October 2019 - Will Fall Weather Bring Out the Bears ?
Updated: Dec 16, 2020
Softening rhetoric between the U.S. and China led to a rebound in risk assets in September, marking a reversal from the August selloff. The MSCI All-Country World Index returned 2.1% on the month in $US terms, bringing YTD gains to 16.7%. Safer assets such as government bonds retreated, with the 10-year U.S. Treasury yield rising 17 bps to 1.66% as the Fed projected a more optimistic outlook in its meeting. Gold prices (-3%) dropped while oil prices (unchanged) swung in volatile fashion due to the attack on Saudi Arabia’s production facilities.
Going forward, talks between U.S. and Chinese trade officials begin this week, and we don’t expect a major deal to be reached. Rather, it is possible that an interim deal will be agreed upon and major aspects of the trade dispute (China’s industrial policy and broader intellectual property rights) will be pushed off to next year. In such a scenario where a modest deal is reached, we expect a modest rally in risk assets though it may be short-lived if investors perceive it as a weak deal. The potential for a selloff in case talks break apart remains, especially as the U.S. is scheduled to raise tariffs on October 15th on another 5% of $250 bn of Chinese goods. Overall, we maintain our cautious stance on risky assets until there is more clarity on the trade war and more concrete signs that the Fed will be more aggressive in cutting rates to support the economy.
The S&P 500 index rose 1.9% in September, and ended the third-quarter up 1.7%. Despite the muted quarter, US stocks have returned 21% YTD on a total return basis – the best start since 1997. On a sector basis, Financials, Utilities and Energy outperformed (4.5%/4%/3.6%) while Healthcare (-0.3%) and Communication Services (0.4%) lagged. Information Technology remains the t
op performing sector YTD (30%) while Energy is the laggard (3%). Recent economic data has shown that the woes in the manufacturing sector are starting to spread into the services sector of the economy (the ISM non-manufacturing index dropped to its lowest level in 3 years). This will likely lead the Fed to be more aggressive in cutting rates compared to its recent dot plot, though the extent of the shift remain unclear even though markets are pricing in around 3 more cuts in the next year. We remain overweight U.S. equities vs. other regions but prefer more defensive sectors and companies that are more leveraged to the U.S. consumer and are resilient to global trade headwinds.
In Europe, the Euro Stoxx 50 index returned 4.3% in September in EUR terms, leaving YTD total returns at an impressive 22.9%. The region’s manufacturing index decelerated further in September (to 45.7 from 47) as the deceleration in global activity and Brexit uncertainty remain major headwinds for the continent. The ECB cut its deposit rate by another 10 bps as expected and restarted its asset purchase program, this time leaving it open-ended. We maintain our marketweight stance on European stocks as Brexit uncertainty and slow growth are likely to remain headwinds though valuations and the ECB are supportive.
Elsewhere, Japanese stocks as measured by the Nikkei 225 outperformed by returning 5.7% on the month in local terms. This came after several months of underperformance driven by companies’ exposure to global trade. The Nikkei has returned 10.7% YTD and we remain underweight even as valuations are cheap. The value-added consumption tax was raised this month and may weigh on economic activity in Japan. Elsewhere, Emerging market equities returned 1.9% in USD terms and are up only 6.1% YTD. The worst performers were Egypt (-3.2%) and Indonesia (-2.5%) given domestic protests against government policies while the outperformers were Argentina and Turkey (18% and 9%). We maintain our marketweight view on EM equities as the exposure to global growth is offset by attractive valuations. We have added exposure to broad Israeli equities, which are benefitting from their defensiveness as well as currency strength (driven by a new natural gas deal and inclusion in a widely followed global bond index).
In fixed income, government bonds retreated modestly, even as major central banks cut rates in September. The stock of negative yielding bonds globally has dropped to $14.8 trillion, but 30-year German bunds still yield -0.1%. The growing pie of negative yielding assets has sparked strong demand for positive yielding assets such as U.S. Treasuries, U.S. corporate bonds, and Emerging Market bonds. This has brought yields to unprecedented levels and is likely to continue in the near-term in our view as central banks continue easing policy and global economic data disappoint.
In credit markets, US investment grade corporate spreads tightened 6 bps in September to 122 bps but total returns were -0.6% given the rise in yields. Top performing sectors were Industrial Products and Food while laggards were Tobacco (failed merger talks) and Autos. Supply volumes were a record $166 bn in September (strongest September and 3rd strongest month ever) bringing the YTD total supply to $991 bn (-4% YoY). Despite the high gross supply figures, on a net basis (after subtracting maturities and calls/tenders) the number was much lower at $55 bn. On the demand side, IG mutual funds received inflows of another 1% of AUM in September. We maintain our overweight view within our fixed income allocation given the defensiveness of the asset class and attractive yield for global investors. We prefer BBB credits with steep credit curves whose management is committed to maintaining an investment grade rating.
US HY credit returned 0.3% (11.5% YTD) as the coupon income of 0.5% was able to offset the rise in yields. Credit spreads tightened by 11 bps to 402 bps. Performance by rating was mixed, with BBs returning 0.3%, Bs 0.6% and CCCs -0.15%. The auto outperformed (1.8%) while the oil field services and pharma sectors lagged (-5.1% and -1.1%). US HY funds received inflows of $4.2 bn, bringing YTD inflows to $13.6 bn. In the primary market, corporations raised $31 bn in USD-denominated bonds, the strongest month of the year. We maintain our marketweight view on US HY given the volatility in equity markets and prefer higher quality credits with improving fundamentals. EUR HY underperformed US HY by delivering total returns of -0.2% (9.1% YTD) as spreads widened 7 bps to 366 bps.
Emerging Market debt had strong performance over the month, driven by accommodative central banks. EM hard currency sovereigns returned -0.2% as spreads tightened 16 bps to 349 bps. EM corporates returned 0.1% as spreads tightened 24 bps to 315 bps. EM local currency sovereigns returned 1% in $US terms, driven by a 0.6% appreciation in local currencies vs. the USD. On a country basis, Argentine external assets rebounded after August’s sharp selloff, with sovereign and corporate indices up 16% and 14% respectively. Turkish government bonds also outperformed ($ bonds up 3.7% and TRY bonds up 12.9%) as inflation has decelerated sharply and the central bank cut rates aggressively. We maintain a positive view on EM debt though acknowledge tighter valuations and the need for broad diversification and country selection.
Overall, central banks are trying to combat the deceleration in global growth and markets are giving them the benefit of the doubt. This month will be pivotal in terms of the trade talks, Fed meeting and Brexit deadline. We remain defensive across our portfolios until we see the risk-rewards as tilted more to the upside. 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.