Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Adapt or die, UK election and the Brazilian superstar
Peter Garnry
Chief Investment Strategist
Summary: In today's equity update we digest the FOMC decision last night that sparked a risk rally in equities and gold as the Fed president Powell opened up for proper QE if needed. We also touch on global leading indicators, UK election, Aramco valuation topping $2trn and take a look at the Brazilian equity market that has been a star performer since 2016.
Yesterday’s FOMC press release gave little to market participants with the key rate unchanged as expected and no major changes in the Fed’s language on the economy and monetary policy. Overall, the Fed is satisfied with the current growth momentum, which has stabilised, against the current policy. The key thing that happened during the press conference sparking a rally in equities and gold while tanking the USD was Fed president Powell’s remarks that the Fed was willing to adapt its strategy on its current liquidity operations which only includes buying Treasury bills.
As we talked about on yesterday’s Market Call podcast there are ongoing structural issues in the US repo market which has been argued by the respected Zoltan Pozsar, an analyst with Credit Suisse that has formerly been with the US Treasury and the Fed, could cause major issues as we get closer to year end. The Fed’s current operations are not QE as it is not buying coupons (duration) but Pozsar’s main argument is that there are too little reserves in the system and the only way to rectify this situation is for the Fed to launch proper QE (that would be QE4) buying various duration levels in the Treasury market. Powell’s comment that the Fed was willing to adapt to an adverse situation in the repo market hinting of QE4 got the rally going.
The immediate implications of QE is a weaker USD and if ECB, which has its first press conference under the new president Christine Lagarde, changes its policy mix following Riksbank in setting policy rates closer to zero, then equities should do well and especially emerging market equities. In our equity update on Monday we wrote about OECD’s global leading indicators suggesting that the global economy has entered a recovery phase following 21 months of declining growth momentum. If it holds that the economy is turning then we are entering historically the best period for equities and especially for emerging market equities.
Today the UK will have its third election in five years and much is at stake for the UK in terms of political direction and Brexit mandate. Surveys have suggested a firm Conservative majority but the party has slipped in recent surveys so it could get much tighter than currently estimated. The polls close at 22:00 GMT and the earliest results will most likely be announced in the early hours of Friday morning. The UK election is a tough event to trade but in our UK election analysis from two days ago we try to lay out the different outcomes across for GBP and UK equities in addition to expected pivot on fiscal spending etc.
The world has also got its first $2trn market value company as Aramco’s newly floated shares have surged from the IPO price of 32 to 38 in today’s session. In our view the $2trn valuation should be viewed with a grain of salt as only 1.5% of the shares are free floating and they are only listed on the Saudi Stock Exchange. We will know Aramco’s true fair value the day the company lists its shares in a more institutionalized capital market center and the free float goes to at least 10%. Our general view on the global energy sector is still negative with global energy companies only delivering around 7% return on equity which is essentially below the required rate of return for equity investors in the energy sector. In addition the recent OPEC+ cuts are likely not enough to lift oil prices much from here going into 2020.
Staying with our overweight emerging market equities given the macro outlook it’s worth looking at Brazil as the central bank cut the overnight interest rate by 50 bps. (as expected) sending Brazilian equities higher. In our equity update on Monday we highlighted Brazilian equities as a top play based on historical performance during a macro recovery phase. With monetary policy easing, strong manufacturing PMI, stable GDP growth and high beta to the global economic recovery Brazilian equities could easily be a stellar performer in 2020. The key equity index Ibovespa is one of the best performing indices in emerging markets since the bottom in January 2016 up 191% in USD terms. If we look at valuation the Brazilian equity market is valued at around 25% discount to developed market equities.
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