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Chief Investment Officer's team, 15.03.2020
The combination of the virus spreading globally and of the oil shock led to a crash in financial markets last week with volatility rising to record levels. Global stocks lost 12% despite a rebound on Friday. In panic selling, driven by loss cutting and margin calls, even safe havens fell, including Gold, -9%, and Government Bonds, down 3.5%.
Our mission is to preserve your capital across good and bad times. This crisis is severe and we admit that we were not initially under estimating its impact. We had however taken a defensive stance in mid-February, by cutting our allocation to equities, our largest risk reduction in 2 years. Last week, in the middle of the crash, we have decided to add to risk, basically by buying back the stocks we had sold 25% higher, adding to Global Real Estate, and also reducing Government Bonds and High Yield due to their poor risk/reward from current levels.
Looking at the evolution of the pandemics where it initially started, in China, but also in South Korea, Singapore or Japan, we believe that the health crisis could be solved in months. The current market valuations, hammered by panic, discount a prolonged global recession which we think is unlikely to materialize. This is why we are now neutral on risk, i.e. aligned with our long-term strategic asset allocation. The short-term remains fraught with volatility, thus dangerous, but the long-term prospects justify starting to re-invest.
Our team and our bank are prepared to work remotely if needed. We wish you all the best - take care.
The losses markets went through in the last three weeks are likely to go down in history as amongst the sharpest ones ever suffered by equities in such a short spell. As unprecedented the fall, so is the cause. Investors were basking in the conviction that, absent crisis-like excesses in the major economies, policy support and low bond yields would justify the TINA (There Is No Alternative) approach, implicitly meaning no alternative to investing in stocks. Rather than being shaken by macroimbalances gradually building up to reach a tipping point, markets were rattled by the large-scale disruptions brought about by the abrupt freezing of economic activity in response to the spreading of the virus in a quickly growing number of countries
The collapse of the crude market following disagreements on oil-price policy between Saudi Arabia and Russia has been a further deflationary shock hitting demand via the probable slashing of investments by major exploration and production companies. But opposite views about how the current oil glut should be handled imply huge social costs which should bring the conflicting parties back to the negotiating table sooner rather than later. And further down the road lower crude prices will translate into stronger consumer purchasing power
Although markets across asset classes are currently discounting a recession, the very sharp slowdown anticipated in this quarter and the next should be partially cushioned by the policy measures announced by an increasing number of nations. President Trump declared a national emergency to free more financial resources and Berlin announced the availability of unlimited credit for virus-stricken businesses. The Federal Reserve is expected reach the zero bound at the next meeting and other central banks are going to loosen policy further. The lack of relevant imbalances in the major developed countries suggests that even an economic contraction would be short-lived, most likely limited to two quarters and then followed by a relatively swift recovery as pent-up demand quickly comes back when the virus subsides.
Investor positioning, pretty crowded at the recent tops, is now much lighter and more in line with what historically has coincided with bottoming market conditions. Sentiment indicators across risk assets point to extreme oversold levels and a rather pessimistic macroeconomic view is embedded in their current levels.
Assuming that three conditions must be met for normalcy to be restored in markets, panicking investors, massive policy action and virus daily infection rates dropping in the single digits, it seems that significant action has been seen on the first two fronts. Hence, time to recovery will critically depend on how the virus crisis is managed and the trade-off the authorities see between total lockdowns and their social and economic costs. Considering the extreme degree of disruption embedded in the current pricing of equity and credit, we think it is not unwise to start adding risk (to neutrality) under the assumption that the major stimulus measures announced will survive the virus and push risk assets higher.
Fixed Income Update
We talked about current events being part of history books on our 1st March weekly write-up. Nevertheless, we would be taking undue credit if we claim that we anticipated the kind of moves that have shocked the fixed income assets last week. Last week could be split into two parts. Monday to Thursday saw extreme risk aversion across the globe with US Treasury 10-year yield hitting an all-time closing low of 0.54% on 9th March. While last Friday, we saw the largest increase in the same yields this year due to the US finally getting its act together to fight the contagion efforts.
However, it has been another story for the credit markets. Most of the HY indices lost more than 5% last week with spreads crossing 2015 levels. Global HY index spread of 819 was last seen in 2012. Meanwhile, the Emerging Market Debt Index spreads reached an alltime high of 504 on Friday. Even Investment Grade credits were not spared this sell-off with the global IG benchmark OAS at 184 as compared to 130 a week before.
Historically, the benchmark rates move first, and then the credit follow. With Central Bankers bringing out their monetary policy bazookas and political leaders following suit with fiscal loosening, our base case scenario remains that the current widening of spreads will reverse once markets stabilize, which would be sooner rather than later for quality credits. We would continue to be very cautious about the high Yield.
With this backdrop in mind, we increased our allocation to Emerging Market Debt by 1% across all the three Tactical Asset Allocation Profiles. We continue to maintain our overweight on the EM Debt and believe the easing liquidity and low inflationary scenario should be suitable for emerging market issuers. We decreased our allocation to Developed Market Govt Bonds since rates are scraping the bottom of the barrel across the developed markets, and there is minimal upside in our opinion. We also confirm our cautious stance on the Developed Market HY credits and have decreased further our allocation to DM HY in our moderate and aggressive profiles, already underweight, whereas we had zero HY allocation in the cautious profile to start with. We believe the High Yield market will continue to see weakness longer as the weak credit profile of the issuers keeps the prices of the bonds lower for longer. Risk-adjusted, we prefer EM Debt anyway.
Closer home, the KSA and UAE Central Banks have come out with supportive monetary policies on Saturday assuring the markets of maintaining the currency peg, freedom for banks to defer SME loans, freeing up capital buffers of banks and giving the lenders a zero-interest credit line to be utilized to bump up credit growth. This would be positive for the regional credits as the primary markets have come to a standstill worldwide, and bank lending would be the main source of capital. We still are cautious about HY sovereigns in the GCC, where low oil prices play havoc with fiscal balance sheets and advise investors to avoid highly leveraged issuers in the real estate, retail, and education sectors of the region.
One of the most bruising and volatile weeks in history, led by US equities ending the week down over 8%. All global indices are negative year to date. The oil exporters have fared the worst (Brazil, the KSA, Russia) whilst China markets have recovered in line with the resumption of business. The week began with a sharp drop in oil prices. Monday saw circuit breakers triggered on US exchanges as the S&P 500 fell 7%. The week progressed with the coronavirus epicenter shifting to Europe and spreading to the US. The WHO declared it a pandemic, and along with the shutting down of businesses and lockdown on travel led to worsened investor sentiment, Thursday saw circuit breakers once again in the US. Friday saw a reversal of Thursdays 9.3% drop as the US government stepped in with liquidity and economic measures. The defensive sectors utilities, real estate, consumer staples and healthcare lead year to date returns with tech the only cyclical sector, to outperform. The energy sector is close to a 50% fall. Financials and materials have also fallen sharply. Large cap and growth have outperformed value, as have companies with stronger balance sheets. .
The sell-off in the GCC has been a broad based, as the falling oil price impacts government revenues and private sector business. Banks have the largest weight in the indices and are seeing the impact of lower rates on their margins along with a slowdown of economic growth. Petrochemicals will see a reduction in revenue as product prices move in line with oil prices. Our preference remains for the larger, more diversified companies and banks with resilient cash flows and dividends.
What do we expect in the near term for markets? We have revised down our fair values for global indices, based on lower earnings growth and Price /Earning multiples. Valuations are well below long-term averages and our fair values indicate upside into end 2020, more so for EM/Asia. We would keep a watch on 3 issues to gauge the timing of the recovery. Firstly liquidity, as companies tap their credit lines (Boeing has completely drawn down on its $ 13 bn facility). Central banks around the world have started bond repurchase programs and lowered rates but that may not be enough. Monetary policy can provide short-term relief and improve sentiment but economic growth and the earnings outlook remain the main drivers for market performance. Secondly, we are uncertain about the severity of the impact on economic and earnings growth, as the timeline of business shutdowns cannot be accurately forecast. We expect financial stress not only in the energy sector but also the hotel, airline, cruise and other service sectors. Thirdly we see lower capex and expect an impact on industrials and hardware and also lower demand for discretionary items such as apparel, luxury goods and services. Markets are likely to stay volatile, as global coronavirus infection rates are yet to peak. We would recommend staying selective, defensive and diversified. Prefer the tech sector for growth and the healthcare and consumer sectors for their resilience through all cycles. We remain overweight the US in DM and Asia in EM, and overall close to neutrality on the asset class in our global asset allocation.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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