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O c t o b e r 2 0 1 8
Q U A R T E R L Y I N V E S T M E N T V I E W
October 2018
The Quarterly Investment View | Page [email protected]
Contents
IntroductionThe downward pressure on emerging markets is not over yet Page 2
Market PerformanceKey indices, Commodities, Currencies and Rates Page 3
OverviewExecutive Summary, Market Outlook and Portfolio Positioning Page 4-6
What’s trending: smart beta ETFs Smart beta ETFs have exceeded the $800 billion assets milestone, reflecting the strong interest the strategies are enjoying Page 7
GCC Rising oil prices bring back governments’ comfort in spending Page 8
United StatesSolid growth outlook cools moderately Page 9
EurozoneGrowth to remain moderate Page 10
United KingdomThe clouds are not clear yet Page 11
JapanEmerging market turmoil is not good for Japan Page 12
ChinaDeleverage at any cost, almost Page 13
IndiaGrowth to pick up, but risks have risen Page 14
Emerging MarketsShaky grounds Page 15
AppendixForecast and valuations Page 16-19
Important Information Sources and Disclaimer Page 20
Luciano Jannelli, Ph.D., CFAHead Investment Strategy
+971 (0)2 696 [email protected]
Prerana SethFixed Income Strategist
+971 (0)2 696 2878
Mohammed Al HemeiriAnalyst
Tel: +971 (0)2 696 2236
Szymon Idzikowski, CFA
Fund Manager
Tel: +971 (0)2 2696 6412
Rahmatullah Khan
Fund Manager
Tel: +971 (0)2 6962 8431
October 2018
The Quarterly Investment View | Page [email protected]
Introduction
This summer emerging markets continued the downwardslide that had started at the beginning of the year. US equitiescontinued their upward movement. Most developed marketsare down for the year, with the exception of Japan which isslightly up. We recognize that the environment for equities isbecoming increasingly challenging. In fact, on June 24 we hadreduced our global equity stance from overweight to neutraland at the same time we had maintained our long-standingUS equity overweight and emerging markets underweightexposure. At this stage we still think that US equity marketshave some more upside. If anything, a temporary correctionof the US equity market in response to the adjustments in theyield curve could provide a buying opportunity, as we haveargued in our latest strategy note. At the same time we believethat emerging equity markets, as well as emerging bondmarkets, have not seen the bottom yet.
The main reason for continuous US equities’ resilience andemerging markets’ vulnerability is, in our view, the combinationof strong us economic growth and complacency by themarkets about the Federal Reserve’s determination to hikerates. The US economy is likely to continue to surprisepositively. Not only are financial conditions still relativelyaccommodating, but also tax cuts and discretionary spendingprograms continue to provide stimulus to the economy, as isderegulation. Perhaps most importantly, whilst householdbalance sheets look better than ten years ago, corporate debt,up from 2008, is still absolutely manageable. What does thatmean? It simply means that the US economy is in a relativelygood position to withstand some more upward pressure oninterest rates. At the same time though, we think that theremight be some surprises on the very extent of the upcominginterest rate hikes. As things stand now, the market is pricingin less than a percentage point of a rise in the Federal ReserveFunds’ rate, whilst the Federal Reserve itself penning in at leasthalf a percentage point more. A closer look at the labor marketand inflation indicators tells us that if there is going to be anysurprise to what the market is expecting, it is going to be tothe upside rather than to the downside.
It is this surprise potential that still spells trouble for emergingmarkets. Most emerging markets’ balance sheets have overthe last ten years gone exactly the opposite direction as thosein the US: emerging markets’ dollar denominated debt hasrisen as a share over GDP, rather than fallen. A stronger USdollar, because of still higher US interest rates, is likely goingto increase that debt burden, which will be detrimental forboth emerging equity and emerging bond markets.
You might ask yourself, of course, if this bad news is alreadypriced into the markets. Perhaps emerging markets are, unlikethe Federal Reserve Futures markets, already discounting amore aggressive stance by the Federal Reserve? A stronger USdollar is already part of the valuations? It is true that on the
equity side we see many emerging markets that are trading ata valuation with respect to the S&P 500 which is significantlylower than their long-term average discount. In our view,however, such valuations should be taken with a grain of salt.What has really driven emerging equity market valuations overthe last years is currency and interest rate movements. It isdifficult to argue that the exchange rates and the bond spreadsof emerging markets already discount the worse scenario. Onaverage these indicators don’t even discount a scenario thatis significantly worse than it was a year ago. Brazil, whichcurrently has a real effective exchange rate that is perfectly inline with its long-term average, is a case in point. Whilst itsexternal US dollar debt appears manageable at 30% of GDP,and has actually stabilized over the last three years, itsdomestic government debt has sky-rocketed from 60% toalmost 90% over the same period. The country is running fiscalaccount deficits to the tune of 8% of GDP. To us it would seemthat its soon-to-be-elected populist president will find it hardto resist the temptation to monetize that growing debt. And,with the exchange rate not particularly cheap, the downsidefor the Brazilian real would be still considerable.
Of course, at some point the situation in emerging marketsshould stabilize. We would assume that to happen when astronger US dollar, and continuing US economic strength, willstart contributing to an improvement of the business cycle inEurope and Japan. Sometime in 2019 we will see risingexpectations of rate hikes by the ECB. This should be thetrigger for the US dollar to stabilize and risk asset markets torotate away from the US into Europe and emerging markets.
For now, there is one more reason for emerging markets arelikely to remain under pressure. It’s called China. Actually, it’scalled China and trade. In 2015 China came to the help ofemerging markets by injecting stimulus to its economy, andby allowing its currency to depreciate only gradually. In 2017China provided further support by actually allowing theRenminbi to appreciate. China is now moving in a totallydifferent direction. As we explain in our China page, theauthorities are now totally dedicated to deleveraging. At thesame time, they are quite happy to allow the Renminbi toresume its downward trajectory. It should be reminded, tradedisruptions are a concern for emerging markets (and forEurope). They are less so for the United States. By attackingChina on trade the US administration has however given theChinese authorities an excuse to insist on deleveraging. Theresulting hardship can now easily be blamed on an externalscapegoat. Its name is Trump. And to the extent that some ofthe hardship must be mitigated, it will happen through furtherrenminbi depreciation. For the moment, this is still bad newsfor emerging markets.
Luciano Jannelli, Ph.D., CFAHead Investment Strategy
The downward pressure on emerging markets is not over yet
October 2018
The Quarterly Investment View | Page [email protected]
Market Performance
Index Snapshot (World Indices)
S&P 500 2,809.9 7.2 9.0
Dow Jones 25,798.4 9.0 7.0
Nasdaq 7,645.5 7.1 16.6
DAX 11,819.0 -0.5 -5.2
Nikkei 225 22,841.1 8.1 6.0
FTSE 100 7,070.6 -1.7 -2.3
Sensex 35,261.1 2.3 6.4
Hang Seng 25,462.3 -4.0 -7.1
Regional Markets (Sunday to Thursday)
ADX 4,910.8 8.2 12.2
DFM 2,743.2 0.5 -15.9
Tadawul 7,674.9 -3.8 10.6
DSM 10,117.4 8.7 15.1
MSM30 4,459.85 -0.6 -10.0
BHSE 1,310.8 2.1 2.5
KWSE 5,006.6 4.9 6.2
MSCI
MSCI World 2,091.2 4.5 3.8
MSCI EM 984.7 -2.0 -9.5
Global Commodities
ICE Brent USD/bbl 81.6 4.1 23.7
Nymex WTI USD/bbl 72.07 -1.2 21.2
OPEC Baskt USD/bbl 79.0 7.7 26.4
Gold 100 oz USD/t oz 1,222.5 -4.8 -8.5
Platinum USD/t oz 838.3 -4.4 -12.1
Copper USD/MT 6202 -7.0 -13.7
Alluminium 2,039 -5.0 -9.0
Currencies
EUR 1.1558 -0.7 -3.3
GBP 1.3168 -1.3 -3.6
JPY 112.29 2.7 0.9
CHF 0.9913 -0.9 0.8
Rates
USD Libor 3m 2.4488 2.7 41.6
USD Libor 12m 2.9668 5.6 38.5
UAE Eibor 3m 2.6775 0.6 36.0
UAE Eibor 12m 3.4628 1.0 28.8
US 3m Bills 2.2943 -42.0 59.7
US 10yr Treasury 3.1615 7.0 27.3
Index Latest Quarterly YTD (30 Sep Change % Change %closing) (Q3 2018) (30 Sep)
Commodity Latest Quarterly YTD (30 Sep Change % Change %closing) (Q3 2018) (30 Sep)
Key indices, Commodities, Currencies and Rates
Past quarter global markets’ performance
October 2018
The Quarterly Investment View | Page [email protected]
Overview
A very strong US economy is providing the backdrop for acontinuous upward revision of the Federal Funds rates. Aslong as we see no clear indications of the ECB alsostarting to hike interest rates, upward pressure on the USdollar is likely to continue. This means continuing pressureon emerging markets, which have bond and currencyvaluations that have not yet been seriously dented by theturmoil of the past summer.
US radical global policy rethink is jeopardizing free tradeacross the world, and fiscal prudence in developedmarkets. We reiterate our stance that these tensions arevery unlikely to go away in 2018. Even if a full blown globaltrade war seems still unlikely, the fear alone of it is likelyto keep markets volatile, with recurring downwardpressure. It will take a while, before they will feel confidentto climb once more the proverbial “wall of fear”.
We had been long surprised by the resilience of emergingmarkets. The end of the US dollar weakness, which hadcharacterized most of 2017, together with the trade warconcerns are now finally exercising their toll on emergingmarkets. The renewed strength in the US dollar, in fact,implicates – together with rising US interest rates – asignificant deterioration in the financial conditions ofemerging markets, in particular those with high US dollardebt levels. The stronger greenback is also not favorablefor commodities, of which some emerging markets aremajor exporters. Finally, global trade concerns impactemerging markets more than developed economies.
Federal Reserve tightening combined with some signs ofgrowth cooling have determined a further flattening of thecurve. Whilst continuing flattening is on the cards, wewould exclude a significant inversion of the US yield curve,as it seems more likely that the Federal Reserve wouldpose hiking towards the end of the year, especially if theUS dollar further strengthens. On the upside, we wouldnot exclude a temporary break-out of 10 year yieldstowards 3.5%.
China is now dedicated to deleveraging. It also feels nolonger committed to prevent its currency fromdepreciating. These are important and radical changes inthe country’s long-standing policy direction. They also addto trouble for emerging markets which at previous timesof global downturn – specifically in 2008 and in 2015 –could at least count on China’s picking up the baton ofstimulus injection. This time China policy is truly different,and we steer clear from those markets that are mostdependent on China.
The key risk to the global outlook remains a further hike inthe oil price as a result of tensions in the Middle East. Thiswould be particularly harmful for emerging markets, andto some extent for Europe too. It would be moremanageable for the United States.
Executive Summary
October 2018
The Quarterly Investment View | Page [email protected]
Overview
Asset Allocation
Equities Neutral Global growth has cooled considerably and has become lesssynchronous across regions. With monetary policy turning lessaccommodative globally, non-restrictive fiscal policy is still creatingequity opportunities, in particular in the United States.
Fixed Income Underweight Whilst high quality government paper might continuing doing well, wesee risks for further spread widening and higher yields on the short endof the curve.
Alternatives Neutral We maintain our exposure to hedge fund strategies that are lesscorrelated to the market, as well as gold and treasuries as an insuranceagainst risk-off moods.
Fixed Income
Duration Barbell approach A barbell approach combining long-term Treasuries and short-termmoney market paper seems most sensitive.
Advanced economycorporate bonds
Underweight Spreads remain unattractive.
EM hard currency bonds
Underweight Hard-currency bonds preferred over local currency bonds as monetarypolicy rhetoric will become more hawkish and emerging currenciesremain under pressure due to broad US dollar strength and tighteningUS financial conditions. We only prefer GCC sovereign dollar bonds.
US Treasuries Overweight duration Any rise in long-term bond yields will be limited compared to short-termbond yields with increasing signs of global slowdown and Fed pressingon more rate hikes this year.
US Credit Underweight Valuations remain expensive. High yield spread compression is not likelywith flattening US yield curve.
Euro Credit Underweight Valuations are more expensive than US credit. Investment grade andHigh yield bonds are trading at yield level lower than some of thesovereign global bonds (safe-haven assets).
GCC Overweight GCC credit spreads yet to fully reflect the recent rise in oil prices.Valuations appear attractive.
India Neutral Rising inflation pressures and front-loaded RBI rate hikes to check thedrop in local-currency sovereign bond yield.
Market Outlook and Portfolio Positioning
October 2018
The Quarterly Investment View | Page [email protected]
Overview
Market Outlook and Portfolio Positioning
Equity Markets
US Overweight Cautiously optimistic as the equity benchmarks constantly scale recordhighs. Earnings growth underpinned by tax reforms and growthpremium associated with positive decoupling from rest of the world.We acknowledge expensive valuations and strong investor positioning.
Energy and Commodity Prices
Energy Neutral OPEC decisions to increase output are likely to have a limited impacton the oil price, given the reduction in output by Venezuela and Iran. Ifanything we would expect the market share of the GCC suppliers torise. Also, the recent increase in tensions between the US and Iran,might well lead to more turmoil in the more troubled parts of the region,specifically Iraq, and thus continue to put upward pressure on the price.
Currencies
EUR Moderate downwardpressure
Trade war concerns and emerging market woes are also more likely tobenefit the US dollar, the Japanese yen, and the Swiss franc, rather thanthe euro. As such we would expect the euro to continue to movesideways with a downward bias, at least until ECB starts thinking abouthiking rates, which is unlikely before 2019.
GBP Some furthercorrections expected
The Pound Sterling is to follow the euro rather than the US dollar. Somemore uncertainty-induced downward pressure on the currency cannotbe excluded, in the run-up to the Brexit deadline for a deal with the EU.
JPY Moderate downwardpressure
The combination of moderate Fed tightening and BoJ yield curvetargeting would normally put continuing downward pressure on the yen.The risk is that further global risk-on concerns would undo that outlook.
Industrial Metals Underweight China tightening will put downward pressure on industrial metals.
Precious Metals Overweight The US “reflation” theme is bad for precious metals. Yet, bouts of risk-off jitters are still very likely over the years to come. Thus we keep themas a “market insurance” risk hedges in our portfolios.
Eurozone Neutral Political risks, Brexit, anaemic earnings growth are key downside risks.Strong cyclicality and light investor positioning stop us from goingunderweight.
Japan Neutral Tail winds come in the form of strong domestics. Tighter labor marketand relatively easier monetary policy are likely to help the domesticsectors. Headwinds could arise from a reversal in yen weakness.
Emerging Markets Underweight For the moment the downward pressure is likely to continue with tradewar concerns and weakening of domestic conditions likely to dominate.Overweight India and Underweight China. We also like GCC equities,and in particular Saudi Arabia. Elsewhere, there could be tacticalopportunities emerging, but it will be key to remain selective.
United Kingdom Neutral No-deal Brexit is a potential risk. However, the equity benchmarks arecommodity-heavy and a still weaker currency because of Brexit wouldbe a positive. Valuations are neither cheap nor expensive.
October 2018
The Quarterly Investment View | Page [email protected]
What's trending: smart beta ETFs
Smart beta ETFs have exceeded the $800 billion assetsmilestone, reflecting the strong interest the strategies areenjoying.
What are smart beta ETFs? Smart beta ETFs just like any other ETFs (exchange-tradedfunds) are securities traded on a stock exchange that trackindexes. The difference between them and traditional plain-vanilla ETFs is the type of indexes they track. Traditional indexestend to be market capitalization weighted. Smart beta ETFs onthe other hand track factor-based indexes, for exampleindexes focused on cheaper stocks, stocks with higherdividend payouts, or stocks with lower volatility.
Consider the S&P 500 index. It is a standard marketcapitalization weighted index. The S&P500 Growth indexwould be an example of a factor-based index; it drawsconstituents from the parent index, the S&P 500, but adds astyle tilt, screening stocks using sales growth, the ratio ofearnings change to price, and momentum factors. While itsconstituents represent different sectors, e.g. Apple from thetechnology sector, or Amazon from the consumer cyclicals,they all share ‘growth’ characteristics as defined above. An ETFtracking this index would be considered a smart beta ETF.
Cost efficient hybridsFor once, smart beta ETFs have gained popularity as a panaceato often criticized market capitalization weighted investmentapproach, which overweight large cap names in equityindexes and debt-laden issuers in fixed- income indexes.Factor investing provides also the cleanest access for investorsseeking access to a subset of a broader index. Given the latterapproach has traditionally been employed by activeinvestment managers, smart beta ETFs are often consideredhybrid solutions, falling between active funds and traditionalplain-vanilla ETFs.
The smart beta ETFs’ growth has also coincided withincreasing scrutiny around high fees charged by activemanagers.
In the US alone, the market has grown to over 700 billion USDsince the launch of the first smart beta ETF in 2003, making itby far the largest smart beta ETF market in the word. But othermarkets are catching up. According to Morningstar, between2016 and 2017 Europe has seen 38% growth and Asia-Pacifica whooping 61% growth, taking AUM of smart beta ETFsglobally to nearly $840 billion by 31 August 2018.
The two players taking the lion-share of the market are iSharesand Vanguard, with the former taking 38.5% of the marketshare and the latter nearly 23%. The third largest providerPowerShares takes only 6.8% of the market share.
In terms of strategies, while historically the bulk of money hasgone to three single-factor products: value, dividend and
growth, multi-factor products have been catching up. For onething, they address the cyclicality problem of single-factorstrategies, but they also allow investors to follow a mix offactors they believe position them better toward achievingtheir objectives. An example of such strategy would includehigh-dividend, low-volatility products. For example, the S&P500 High-Dividend Low-Volatility ETFs track a dividend-yield-weighted index comprising the 50 least- volatile nameschosen from a shortlist of the S&P 500's 75 highest- dividend-yielding securities.
No such thing as a free lunchSmart beta ETFs tend to invest in sub-set(s) of broader indexes:they are more concentrated, carry higher security specific risksand are more likely to suffer from a crowding effect. Whilesmart beta ETFs are cheaper than active funds, they tend tobe more expensive than traditional plain- vanilla ETFs. Also alot of factor-based strategies have been introduced throughback-testing and may be unable to replicate hypotheticalresults in real life market conditions.
How to go for itOur Investment Advisory team has identified a number ofsmart beta ETFs, which are also in line with our house view.If this is of interest to you, please reach out to yourrelationship manager.
Dividend 25%
Other 21%
Growth 20%
Value 18%
Multi-Factor 10%
Minimum Volatility 6%
Smart Beta Strategies Breakdown
Source: Morningstar Direct. Data as of 31.08.2018
Global Smart-Beta ETF Asset Growth
USD
Bill
ion
Sep
-20
03
Sep
-20
04
Sep
-20
05
Sep
-20
06
Sep
-20
07
Sep
-20
08
Sep
-20
09
Sep
-20
10
Sep
-20
11
Sep
-20
12
Sep
-20
13
Sep
-20
14
Sep
-20
15
Sep
-20
16
Sep
-20
17
Sep
-20
18
0
100
200300
400
500600
700
800900
Source: Morningstar Direct. Data as of 31.08.2018
October 2018
The Quarterly Investment View | Page [email protected]
GCC
Oil price recovery looks sustainable The dynamics of the oil market once again seems to have turnedinto the producers’ favour as the recovery in the price of thecommodity has been sharper than analysts expected. Strongdemand growth, at more than 5 million barrels a day since 2014,sharp cuts in investments during the low oil price period, as wellas supply disruptions (mainly Venezuela and Iran) have supportedthe price rally. These three broad factors remain in place as totaldemand for oil is expected to increase another 1.4 million barrelsa day into 2019, thereby exceeding, according to the IEA, 100million barrels a day. According to IEA, demand for oil hassurpassed the total supply in the last six quarters, reflective ofdeclining crude oil inventory.
Current oil prices above fiscal breakeven levels With the oil price recovery, most GCC countries seem to havereached to a comfortable fiscal situation where governmentbudgets are soon expected to be in surplus. The average Brentprice in the first three quarters of 2018 was 73 US dollars per barrelwhich is significantly above the required level for balancinggovernment budgets in the UAE (62), Kuwait (47) and Qatar (also47). At the same time, it is not far from the levels required tobalance the budget in Saudi Arabia (70) and Oman (USD76.3),according to the IMF. Decline in the fiscal breakeven oil prices hasnot come at the expense of spending cuts this year, rather it hascome on the back of governments’ reforms that has boosted theirnon-oil revenues (implementation of VAT, rationalizing fuel andenergy subsidies, increasing fees for most government services).Saudi Arabia’s fiscal spending is expected to grow by 10% this year,and then again by 7% in 2019, taking total spending in excess ofSAR 1 trillion next year. Pressure on foreign reserves has alsoabated as Saudi Arabia added SAR 84 billion in its foreign reserveassets from the lows in February this year.
Reforms continue beyond managing fiscal balance Reforms in the region started with managing the fiscal balance inthe wake of lower oil prices two years ago, and have now movedto social and structural labour reforms. In Saudi Arabia labourreform has received renewed impetus to replace expat workerswith local workers which is now leading to exodus of expats andtheir families. This has been affecting consumption negatively inthe recent past. However, we believe that as local workers withrelatively higher salary and higher propensity to spend adjust intheir new jobs, consumption is likely to recover sooner rather thanlater. Social reforms such as women driving is likely to facilitatethe labour reform in the next few years as more women will beable to drive to work. On the other hand, reforms in the UAE arefocused on bringing in more expats and incentivising them to stayhere for longer. The recent announcement of retiree visa alongwith the liberalization in business environment and additionalspending of 50 billion Emirati Dirhams in Abu Dhabi over the nextthree years go in the similar direction.
Attractive valuations underpin GCC bond marketsWhile some pressure of external headwinds is evident, GCCsovereign bond yields have remained anchored given their low-correlation characteristics. In addition, jump in oil prices, lowergovernment bond issuance and better economic prospects haveprovided support to the GCC sovereign bond markets. Weakereconomies like Bahrain and Oman have outperformed the most.Bahrain, in particular, has fully recovered its previous losses with
the sentiment boosted by the confirmation of financial supportextended by its rich neighbours.
Overall, we believe that bond market sentiment should remainsanguine given the backdrop of higher oil prices. In addition, theGCC inclusion in JP Morgan EM bond index will further boostappetite. The inclusion in the bond index is likely to improve thevisibility of GCC bond markets and result in index-related inflows,leading to tighter spreads Separately, GCC government’sproactive stance in boosting economic outlook and increasingspending at a time when oil prices are moving higher are alsopositives.
In spite of the recent EM sell-off, valuations of GCC bond marketsare still attractive. Lower-rated sovereigns including Bahrain andOman, even after rallying recently, are trading cheap versus someof their EM peers. As such, with other EM more susceptible toexternal headwinds, GCC bond markets is an attractiveproposition given its low-correlation characteristics.
Regional equity markets defy the EM routRegional equity markets have avoided the negative sentimentsprevailing in the Emerging Markets as most regional equity indexesare up on a year to date basis, with the exception of DFM and MSMindexes. The rise in crude oil prices not only bodes well for theregional equity markets in general but specifically for thepetrochemical sector in Saudi Arabia as prices of petrochemicalshave a high positive correlation with the crude oil price. The sectorconstitutes almost one-fourth of the Tadawul marketcapitalization. Another sector that we believe is expected tobenefit from the early phase of the business cycle turnaround isthe banking sector. Overall the Saudi equity market is poised toreceive global capital flows starting next year owing to its inclusionin the MSCI and the FTSE Emerging Market indexes. Kuwait equitymarket is likely to remain the investors’ favourite on the back ofstrong government infrastructure spending and potential inclusioninto MSCI Emerging Markets index next year. UAE equity markets,especially the real estate sector has been under pressure due to asoft residential market. However, the sector offers one of thecheapest valuations globally.
Overall, the UAE equity market, part of the Emerging Marketsgroup, has one of the lowest valuations.
Rising oil prices bring back governments’ comfort in spending
Source: Bloomberg
Bahrain has reversed its losses
EM
EM LATAM
EM EMEA
EM Asia
Bahrain
Kuwait
Qatar
Saudi Arabia
UAE
-4 -3 -2 -1 0 1 2 3
-2.23
-3.33
-2.18
-1.27
2.64
-0.36
1.49
-0.36
0.12
Bloomberg Barclays Total Return (Year-to-date, %)
October 2018
The Quarterly Investment View | Page [email protected]
United States
Some cooling is inevitable, and with it long-term yields will stabilizeWhilst the US economy is by and large steaming on, some coolingshould occur as credit conditions tighten marginally, also as aconsequence of the stronger greenback. This should also lead tosome flattening of the yield curve as treasuries appear at this stageoversold. Having said so, the general backdrop of increased deficitspending is and the tax reductions are likely to keep the overalleconomy in expansionary territory and the unemployment level,already at a historically low level, might well end up below 3.5%of the total workforce.
Balance sheets are solid and policies more stable than you thinkBalance sheets in the US are today more stable than they were in2008. True, we have seen a rise in corporate debt, but that rise isabsolutely manageable. In addition, and in spite of the increasedpolitical polarization the country is facing, economic policy is infact stable. Whatever happens in the upcoming NovemberMidterm elections, the current profligate fiscal policy, based ontax cuts for the rich and increased spending across the board, isunlikely going to be undone. The rise in rates, as well as in thevalue of the US dollar, should therefore not have an enormousimpact on either consumer spending or investment spending.This environment remains overwhelmingly favorable tocontinuing growth.
The key concern in our view remains a higher than expected rise inthe oil prices. Such rise might impact consumer confidence anddeter investment growth. Even in such an eventuality though, theUS would likely be less affected than other economies. It would beless affected than most other developed markets because it importsless oil. It would be less impacted than emerging markets becauseenergy is simply a smaller size of consumer spending. Having saidso, the oil price is currently probably the single biggest risk for theUS business cycle and even more so for the global economy.
Fixed income: Curve to flatten The 10-year US Treasury yields have edged higher in reaction tostrong economic data, touching the highest level since 2011. Thesell-off in long-end US treasuries has resulted in steepening of thebond yield curve. The main trigger of the sell-off was the upbeatISM non-manufacturing release, followed with the job reportsindicating unemployment rate declining to lowest level sinceNixon era. However, the sell-off appears exaggerated particularlypost the “mixed” jobs report of September. Wage gains asindicated by the change in average hourly earnings has not seenany upward surprise. The only reason of the steepening of thecurve could be attributed to the recession risks being pushed backgiven the backdrop of strong US economic data. We believe that,barring these bouts of jump in long-end bond yields, the 10-yearUS treasury yields are likely to settle around 3%. At current levelswhich are above the indicated long-term Fed median rate, thelong-end US treasury yields are pricing in a possibility that the Fedcould turn more aggressive than its current indicated rate hiketrajectory. We believe that the Fed will stick to its current dot plotunless economic data showing signs of weakness going into 2019.The Treasury yield curve will continue to see more flattening
pressures. The markets are underpricing the 2019 and 2020 Fedrate hikes, signaling more volatility in the short-end of the curve.On the other hand, long-term bond rates (US 5yr5yr forward swap)are fulling pricing in the Fed's current indicated long-term medianFed rate. Separately, inflation expectations are likely to remainstable as stronger dollar and Fed tightening stance will keep pricepressures anchored.
US credit spreads tightened during the third quarter with signs offurther improvement in US growth outlook and strong Q2 USearnings season. In fact, US credit was largely immune to theAugust sell-off as well. While the high yield sector continued tooutperform in the third quarter and also year-to-date basis, theinvestment grade sector managed to reverse its previous losses.Lower corporate issuance coupled with the backdrop of robusteconomic growth and US corporate profitability has contributedto recent performance of the US IG sector. With the US economygearing up to grow at almost 3% this year and low corporatedefault rates could support the US credit sector. Yet, valuationscontinue to remain stretched, particularly in the US high yieldsegment. In addition, the flattening yield curve environment doesnot bode well for performance of the US high yield sector. Weremain underweight on US credit.
US equities: party before the hangover – remain overweightUS equity performance has been strong with the market indicesconstantly scaling new highs - this has been, in our view,underpinned by strong earnings growth and up-trending totalreturns to shareholders. Also, the US economy has positivelydecoupled from the rest of the world and this is giving the assetclass a positive growth premium. Make no mistake – downsiderisks are building, though they may take time to materialize.Weaker earnings growth and associated disappointments aremajor risks and they are likely to come through when the tailwinds associated with tax reforms fade. Valuations are expensiveand investor positioning is high too. Also, so far, the tradeskirmishes have had a limited impact on US equities but this couldchange looking ahead.
Overall, from an equity strategy perspective, we remain cautiouslyoptimistic on US equities. Our overweight on US equities alsoreflects the lack of strong plausible alternatives.
Solid growth outlook cools moderately
Source: Bloomberg
Markets behind the Fed curve
Spread between eurodollar 2018-2019Spread between eurodollar 2019-2020
-0.1
0.0
0.1
0.2
0.3
0.4
0.5
0.6
Jan-18
Feb
-18
Mar-18
Ap
r-18
May-18
Jun
-18
Jul-18
Au
g-18
Sep
-18
Oct-18
October 2018
The Quarterly Investment View | Page [email protected]
Eurozone
For the moment Europe remains hostage of Asia slowdown andtrade concernsEurope, much more than the United States, remains hostage oftrade concerns and the Asia slowdown caused by Chinatightening. The European Union has in fact the largest currentaccount surplus in the world, and its economies and companiesare among the most exposed to China and Asia. Whilst our callfor weaker growth in Europe was originally mainly driven by Chinastimulus tightening and the 2017 strengthening of the euro, it isnow being additionally supported by concerns about global trade.The bad news is that Europe’s growth engine Germany has alwaysbeen particularly sensitive to the Chinese cycle because of itssignificant exports to that country. The good news is that overallthe euro is strong compared to where it was about a year ago, buthistorically still quite competitive.
Even if Europe’s growth context has deteriorated since 2018, andwe think that growth will remain moderate, a full blown recessionseems unlikely. For one thing the real effective exchange rate isfrom an historical perspective not overvalued, and the recentappreciation of the US dollar is further helping. The ECB,furthermore, is, yes, going to normalize its policy but will do so in agradual manner. Finally, whilst the risks of trade confrontation haverisen substantially, it would be still most realistic to bet on a positivesolution for Europe. For one thing, the United States might at timesthreaten Europe too, but it has an inherent interest in keepingEurope on its side as it renegotiates its relationship with China, itsmain antagonist. The European Union has also just concluded freetrade agreements with Canada and Japan. Nonetheless, the riskshave been rising recently and might remain high until later this year,as Trump is likely to maintain an aggressive stance until theNovember US Midterm elections. Critically, there is also the risk thatby October there might be no deal with the UK on Brexit.
Political risks are here to stayItaly’s populist government has surprised expectations and openlyengaged in actions that defy EU fiscal budget rules. By significantlyaltering the country’s fiscal stance, it has put bond markets on thealert, triggering a rise in spreads. Italy’s equity market has tumbledas a result. Going forward political risks are on the rise in Europe.Italy’s electorate feels, rightly or wrongly, that Europe is nothelping the country enough on handling immigration. At the same
time, Italy’s northern neighbours are increasingly unwilling to takeon more immigrants.
Whilst we believe that the situation is for now manageable, in thesense that Italy is likely not to push for a major crisis, at some pointthis situation might change if and when a recession would hitEurope and the country would not be willing to undertake fiscalpolicies compatible with the European Central Bank framework.It is however also critical to stress that Italy troubles are this timeless likely to trigger contagion to other periphery countries, suchas Spain, Italy or Greece. This is simply so because in thosecountries public opinion is less averse to austerity and, unlike thesituation in 2012, the ECB now has the tools to immediately helpcountries willing to abide to austerity policies. This also weakensItaly’s bargaining position as Mr. Draghi would not be able to enactpolicies that support Italy alone, in the absence of the country’scommitment to fiscally sound policies.
Bunds to benefit from dovish ECBEurozone core bond yields have moved higher, mostly trackingthe recent back-up in US treasury yield. However, the sell-off inUS treasury yields has been excessive and a consolidation, henceis likely in German bund yields. Separately, risk-off sentiment alongwith ongoing uncertainty over Italy’s expansionary budget plansshould drive demand for safe-haven assets including Germanbunds. While the ECB advocated a hawkish stance at itsSeptember meeting, it is unlikely to rush in moving to a lessaccommodative stance. Economic indicators out of Europecontinue to remain disappointing with lower than expected coreinflation numbers and PMI releases. As such, we believe that theabove-mentioned factors will keep the bund yields consolidated.
Similar to US credit, European credit spreads have tightenedduring the third quarter, with the high yield sector outperformingthe investment grade counterpart. This strong performance ofEuropean credit is difficult to sustain. Unlike US, growth outlookin the Eurozone has been underwhelming. PMI indicatorscontinue to show signs of slowdown in growth. Separately,Italian uncertainty has increased and is likely to further weigh onthe sentiment. Overall, we remain underweight on Europeancredit and expect the European credit to underperform its UScounterpart.
Eurozone equities: waiting for Godot – remain neutral Eurozone equities are more cyclical when compared to the USand are likely to rebound quite aggressively when they do. Also,cheap valuations and light positioning are supportive too. So nowthe key question is “What factors are likely to cause a rebound?”.Some endogenous and some exogenous, we believe. Fadingpolitical risks, an uptick in economic activity and resultant earningsrecovery are the endogenous ones. On the exogenous side,Europe being the most open region globally in terms of trade, islikely to benefit disproportionally from an improvement in thenews flow relating to trade wars. Risks present themselves in theform of Brexit and associated currency moves. Overall, while thecase for Eurozone equities is clear, we think timing becomes key.For now, we stay neutral.
Growth to remain moderate
Source: Bloomberg
EUR Real e�ective exchange rate Long-term average
Euro is not overvalued
80
85
90
95
100
105
110
115
Oct-9
3
Oct-9
5
Oct-9
7
Oct-9
9
Oct-0
1
Oct-0
3
Oct-0
5
Oct-0
7
Oct-0
9
Oct-11
Oct-13
Oct-15
Oct-17
Oct-18
October 2018
The Quarterly Investment View | Page [email protected]
United Kingdom
Economy stabilisingEconomic indicators showed signs of improvement in the UKeconomy during summer months. GDP in the second quartergrew by 0.4% from the previous quarter, mainly led by strongconsumption demand as hot weather and World Cup mayhave boosted consumer spending. Labour market alsostrengthened with unemployment rate dropping to the lowestlevel in almost 40-years while wage growth also rose at adecent pace. At the same time, more frequent core-inflationfigures show that price pressures may have stabilized.
However, it may be difficult for the UK economy to sustainthe same rate of growth given the global slowdown in growthand increased Brexit-related volatility. Economic activity mayhave slowed in August with industrial output having declined.Service PMI indicators also indicate that the consumptiondemand likely to have flat-lined in the third quarter. Goingforward, we expect that economic growth is likely to besteady, yet downside risks still remain given the Brexit relatedvolatility.
Brexit uncertainty lingers Brexit continues to remain the biggest risk and the mostprobable drag on economic growth. Increased possibility ofthe EU and the UK reaching an agreement were dashed withthe latest reports indicating that the negotiations betweenthem stalled again. While there has been decent progress inmany issues, the key issue remains on the open border withthe Northern Island. We could particularly see increasedvolatility in the UK markets if the possibility of a “no deal”increases significantly. The Bank of England has highlightedthat the consequences of a no deal will severely impact thecorporates and the property prices.
While we believe that the eventually both the sides will comeon terms, however, this will not be any time before Decemberand could well be extended even onto next year. Lack ofclarity until then and increased Brexit uncertainty will continueto weigh on the markets and the business sentiment.
Gilts: remain bullish Gilts yields rose in September, tracking the jump in developedmarket bond yields and breaking their tight trading rangewhich lasted during most of the summer. In addition to theglobal bonds sell-off, gilts have come under pressure onexpectations of Brexit agreement being finalized. Separately,markets are also anticipating that the Bank of England maybecome more aggressive in raising policy rates, in case a"softbrexit" scenario materializes. However, the likelihood of anaggressive monetary policy is low. Even though economicindicators are showings signs of rebound in growth, UKeconomy is still likely to face many risks with the Brexituncertainty weighing on the business sentiment. In addition,the recent improvement in economic growth has been in linewith central bank growth estimates. The UK economy willhave to witness a substantial jump in growth rate (way above
the BoE estimates) for the central bank to turn aggressive intightening the monetary policy.
As such, we believe there are still many downside risks togrowth even if the Brexit deal is finalized, meaning that theBank of England will remain in a “wait and watch” mode for awhile. Thus, the long-end Gilt yields will remain anchored aseconomic outlook is unlikely to undergo a massive expansion.We hold a positive stance on the gilt market.
UK equities: a double-edged sword – remain neutralBrexit risks loom, especially with the chances of “no-deal”being increasingly talked about. Whilst the Brexit is likely toimpact the businesses fundamentally, the key disruption islikely to come in the form of a weaker currency which couldalso impact in translation for USD investors. Weaker GBP is anequity positive given the benchmark index composition –loaded with Global commodity and Global consumer stocks.Commodities equities – especially the oil counters – have heldup relatively well over the recent months. Consumption seemsto be relatively strong across regions. Valuations are neithercheap nor expensive when compared to history.
The clouds are not clear yet
Source: Bloomberg
Bond yields sold-o� on soft Brexit expectations
10yr UK gilt yield (RHS) GBP Currency (LHS)
Jan-18
Feb
-18
Mar-18
Ap
r-18
May-18
Jun
-18
Jul-18
Sep
-18
Oct-18
1.25
1.30
1.35
1.40
1.45
1.0
1.2
1.4
1.6
1.8
October 2018
The Quarterly Investment View | Page [email protected]
Japan
Bank of Japan has suddenly more reasons to remain cautiousPrime Minster Abe has been very active recently, regaining theparty’s leadership and looking for practical solutions andcompromised with Mr. Trump on trade. His hold on powerremains very solid and he is still dedicated to push throughconstitutional reforms.
At any rate, the key concerns for Japan regard much morewhat is happening in Asia at large, than what is happening inJapan itself. The US seems much more willing to strike a tradedeal with Japan than with any other of its allies. But theuncertainty created by the slowdown in China, potentially tobe aggravated by US trade tariffs, is now being compoundedby additional turmoil in emerging markets. Such developmentsalways trigger upward pressure on the Japanese yen, and thushave the potential of compromising the accommodatingstance of the Bank of Japan. Thin turn might then lead to lesswage growth, and less consumer price inflation.
In this sense, the Japanese economy, in spite of – or perhapsprecisely because of – its global position as a net creditor – ismore vulnerable to any global downturn than most otheradvanced economies. Perhaps surprisingly in a context ofemerging markets’ weakness, the yen has actually weakenedconsiderably in 2018. Critically, as the chart below shows, Yenweakness is always a boon for equity prices.
Can monetary policy continue to deliver amidst a continuingemerging markets’ correctionThe fact that the yen has depreciated in the presence of anemerging equity market correction is perhaps a bit surprising.What to make of it. In our view it probably means that thecorrection in emerging equity markets has not yet morphedinto a general emerging markets crisis, affecting also bondyields and currencies, at least not at a general level. Indeed, itwould be the unwinding of the carry trades in the emergingfixed income space that would trigger an appreciation of theyen. Another explanation would be the fact that monetarypolicy in Japan, specifically its continuing extra-ordinarymonetary accommodation, has become more effective when
it comes to impacting the exchange rate. We doubt that thisis the case.
Indeed, whilst it is true that the Bank of Japan seems muchmore reluctant than the Federal Reserve, or even the EuropeanCentral Bank, to unwind its massive balance, it is not at all clearhow meaningful its impact will be on domestic inflationexpectations going forward. The current policy of yield curvetargeting – specifically intervening in the market such thatinterest rates are negative and long-term yields are zero – canno longer be perceived as shocking the markets. It hasbecome part of the landscape and, as such, inflationexpectations might become entrenched, and thus indifferentto additional measures of monetary policy.
What kind of inflation expectations might becomeentrenched? That is the bug question of course, but whatmatters is that it may be out of the hands of the Bank of Japan.If the current emerging markets correction would morph intosomething more serious, the Japanese yen – which is perhapsthe most important funding currency for emerging marketinvestments – is likely to appreciate, regardless of yield curvetargeting. Only direct intervention by the Bank of Japan,something politically less obvious, would then be able toprevent such a rise. A stronger yen would immediately bringdown inflation expectations, and deteriorate the country’sgrowth outlook.
Japanese equities: headwinds vs. tailwinds – stay neutralHeadwinds are likely to present themselves in the form of anappreciating currency. Thanks to the weaker yen so far, theNikkei composite has hit a 27 year high recently. This we thinkwill likely change looking ahead. Especially given the traderisks, any currency appreciation is likely to be receiveddisproportionately negatively by the markets. While the capextrends are still strong, the recent tankan survey showed thatrising raw material costs impacted the business confidenceamong Japan's big manufacturers in the third quarter. In ourview, tail winds come in the form of strong domestics. Tighterlabour market and relatively easier monetary policy are likelyto help the domestic sectors, in our view. Taking the roughwith the smooth, we stay neutral Japanese equities.
Emerging market turmoil is not good for Japan
Source: Bloomberg
Japan stocks benefit from weaker currency
Nikkei (LHS) USD-JPY
Oct-16
Dec-16
Feb
-17
Mar-17
May-17
Jul-17
Sep
-17
No
v-17
Jan-18
Mar-18
Ap
r-18
Jun
-18
Au
g-18
Oct-18
102
104
106
108
110
112
114
116
118
16700
17700
18700
19700
20700
21700
22700
23700
24700
October 2018
The Quarterly Investment View | Page [email protected]
China
Sticking to policyThe recent decision to reduce to reduce the reserverequirements for banks should not mislead you. This is not2015, and it certainly is not 2008. China is not going tomeaningfully provide stimulus to its economy. And if it is goingto do so, it will rather be through a weakening exchange rate,which means stimulus for China only. The appointment of LiuHe as China’s Vice Premier of Economics is in fact a clearsignal. President Xi Jinping has been give wide powers. Theultimate goal of such powers is to pursue deleveraging even inthe presence of significant market turmoil. This more hawkishpolicy stance had been in the making through 2016 and 2017as Xi was preparing for the November 2017 Congress toappoint a Standing Committee of the Politburo of the Partypretty much in his own image. That very policy is also inevitablein view of the massive debt accumulation that has beenaccruing since 2009 as the country financed domesticinvestment spending with a view of compensating for slowerglobal demand growth for its products.
We are now assisting to a significant correction of the country’sequity market combined with a depreciation of the renminbi,the country’s still non-convertible currency. Again speculationsare rife for the government to do something, perhaps releasesome addition credit spending to prop up equity and propertyprices. Whilst we believe that the government will do all that isin its power to prevent domestic destabilization, it is likely to doso without injecting further credit into the system. The reasonis simple. The hawkish policy stance of reigning excessive creditspending, of which Mr. Liu He is the personification, is absolutelynecessary if the country is put itself on a sustainable growthpath, capable of lifting it from a middle income- to a highincome country. Also, now that the population growth hasstabilized, there is less need to create each year millions of newjobs. Thus, from the government’s perspective, it is better toallow some financial unrest, and compensate that with socialspending aimed at alleviating the pain for the weaker parts ofthe population, rather than increasing debt levels again andkicking the can down the road once more.
Trade conflict might make the policy choice even easier. China is suddenly immediately exposed to the risks inherent ofan economy that is too much tilted towards manufacturingexports. Whilst a slowdown of the Chinese economy wasalready in the cards with the government trying to reduce bankcredits, deflate the real estate bubble and bring down excesscapacity in key manufacturing sectors, it certainly would havepreferred doing so in a gradual fashion, not as a result of (theimposition of reduced) export revenues.
Then again, the Chinese authorities have now an externalscapegoat to whom – if necessary – blame the hardship ofdeleveraging, and in reality rally support for the policy ofdeleveraging. Again, one should not take China’s commitmentto deleveraging as a non-pragmatic rejection of any form ofsupport to the domestic economy. This is ever so true becausemanufacturing in China is still more than 20% of gross domesticproduct and employs also more than 20% of the labour force.In other words, China is much more vulnerable to a potential
trade war than the United States which employs only 10% of thework force in manufacturing and which exports to China lessthan half the value of what China exports to the United States.But China will maintain steadfast to a process that ultimately willreduce debts, and slowdown the economy. And the hardshipthat will inevitably follow from that will be conveniently blamedto the trade war initiated by the US.
China will try to play ball, without giving in to total capitulationWhilst the Chinese authorities will keep their heads cool and tryto accommodate, they will not give in to easily. It is true, the USis mostly concerned about having more access to certaindomestic sectors of the Chinese economy, than to put tariffson Chinese imports. Critically, the US wants relaxation on USinvestments in China, but on the other hand also wants to puta halt to Chinese companies buying US companies. It alsowants more Chinese cooperation in cracking down on cyber-attacks and intellectual property rights. China will accommodateas much as possible, provided it can do so without giving theimpression of a total and humiliating surrender.
What China will not be able to offer will be a total liberalizationof the capital account since such a move would risk triggeringmassive capital outflows and thus domestic instability. Rather,whilst the country might well further open the finance sectorto foreign operators, it will keep the capital account largelycontrolled also with a view of avoiding excessive fluctuations ofthe renminbi.
Chinese equities: dark clouds everywhere – remainunderweightChinese equities are a strong structural proposition but the nearterm outlook remains darkly clouded, especially with the tradewar looming. This has in turn started to impact the domesticconditions. For instance, the latest reading of the PMI indicatedweakness not only in the export sector but also in the domesticsector. This is likely to impact both the H-shares and A-sharesnegatively. The key risk to our underweight is the prospect of astrong reflationary policy by Beijing. As mentioned above, wedeem this extremely unlikely given the debt load the countryfaces. So, in our view, there is no easy solution to the rathertricky situation the country faces. For now an underweightstance on Chinese equities is warranted.
Deleverage at any cost, almost
Source: Bloomberg
CN
Y b
n
China Total Social Financing (12mma, YoY change)
China tightening to continue
-400
-200
0
200
400
600
800
2009 2010 2011 2012 2013 2014 2015 2016 2017 2018
October 2018
The Quarterly Investment View | Page [email protected]
India
Fast-paced growthGrowth in the second quarter beat market expectations as GDP roseby 8.2%, making India the fastest growing economy in the world. Astrong GDP print was expected, mainly on account of the lower base-effects of last year. The 2Q GDP saw a strong revival of themanufacturing activity. On the expenditure side, governmentspending continued to rise, but the strong increase in privateconsumption was the dominant driver. Going forward, increasedgovernment spending along with improved agricultural productivityon account of better monsoons should keep the growth momentumgoing. However, the pace of the growth momentum coulddecelerate a bit, taking into account the concerns of global growthslowdown and trade uncertainty. To add, with the challenges ofhigher interest rates, weaker rupee and higher oil prices, there is ahigh possibility of growth moderating in the coming few quarters.Having said that, India’s economic fundamentals are still strong andfare better when compared to 2013 taper tantrum period. In spite ofthe volatile external environment, strong macro fundamentals andbetter reform momentum to keep the country better placed withinemerging market.
Weaker trend in rupee calls for more RBI rate hikesThe Indian rupee was not an exception to the broad-based EMcurrency sell-off recently. The currency has lost almost 7% versus thedollar since end-June 2018, now trading at its weakest level againstthe dollar till date. In addition to spill-over effects of the recent EMcontagion and the impact of dollar strength, rising oil prices have yetagain brought back investors' focus on the country’s twin deficitgiven the country’s huge import bill. As a result, the current accountdeficit has widened this year and is likely to widen further. Eventhough, India is relatively less susceptible to external volatility, thecountry still relies on capital flows due to its current account deficit.Hence, it was not surprising when the government announced newreforms- a five-step strategy to boost foreign inflows includingrelaxing offshore investment restrictions on corporate bonds. This isin addition to the policy rates being raised twice by the central bankthis year. However, these measures may not be enough tocompletely reverse the current rupee depreciation trajectory,especially considering the external backdrop of stronger dollar, Fedtightening and rising oil prices. As such, more measures are likely tobe introduced followed with further tightening by the RBI expectedas weaker rupee will boost inflationary pressures.
Bonds: Stay neutralSimilar to other emerging markets, the local currency sovereignbond market has been heavily sold by the market. Significant
rupee depreciation and rising oil prices have aggravatedinflation concerns. The central bank has raised policy ratestwice in order to combat the inflation pressures. Headlineinflation in August slowed with the decline in food pricesoffsetting the impact of higher rupee depreciation and fuelprices. However, core inflation still remains high on account ofhigher import prices and credit growth. Increase in privateconsumption is likely to keep core prices elevated. Overall,upside risks to inflation remain taking into account the rupeeweakness and rise in oil prices over past month. Higher coreinflation at a time when the economy is growing at record highlevels also signal risks of overheating. This means that the RBIis likely to stick to its tightening mode for now.
Local currency government bond yields are now trading above8%. However, the upward trend in bond yields is likely tocontinue as markets price in the probability of more RBI ratehikes. Separately, interbank liquidity has significantly tightenedand the RBI has been conducting open market operations torelease liquidity into the system. However, most of the openmarket operations are likely to be streamlined in a manner toadd only a ceiling to the government bond yields. As such, weremain neutral on Indian government securities.
Indian equities: a thin silver lining – remain overweightEquities in India along with their counterparts in other EMs, have comeunder selling pressure in the recent months. Stronger USD, higher USTyields and higher oil prices have brought to the surface, externalvulnerabilities of the country. Also, the concerns around the NBFCsector exacerbated the selling pressure.
However, looking ahead, the focus is likely to shift (away from USDstrength) towards trade wars and here, India is relatively immune toany negative developments. India is also a bright spot (amongst EMs)with strong earnings growth. While the national elections in 2019 arelikely to slow the capital investments, we think equity investors arelikely to miss the boat should they decide to stay on the side-lines fortoo long and till clarity emerges.
Further we view our Indian equity position from a longer-termperspective. The structural underpins of favourable demographics,rising middle income class and domestic orientation of the economyare likely to help.
Growth to pick up, but risks have risen
Source: Bloomberg
India Policy rate (LHS) USDINR Currency (RHS)
Rupee weakness warrants more rate hikes
Jan-18
Feb
-18
Mar-18
Ap
r-18
May-18
Jun
-18
Jul-18
Au
g-18
Sep
-18
Oct-18
5.7
5.8
5.9
6.0
6.1
6.2
6.3
62
64
66
68
70
72
74
76
Source: Bloomberg
Commercial Credit YoY (LHS) Core Inflation YoY (RHS)
Domestic factors also pushing inflation higher
Jan-14
Jun
-14
No
v-14
Ap
r-15
Sep
-15
Feb
-16
Jul-16
Dec-16
May-17
Oct-17
Mar-18
Au
g-18
2
3
4
5
6
7
8
9
4
6
8
10
12
14
16
October 2018
The Quarterly Investment View | Page [email protected]
Emerging Markets
Dollar, Hawkish Fed and trade conflicts pose risksEmerging markets experienced a volatile summer with thedollar appreciation, tightening US financial conditions andescalation of global trade tensions. The sell-off was furtheraggravated by EM contagion fears with risks emerging fromTurkey and Argentina.We believe that the recent contagion wasmainly driven by the strength of the dollar which deterioratedthe situation further, with other emerging market currenciesfalling prey. The lira crisis and EM contagion is a reminder ofhow stronger dollar and increased geopolitical tensions couldexacerbate the economic position of emerging markets,particularly with weaker fundamentals. Increased global risksand dollar rebound were also the main underlying reasons whywe reduced risk in June, turning neutral on global equities andclosing our selective overweight on Indonesia bonds.
Post the sell-off in August, stability returned in most of theemerging market assets in September. While valuations maylook attractive after the recent cheapening, we do not believethat that recent relief rally in emerging market assets has furtherlegs. Firstly, there has not been any significant change in theexternal headwinds. In fact, the external risks have nowincreased. Compared to other emerging economies and evendeveloped ones, US economy is not showing any signs ofslowdown meaning that the Fed will remain committed to hikepolicy rates. Higher US rates have so far not tightened financialconditions in the US, but the same cannot be said for theemerging markets. As such, the greenback will remain strongon the back of the global policy divergence and Fed’s aggressiverate hike stance, putting pressure on emerging marketcurrencies. While emerging market central banks have beenproactive in stemming their currency depreciation via raisingpolicy rates, it is coming at the expense of boosting growth andweaker economies are the most vulnerable. Secondly, US andChina trade tensions are far from over and possibility of furtherescalation going further into 2019 remains if there is no progressmade on US-China negotiations. Thirdly, China growthslowdown concerns have intensified with the economyshowing signs of cooling. Even though, the Chinesegovernment and central bank have recently undertakenmeasures to stimulate growth, the room for stimulus is limitedgiven their high debt levels. As such, China growth slowdownrisks could ultimately spill over to other emerging markets aswell. Lastly, rising oil prices are hurting emerging market oilimporters, posing risks for higher price pressures and likely toresult in more aggressiveness in EM central bank tightening.
EM Bonds- Stay underweight Emerging market sovereign dollar bonds have rallied inSeptember, partially erasing the losses suffered during theAugust sell-off. However, on a year-to-date basis, emergingmarket dollar bonds still remain one of the worst performerswithin the fixed income asset class. In fact, the recent rally wasmainly driven by country-specific factors, i.e. stability in Turkeyand Argentina. However, the decline in dollar sovereign bondyields has come at a time when core bond yields have beenon the rise. In August, we removed our selective overweighton Russia dollar bonds on sanction concerns. Even though,
valuations may look cheap in some of the emerging bondmarkets, we still express a cautious stance on emergingmarket bonds. Given the broad-based nature of the sell-offwhich even impacted countries with relative strongfundamentals, it made sense to close our selective overweightcall on Russia dollar bonds. With higher US rates and strongerdollar bias tightening financial conditions in the emergingmarkets, we expect that emerging market bond markets willremain vulnerable to any jump in global market volatility. Atthe same time, we believe there are better opportunities in theGCC bond market. Mexico is also looking attractive post thefinalization of the new NAFTA deal.
Separately, EM local currency sovereign bonds haveunderperformed more compared to the EM dollar sovereignbonds. Sharp depreciation in EM currencies has resulted in EMcentral banks to turn aggressive in their tightening stance.Upside risks to inflation in emerging economies have risen withcurrency weakness and rising oil prices. As such, we believe thatthe most of the EM central banks will remain in tighteningmode, adding pressure on local currency bond markets.
EM equities: selectivity is the key (but) – remain underweightOur overall view of EM equities is still negative. A range ofheadwinds have impacted the performance of the asset class.Stronger USD, higher US rates, trade tensions and weakeningdomestic growth are the four key forces. So far this year, theformer two have dominated the EM landscape but the latter twoare likely to drive the asset class performance looking ahead.
Stronger USD and higher US rates have, more or less, impactedall EMs equally negatively. However, trade tensions andweakening domestic conditions are likely to create relativewinners and losers within EM. As discussed in previous sections,China (underweight) is likely to be impeded by trade tensionsand weaker domestic conditions while India (overweight) islikely to be immune here. Elsewhere within EMs, some tacticalopportunities might be emerging in countries where theequities have suffered losses aggressively – think Argentina andTurkey here. Russia and Brazil, given their higher beta, are likelyto respond quite strongly to any cyclical rebound. In case ofSouth Africa, it might be worth to focus on export segmentsthat benefit from weaker currency.
Shaky grounds
Source: Bloomberg
EM USD aggregate yield to worst (LHS)10-yr US treasury yield (RHS)
EM bond yields dropped while US yields rose
Jan-18
Feb
-18
Mar-18
Ap
r-18
May-18
Jun
-18
Jul-18
Sep
-18
Oct-18
4.2
4.7
5.2
5.7
6.2
2.4
2.6
2.8
3.0
3.2
3.4
October 2018
The Quarterly Investment View | Page [email protected]
Appendix
GDPForecast Consensus ADCB Consensus ADCB
2018 2019
US 2.9% 2.5%
Eurozone 2.0% 1.8%
Japan 1.1% 1.1%
China 6.6% 6.3%
India 7.5% 7.4%
In agreement Expect significantly moreExpect significantly less Expect moderately moreExpect moderately less
CPIForecast YoY Consensus ADCB Consensus ADCB
2018 2019
US 2.5% 2.3%
Eurozone 1.7% 1.7%
Japan 0.9% 1.1%
China 2.1% 2.3%
India 4.8% 4.6%
Source: BloombergSource: Bloomberg
BofA ML US Corp AAA E�ective Yield & US Treasury 10 yrs spread
BofA Merrill Lynch US Corporate AAA E�ective Yield%
-1
0
2
1
3
4
5
6
Sep
-00
Sep
-01
Sep
-02
Sep
-03
Sep
-04
Sep
-05
Sep
-06
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Average: 0.49
Source: Factset, Federal Reserve Bank of St. Louis
Bofa ML Glb Broad Mkt Corp. & HY Idx-US Treasury 10 yrs spread
Merrill Lynch Global Broad Market Corporate & High Yield Index
%
0
5
10
15
20
25
Sep
-00
Sep
-01
Sep
-02
Sep
-03
Sep
-04
Sep
-05
Sep
-06
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Average: 5.17
Source: Factset, Federal Reserve Bank of St. Louis
Bofa ML EM Corporate Plus Index-US Treasury 10 yrs spread
Merrill Lynch USD Emerging MarketsCorporate Plus Index
%
0
2
4
6
8
10
12
14
Sep
-00
Sep
-01
Sep
-02
Sep
-03
Sep
-04
Sep
-05
Sep
-06
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Average: 3.32
Source: Factset, Federal Reserve Bank of St. Louis
BofA ML US Corp BBB E�ective Yield & US Treasury 10 yrs spread
BofA Merrill Lynch US Corporate BBB E�ective Yield%
0
1
2
3
4
5
6
7
8
9
Jun
-00
Jun
-01
Jun
-02
Jun
-03
Jun
-04
Jun
-05
Jun
-06
Jun
-07
Jun
-08
Jun
-09
Jun
-10
Jun
-11
Jun
-12
Jun
-13
Jun
-14
Jun
-15
Jun
-16
Jun
-17
Jun
-18
Average: 1.77
Source: Factset, Federal Reserve Bank of St. Louis
Bond Market Spreads
Appendix October 2018
The Quarterly Investment View | Page [email protected]
Equity Market Valuations
Di�erence from S&P 500 12m forward PE Average
Euro Stoxx 12m forward PE - S&P 500 forward PEPE x
-6
-5
-4
-3
-2
-1
0
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Fed Model- (Earnings yield-Bond yield) Average
Relative valuation US equities v/s US 10yr Treasury(%)
-5 -4 -3 -2 -1 0 1 2 3 4 5 6
Oct-9
0
Oct-9
4
Oct-9
8
Oct-0
2
Oct-0
6
Oct-10
Oct-14
Oct-18
Average: (0.59)
Source: Thomson Reuters, multpl.com
Di�erence from S&P 500 12m forward PE Average
Nikkei 225 12m forward PE - S&P 500 forward PEPE x
-30
-25
-20
-15
-10
-5
0
5
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
12m forward PE Average
Euro Stoxx 12m forward PE PE x
6
8
10
12
14
16
18
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
12m forward PE Average
Nikkei 225 12m forward PEPE x
6
11
16
21
26
31
36
41
46
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Shiller PE ratio Average
Absolute valuation US equities(X)
0
10
20
30
40
50
Oct-6
4
Oct-70
Oct-76
Oct-8
2
Oct-8
8
Oct-9
4
Oct-0
0
Oct-0
6
Oct-12
Oct-18
Average: 20.23
Source: Thomson Reuters, multpl.com
Di�erence from S&P 500 12m forward PE Average
PE x
-6
-5
-4
-3
-2
-1
0
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
12m forward PE Average
FTSE 100 12m forward PEPE x
6
8
10
12
14
16
18
20
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Appendix October 2018
The Quarterly Investment View | Page [email protected]
Equity Market Valuations
Nifty 12m forward PE - S&P 500 12m forward PE
Di�erence from S&P 500 12m forward PE Average
PE x
-4
-2
0
2
4
6
8
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Di�erence from S&P 500 12m forward PE Average
DAX 12m forward PE discount - S&P 500 12m forward PEPE x
-6
-5
-4
-3
-2
-1
0
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Di�erence from S&P 500 12m forward PE Average
Jakarta composite 12m forward PE- S&P 500 12m forward PEPE x
-6
-4
-2
0
2
4
Ap
r-09
Jun
-10
Au
g-11
Oct-12
Dec-13
Feb
-15
Ap
r-16
Jun
-17
Au
g-18
Source: Bloomberg
Di�erence from S&P 500 12m forward PE Average
Shanghai composite 12m forward PE - S&P 500 12m forward PE
PE x
-10
-5
0
5
10
15
Ap
r-09
Dec-0
9
Au
g-10
Ap
r-11
Dec-11
Au
g-12
Ap
r-13
Dec-13
Au
g-14
Ap
r-15
Dec-15
Au
g-16
Ap
r-17
Dec-17
Au
g-18
Source: Bloomberg
Nifty 12m forward PE
12m forward PE Average
PE x
68
1012
14
1618
2022
24
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
12m forward PE Average
DAX 12m forward PEPE x
6
8
10
12
14
16
18
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18Source: Bloomberg
12m forward PE Average
Jakarta Composite 12m forward PEPE x
6
8
10
12
14
16
18
20
Ap
r-09
Jun
-10
Au
g-11
Oct-12
Dec-13
Feb
-15
Ap
r-16
Jun
-17
Au
g-18
Source: Bloomberg
12m forward PE Average
Shanghai Composite 12m forward PEPE x
6
11
16
21
26
31
36
41
46
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Appendix October 2018
The Quarterly Investment View | Page [email protected]
Equity Market Valuations
Istanbul stocks 12m forward PE- S&P 500 12m forward PEPE x
Di!erence from S&P 500 12m forward PE Average
-14
-12
-10
-8
-6
-4
-2
0
Mar-0
9
Sep
-09
Mar-10
Sep
-10
Mar-11
Sep
-11
Mar-12
Sep
-12
Mar-13
Sep
-13
Mar-14
Sep
-14
Mar-15
Sep
-15
Mar-16
Sep
-16
Mar-17
Sep
-17
Mar-18
Sep
-18
Source: Bloomberg
Di�erence from S&P 500 12m forward PE Average
Taiwan stocks 12m forward PE- S&P 500 12m forward PE
PE x
-10
-5
0
5
10
15
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18
Source: Bloomberg
Di�erence from S&P 500 12m forward PE Average
Bovespa 12m forward PE- S&P 500 12m forward PE
PE x
-8
-6
-4
-2
0
2
4
6
Mar-0
9
Sep
-09
Mar-10
Sep
-10
Mar-11
Sep
-11
Mar-12
Sep
-12
Mar-13
Sep
-13
Mar-14
Sep
-14
Mar-15
Sep
-15
Mar-16
Sep
-16
Mar-17
Sep
-17
Mar-18
Sep
-18
Source: Bloomberg
12m forward PE Average
Istanbul stock exchange 12m forward PEPE x
5
6
7
8
9
10
11
12
13
Mar-0
9
Sep
-09
Mar-10
Sep
-10
Mar-11
Sep
-11
Mar-12
Sep
-12
Mar-13
Sep
-13
Mar-14
Sep
-14
Mar-15
Sep
-15
Mar-16
Sep
-16
Mar-17
Sep
-17
Mar-18
Sep
-18
Source: Bloomberg
Taiwan stock exchange 12m forward PEPE x
12m forward PE Average
6
11
16
21
26
31
Sep
-07
Sep
-08
Sep
-09
Sep
-10
Sep
-11
Sep
-12
Sep
-13
Sep
-14
Sep
-15
Sep
-16
Sep
-17
Sep
-18Source: multpl.com
12m forward PE Average
Bovespa 12m forward PE PE x
5
7
9
11
13
15
17
19
Mar-0
9
Sep
-09
Mar-10
Sep
-10
Mar-11
Sep
-11
Mar-12
Sep
-12
Mar-13
Sep
-13
Mar-14
Sep
-14
Mar-15
Sep
-15
Mar-16
Sep
-16
Mar-17
Sep
-17
Mar-18
Sep
-18
Source: Bloomberg
Important Information October 2018
The Quarterly Investment View | Page [email protected]
All information in this report has been obtained from the following sources except where indicated otherwise:
1. Bloomberg
2. Wall Street Journal
3. RTTNews
4. Reuters
5. Gulfbase
6. Zawya
Sources
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