Panorama - October 2021 -
The markets’ resilience will once again be tested
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
Western equity markets barely flinched at the Evergrande episode or the announcement that US monetary policy would be tightened earlier than expected...
The markets’ resilience is exceptional, but it could be challenged once again by several major issues as we enter a period that, statistically, is less favourable to Wall Street, with questions on how long the recovery will last, the impact of renewed inflation on household consumption and companies’ margins, China, and, of course, monetary policies!
Context and analysis
For the first time in seven months, US and European equities fell in September, albeit only slightly, by about 2% so far. Year-to-date performances have been very strong, with gains of more than 15% in most developed country indices. Moreover, these gains have occurred in unusual market conditions, including exceptionally low volatility.
For example, there have been no 10%-plus corrections for more than one and a half years.
The reasons for this is that, so far, the markets have been driven by a combination of two very powerful forces: 1/ the ongoing, very powerful “post-Covid” recovery, which has resulted in a spectacular improvement in companies’ earnings; and 2/highly accommodative monetary policies that have kept liquidity abundant on the markets and kept interest rates very low, despite a resurgence in inflation. This has naturally pushed investment flows into equities, as well as unlisted assets, particularly real-estate and private equity, excessively so, according to some strategists.
But now these very powerful forces seem to be running out of steam.
First of all, because of how “growth momentum” is slowing. Is this due to the temporary impact of the Delta variant wave? That’s possible, but, in any case, growth is slowing at a faster pace than expected, especially in China and the US.
In China, growth peaked early in the year. Since then, indicators have shown something of a slowdown, and growth will have a hard time hitting 8.4%, which is what is expected by the consensus of economists surveyed by Bloomberg. For 2022, the consensus forecast is for growth of just 5.6%. The Chinese economy was the first to open after Covid lockdowns. The initial catching-up phase has naturally slowed, but that’s not all. China has been “shaken” by a regulatory crackdown. The goals of this crackdown are certainly praiseworthy (to restore some societal harmony by reducing wealth gaps, to restart birth rates, and to accelerate the shift towards a decarbonated economy), but it is causing real tensions. It was against this backdrop that Evergrande, which until recently was the world’s largest real-estate developer, almost went under. This is a purely Chinese issue. International banks and investors have little exposure to the Chinese realestate sector. So, there are few risks of contagion of the type that occurred during the US subprime crisis in 2007. That being said, a new bout of weakness in the Chinese economy would have global repercussions. The Chinese government is trying to rein in surging real-estate prices and the resulting debt levels, but real estate does account for at least one quarter of the Chinese economy. Real estate is also a pillar of Chinese households’ wealth, accounting for 40% of their assets. A decline in prices could weigh on confidence, slow domestic consumption and, hence, exacerbate the current economic slowdown, this time potentially spilling over into the entire global economy. The Chinese authorities appear to have properly assessed this risk, especially in the run-up to a very important year in which the Communist Party congress will be held. At the congress, President Xi Jinping will seek unanimous approval for a third term, which would open the door to a presidency “for life”, something that hasn’t occurred since Mao Zedong. The Peoples’ Bank of China has therefore just injected liquidity into the banking system, which is also monetary creation. The risk premium on Chinese equities has naturally risen in recent weeks and is likely to remain rather high. Even so, there will be investment opportunities in the current environment.
In the United States, many economists have raised their growth estimates significantly for the third quarter. The Atlanta Fed’s “GDP Now Model”, which provides the most real-time indication possible, forecasts 3.7% for the quarter, down from 5.3% in early September. In its latest Beige Book, the Federal Reserve stated that, while the resurgence in the Delta variant has contributed to this slowdown, it is far from being the only reason. Another reason is that household consumption has fallen sharply, due probably to higher prices, particularly for energy, and to expectations of tax hikes. Higher prices could also ultimately eat into companies’ margins. This will be a very important parameter to keep an eye on during the upcoming quarterly reporting season, as inflation has exceeded 5% on a 12-month basis in the US, which is beginning to look significant. For the moment, the consensus of economists forecasts 6.2% growth in the US economy this year and 4.3% in 2022.
In the euro zone, the pace of the recovery has so far beaten forecasts, and momentum on the whole is still strong. European countries took the gamble of reopening their economies rather early, despite the spread of the Delta variant. This turned out to be a winning bet, as there haven’t been too many negative health consequences, thanks to vaccination campaigns that have ultimately borne fruit. We nonetheless see a certain slackening in consumer confidence. Business confidence is very high on the whole, but, here again, some signs of overheating are emerging, with shortages of intermediate goods and labour, along with risks to margins due to higher prices of commodities and intermediate goods. The price index is also at a 10-year high, at almost 3.0% over the past 12 months. Growth is currently forecast at 4.8% this year and 4.4% for 2022.
It is against this backdrop, that the US Federal Reserve decided to begin normalising its monetary policy, a little earlier than expected. It telegraphed a reduction in its asset purchases on the bond market as soon as yearend, and an initial hike in key rates within one year.
During the Covid-19 crisis, central banks have been praised in public debate for having assumed their responsibilities. In some ways, they have stepped beyond their purely technical functions and assumed a societal policy role. But serious questions are now being asked about whether their monetary stimulus policies have gotten out of hand. For, these policies have triggered a spike in asset prices, which has, de facto, exacerbated the wealth gap between those who own assets and those who don’t. Moreover, they are suspected of taking an overly lax attitude in financing governments, which is not pushing those governments back to a measure of fiscal discipline. In light of the above, the Federal Reserve’s decision seems to make sense. After all, the economy has taken off again, unemployment has fallen drastically, and inflation has at last exceeded its targets. The markets themselves have taken a lax attitude to all this, and interest rates have risen only by about 15 basis points on 10-year paper, to something approaching 1.50%. So, the markets ultimately do not seem to believe in a sustained rise in inflation, or they are anticipating a greater economic slowdown, or they believe that central banks won’t carry their thinking to its logical end, i.e., that they will keep real rates in negative territory for a long time to come, to help governments shrink their debt burdens, to the detriment of bondholders.
On the road to normalisation?
The 22 September Fed meeting brought to a close a month that saw the major central banks become a notch more hawkish (i.e., with tighter policies to fight inflation, particularly through interest-rate hikes), driven by inflation that is higher than in their latest projections, put out in June. Central banks have become more confident in growth, albeit growth that is on a more chaotic trajectory, owing to the Delta variant. It is the Delta variant that forced the Fed to lower its 2021 forecasts, while raising its 2022 and 2023 forecasts. In Europe the schema is somewhat the reverse, with growth forecasts being raised for 2021 and marginally downward for 2022.
However, the big picture seems to be moving towards a baseline scenario of less monetary support from the Fed and the ECB, beginning in the fourth quarter of 2021, slowing but solid growth, and inflation moving towards normalisation in 2022. This scenario would see bond yields rise back towards 0.00% in Germany and to about 1.75%/2.00% in the US in the coming months.
The upcoming monetary shift is not without risk, and the markets will constantly keep one eye out for inflation that is “not so transitory”, which would force central banks into faster normalisation than currently planned.
Against this backdrop, the credit market will continue to be driven mainly by shifts in interest rates, rather than credit margins. Investment grade is likely to stay expensive, with very little narrowing room. On the high yield market, the thinking is rather similar, as spreads (difference between rates) are rather narrow, but the carry trade remains attractive in relative terms. In addition, the economic recovery story should carry the day vs. the risk incurred by the expected monetary tightening.
Keep in mind that amidst a gradual exit from the pandemic, emerging bonds – which have been beaten down in 2021 – should become attractive once again in the coming months, once the Fed has conducted its monetary shift and the pandemic has been brought under better control in emerging market countries.
A relatively quiet quarter
The equity markets experienced a relatively quiet quarter, and they are currently close to their June levels. Volatility is nonetheless moving back up against a backdrop of concerns over the Chinese economy, as well as the tightening that is likely by monetary authorities, at least in the US. Whenever this prospect comes to the fore, it is interesting to see the aggressive sector rotation that follows. The reason for this is that the equity markets have for 30 years now been operating in an environment in which interest rates have moved only downward, despite some one-off upticks. With this in mind, all high-visibility companies, “defensive” and growth stocks – even though the term is overused – are regarded as alternatives to bonds. They are driven by discounting of their future earnings at a very low rate. If interest rates were to rise, even slightly, valuations of this segment would be affected. Meanwhile, banking stocks, which benefit when rates rise, are seeing their share prices rise, although we are still very far from the levels of a decade ago.
The coming weeks will feature the third-quarter reporting season. Secondquarter results were excellent. On top of the figures themselves, earnings releases will tell us whether companies have managed to pass higher commodity prices on to their customers, along with higher wages in service sectors, for example. The answer to this question, along with the speed and amplitude of higher interest rates will determine whether the recent sector rotation continues. But keep an eye out for the false starts that have often occurred in this area.
Our central scenario
Announcements of a gradual withdrawal of monetary support by the US Federal Reserve and the European Central Bank are likely to continue between now and yearend, driving bond yields up in proportions that we believe will be reasonable. This trend, against a backdrop of reopening of the economy and cautious central banks, will limit upside potential on equities. When combined with possible disappointment in thirdquarter earnings, this could trigger a phase of volatility that would be an opportunity to move back to a risk-on stance in portfolios.
As for risks, the past few years may have made us forget that interest rates can rise suddenly and significantly. Such an alternative scenario could bring us to our senses, with inflation that would remain high for a longer time than central banks believe.
Document completed on 29/09/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com