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Chief Investment Officer's team, 14.06.2020
We concluded our previous weekly publication by writing: “The rally is understandable, but it may not be sustainable: we won’t get incrementally good news every week and at some point investors’ positioning will reach neutrality”. The rally has been fueled by a combination of two factors: 1. a constant stream of incrementally good news and 2. A collectively defensive positioning from investors, pushed to buy before the quarter ends.
Last week, the Fed policy meeting didn’t add to an already formidable monetary support. More importantly, there was an increase in COVID-19 infections globally, from some US states to Beijing which shut-down a food market and residential districts. Global stocks lost 4.5% over the week, with a “black Thursday” in the US. Only the most defensive assets were sought-after. Brent crude closed just below $39.
We held our monthly tactical asset allocation committee last Tuesday, and took the decision to start reducing risk. We cut equities to underweight across profiles, including our long-term conviction Emerging Markets, now close to neutrality. We reduced risk but didn’t turn outright defensive: we added to High Yield bonds in our Moderate and Aggressive profiles. /p>
Our scenario hasn’t changed: a rise of infections is a natural consequence of restrictions being lifted and we don’t assume a second wave and renewed lockdowns on large scale. We reduced exposure because our scenario was, and still is, fully priced in by some markets, not because we think it’s not going to actually happen. We may find better opportunities to reenter markets further down the road. Stay safe.
The consensus interpretation for the tumbling of global markets last Thursday, which may have upended an impressive winning streak from the March lows, is that investors were spooked by the grim outlook painted by chair’s Powell and the resurgent virus cases in some reopening states in North America. Although plausible, the Fed made it clear from the very start that a V-shaped recovery is indeed far from its base-case, while the second wave in the United States is for now limited to some states and well within tolerance limits, considering the early reopening of the economy across the country. With global equities and DM credit having retraced 65 and 70 percent respectively of their year-to-date losses, it seems that some pretty quick economic gains are by now fully discounted, leaving little room for error and quite some leeway for jitters. Overall, encouraged as they have been by immense stimulus efforts to discount the perfect scenario, investors should be in for a spell of more muted gains in the next few months. The recent activity slump should be followed by impressive sequential growth rates, counterbalanced by rich valuations and unavoidable pandemic drags.
Some important studies are shedding more light on the possible shape of the recovery and its longer term implications. A recent paper by the National Bureau of Economic Research puts the jobs lost in the United States that will never be recovered at a stunning 42%, due to a so-called reallocation shock. In other words, while some sectors are plagued by the pandemic and seem to be set to shrink for good, for instance brick and mortar retailers and the hospitality industry, others are benefitting from new or accelerating trends, e.g. e-commerce platforms and in general both the technology and healthcare sectors. This cannot be simply labelled as creative destruction or cheered in the name of technological progress eventually benefitting the whole of society. A restructuring of the economy would imply a prolonged period of unemployment, hence a jobless recovery. This may be the reason why Jerome Powell said Wednesday that the economy “probably will need further support”, spurring Congress to adopt new measures. To be sure, at some point policies will have to be aimed at bolstering the shift of capital and labour to different and more productive uses, an exercise which is well different than just throwing money at the system.
Amidst lasting uncertainty and a favourable backdrop for renewed policy support, gold is again trading not far away from this year’s highs. With upward momentum in equities possibly stalling and the US dollar showing more than one sign of weakness, the likelihood of deeper retracements has substantially diminished, in spite of already pretty compressed real rates. Investors who still are underweight the yellow metal should think of it as a hedge partially substituting for government bonds currently offering no value and add to their gold allocation. Expectations of eventual new all-time highs are also predicated on the global economy not regaining pre-crisis levels anytime soon, never mind the endless stimulus.
Fixed Income Update
“Lower for longer” view got strong support from the FOMC announcement last Wednesday. Powell’s “… not thinking about thinking …” speech will be a part of the history books. With rates at rock bottom at least through 2022, the credit market will benefit from the improved liquidity without being unduly worried for a sharp rise in yields. Markets also anticipate FED to announce yield curve control measures in the front end of the yield curve to make sure the yields remain lower till there is a semblance of recovery in the economy.
While credit outperformed the S&P 500 last Thursday, most indices experienced their largest daily moves since mid-April. We think positioning and some discomfort with valuations given the speed of the rally played a bigger role. Spreads moved from recession territory into early-cycle territory in a little more than one month. Where to from here? We continue to expect a range-bound trajectory with a slightly positive asymmetry, given the prospect of rebounding sequential growth, declining new issue volumes, and continued policy support. This convinced us to take on more risk on our moderate and aggressive TAA profiles with increased allocation to High Yield which was funded by IG credit. Corporate IG credit is a crowded trade and the risk adjusted returns in HY at this point does look attractive.
ECB will offer cheap loans to the banks this Thursday under its sweetened TLTRO program in an effort to boost lending and further ease stress in Europe’s money markets. The take up is expected to be high from the banks. Europe’s primary market issuance crossed 1 Trillion Euros last Tuesday reaching the mile stone close to three months earlier than in 2019. BoE is expected to increase its bond-buying stimulus to 845 Bn Pounds according to some estimates.
Curious case of trades being cancelled in the Kuwait Stock exchange happened last Wednesday. The banking association of Kuwait came out with a communique mentioning that banks would stop dividends for 2020 that led to large drops in the share prices of the major banks for the country. However, the market regulator clarified the association doesn’t have the power to take such a decision followed by the banks clarifying that no such decision has been taken. We haven’t seen any large movements in the Bank Tier 1 securities from Kuwait. The Kuwaiti banks are well capitalized and we don’t see any large upcoming risks of coupon cancellation or call date extension of the perpetual securities.
DIB was the first non-sovereign UAE based entity to tap the markets post March. The bank sold $1 Bn USD denominated 5-year Senior Sukuk last week. Massive appetite from investors resulted in spreads tightening by 45 bps between IPTs and final pricing with Sukuks getting launched in line with secondary market without significant new issue concessions. DIB issuance was well bid with strong demand from local investors as evidenced by more than 50% allocation to the MENA region. Institutional investors dominated the order book with majority allocation to Fund Managers. This augurs well for other local corporates willing to come to the market.
With most global equity indices now trading above our 2020 year end fair values, up 40% from their March low before last week’s sell off, we have reduced our weight to equities bringing them in line with our strategic asset allocation model but with a slight underweight on developed markets and almost neutrality for emerging markets. Within DM we remain overweight the US, but lower the tilt bringing the Eurozone to an almost neutral positioning. In EM we have shifted the Asia OW to India.
What led to the unprecedented record rally for global equities with unemployment rising, demand falling and many industries still at low capacity? The recent pick-up in retail trading activity in US markets has led to short retail bursts of trading bankrupt companies such as Hertz but is not a contributor to the rally in any meaningful manner. The fear of missing out has led to small-account trade in the US, those with $2,000 or less in investment, now at 2.3% of the total, up from 1.5% at the beginning of 2020 (Goldman Sachs data). Sites with zero trading fees such as Robinhood have multiplied distinct users, with a waiting list to set up an account. However, this is not a retail rally and is driven by low interest rates for the conceivable future, central bank stimulus providing liquidity and hope on the economies opening. What’s performed is tech, healthcare and consumer stocks, with a bias to quality and growth.
What led to last week’s volatility? Though the Vix Index reached the mid 40’s it stays well below the high of 82 in March. US markets lost close to 5% taking them into negative territory once again for the year. Tech outperformed the broader market and the Nasdaq (+7.4%) is the only major index up in 2020 along with China which just about makes it (+0.2%). Fed remarks, COVID-19 fears, economic data and overbought conditions played their parts. After the recent rotation into value and cyclical sectors the week saw energy, financials and industrials fall c. 10%. The return to growth brought outperformance back to Tech and Comm. Services on a relative basis. The Fed's commitment to a zero interest-rate policy through 2022 may create a cap on value stocks' performance due to the impact on financials. The valuation discount in favour of banks can only close with the yield curve steepening. The bright spark last week was the GCC with the KSA and UAE markets both up, led by the Dubai Index. This is a direct result of improved sentiment as the economy opens up. Trading volumes were up too and real estate saw some bids.
We retain our preference for the US as it has a stronger central bank backstop over Europe with ECB’s balance sheet support. Style rotation has recently aided European equities which have outperformed US equities by 12% in USD, over the last 3 weeks. EM and Europe have gained recently with a rotation into value. However, while this rotation may run a bit longer and Eurozone may see some relative upside in the short term, the longer term EPS uptrend of the US vs Eurozone will dominate. US indices have greater weight to Tech which is a growth sector and the greater weights in EM and Europe are towards Value and Cyclicals. EM remains a strategic play with demographics in favour and we like India for its domestic oriented growth and expect a strong recovery once the lockdowns ease.
Written By:Maurice Gravier Chief Investment Officer, MauriceG@EmiratesNBD.com
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