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CIO Weekly View | 5th July, 2016
Gary Dugan | Chief Investment Officer | Emirates NBD
Political turmoil in the UK
Second quarter was filled with risk and modest returns
It all seems a bit odd. Equities have moved back towards the top of their recent trading sessions, and yet the US ten-year government bond yield continues to languish at one of the lowest yields in 10 years. The bond market is still deeply sceptical about the outlook for growth, while equities hold at their highs in the hope of growth. Meanwhile, Brexit has caused mayhem in European political circles. We are waiting for new leadership in the UK and possibly Europe to guide us on how discussions over the UK’s exit may develop.
The second quarter has shown us that risk is very much at large. It was a quarter which again proved that a bias to fixed income investment worked best. Trying to time the markets was at best hazardous if not outright destructive of portfolio returns. The markets have not just had to deal with Brexit, but a Federal Reserve that has shifted from hawks to doves and are possibly on their way back again. The US 10 year government bond yield that started the month at 1.77% traded as high as 1.92% and ended the quarter at 1.47%. The global developed market equity index in dollar terms traded in an 8% band, but delivered just a 0.3% capital return for the second quarter. Global sovereign debt gave 4.3% return. Bonds still reign supreme on a risk-adjusted basis.
The market is still picking over what Brexit means for the medium-term outlook for the UK and EU. To be honest, it is very difficult for the financial market to come to any firm conclusions about the impact of the UK leaving the EU. At this stage, we don’t even know how the UK and the EU will position themselves in the negotiations. The result of the UK Conservative party leadership election will be announced on the 9th September, unless the candidates decide to stand aside and allow one candidate to run unopposed. Until we know who has one and hence what strategy they are likely to adopt in their negotiations with the EU, it is difficult to gauge just how difficult those negotiations will be. Equally from the EU side, the politics of the situation looks murky. The press is suggesting that the current President of the European Commission Jean-Claude Juncker no longer has the full support of the German government. His rather belligerent attitude post to the Brexit vote appears to have not resonated with the majority of EU heads of government.
The markets are starting to see a more dynamic situation in the UK where the conversation is moving away from just how bad it is going to be, to what we are going to do about it. Mark Carney the Governor of the Bank of England in the past week talked about “some monetary policy easing”. While George Osborne the UK Chancellor of the Exchequer talked about the possible need to accelerate cuts in corporation tax, probably down to a lower level of 15% as opposed to the 17.5% the government mentioned before.
UK sterling, while stabilising at levels of around $1.33, still looks vulnerable. Although the fall has made UK exporters immediately more competitive in global markets, it will take some time, as it always does, for a much improved competitive position to translate into a marked improvement in export volumes. Also in the background, the UK has an enormous current account deficit to fund that requires capital inflows to stabilise the currency. With such uncertainty over the UK’s access to the EU, companies that were considering expanding their businesses in the UK to gain access to the EU may at the very least hesitate.
Equity markets have made progress, but they still struggle to get support from the fundamentals such as corporate earnings. The latest set of corporate earnings revisions for June shows another round of downgrades to numbers for the developed markets. Despite the bad news flow, the equity markets have pushed to their highs in recent trading sessions. However, investor interest has centred on defensive stocks; cyclical stocks have underperformed defensive stocks in Europe since the Brexit vote.
With such challenges in Europe, investors are revisiting other parts of the world in search of safer and more predictable investment opportunities. Attention has turned to the ASEAN region where GDP growth of 5% is being maintained. Indonesia, for example, should see higher GDP growth in the second half of the year. A pick up in government spending should reinforce strong investment spending taking GDP growth to 5.0%.
The quality of the situation has been getting better with Indonesia’s short-term external debt falling to $38.1 billion, the lowest since 2012. Indonesian equities have made new highs in recent trading sessions and remain well supported by Asian institutional fund buying. Indonesia bonds still trade at reasonable spreads over treasuries and should find more support, despite the likelihood of more debt issuance in the coming months. The equity and bond markets of Thailand and Philippines have been much in demand and are probably fair value at present.
As the Holy month of Ramadan draws to a close the regional and fixed income markets are looking forward to a strong pipeline of deals. Kuwait is also aiming to tap international capital markets to raise close to $10 billion in Eurobonds to help bridge their budget deficit. We expect GCC and international investors to welcome a new issuer of benchmark size to the GCC bond markets, and we expect any bond sale to do well. We still await the Kingdom of Saudi Arabia Eurobond multi-tranche transaction, which we expect to see post-Eid. Given market appetite we expect the tenures to be skewed towards five and ten years with some proportion possibly aimed at a 30-year maturity. In a sign of the international interest in the Kingdom, Saudi Electricity secured $1.5 billion in unsecured financing from China’s ICBC.
Global bond markets will be looking to some key data this week to see if yields are going to hold at current low levels. The employment report on Friday will be chewed over by the markets to see if there are any signs that the labour market will be sufficiently vibrant to push the Fed to increase interest rates. The market is pricing a very low probability of Fed funds rate rise this year (12%). The market expects a 170,000 change in non-farm payrolls up from last month’s lowly 25,000.