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Chief Investment Officer's team, 10.01.2021
The first week of 2021 was eventful, volatile, and eventually positive for cyclical assets.
With a record voter turnout, the last two undecided seats of the US Senate were won by the Democratic candidates, providing President-elect Biden with a tiny majority over the whole congress. This situation is another incremental improvement to the investment outlook: the majority is enough to allow more fiscal stimulus to be passed, but this is not the massive lead which would have been needed for the most radical items of the Democratic agenda on taxes and regulations.
Markets took note of the perspectives of more stimulus, and ignored disappointing economic data. After tepid PMI indices, especially in services, the monthly US job report in particular was terrible with 140k jobs being lost in December, while the consensus expected 50k creations. Never mind, with more stimulus ahead, cyclical assets had a strong week, led by emerging market stocks, up 4.8%, followed by their developed peers which added 2.4%. In a typical “risk-on” pattern, the fixed income asset class was penalized. The 10-year Treasury yield closed at 1.12%, a level not seen for months, weighing on all the sub segments and on gold.
In the week ahead, we will hold our monthly tactical asset allocation committee, the first one since our new strategic allocation was implemented on December 31st. We will consider adding more emerging markets to our actual positioning. We will also pay extreme attention to the start of the Q4 earnings reporting season: numbers matter for the fundamental picture, and market reaction also matter for the behavioral picture, which looks a bit too optimistic. Stay safe.
The so-called Democratic sweep in the US Congress, that is Democrats now controlling both chambers, though by the closest of margins in the Senate, is already having ripple effects across asset classes. The common denominator to market swings is that higher odds of more fiscal stimulus early this year, even as monetary policy remains extraordinarily accommodative globally, keep on fanning the flames of the reflation trade. Value stocks are outperforming, yields rising, credit spreads grinding lower, and gold’s rally has stalled. Cyclical assets are bid across the board as higher growth and inflation are being discounted further down the road. While growth should be easier to come by, price pressures are still likely to remain contained this year due to the deflationary effects of the pandemic. This in turn should further boost risk assets, in particular equities, which fare best in a stronger-growth, moderate-inflation environment. If equity investors are rejoicing, bond investors much less so.
As the policy backdrop changes, so do markets. In past issues of this publication we have repeatedly mentioned that the fiscal lever, putting money directly in people’s pockets so to speak, tends to exert upside pressures on Treasury yields, something market participants may not be that accustomed to after decades of Fed’s net easing generating exactly the opposite outcome. The combined effect of the two policies should see upside risks to our US 10-year Treasury yield fair value, that was estimated to be at 1.2% under a split-Congress scenario. While intra-year excesses well above that level had already been taken into account, now odds of a higher year-end target are rising as well. Treasury losses driven by stronger growth are equity-bullish, but could end up having negative repercussions on some credit segments especially the most defensive ones. With spreads well below their longer-term averages and yields at historic lows, spreads tightening might not be enough to offset duration risk. We had to an extent pre-empted this by encouraging investors in late Q3 last year to switch from IG to HY corporate debt, the latter offering more protection against higher Treasury yields.
We still believe that in fixed income portfolios duration risk should be swapped for credit risk by allocating more to global HY debt and in particular EM HY bonds. If history is any guide, inflationary pressures should remain moderate and not be long-lasting. Although deflationary scenarios could come into play again in 2022, in the current year investors could be tempted to reassess the reaction function of central banks and push long-dated yields to new highs in the process. According to some models inflation should peak in the middle of this year and then decline. While this would not equate to a prolonged government bond bear market, hence we see no reason to panic, duration risk should be taken into account by investors when they build their fixed income portfolios.
Fixed Income Update
The much anticipated "Blue Wave" happened a couple of months after the US Elections. We have been harping on the risk of yield rising due to reflation trades due to fiscal support and higher inflation expectations. Sometimes markets do behave as they are supposed to. The US 10-year treasury yields crossed 1% for the first time since Feb 2020 and closed the week at 1.12%. The treasury yield curve bear steepened with the 30-year yield going up by 23 bps over the week. The theme reverberated across other developed Market Govt bond sectors with core-Euro Area yields increasing by 5-10 bps. Peripheral Euro Govt yields benefited from the risk-on positioning with Greece Govt benchmark yield tightening by c.5 bps.
The corporate bond indices behaved predictably, with most defensive sector bond indices in red and the riskier indices such as High yield and Emerging Market indices benefiting from the treasury move. Investment Grade bond yields crossed 1.3% last week. IG spreads have hit multi-year lows trading at 91 bps. M&A announcements and IG new issue market activity have ramped up in 2021. However, investors have to be careful about investing in DM IG bonds, which provide a negative real yield.
High-yield bond index OAS spreads have come below 400 bps and continue their strong performance as we had predicted earlier. Global corporate defaults in 2020 totaled 226, up by 91% from the previous year's tally of 118 according to S&P. While the US led the default tally with 146, defaults in Europe reached an all-time high of 42, far surpassing its previous record in 2009 of 22 defaults. However, globally, the 2020 default tally was still well below the 2009 total of 266. Globally, the oil and gas sector led defaults in 2020, with 50, followed by consumer products and media and entertainment, with 35 and 31 defaults, respectively. Distressed exchange-related defaults led the tally in 2020, with 78, followed by missed principal and interest payments, with 73.
Weekly fund flows indicate a preference of aggregator funds within Fixed Income while sell-off in the Govt bond focused funds continues. Net inflows into the fixed income funds were $15 Bn out of which agg. Funds received $7 Bn. Flow into EM bond funds remains healthy, with weekly volumes close to $3 Bn equally distributed between hard and local currency.
Emerging Market primary issuance volumes are up with $34 Bn of deals priced in YTD 2021. China leads the issuance bandwagon accounting for $12 Bn sales. Only UAE banks from the region have been able to tap the markets in the first week of January. Emirates NBD and FAB issued 5-year senior papers with books covered by close to 3x. Spreads tightened by 15 bps for FAB and 25 bps for Emirates NBD, indicating strong investor demand. FAB issue was also the first Sukuk of the year for the option starved market.
Has all the good news been priced in for markets after the 2020 rally and the strong start to 2021? Global equities gained 2.7% in the first week of the year with EM equities up 4.8% (we are overweight) and DM equities up 2.4%. What supports market performance in 2021? A broader participation from regions and sectors in the rally. Rising bond yields are supportive of financials as bank net interest margins benefit. Rising oil prices have led the energy sector, last year’s worst performer, to be the best sector so far this year. Rising commodity prices are leading to gains in the material sector. And US tech hasn’t had the envisaged sell off on regulatory concerns, though China’s tech companies are in the headlights of China and US governments. Also real bond yields have been falling, making equity valuations look reasonable. Vaccine approvals and distribution support a recovery in global growth and corporate profits in 2021 and wider performance than just by the COVID winners of 2020. Restaurants and travel will benefit as consumers become more confident and unlock service sector activity.
China has been a forerunner in the economic recovery with India demand metrics indicating it too is following a recovery path. LATAM and GCC economies are beneficiaries of the higher oil price. The Dubai Index has gained over 5% last week with real estate stocks boosted by tourism, a control of supply and measures to encourage long term residency. Geopolitics is also in favour with improving relations with Israel and Qatar. The global backdrop: vaccine-led global growth, accommodative financial conditions and recovering commodity prices remain supportive of EM assets
U.S. equities finished higher after an eventful week, with small caps in the lead. S&P 500 +1.8%, Nasdaq +2.4% and the Russell 2000 +5.9%. On the sector front the top performing sectors were Energy, Materials and Financials. Following the Democratic sweep in the Georgia Senate run-off race, hopes of additional stimulus and government spending provided a tailwind and pushed all major U.S. indices to record highs. All eyes on earnings this week with consensus expectations of a 9.7% drop over last year for Q4 in the US. This should be followed by a 20%+ earning growth in 2021 as loss making oil companies turn profitable and industrials see a pick up in demand. Tech and comm. Services the largest component of the S&P 500 are expected to see 14% earnings growth.
Besides Genomics and Electric Vehicle stocks which continue their outsize gains into 2021, renewables are strong gainers this year. ESG and renewable themes have gained traction during the pandemic and also as this has been a major agenda on President elect Biden’s agenda. December saw a number of vaccine rollouts starting with Pfizer- BioNTech and then Moderna, both with the mRNA methodology and in the UK Oxford-AstraZeneca vaccine first rounds have begun.
Whilst we begin 2021 at elevated levels for most markets, the economic recovery should aid further upside with a caveat of being selective and diversified. Central bank and government support provide a strong backstop. We will of course see volatility, which is a norm even when there are no crises.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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