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Chief Investment Officer's team, 18.08.2019
In our Investment Outlook Mid-Year Update, released a month ago, we wrote that we had turned our previously constructive positioning into a more defensive one, as we saw vulnerability caused by the combination of high market valuations with many geopolitical uncertainties. The current “risk-off” episode should not come as a surprise. In a nutshell, trade tensions are a shock to business sentiment, lowering growth expectations and bond yields as a consequence. The resulting yield curve inversion also amplifies recession fears, making market participants nervous, especially as they still sit on very positive year-to-date performance.
We have seen this movie before, and it is interesting to note that the current episode is not as severe as the last one, in May, triggered by the very same drivers.
Our take on the current situation is simple. We do not forecast an imminent recession in the US, as consumption is strong and supported by growing wages, and China is committed to support growth in every possible way. Yes, equity valuations are elevated in absolute, but the yields and liquidity context are driving their risk premium cheaper. Volatility will remain high, with so many concerns on the horizon (from trade to Brexit, Hong-Kong, Argentina…) but the potential for monetary and economic stimulus is also significant. In such a context, the current dip is not deep enough to be bought, and we keep our moderately defensive positioning.
As we write, the performances of our three investment profiles are very close to each other so far in 2019, with respectively +8.1%, +8.6% and +8.8% in US Dollars. This situation might look odd in what was not that long ago a record first half of a year for equities. But as Gold is now the best performing major asset class globally and as global government bonds delivered an impressive 7% return in USD, defensive assets are back. Indeed, 8% in 8 months is a very good performance for an aggressive profile and an outstanding one for a defensive profile. This is what happens when markets are primarily driven by liquidity and monetary support, lifting all valuations, rather than a change in economic fundamentals, which creates divergence based on the cyclical sensitivity of the underlying asset classes.
Looking forward, one key question is whether the primary driver of markets will change, or not. This question is particularly relevant for the near-term. The current volatility episode is precisely the fear of a change: the sentiment shock from trade war would put an end to the current economic cycle, lowering profits or demand for cyclical commodities but also triggering massive response from central banks and a fly to quality on long dated government bonds and “safe haven” currencies. This would be divergence, with a bearish stance. The second option would be a status quo on the economic front, i.e. a tepid but still positive growth, with preventive action from Central Banks. In this case liquidity wins, and as bond yields become microscopic, all other assets look comparatively attractive and there is some upside potential due to valuations expanding further.
Our stance on this point favors the latter, as the world’s two largest economies are as aligned in their near-term agendas as they are ruthlessly opposed for the long-term leadership. With Presidential elections in 2020, Mr. Trump can simply not afford a recession, which should anyway not spontaneously happen given the current levels of employment and wage growth, in a consumption dominated economy. China on the other hand doesn’t have an electoral agenda and generally doesn’t care much about the short-term, but the timing for having an economic issue wouldn’t be appropriate, in the middle of its deleveraging process, and as it is dealing with the situations in Hong-Kong and imminently Taiwan. This is why every possible stimulus measures are on, including today’s PBOC announcement of an interest rate reform. In Europe, Germany is considering using its fiscal leeway, and the ECB made it clear support is coming in September. The situation is similar in Emerging Economies, with more than 15 Central Banks having cut rates in the last three months, the latest being Mexico.
We are thus confident in our moderately defensive positioning. But don’t get us wrong: we can’t help thinking that we are borrowing returns from the future. A world with negative risk-free rates and high valuations is a dangerous environment, which requires an extreme vigilance for the long-term.
Fixed Income Update
Volatility led the global risk-off sentiment and fueled the rally for safe-haven assets. Bond yields touched a record low together with a new high of $17 trillion of negative-yielding debt. The thirty-year US Treasury yields fell to a record low of 1.91% from as high as 2.67% in the middle of July and retraced to close above the 2% post announcement that the Treasury Department is contemplating to sell 50 and 100-year long bonds. The US yield curve (ten-year minus two-year) inverted briefly and closed the week at 7 basis. European Sovereign yields edged higher on the back of the news that Germany is considering fiscal stimulus. On the European credit front, Nestlé’s Euro-denominated 10 year bond became the first corporate bond to offer negative yields to investors.
Investors’ worries intensified on US-China trade relationship, macro events unfolding in Argentina and Hong Kong together with softening global macro data. That said, strong inflation readings on inflation and retail sales out of the US did little to stabilize bond yields. Looking ahead this week, investors will pay close attention to the Federal Reserve’s annual symposium in Jackson Hole, Wyoming. Fed Chairman Jerome Powell will take the stage on Friday to deliver a speech titled “Challenges for Monetary Policy.”
China has moved towards a market-based rate-setting structure for deciding bank lending rates to effectively influence and control interest rates. Under the new system, a consortium of 18 lenders selected by the People's Bank of China will submit their one-year and five-year loan prime rates to the central bank monthly. The average of those rates will then be published at 9.30am on the 20th of every month starting from Tuesday. PBOC highlighted that the rate-setting group had been expanded to 18, from an existing group of 10 big banks, to "make the group more representative" by including foreign banks, rural commercial banks, city commercial banks and even private banks. Notably, HSBC has been left out of the rate setting consortium of banks.
Bank Indonesia joined the swelling number of central banks with a dovish outlook. Despite the fact that Indonesia’s economy expected to expand at the fastest pace in a decade, Bank Indonesia said there is still pace for policy rate cuts. Meanwhile President Widodo proposed record government spending next year to drive the economy. India’s CPI was at 3.15% in July compared with 3.18% in June, while WPI slowed more-than-expected to 1.1% from 2% the previous month. Indian Government bonds have weakened in the fear that the expected foreign bond issuance might get delayed.
Fitch Ratings cut Argentina’s Sovereign rating by three notches to CCC from B. The surprise win on the preliminary-election round for opposition presidential candidate Alberto Fernandez ignited a sharp sell-off as investors’ feared the return of populist policies. As of March 31, Argentina had $33.7 billion in foreign-currency debt payments due by year-end, the vast majority in short-term Treasury bills according to the Finance Ministry.
Equity markets experienced another volatile week as US-China trade issues, and the potential spillover to the global economy took center stage. Pres. Trump delayed the imposition of new tariffs from September to December, and late-week consumer data in the US helped the S&P 500 recover from a sharper sell-off, but the index still closed the week 1% lower. This brings year to date gains to 16.7%, just 6% below the peak of 22% in 3rd week July. The S&P 500 has recently been trading in a channel with the possible impact of tariffs on profit margins a headwind, counteracting the positive impact of lower interest rates. Other DM’s performed similarly and the FTSE 100 and Euro Stoxx 600 fell 1.52% and 0.44%, respectively last week. EM equities have given up almost all their gains in 2019 in USD (+2.3%) as weak currencies have added to the market sell-off. DMs retain a strong 13.5% year to date gain.
We expect volatility to continue. Supporting a market bounce back are oversold conditions, recent positive developments around US and China trade, China's stimulus measures, potential German fiscal policy stimulus, strong US consumer data (Walmart earnings also helped send a positive message on the consumer) and better-than-expected earnings reports. However, still weighing on sentiment are an earnings slowdown, limited scope of central banks to implement policy to boost economic growth and geopolitical tension. The US treasuries 2-10 year spread experienced brief bouts of inversion earlier last week and spooked markets as it brought up recession talk. US economic data is mixed on aggregate but better than estimated, hence imminent recession fears are unwarranted.
S&P 500 EPS grew by +1% in 2Q, 2 percent higher than consensus estimates. However, margins will likely come under pressure, even though a profitability rebound into 2020 is widely expected. After dropping for three straight quarters from its peak of 12.6% in 3Q18, the S&P 500 net income margin is expected to fall to 11.7% in 2Q, the lowest since 4Q17 but still above the five-year average of 11%. Revenue growth is also expected to aid earnings, ticking up to almost 7% by the middle of 2020 from 1.4% in 2Q19. As per Bloomberg analysis, a 10% increase in U.S. tariffs on $300 billion of products imported from China could cost the S&P 500 $11.3 billion (0.7%) in fiscal 2019 Ebit. Ebit forecasts have fallen 5.6% so far this year.
A good time to get a little defensive and to shore up portfolios with some yielding strategies. The S&P 500 currently offers a trailing 12-month dividend yield of 2.0% – higher than the 10-year US Treasury yield for the first time since October 2016. US companies continue to grow dividends; 9% last quarter. Investors who are looking for yield should consider companies with high dividend yields, strong dividend growth, and payouts that are not funded by leverage. A few quality healthcare and consumer sector companies screen well for these criteria, yielding over 3%.
The Dubai Index is now leading regional returns (+15% TR year to date). A number of UAE companies, particularly the banks, offer growing and high dividend payouts. Some of the real estate companies too offer high yields, but these may be less sustainable than the bank payouts.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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Waiting for the Fed - 28 July 2019
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