Friday 8th October, 2021
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Since Q1 2020 when the coronavirus reared its ugly head beyond China, the world economy came to a grinding halt, and asset markets collapsed, the S&P 500 Index has experienced just four down months (out of eighteen) in total. September 2021 was one of them; indeed, it was the worst of the lot, with the index falling -4.8%. Other major markets faced similar selling pressure during the month. For example, the pan-European Euro STOXX 600 Index was down -3.4% and the MSCI Emerging Market Index sank -4.3% (in USD). But the correction was deepest in the US where many red-hot tech stocks trading at stretched valuations found themselves in the eye of the re-rating storm. The sell-off was largely driven by mounting fears about inflation, softer data out of China and the US, and the imminent tapering of asset purchase programmes by Western countries, which caused interest (and discount) rates to rise across the curve. Most markets have been on a sounder footing in October so far, but some volatility and much anxiety seem to have carried over from last month. A further drawdown cannot be ruled out; and the fundamentals are no different. But predicting short-term moves is no one’s forte.
As discussed in our last letter, the crisis facing Chinese real estate development company Evergrande made waves last month and still is given the high risk of contagion to China’s wider and truly gargantuan local property market. The current debt crisis comes hot on the heels of a serious regulatory crackdown on monopolistic technology companies this summer, and it has pushed RMB downwards and China risk appetite to its lowest level in months. Indeed, the MSCI China was down -5.2% (in USD) in September, following on from flattish performance in August and a -14.2% fall in July. We think that the authorities are in something of a catch-22 situation with regards to Evergrande. Do they bail out the real estate behemoth and thus reinforce the perception that such companies are ‘too big to fail’ no matter the extent of their profligacy (storing up problems with moral hazard for the future), or do they let the business fail, risk a slump in property prices, and upset their middle-class supporters? Furthermore, does the PBOC cut interest rates or ease credit conditions to stabilise the economy and the real estate sector, or keep policy as it is to ensure that the indebtedness of corporates does not balloon further and precipitate a bigger crisis down the line? China will want to take a long-term view, of course. But all governments are susceptible to myopia and are would-be victims of social and economic instability. Heightened tensions with Taiwan could be a useful distraction.
There are plenty of challenges ahead in the Western world too. Since the start of the pandemic, all of our central banks have promised there would only ever be a very slow crawl back to monetary policy normalisation given the extent of the economic turmoil caused by covid-19. However, soaring energy costs for businesses and households, ongoing global supply chain disruptions, and the rapid tightening of labour markets in the US and parts of Europe (at least according to the headline figures) have caused many to question the sustainability of this policy in the face of persistently above-target consumer price rises. Although the US payroll data came in c.500K behind consensus today, the Fed may well decide to kick off stimulus withdrawal next month and at a faster pace than initially indicated. (And the ECB will be sure to follow suit in due course). Since investors have spent 18 months riding an ocean of liquidity to all-time highs in many markets, the notion that they will now have to stand on their own two feet (to some extent, at least) is causing consternation. What is more, growth is slowing at the same time that tapering is being mulled, and some investors are understandably fearful that we are entering a period of stagflation as a result. There is good evidence that supply constraints are driving up prices at least as much as demand, and this is not the kind of inflation that anyone wants to see.
Of course, there is plenty of uncertainty about how long high inflation will last if it is primarily pandemic-related supply constraints that are at fault. The global vaccination drive continues apace; and, thus far, there have been no new coronavirus variants beyond Delta to halt the re-opening momentum. Winter is coming, but trends in countries with high rates of vaccination have not become noticeably worse since the balmy months of summer. This should help to allay fears that aggressive distancing restrictions will be necessary to avoid the failure of healthcare systems at Christmas; and, in such case, supply chains should gradually stabilise, bringing some sanity back to pricing. We expect that central banks will want to hold off from hiking rates if this is what they expect. Remember, we are not at the beginning of a new economic cycle. Most crucially, there has been no cathartic expulsion of over-leveraged or otherwise failing firms from the corporate landscape – one that could prime the economy for sustainable growth through a hiking cycle. This time round, governments have rescued all the zombie companies, and any defaults must necessarily still be ahead of us. The Fed and the ECB will be well aware of this fragility, and we expect policymakers to proceed with extreme caution on interest rates as a result.
Despite this, we favour low duration positioning in fixed income (not least because you do not get paid to take the risk of higher rates), and exposure to commodity equities and precious metals, poised to benefit from low real rates (which should result from a dovish central bank policy rate response to above target inflation). However, a wholesale shift from growth equities to value equities which might benefit short-term from higher nominal rates seems excessive. We prefer portfolio diversification and humility in the face of uncertainty, not swinging with the consensus on which factors will outperform in any given month.
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