FIXED INCOME INVESTMENT STRATEGY Economic Cycles: Charting the uncharted

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20192

Financial Markets are becoming increasingly volatile with deep market gyrations and price swings. The last decade-long bull market, the “everything rally”, was supported by a combination of fundamental growth and abundant liquidity. Where we are in the economic cycle is thus a key question. While the economic growth still is at trend levels we remain cautious, and closely monitor all the ongoing concerns surrounding global trade, currency wars, slowing manufacturing activity, and overall heightened geopolitical uncertainties. Despite these potential negative catalysts, we still think it’s premature to call for the end of the cycle. We, however, are in its late stages. Investors need to turn more prudent in their allocation and portfolio construction within the fixed income asset class, to prepare for not only low yields, but higher volatility. Having the right sectors and geographies is key for both individual risk/return and portfolio level diversification, to mitigate any unforeseeable market stress.

THE BIG PICTURE

HISTORICAL PERFORMANCES ACROSS EACH STAGES OF PAST ECONOMIC CYCLES

KEY TAKEAWAYS

It is important to keep in mind the time between yield curve inversion and economic slowdowns do not spark an immediate catastrophe. The yield curve from 3 to 5 years dipped below zero during the last cycle for the first time in August 2005, some 28 months before the recession began. Since the early 1980s, the reversal of financial boom, and not central bank tightening to control inflation has often triggered recessions. There are several indicators to constantly keep a close watch, and the “yield curve” is just one of the many financial-cycle indicators. Inflation levels, the cycle of monetary policy, the returns on risk assets (stretched valuations), poor economic activity, as well as property prices are a few others.

THE US YIELD CURVE

Early Mid Late Recession

High Yield Investment Grade-5%

0%

5%

10%

15%

20% 19.0%

7.5%

1.5%

-0.5%

6.0% 5.5%4.0%

13.0%

Early Mid Late Recession

Stocks Bonds Cash-10%

0%

10%

20%

30%25.0%

14.0%

5.5%

-8.0%

6.0% 5.5% 4.5%

13.0%

4.5% 4.8% 5.5% 5.5%

Source: Fidelity Viewpoints Source: Fidelity Viewpoints

■ We prefer long duration developed markets Sovereign bonds. We favour investment-grade bonds over high-yield. Sector-wise, we opt for a defensive stance; Sovereigns, health care, consumer staples, and utilities.

■ Within emerging markets, credit selection is vital and by deploying good bottom-up analysis, opportunities to protect from downside risks could be attained.

■ Cash in a fixed-income portfolio is not the panacea for all volatility woes.

Manufacturing sector in a downtrend

Yes

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20193

It is generally observed that no two market cycles across different time horizons are alike, and the current one is no exception, should it be its length (a decade), its pace (relatively slow for a post-crisis recovery) and of course the never-seen-before role Central Banks played in it. Investors are thus questioning its longevity and ability to be extended further through the current headwinds. We strive to find answers to some frequently asked questions; (1) Why do markets send mixed signals (Bonds and

Equities moving in the same direction)? (2) What’s next? Are we moving into a recessionary

phase? (3) Do we hold only cash in our investment

portfolios? The answer to the first question is straightforward. It is the Tsunami of monetary policy easing that has lifted all the asset classes in H1 2019. S&P 500 has hit a record high despite seeing earnings estimates revised down, a valuation re-rating. The German and Swiss Sovereign bonds are yielding negative across the entire term structures. Inflation has been stubbornly low and global manufacturing has begun to show weakness. We do not believe a recession is imminent. The trade tensions create a shock on business

sentiment and pressure the industrial activity, but consumption is resilient and the US job market is very strong. Growth expectations are lower, pushing rates lower, and markets’ psychology amplifies concerns. That said, locking in YTD gains on some of the bonds across cyclical sectors makes sense in our view, which is a part of a broader recommendation to start turning more defensive within the fixed income portfolios.

A DIFFERENT TYPE OF LATE CYCLE?

During periods of uncertainties, it can be tempting to increase cash positions in fixed income portfolios. Cash outperformed long-term bonds in 2018 and in similar periods over the past quarter-century where investors grappled with concerns surrounding inverted yield curve. However, these periods of outperformance tend to be short-lived, because they typically also represent the beginning of a shift in monetary policy from tightening to easing. In fact, over the past quarter-century, the longest period of outperformance was a single 24-month period in 2005 and 2006. Today, the Fed has already scaled back its expectations for further rate increases in 2019 and markets anticipate four rate cuts till December 2020, which would benefit longer-maturity bonds over cash. Cash makes full sense as a risk mitigator in a multi-asset portfolio, but it is not a panacea within a fixed income portfolio.

CASH AS AN ASSET CLASS

LATE CYCLE CHARACTERISTICS

CHARACTERISTIC COMMENTSTRUE FOR CURRENT CYCLE?

CYCLE ENABLERS (+)

CYCLE INHIBITERS (–)

Consumption tapers off

Auto sales decline

Fixed Investments slowdown

Property markets in a downturn

US consumer consumption is driving GDP

Auto Sales are falling

Home prices are well supported in the US. However, new home sales and Mortgage applications data prints have been poor

Significant monetary stimulus underway is a powerful tool to support asset prices. Helicopter money (yet to be exercised) Fiscal stimulus (if any) such as corporate tax cuts, Increase in Govt expenditure, Credit creation, Infrastructure development spends

Protectionism and prolonged trade wars, Currency wars, Policy errors by Governments and Central Banks, Tightening of regulations leading to liquidity crunch, Rise in default rates

No

Investments to increase capacity has slowed globally

Global PMI indicators are contracting in over 28 countries, contributing to 60% of the world GDP

Tightening of Monetary policy

No Global central banks have an accommodative / easing stance

Inflation increases No Global inflation readings are benign; central banks are revising inflation expectations lower

Yes

Yes

Mixed

Bond yields rise Bond yields have hit new record lows. The aggregate volume of negative yield debt exceeds USD 16tn

No

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20195CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20194

ILLUSTRATION: SAMPLE FIXED INCOME GLOBAL PORTFOLIO

NAME / ISSUER COUPON % MATURITY YIELD TO MATURITY

MODIFIED DURATION

RATING BB COMPOSITE

COUNTRY SECTOR GEOGRAPHY WEIGHT

EMIRATES TELECOM CORP 3.50 06/18/2024 2.529 4.42 AA- UAE Communications EM 1.79%

ALLERGAN FUNDING SCS 3.80 03/15/2025 2.876 4.75 BBB- USA Health Care DM 2.00%

TABREED SUKUK SPC LTD 5.50 10/31/2025 3.215 5.24 BBB- UAE Utilities EM 1.79%

ABBOTT LABORATORIES 3.75 11/30/2026 2.23 6.18 BBB+ USA Health Care DM 2.00%

PFIZER INC 3.45 03/15/2029 2.444 7.91 A+ USA Health Care DM 2.00%

DUKE ENERGY CORP 3.40 06/15/2029 2.739 8.14 BBB+ USA Utilities DM 2.00%

CVS PASS-THROUGH TRUST 7.51 01/10/2032 3.759 5.79 BBB USA Health Care DM 2.00%

SOLAR STAR FUNDING LLC 5.38 06/30/2035 4.197 7.20 BBB- USA Utilities DM 2.00%

GE CAPITAL INTL FUNDING 4.42 11/15/2035 4.029 11.52 BBB+ USA Diversified DM 2.00%

RUWAIS POWER CO PJSC 6.00 08/31/2036 3.926 10.18 A- UAE Utilities EM 1.79%

TAQA ABU DHABI NATL ENER 6.50 10/27/2036 3.526 11.29 A- UAE Utilities EM 1.79%

DEUTSCHE TELEKOM INT FIN 4.75 06/21/2038 3.46 12.66 BBB+ Germany Communications DM 2.00%

ELECTRICITE DE FRANCE SA 6.95 01/26/2039 3.476 12.28 A- France Utilities DM 2.00%

SAUDI ARABIAN OIL CO 4.25 04/16/2039 3.413 13.50 A+ KSA Energy EM 1.79%

DUBAI GOVERNMENT INT'L BONDS 5.25 01/30/2043 4.221 14.12 NR UAE Government EM 1.79%

ROCHE HOLDINGS INC 4.00 11/28/2044 2.814 16.48 AA- Switzerland Health Care DM 2.00%

NOVARTIS CAPITAL CORP 4.00 11/20/2045 2.967 16.76 A+ Switzerland Health Care DM 2.00%

BASIN ELECTRIC PWR COOP 4.75 04/26/2047 3.544 16.16 A- USA Utilities DM 2.00%

SAUDI INTERNATIONAL BOND 5.00 04/17/2049 3.792 16.52 A+ KSA Government EM 1.79%

AMGEN INC 4.66 06/15/2051 3.659 17.53 A- USA Health Care DM 2.00%

PIMCO GIS INCOME FUND 4.03 4.510 0.99 A Global Diversified Debt Fund Global 10.00%

NNL EM (SOV) 4.12 6.130 7.31 BB- EM Diversified Debt Fund EM 19.50%

JUPITER DYNAMIC BOND FUND 3.61 3.560 6.67 A- Global Diversified Debt Fund Global 10.00%

ISHARES 20Y+ ULTRA LONG BOND ETF 2.17 2.170 17.73 AAA USA Government DM 22.00%

Note: The portfolio constructed are based on the sub-asset class allocations. The portfolio includes bond funds and bond ETF. The coupons stated under the funds/ETF are those with trailing 12M distribution. The portfolio weights have been based on the weightings from the Asset allocation grid stated on page 6 (Moderate profile). The high yield component is incorporated under the EM allocation itself. Source: CIO Office, pricing source from Bloomberg as of 12 Aug 2019

Diversified Debt Fund 40%

Government 26%

Health Care 14%

Utilities 13%

Communications 4%

Diversified 2%

Energy 2%

USA 40%

EM 20%

Global 20%

UAE 9%

KSA 4%

Switzerland 4%

Germany 2%

Source: CIO Office, pricing source from Bloomberg as of 12 Aug 2019 Source: CIO Office, pricing source from Bloomberg as of 12 Aug 2019

SECTOR ALLOCATION COUNTRY / REGION ALLOCATIONPORTFOLIO WEIGHTED YIELD 3.76%

PORTFOLIO DURATION 10.3 YRS

WEIGHTED COUPON 3.90%

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20196

GRAPH SHOWCASING RELATIVE VALUE VS THEIR RESPECTIVE YIELD CURVES (CORPORATE IG AND SOVEREIGN)

CIO OFFICE TACTICAL ASSET ALLOCATION AS OF AUGUST 2019 – PUTTING FIXED INCOME BUCKET INTO CONTEXT

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

5.5

6.0

6.5

0 5 10 15 20 25 30

NN L EM (BB-)

Jupiter DynamicFund (A+)

Pimco GISFund (A-)

Ishares 20+UST ETF (AAA)Abbott (BBB+)

Allergan (BBB-)

Amgen (A-)Saudi Aramco (A+)

Basin Electric (A-)

Solar Star (BBB-)

CVS (BBB)Deutsche

Telekom (BBB+)

Dubai Govt

Duke Energy (BBB+)

Electricite DeFrance (A-)

Etisalat (AA-)

GE Capital (BBB+) KSA Bond (A+)

Novartis (A+)

Roche (AA-)

RuwaisPower (A-)

Tabreed (BBB-)Taqa AbuDhabi (A-)

US BBB Corp Yield Curve

Yiel

d

DurationUS A Corp Yield Curve UST Yield Curve

CAUTIOUS MODERATE AGGRESSIVE

TAA SAA REL TAA SAA REL TAA SAA REL

CASH 19.6 15.0 4.6 15.0 10.0 5.0 10.6 5.0 5.6

US DOLLAR CASH 19.6 15.0 4.6 15.0 10.0 5.0 10.6 5.0 5.6

FIXED INCOME 50.8 50.7 0.1 40.1 39.8 0.3 25.8 22.9 2.9

DM GOVERNMENT 19.8 21.3 -1.5 11.3 12.8 -1.5 0.0 0.0 0.0

DM INV GRADE 24.4 23.1 1.4 15.7 15.5 0.2 8.7 8.5 0.2

DM HIGH YIELD 0.0 0.0 0.0 2.9 3.6 -0.7 3.9 4.6 -0.7

EM GOVERNMENT 6.6 6.3 0.3 10.2 7.9 2.3 13.2 9.8 3.5

EQUITY 19.2 20.1 -1.0 34.6 35.2 -0.6 52.2 55.1 -2.9

DM GLOBAL EQUITIES 15.3 16.2 -0.9 25.8 26.2 -0.4 37.6 40.2 -2.6

EM GLOBAL EQUITIES 3.9 4.0 -0.1 8.7 8.9 -0.2 14.5 14.9 -0.3

ALTERNATIVES 10.4 14.1 -3.7 10.4 15.1 -4.7 11.5 17.1 -5.6

GOLD 4.0 4.0 0.0 3.5 3.5 0.0 3.0 3.0 0.0

HEDGE FUNDS 6.4 6.5 -0.1 6.9 7.0 -0.1 8.5 8.5 0.0

REAL ESTATE 0.0 3.6 -3.6 0.0 4.6 -4.6 0.0 5.6 -5.6

Source: Bloomberg pricing as of 12 Aug 2019

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20197

SCENARIO ANALYSIS OF SIMULATED DRAWDOWN EVENTS AND YIELD CURVE SHIFTS ON THE SAMPLE BOND PORTFOLIO

Source: Bloomberg pricing as of 12 Aug 2019

Note: Scenario Analysis is simulated using Bloomberg on 15 Aug 2019. Curve shift scenario returns are based on instant market reactions.

SCENARIO

HISTORICAL DRAWDOWN SCENARIOS

BEST WORST PORTFOLIO PERFORMANCE

Lehman Default - 2008 Utilities EM Debt

Russian Financial Crisis - 2008 Treasury EM Debt

Equity Markets rebound in 2009 EM Debt Treasury

EUR Down 10% Vs USD Energy EM Debt

Equities down 10% Treasury EM Debt

Equities up 10% EM Debt Treasury

Libya Oil Shock - Feb 2011 Treasury EM Debt

Greece Financial crisis - 2015 Treasury EM Debt

Japan Earthquake in Mar 2011 Treasury EM Debt

Oil Prices Drop - May 2010 Treasury EM Debt

EUR up 10% Vs. USD EM Debt Energy

Debt Ceiling Crisis & Downgrade 2011 Treasury EM Debt

SCENARIO

CURVE SHIFT SCENARIOS

BEST WORST PORTFOLIO PERFORMANCE

Up Parallel shift (+100 Bps) Treasury Long Duration

Up Parallel shift (+50 Bps) Treasury Long Duration

Steepener (Short -25 bps Long +50 Bps) Treasury Long Duration

Butterfly 3-5yr short dated Long Duration

Flattener (Short +25 Bps Long -50 bps) Long Duration Treasury

Down Parallel shift (-50 Bps) Long Duration Treasury

Down Parallel shift (-100 Bps) Long Duration Treasury

4.1%

1.6%

0.8%

0.7%

0.7%

0.6%

0.3%

-0.2%

-1.6%

-2.8%

-5.6%

-10.1%

4.7%

2.2%

1.9%

-1.7%

-1.8%

-2.0%

-3.9%

2014 2015 2016 2017 2018 20190

20406080

100120

02468101214

Bond (R2) Stocks (L1) FX (R1) US EU Japan Switzerland

1Y 2Y 3Y 4Y 5Y 7Y 10Y 30Y 40Y 50Y-1.5

-0.5

0.5

1.5

2.5

2000 2004 2008 2012 2016 201930

35

40

Expansion

Contraction45

50

55 60

2019201820172016201520140369

121518

BOUTS OF VOLATILITY GLOBAL YIELD CURVES

GLOBAL PMIS ON THE DECLINENEGATIVE YIELDING DEBT ON THE RISE

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20198

LENGTH OF PAST ECONOMIC CYCLES

Jul-80Apr-58Nov-70Oct-45

May-54Oct-49Mar-75Nov-01Nov-82Feb-61Mar-91

Current (June 2009)

Duration of economic cycles (in months)

0 20 40 60 80 100 120 140

1224

363739

4558

7392

106120

123

Source: National Bureau of Economic Research

SPREAD WIDENING DURING MARKET STRESS

QUALITY AND SELECTION REMAINS KEY FOR PORTFOLIOS

Global HY

Global FinancialCrisis

SovereignDebt Crisis

ChinaGrowth Fears

OngoingTrade Wars

Global IG EM Debt

0

2

4

6

8

10

12

14

16

18

2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019

Source: CIO Office, Bloomberg

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 20199

UNDERSTANDING THE STAGES OF ECONOMIC CYCLES

EARLY-CYCLE MID-CYCLE

■ Activity rebounds (GDP, industrial production, employment, incomes)

■ Credit expansion ■ Growth in corporate profitability ■ Stimulative monetary and fiscal policies ■ Low inventories

MARKETS SIGNAL ■ Bond yields bottomed out ■ Short-term interest rates low ■ Stocks rise ■ Commodities rise ■ Property prices low

SECTORS THAT BENEFIT ■ Financials ■ Industrials ■ Technology ■ Consumer discretionary ■ Real estate

■ Growth moderates ■ Tighter credit conditions ■ Corporate earnings under pressure ■ Inventories build-up ■ Sales growth falls ■ Policy contractionary

MARKETS SIGNAL ■ Short-term interest rates on the rise ■ Bond yields rise ■ Stock markets making new highs ■ Commodities rising strongly ■ Property prices rising strongly

SECTORS THAT BENEFIT ■ Materials ■ Consumer staples ■ Utilities ■ Energy ■ Health care ■ Real estate

■ Growth peaking ■ Strong credit growth ■ Corporate profit growth peaks ■ Neutral policies ■ Inventories, sales grow

MARKETS SIGNAL ■ Short-term interest rates neutral ■ Bond yields stable ■ Stock market on the rise ■ Commodities strong ■ Property prices pick up

SECTORS THAT BENEFIT ■ Industrials ■ Technology ■ Energy ■ Consumer discretionary ■ Real estate

■ Economic activity falls ■ Credit dries up ■ Policy eases ■ Profits decline ■ Sales and inventories fall ■ Unemployment rises

MARKETS SIGNAL ■ Short-term interest rates fall ■ Bond yields fall ■ Stock markets fall ■ Commodities fall ■ Property prices fall

SECTORS THAT BENEFIT ■ Consumer staples ■ Utilities ■ Health care ■ Sovereigns

LATE-CYCLE END-CYCLE (RECESSION)

CONTACT

SYED YAHYA SULTAN Head of Fixed Income Strategy Email: yahyas@emiratesnbd.com

Telephone: +971 4 609 3724

Mobile: +971 55 886 3947

SATYA JIT SINGH, CFA Fixed Income Analyst Email: satyajitsi@emiratesnbd.com

Telephone: +971 4 609 3795

Mobile: +971 56 367 5265

CIO OFFICE - FIXED INCOME INVESTMENT STRATEGY - AUG 201911

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