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A Flight to Safety and Quality…at least this Week

CIO Weekly View | 8th  May, 2016

Gary Dugan | Chief Investment Officer | Emirates NBD

Gary DuganInvestors switch into the safety of government bonds

US data disappoints: non-farm payrolls below forecasts

Global industrial confidence sags as do global equity markets

Investors in disbelief as Australia faces a concrete deflationary risk

Saudi Arabia: change spurs more change and more …

The backwards and forwards of markets continued last week as a very mixed US employment report led to a flight to safety and quality into government bonds. Non US equities underperformed, with investors wondering if the massive ECB stimulus has lost its ability to translate into more credit creation, while emerging markets were under pressure after a disappointing industrial sentiment release. Credit markets, although a little weaker, held up relatively well and in our view remain a sweet spot in an environment where income generating strategies to a degree offset the uncertainty of capital gains.

It’s difficult to be convinced that the US economy is truly about to re-accelerate. Many of the elements are there for better times, wage growth has picked up, a lack of an inventory overhang and of course very low interest rates but something still feels as if it is missing. The latest US employment report was a case in point. Wage growth and hours worked was good, but the headline number of new jobs at 160,000 was well below expectations of 200,000. The participation rate fell to 62.8%, suggesting that people are again leaving the available workforce – not a good sign.

The challenges in the US economy are only amplified in the global economy where the data for April is showing that life remains difficult. Global manufacturing confidence slipped again in April and it is now in keeping with only 2% global growth, an astoundingly sluggish level by all standards and sparking concerns of recession, were it not for a dovish stance or continued outright stimulus by major central banks. Businessmen would most likely want to see improving demand on the horizon rekindling their animal spirits, before committing to new capital expenditure, whose anemic level remains the main missing link in the global economic recovery.

Australia cut interest rates, following a sharp fall in the consumer price index in the first quarter of the year. The RBA may be on its course to join the bandwagon of monetary authorities slashing benchmark rates towards the zero bound and below, as inflation is expected to remain below 2% through to the end of 2018, according the official forecast released Friday. The risk of a deflationary spiral is looming large for the country, in spite of almost trend economic growth and almost full employment, as core inflation has held below the RBA target for the last six quarters.

Equities had a poor week, particularly in Japan (-7.6%) with investors still fretting about the decision of the Bank of Japan (BoJ) not to ease policy. We remain of the view that the Japanese government and the BoJ will be forced to intervene at some stage to underpin the economy. Hence very tactically the weakness of the Japanese market is offering a possible buying opportunity on a hedged basis.

Eurozone equities also performed poorly last week down 3.5%. This was despite the recent release of better than expected GDP figures. However the market was not too pleased to see weaker than expected retail sales figures for March, although offset to a degree by upgrades to the previous month’s data. Other data though was comforting; industrial confidence met expectations (a contrast to weaker global confidence). Also there are further signs of a drop in the lending rates to corporates and households.

The flight-to-safety by investors over the week lowered yields across developed government bond markets. US 10- year sovereign bond yields were lower by 9 bps to close at 1.77%, while similar maturities of the UK gilts and German bunds fell to 1.41% and 0.14% respectively leading to good capital gains for bond holders.

According to, the implied probability of an “in” vote for the UK remains steady at 70% for the week. Official polls continue to suggest more uncertainty, with the latest one, taken April 27-29, showing a 50-50 split on EU membership. One thing is for certain: ahead of next month’s vote the British economy remains on a knife edge. A marked slowdown is emerging, with the UK economy growing less strongly than the Eurozone in the first quarter, the first time this has happened in years. This reflects unprecedented levels of uncertainty about the outlook: forecasts for sterling range from the currency falling to as low as $1.25 in case of a Brexit, to it rising to as high as $1.65 if EU membership is retained.

Some concerns about some emerging markets are resurfacing, with last week marking the first disorderly selloff seen since the rebound in the emerging economies started in February this year. The manufacturing leading index in China missed estimates, spurring doubts about the resilience of stimulus traction. The lackluster business survey reflects muted demand abroad and high debt levels at home, both a drag on businesses’ intentions to invest and hire people. We hold the view that the current government spending and monetary stimulus remains a significant tailwind for the Chinese economy. Commentators will be looking at this coming week’s data for important clues as to whether the economy has maintained its recent stronger patch of growth.

In Saudi Arabia there is more evidence of ongoing change to back the recent aspirations expressed in the latest speech by the Deputy Crown Prince Mohammad bin Salman Al Saud. The replacement of the longstanding Saudi Oil Minister Ali AlNaimi with Khalid Al-Falih, the current chairman of the Saudi Arabian Oil Co, is another sign of changing times in the kingdom. Developments in the capital markets also show that the authorities are keen to keep up a pace of change that can only be a positive for the Saudi asset markets.

The Saudi equity market appears on the right track for inclusion in the Morgan Stanley Capital International (MSCI) Emerging Market Index after it announced a major set of reforms to its capital market regulations to be implemented in early 2017. The most significant change is to move from the current cash prefunding requirement for an equity bargain to a T+2 settlement cycle. The change would bring the Saudi equity market settlements procedure into line with the standard international practice. The plan to allow covered short selling helped by the ability to lend and borrow securities, enhanced custody controls and the introduction of proper delivery versus payment (DVP), should all make the Saudi market competitive with its global EM counterparts. The authorities also announced to broaden the base of the market reducing the minimum market capitalization to $1bn and broadening the scope of the entities allowed to register.

Saudi equities should gain support from the announcements, although to be fair investor sentiment will probably remain dominated by developments in the crude oil demand-supply dynamics. Historically markets tend to run up prior to inclusion of indices in benchmarks. The positive of the introduction of the Qualified Foreign Investor (QFI) scheme announced in April 2015 did not provide the Saudi market with much of an impetus as it came at a time of falling oil prices.

The main the Saudi equity index, the Tadawul Index has 172 members and a market cap of $415 billion and inclusion in the MSCI EM Index indicates a c.1.5 to 2%weighting based on Foreign Ownership Limits (FOL’s). The UAE and Qatar have weights just below 1% each. Privatization measures will add to the market cap with the earliest being the listing of the Saudi Stock Exchange and Saudi Aramco. These will add to Saudi Arabia’s weight in the MSCI EM and could take it up to 4% similar to Turkey.

Political noise surrounding Turkey weighed on sentiment, leading to its underperformance amongst EM. Speculation is running high as to the successor of the resigned Turkish Prime Minister Davutoglu, who will be tasked with forming a new government: candidates could be from the Ministry of Energy, of Transportation, as well as the current Deputy PM himself. We do not expect to see major political shifts, given the fact that President Erdogan would continue to lead the party. Turkish 10-year benchmark sovereign bonds weakened by 27 bps to close at 4.55%. We continue to be positive about Turkish corporate bonds and look to add to positions into any weakness as fundamentals continue to be robust and the political impasse is expected to be temporary.

Middle East new issuance seems to be on the roll with large-sized deals being announced after Abu Dhabi government’s successful $5B transaction. The State of Qatar announced a $5B bond transaction as well. Multiple tenures may be on the offering and we expect it to be well placed with similar spreads and yields to the Abu Dhabi’s sovereign bonds. We also expect Mubadala’s $500M 7-year bond transaction to be priced as early as Monday. The pricing range should be between 145 and 155bps over the 7-year benchmark.

Boubyan bank – a leading Islamic bank in Kuwait and a subsidiary of the National Bank of Kuwait – is also set to conclude investor meetings on Monday in Zurich and Geneva. Emirates NBD alongside other banks have been mandated for a US dollar, perpetual, additional tier 1 sukuk offering, subject to market conditions. We expect it to be priced in the mid to high 6% range and to be well received by the regional investors.

Ezdan Holding group – a leading real estate developer and operator in Qatar – is also meeting investors for a maiden sukuk issuance under its Ezdan Sukuk Company Limited’s $2B trust certificate issuance program. Rated BBB- / Ba1 by S&P and Moody’s and a top 50 company in the Forbes list of the largest 500 Arab corporations in 2015, we see interest from the GCC market on expectation of an appealing pricing for yield-seeking investors.

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