Panorama - September 2021 -
What are this autumn’s market movers?
Head of Investment Strategies
Deputy Chief Executive Officer, Chief Investment Officer
This summer was rather quiet and positive on the financial front.
US equity indices once again set all-time records. In Paris, the CAC 40 brushed up against its all-time high, which dates back to September 2000. The markets in general were once again highly resilient, driven by the economic recovery and surprisingly low interest rates despite some inflationary pressures. The underlying positive trend thus looks to be well on track but could be disrupted by three major issues – monetary policies, China and, once again, Covid-19, among other things.
Context and analysis
Corporate earnings released this summer exceeded by far analysts’ forecasts, riding a highly robust economic recovery driven, in turn, by consumption and investment that had been pent up during the lockdowns. Moreover, business leaders have struck a highly optimistic tone on the whole, despite the many production bottlenecks and even shortages, which have sent up prices and, hence stoked inflation. This all makes perfect sense after months of economic shutdown. What makes less sense is why bond yields are staying so low for so long. Yes, we understand that central banks have taken control of the yield curve since the crisis began for the purpose of financing governments that are even more heavily indebted after the huge fiscal support they have injected into the economy. Even so, the most recent shifts have been surprising. Long-term yields eased by another 10 basis points this summer, stabilizing at around 1.30% on 10-year T-Notes and –0.40% on 10-year Bunds. Does this point to slack in the economy? In other words, has positive momentum peaked?
How and when will central banks’ monetary support end? The markets are dreading this, given how clearly current policies are inflating asset prices. But rest assured, it won’t happen any time soon. The US Federal Reserve once again offered soothing words at the Jackson Hole meeting, while staying very fuzzy on the timing on tapering of its asset purchases, which currently amount to $120bn per month. Nor is there any urgency to raise interest rates, according to Fed chairman Jerome Powell, and that could mean zero US monetary rates during most of 2022. Investors have understood that there’s no point in fighting the Fed, which has unlimited resources at its disposal, and the markets also seem to have fallen into line with the Fed’s belief that inflation is merely transitional. On top of that, we understand that the Fed is also acting on behalf of a US federal government that is heavily indebted and will remain so, judging by its investment plans. Paradoxically, the latest Covid-19 wave has, in a certain way, made things easier for Jerome Powell, who is at increasing pains to justify monetary policy that is so accommodative.
The resurgence in the pandemic is keeping economic risk in the spotlight, although vaccines have, after all, proven their efficacy. The problem is that less than 65% of the world’s population has been vaccinated, and, more importantly, only about 10% of the emerging world has been (outside of China). Some experts therefore believe that we will have to live another few years with the possibility of successive waves of various variants, which will require more and more vaccinations and will drag down growth potential. We have no definitive opinion on this issue, but, in any case, it could have an economic impact and make investors more cautious in the event of a surge in infections this autumn.
It will also be worth keeping an eye on the third-quarter corporate reporting season. Second-quarter results were exceptional, and analysts reacted by aggressively raising their forecasts. Any slackening in momentum in thirdquarter results could therefore catch the markets wrongfooted.
In the euro zone, the resurgence in inflation and economic activity is also exerting pressure on the ECB. The issue of whether or not to keep emergency measures in place will therefore be raised. The answer will come on 9 September, at the next monetary policy meeting. In any case, keeping key rates at current levels is, for all intents and purposes, already decided.
China was also in the news this summer. Its economy is showing serious signs of slowing down, which is noteworthy, as it is ahead of the curve in the spreading of the pandemic and also in the reopening of its economy. China, the world’s second-largest economy, naturally has a heavy impact on the global economy. But that’s not the only thing that drew notice. There was also the tough “regulatory” shift the Chinese government took. The swoon by luxury stocks in Paris is a clear illustration of the impact that China’s sudden policy shifts can have on the rest of the world. This correction occurred after the authorities served notice of the need for a more redistributive economy, clearly targeting the richest of the rich and their consumption habits, which, in a way, were deemed indecent. These events are not unrelated and it is worth analysing recent developments in China from a holistic point of view and recognising that China’s societal problems in many ways are like those in the West. The difference is that China is “taking the bull by the horns” before the West has, in a rather direct approach that a different sort of political regime can afford to take.
China is indeed facing several major issues that are also faced by Western countries:
- a low birth rate, which is dragging down long-term growth and making pension financing more difficult;
- social cohesion. The crisis has also exacerbated the already-wide gap between rich and poor. The wealth gap has tended to discourage the younger generations from having children at a time of skyrocketing prices of homes and of educating those children to ensure them a decent future. All this has sparked the “lying flat” movement among the younger generations – in other words the right to laziness – and that has the Chinese government worried;
- The issue of data control by the large tech monopolies.
It is through this prism that current trends must be viewed, trends that have pushed share prices down for large tech companies, as well as for private education, luxury spirits, and other companies. This untimely “regulatory” uncertainty may continue to weigh on the short-term market trend. There are diverging opinions on Chinese equities. Some are concerned about the state’s increasing and structural interventionist tendencies, believing it could drag down entrepreneurial-based economic momentum. However, more numerous are those experts who continue to see Chinese stocks as a long-term buy. The recent corrections have lowered valuations across-the-board, and China cannot do without the creativity of its tech sector if it wants to be competitive vs. the US as part of its drive to acquire supremacy and independence.
Similarly, on the societal level the private sector accounts for almost 90% of urban jobs, and the digital economy for almost 40% of China’s GDP. Moreover, Chinese equities will be a larger component of international portfolios as they will be more heavily weighted in the indices, and several sectors continue to offer long-term growth potential –all the more so as the authorities seem to want to draw in more international capital.
Another highlight of this autumn will be general elections in Germany and the nomination of Angela Merkel’s successor as chancellor. A significant shift occurred in voting intentions this summer, and a victory by the Christian Democratic Union (CDU) looks increasingly unlikely vs. Olaf Scholz, the head of the Social Democratic Party (SPD). Scholz will probably have to join with another party in forming a governing coalition.
This matters to the markets, as that would mean that that a party that is excessively “orthodox” from the financial point of view would be very unlikely to head the country. This, in turn, would lessen the likelihood of widening peripheral euro zone spreads (Peripheral spreads: the difference in yields between southern Europe and Germany) and would leave some leeway for a more flexible interpretation of member-country’s fiscal rules or even a resetting of those rules.
Ultimately, as long as interest rates are being “steered” and kept very low during this intense phase of recovery, underlying market trends should remain positive. However, this will not prevent phases of heightened volatility that could be generated by the parameters that we have just described.
Jackson Hole, a soft tapering
The long-awaited annual Jackson Hole meeting of central bankers was held, and although the Fed is walking a tightrope, it is doing so admirably well. Jerome Powell’s eagerly awaited speech was a perfectly orchestrated exercise in public relations.
The markets had long expected this to be when the Fed chairman would flag a tapering in its asset purchases.
And his finely carved speech did indeed mention a possible tapering this year but with no precise timing, and that reassured investors. So, despite inflation of more than 5.0% and heavy job creations that have sent the unemployment rate down to 5.4%, Powell managed to ready his listeners for less monetary support with no impact on long bond yields, which stayed calmly near 1.30%.
On the whole, the markets seem to have priced in a reduction in Fed monetary support and are now just trying to figure out the timing.
Meanwhile, the ECB, which has been mute on this issue for several months, began to come out of the woodwork after the release of euro zone inflation figures (3.0% total inflation, including 1.6% in core inflation (Core inflation: inflation ex food and ex energy)). It raised the possibility of a slower pace in purchasing, which would merely adjust the amount set in the Pandemic Emergency Purchase Programme (PEPP) between now and March 2022.
With this in mind, we see a very gradual rise in interest rates between now and yearend in both the US (1.75%) and in Europe (-0.20%). This gradual, central bank-steered rise is unlikely to cause any large volatility shocks to the markets.
The risk, albeit currently very small, would be a disorderly rise in rates driven by persistent inflation and central banks that are backed into a corner.
On the credit markets, companies have improved their financial standing and this will not be a catalyst of concerns. The mechanism of the quest for yield and investments, along with central bank purchases (even if they are reduced) will keep spreads (Spread: the yield differential.) at their current rather narrow levels. We don’t expect any further tightening on the high yield market, but in relative terms yields remain attractive and will continue to drive the asset class.
A summer break
After surpassing their all-time highs or coming close to doing so (in the case of the CAC 40), equity markets paused for breath, mainly in Europe, on pandemic fears, which have not receded entirely, on Chinese economic statistics, and on uncertainties surrounding the pursuit of central banks’ accommodative policies. On the bright side, and as we expected, interim corporate results were excellent on both sides of the Atlantic. What’s more, business leaders, who are generally very cautious in their outlooks, expressed firm optimism. In both the US and Europe, results beat forecasts in almost two thirds of cases against a backdrop a fasterthan-expected normalisation in global economic activity.
That being said, analysts’ 2022 earnings forecasts look rather conservative and they may revise them upward in the coming weeks. Margins have improved considerably, which does leave less upside potential beyond 2022.
Note the weakness in the luxury goods sector during the month in reaction to the economic slowdown in Asia.
Despite gains of about 20 percent in developed economy markets, they have not become any more expensive, as those gains have come with upward revisions in earnings forecasts. Even so, at P/Es of 22 and 17 for the US and the euro zone, respectively, for 2021, we see little additional upside between now and yearend. That being said, we cannot deny the powerful support being provided to global equity markets by short- and long-term interest rates and are therefore sticking to neutral stance for the coming weeks.
Our central scenario
The flagging of reductions in monetary support by the Federal Reserve and, to a lesser extent, by the ECB, have so far gone off smoothly. The central banks must ensure that this continues to be the case during the gradual emergence from the pandemic in developed economy countries. Interest rates are expected to trend moderately upward and not be of excessive concern to the markets for risky assets.
Against this backdrop, we reiterate our neutral stance on equities in our strategic allocations, based on our view that a more volatile phase on the markets – driven by disappointing third-quarter corporate results or by a rise in bond yields – could offer an opportunity to overweight them at more attractive levels.
Our thinking is based on the fact that the stimulus measures announced in various countries will provide a positive outlook for the coming quarters… as long as investors are reassured by central bank policies for managing interest rates.
Document completed on 02/09/2021
Investing in financial markets involves risks, including risk of capital loss. Source of indexes cited: www.bloomberg.com