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Chief Investment Officer's team, 26.07.2020
Our last weekly publication was titled “the end of the beginning”, as we think that the fastest phase of the recovery, its initial rebound from very low levels, is now behind us. As it was probably the best part from a market performance perspective, we have slowly but steadily started to implement a more defensive stance in our allocations. Last week indeed provided some signs of an –unsurprising- deceleration of the so far rocketstarting rebound of economic activity: initial jobless claims rose again in the US, and consumer confidence didn’t rebound in Europe. At the same time, two dark clouds remained on the horizon: the number of daily infections in the US approached its record high, and tension escalated one notch with China with the closure of their respective consulates in Houston and Chengdu. In addition, the end of special social benefits in the US is looming for the coming days.
It was enough to propel Gold which added 5% in a week, lifting its 2020 return to +25%. It was however not enough to derail cyclical assets. They underperformed their defensive peers, but were actually flat. In such a context, we are very happy to see our three asset allocation profiles in positive territory year-to-date, with respectively +4%, +2.4% and +0.3%.
We still expect markets to be volatile and are preparing to seize the opportunities of the coming months. There is no obvious catalyst either way and little visibility on timing to be fair. But there is medium term potential, should it be for the economy with high savings rates of for markets with huge piles of cash still waiting to be put to work. In the meantime, we wish you a great summer and all the best for the upcoming Eid Al Adha.
Last week was quite eventful for the acceleration in upward momentum shown by gold and US Treasuries, the former pointing to increased uneasiness about currency debasement, the latter to the slowing of the recovery in the United States. We were surprised, as most in the market, to see that yields could be further compressed in spite of the recent surge in business activity. Gold‘s trend is also being reinforced by the weakening of the dollar, which represents one more piece falling into place in the current cross-asset puzzle.
The resurgence of the virus, the so-called “second wave”, has been particularly dramatic in the US, causing a slowdown in the pace of economic gains achieved following the Q1 slump. A few signs in this direction were provided by the recent jobless claims release, with requests for benefits rising again, and falling consumer confidence both in the United States and in Europe. Business confidence for the month of June as reported by the Institute for Supply Management was way above consensus forecasts, especially for services, yet respondents failed to express as much optimism about the outlook; and the alternative services reading provided by Markit was still below 50, pointing to contraction. The outlook for the next two to three months does not seem to offer reason for optimism either, considering also the mini fiscal cliff at the end of this month, when enhanced unemployment benefits are set to expire with Congress unable to find an agreement in time to just roll them over.
The Fed is likely to pull out all the stops to try to support the economy, if not at the forthcoming July meeting, at the September one, when a renewed framework should be announced, whereby chair Powell is expected to shift to an outcome-based forward guidance. It would mean that the Fed would be raising policy rates conditional on full employment and 2% inflation, projected to occur only some years down the road. Markets are already starting to discount the event which, alongside the rolling over of economic momentum, is exerting downward pressure on Treasury yields. The US 10-year Treasury yield could end the year below 1%, our fair-value for 2020, unless market expectations about the new Fed course are disappointed.
Gold has been rising forcefully along the lines of falling nominal yields and higher inflation embedded in Treasury Inflation-Protected Securities, which together caused real rates to collapse. Although there does not seem to be much room for market-implied inflation to rise significantly from current levels, after all the Covid backdrop remains deflationary, the compounded effect of strong price momentum, depressed real rates and of the possible inflation-targeting Fed’s framework could see gold trade around $2,000, beyond our fair-value of $1,800 for the year.
Both gold and Treasuries are suggesting that more stimulus will come to the markets, which eventually could be inflationary. Until that point is reached, gold and yields should continue to travel in opposite directions.
Fixed Income Update
Yields and rates are trending lower, breaking new records. US 10-year Treasury yields have come below 0.6% for the first time since April 2020, indicating higher investor uncertainty about rising geopolitical tensions and increasing daily new infections. Does this change our base case is the most pertinent question? Our asset allocation within the Fixed Income class has been marginally defensive, and we have increased High Yield exposure only in June, bringing our exposure to neutral. We continue to maintain an overweight in investment-grade credit and Emerging Market Debt. We like Investment Grade Sovereigns and quasi-sovereign entities within the Emerging Market as we don't believe sovereign solvencies are a significant risk this time. In terms of geographical preferences, we like Asia and LATAM entities because we think most of the downgrades are behind us, and a stable oil price outlook should benefit these issuers.
We don't believe that the 10-year treasury can go marginally below their all-time lows even though the UST yield curve's flattening is possible. While 10y OIS and UST yields are close to all-time lows, 30y yields are still some 20-30bp above the lows set in March. Two factors support our hypothesis of a flatter long-end, especially the 10s30s part of the curve. Firstly, increasing investor positioning on the long-end to capture the higher yield and secondly recent weak economic data might drive the 30y a little lower.
Investment Grade credit spreads have been gradually tightening with the Bloomberg-Barclays benchmark yield hitting an all-time low at 1.50% with spreads at 127 bps, which is 35 bps above the lowest level in the last decade achieved in February this year. While we don't think that spreads could rush to the bottom so fast, the asset class has emerged as a choice for hedging against market turbulence as compared to US treasuries due to the FED's backstop and its higher yield.
Global High Yield has also tightened significantly with spreads now below 600, while defaults have continued steadily. In contrast, outside of the affected sectors, the default rates have been pretty benign. Seven more issuers defaulted last week, taking the year-to-date tally to 141. The trailing 12-month default rate is at 3.8%. Out of the 92 US corporate defaults this year, 43 have been related to sectors at the epicenter of the disruption, including energy, retail, and Hotel/Gaming/ Leisure.
GCC bonds have provided 11.73% in the last three months, and YTD returns are more than 5.42% driven by significant tightening in front-end IG sovereigns. While the index average duration is 8.06 years and spread is 2.20%. KSA and Abu Dhabi's sovereign front-end spreads are below 100 for less than five-year maturity and around 150 for 10-year maturities. This spreads level is very tight and comparable to developed market IG credits eliminating the regional premium available to investors. Hence, it makes sense to take a position in quasi-sovereigns that trade 25-50 bps wider to the sovereigns and extend maturities to take a position in sovereign bonds that offer more than 200 bps spreads.
Whilst COVID-19 remains in the headlines, China tensions, earnings and concerns around the tech rally were the larger market catalysts. Global equities finished flat for the week as did DM equities. The US closed lower: the S&P 500 fell -0.28% and the Nasdaq -1.33%. EM equities gained +0.6%, however MSCI China ended the week down -0.5%. The India market was up +2.7%, largely led by Reliance, a heavy weight in the MSCI India Index at 16% and which continues to see investments into its digital and retail forays.
Facebook, Apple, Amazon Microsoft and Alphabet were down last week after an almost consistently unbroken trajectory of gains since March. Between them Apple, Amazon and Microsoft have added a trillion dollars in market value since the start of 2020. The FANG Index is a healthy +46% year to date. While these top five companies represent about 25% of S&P 500 market cap they also capture a greater percentage of the market's earnings, are delivering better growth and valuation multiples are not elevated. After week two of Q2 earnings season 26% of S&P 500 constituents have reported thus far -42% EPS growth on -10% Sales growth according to FactSet research. Notable are Microsoft (+28%YTD) which dipped post earnings on guidance that warned of an economic slowdown; Tesla +239% YTD which announced a fourth quarter of profits and is a possible entrant to the S&P 500; Intel announced a delay in development of its superfast chips and saw a 16% fall in its share price even though it beat on earnings; Netflix added 10 mn users last quarter but gave guidance of only 2.5 mn for the next quarter as it reaches saturation level.
From a relative valuation perspective the Healthcare sector still trades extremely cheap, the overhang of regulatory and pricing constraints from governments has taken a back seat, giving the Healthcare sector a structural tailwind. Many of the healthcare companies have strong balance sheets, ROEs in the high teens, stable free cash flow and attractive and steady dividend yields. They are high on ESG rankings too providing all the ingredients for market leadership. Healthcare constitutes 13% of the MSCI All Country World Index and 15% of the S&P 500. Governments’ investment in preventative healthcare has increased with a focus on healthy lifestyles and vaccine procurement. The US has a deal with Pfizer for $2 bn for 100 mn doses of their experimental vaccine and other governments have similar deals with AstraZeneca and Sanofi. Please refer to our recent note for investable ideas across large pharma, biotech, digital healthcare and telemedicine. There are promising results on both antibody therapies and vaccine development and the healthcare industry is being looked to for getting the virus under control and economies back to normal functioning.
The UAE and KSA markets were in line with global equities close to flat for the week. Du posted disappointing 2Q20 results, affected by the lockdown and lower tourist arrivals into the UAE. Net income fell by 54% year/year and revenue was -16% year/year with a higher than usual effective royalty rate. Etisalat 2Q20 net income was +7% year/year whilst revenue was slightly down -3% year/ year.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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The “end of the beginning” of the recovery
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