reported an average EPS growth of 4.01% (estimates are for a decline of -2.6%) with 2.8% sales growth (estimates are for growth of 3.8%) according to FactSet. The earnings-growth rate in Q2 will not reach 2018’s 20%-plus growth, but should be positive. Also, higher wages, rising input costs and strength in the US dollar should pressure margins, expected to contract to 10.8% down from 11.5% a year ago. Material companies with the most sensitivity to China, are expected to be the most impacted. While showing signs of slowing, U.S. economic data is still supportive of markets, with unemployment close to a half-century low (positive for consumption).
Whilst trade tariff issues have been temporarily soothed for the US and China, Europe and Japan companies await clarity. In Europe Daimler has already warned of a sharp drop in profits, hit by the trade war, because it ships vehicles from the US to China. China Exports and Imports Y/Y for June missed expectations. The Nikkei cited SEMI data showing global chip sales for 2019 were revised down to an 18% fall, the first decline in four years.
The UAE saw a rally last week (+3%) with improved liquidity. Plans to increase Foreign Ownership Limits (FOLs), with First Abu Dhabi Bank planning to remove the cap and other companies considering doing so, would boost their weight within EM indices. The banking sector has so far had better than expected earnings.
Amazon’s revenue growth may be slowing (17% in Q1) but Prime members top 100 mn globally with India and the UAE the latest to be added. Whilst the service costs $119 in the US, it costs only $2 in India where Amazon hopes to gain market share.
India’s car sales may have slowed but consumption and digital growth is exponential with Reliance Jio reaching 330 mn telecom subscribers, and the Reliance retail arm rapidly expanding stores and increasing online sales.
For the first time in a decade Netflix lost U.S. subscribers and only grew half the estimated number in Emerging markets. Competition is ramping up from unexpected fronts: hardware company Apple, ecommerce giant Amazon and traditional box office content maker Disney.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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More data, less certainty - 07 July 2019
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