November 2019 - Stocks Rise to New Highs on Receding Risks
Risk assets continued their upward trend in October, driven by trade optimism, strong corporate earnings and stabilizing economic data. The MSCI All-Country World Index returned 2.8% on the month in $US terms, bringing year-to-date gains to 20%. Government bond yields were relatively unchanged on the month while credit products had positive returns. The U.S. and China appear likely to sign a phase 1 trade deal, which would provide a bit more ammunition for risky assets. In order to achieve this, both sides would have to make concessions (such as the U.S. removing existing tariffs and the Chinese accepting stronger IP protection and purchasing more agricultural goods). Our view is that both sides have an incentive to do so. The risk that talks collapse remains but with the U.S. elections approaching and Chinese data weakening, we think that a re-escalation will likely be avoided. Coupled with stabilizing economic data and less Brexit uncertainty, we turn more neutral on risky assets (from negative) though are wary of rich valuations.
The S&P 500 index delivered total returns of 2.2% in October, bringing year-to-date gains to 23%. On a sector basis, Healthcare, Technology and Communication Services outperformed (5%/3.8%/2.7%) while Energy (-2.4%) and Utilities (-0.8%) lagged. Information Technology remains the top performing sector YTD (35%) while Energy is the laggard (0.6%). Corporate results for the third quarter have largely beaten expectations: overall earnings growth has been -3% YoY, compared to expectations for a -5% decline. Revenue growth has come in at +3% YoY, helping stave off imminent recession worries. Health Care and Technology companies have seen the biggest beat compared to expectations, while Energy has been the big disappointment. We remain overweight U.S. equities vs. other regions given stronger growth dynamics and maintain a preference for domestic sectors that benefit from the resilient consumer such as Consumer Discretionary and Financials.
In Europe, the Euro Stoxx 50 index returned 1.1% on the month in EUR terms, bringing YTD returns to 24.3%. The region’s manufacturing index stabilized in October but remains at contractionary levels. The Brexit deadline was extended again, sending the Pound 5.3% higher against the dollar and leading to an under-performance of large cap UK equities (down 2% on the month). The U.K. will hold general elections in December and uncertainty remains regarding the precise path of Brexit. The ECB left its deposit rate unchanged but has started purchasing corporate bonds as part of its quantitative easing. We maintain our marketweight stance on European stocks given weak growth prospects offset by the ECB’s QE. We see value in UK equities (12.6x forward P/E and a dividend yield of 4.7%) assuming Brexit continues to be dragged out.
In Japan, Japanese stocks as measured by the Nikkei 225 outperformed again by returning 5.4% on the month in JPY terms. The Bank of Japan left rates unchanged at -0.1% but flagged the possibility that it may lower rates again in the future. The Nikkei has returned 16.8% YTD and we see scope for further out performance if the U.S. and China sign a phase 1 trade deal. In the Israeli market (which we like for its defensiveness and strong economy), there has been a strong divergence between large-cap and mid-cap equities. The TA-35 index returned 3.2% in October and 12.9% YTD (in Shekel terms), while the mid-cap TA-90 index returned 5% in October and 32% YTD.
Elsewhere, Emerging Market equities returned 4.2% on the month in USD terms, bringing YTD gains to 11%. We maintain our overall marketweight view on EM equities until signs of stronger global growth materialize. Chinese offshore equities returned 4% on the month, bringing YTD gains to 15.9%. We returned from a trip to Beijing relatively optimistic on the outlook for the Chinese consumer, as various tax cuts have helped boost purchasing power. The industrial part of the economy remains weak due to weak credit growth as well as the trade war, and the property market has also slowed down. Given this backdrop, we prefer Chinese equities that are leveraged to the Chinese consumer such as technology and healthcare stocks.
In credit markets, US investment grade corporate spreads tightened 6 bps in October to 117 bps and total returns were 0.6%. Supply volumes declined to $84 bn from $166 bn in September, which provided a positive technical boost as there was excess demand for bonds. Net supply (after subtracting maturities and calls/tenders) was -$6 bn. On the demand side, IG mutual funds received inflows of another 1.2% of AUM in October. We maintain our overweight view within our fixed income allocation given the defensiveness of the asset class and attractive yield (3%) for global investors. We prefer BBB credits whose management is committed to maintaining an investment grade rating and enacting creditor-friendly policies.
US HY credit returned 0.3% as the coupon income of 0.5% was able to offset a decline in prices. Credit spreads widened by 13 bps to 415 bps (yield of 5.9%). Performance by rating was skewed towards higher quality, with BBs returning 0.6%, Bs 0.1% and CCCs -0.2%. Financials outperformed (1.7%) while energy lagged (-2.2%). Year-to-date, US HY ex-energy has returned 13.5%, while US HY energy has returned only 0.3% as the default rates has picked up. On the demand side, US HY funds received inflows of $2.9 bn, bringing YTD inflows to $16.5 bn. In the primary market, corporations raised $19 bn in USD-denominated bonds, down from $31 bn in September. We maintain our marketweight view on US HY given tight spreads and prefer higher quality credits with improving fundamentals. EUR HY delivered total returns of 0% (9.1% YTD) as spreads widened 6 bps to 372 bps (Yield of 3.1%).
Emerging Market debt had a mixed performance with a large divergence across the asset classes, driven by idiosyncratic country events. EM hard currency sovereigns returned 0%, while EM corporates returned 0.8%. EM local currency sovereigns returned 2.8% in $US terms, driven by a 1.2% appreciation in local currencies vs. the USD. In the sovereign space, there was a big divergence between countries driven by various idiosyncratic events. Some examples include social protests in Chile (which weighed on the CLP), Ecuador ($ bonds dropped -4.3%), Lebanon ($ bonds dropped -14%), and elections in Argentina (bonds dropped 2%). We maintain a positive view on EM high yield debt given attractive relative valuations though acknowledge the need for broad diversification and country selection.
Overall, the deceleration in global growth is showing signs of stability but it is too early to call a turnaround. Central banks are still in accommodative mode while the trade talks are progressing towards an interim phase 1 deal. Financial markets have cheered all of these moves, sending equity prices to new all-time highs. We moved to a more neutral risk stance across our portfolios but are not ready to be in full risk-on mode given rich valuations. As always, risk-management combined with rigorous sector and geographical diversification will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.