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Emerging markets watch central bank trinity

Weekly Investment View – 10 June 2018

  • Abu Dhabi’s US$ 13.6bn stimulus package boosts UAE stocks
  • ECB talks about ending stimulus
  • Fed will continue normalization, adding volatility to EM currencies
  • RBI rate hike spurs rupee and Sensex rally

INVESTMENT SUMMARY: The most liquid stock market in the Middle-East is rallying after the UAE unveiled a round of stimulus. Meanwhile, the Fed is expected to continue to hike interest rates, prompting more volatility of emerging market assets. The FAB Asset Allocation Committee meets this week and strategy remains unchanged until the meeting.

United Arab Emirates stocks rallied after His Highness Sheikh Mohammad bin Zayed Al Nahyan, the Crown Prince of Abu Dhabi, unveiled an AE$ 50 billion (US$ 13.6 billion) stimulus package aimed at helping small and medium enterprises, supporting new industries, encouraging tourism and making it easier to do business. The stimulus will be rolled out over three years.

The effect, however, was immediate. Abu Dhabi’s stock index rose 1.1% after the announcement, ending the week up 1.25%, while Dubai’s closed 2.6% higher for the week.

The announcement follows only weeks after the UAE Cabinet allowed foreigners to set up businesses outside free zones.

Both announcements help diversify the UAE’s economy and may support property prices.

The property sector has already shown signs of stabilizing anyhow. Last week, Dubai’s Land Department announced monthly sales figures that showed the total value of property units sold in May increased 12.88% compared to April. Year-to-date, however, the figure is still 26.4% behind the same period of 2017.

Higher average oil prices and the stimulus and liberalization measures will accelerate growth in the UAE. That should support stocks, especially in the construction and financial sectors, which are more sensitive to economic cycles.

Dubai’s stock market index trades at 8.25 times forward earnings and offers a dividend yield of 5.57%, making it very cheap. And Abu Dhabi’s stock index trades at 11.60 times expected earnings with a dividend yield of 5.15%.

As a comparison, the Stoxx 600 trades at 14.71 times forward earnings and offers a dividend yield of 3.46%, while the S&P 500 trades at 17.47 times earnings and yields 1.88%.

Outside the UAE, all eyes are on this week’s meetings of the US, European and Japanese central banks.

Particular attention is being given to the ECB after Chief Economist Peter Praet suggested it is time to talk about ending quantitative easing. The euro rallied on the comments, spurring a sell-off in some emerging market currencies, particularly the Brazilian real.

The euro touched US$ 1.1800 on Thursday and the yield on the 10-year German bund rose six basis points. On Friday, however, the currency dropped to US$1.1769 and the 10-year bund yield dropped three basis points to 0.45%.

It’s a catch-22 for the central bank. The Eurozone’s inflation is over 1.5% and on track to reach the 2% ECB target. Unemployment in the Union is now at 8.5%, the lowest since 2009. Yet, just last week German factory orders came in at negative 2.5% when economists expected a positive print. That was days after the euro-area’s own manufacturing measure showed a fourth successive decline.

Now, Citigroup’s euro-area economic surprise index is near its most negative since 2011. It has been seven years since economists were so bullish – and wrong – about Europe.

Add turmoil in Italy to that. Last week, a government was finally formed around Prime Minister Giuseppe Conte, but it has 31-year old Eurosceptic Five Star leader Luigi Di Maio as labor and economic minister, and anti-immigration advocate Matteo Salvini as interior minister. Salvini has promised tax cuts while Di Maio wants to increase welfare expenses, a difficult combination in a country that has not had a fiscal surplus in more than two decades.

Conte said he was committed to the European Union last week but signaled higher spending plans. That raises the prospect of clashes with Germany and more talk of schism from the Eurozone, which could impact the single currency.

Praet’s words may be just setting the stage for actual announcements of quantitative easing curbs in July or even later, depending on political and economic developments. The ECB is likely to keep its wait-and-see statement for now, which could force the euro to give back some gains and compress bund yields.

The Bank of Japan also meets this week but is unlikely to change its easing stance. The country grew 1.7% last year but the OECD expects it to expand only 1.2% in 2018.

Meanwhile, the Federal Reserve is expected to increase its benchmark rate by 25 basis points to 2%, the highest level since September 2008, on the eve of the Lehman Brothers bankruptcy.

Unemployment in the US is at 3.8%, the lowest in 18 years. Core CPI, excluding food and energy, came in at 2.1% in April and is expected to show further increases when May numbers are revealed on Tuesday.

The strength of the US economy supports the Asset Allocation Committee’s expectations of three rate hikes this year and two in 2019.

The two most recent US interest rate hike cycles were accompanied by gains in US stocks. Indeed, the equity gauge is up 3.94% this year, having rallied 1.62% only last week. At 17.4 times forward earnings, the index is close to the 17.3 five-year average for the measure and off highs of more than 20 times seen last year.

As rates rise, so will US Treasury yields. The yield on the 10-year bond closed at 2.95% last week, inching back toward the key level of 3% and having risen sharply from the 2.78% it hit on 29th May, amid the political impasse in Italy.

Rising Treasury yields have taken their toll on investment grade bonds. The Bank of America Merrill Lynch US Corporate Index is down 3.23% year to date, having dropped 0.26% last week. If the yield on the 10-year US Treasury holds above 3% for a couple of weeks that movement could accelerate.

The biggest losers, however, have been emerging market currencies – which is consistent with what happened in the two most recent rising interest rate cycles in 1994 and 2004.

The MSCI Emerging Market Currencies index is down 0.7% this year, having lost 0.33% last week as investors used the prospects of reduced easing in Europe as an excuse to exit developing countries. The PIMCO Emerging Markets Advantage Local Currency Bond Index is faring worse, down 4.71% this year and having dropped 1.2% last week.

Last week’s move was mostly driven by the Brazilian real, which dropped 1.51%. The currency rout in Latin America’s largest economy is only the latest of a string. The Brazilian central bank so far has refused to take the same tack as other victims, such as Turkey, Indonesia and India, which raised interest rates in response to outflows.

Unlike Brazil’s central bank the Reserve Bank of India took the cue and raised its repurchase rate by 25 basis points last week to 6.25%, a move hardly anyone expected. While Indian inflation was running at a high 4.58% in April – with some predicting an even higher print in May – the price rise has been pushed mostly by oil prices. In other words, the increase in prices is not a result of stronger demand in the economy.

Were it not for the rupee depreciation, the central bank may have looked beyond the oil-price-rooted inflation. However, the central bank needed to restore confidence after spending 3.2% of its foreign reserves in less than two months defending the currency.

That move mirrored the recent decision by the Turkish central bank to increase rates by an unexpected 125 basis points, a move it repeated last week and which helped support a 5.4% rally in the lira over the past two weeks.

It worked for India too. The rupee finished the week at R$ 67.5075 per US$ 1, up 0.66%. The stock market also responded to the move and the Sensex index closed the week up 0.87%. The rally may have been counterintuitive, given that the rate hike may slow the country’s economy and reduce company earnings.

India-focused funds, however, have suffered the worst outflows of large emerging markets this year. The RBI’s move may reverse that, and is therefore bullish for Indian stocks. Furthermore, technical analysis suggests there is room for the Sensex to rally further, as the index has found support at the 50-day moving average recently and that measure is still trending upward.

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Weekly Investment View – 10 June 2018

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