A Hidden Equity Market Correction
August 12, 2021
The unprecedented nature of the pandemic, as well as the unclear impact the delta variant will have given prevailing rates of vaccination in advanced economies, has clouded the near-term economic outlook.
In the last few weeks, investors began to worry about global growth as the number of Covid cases started to rise due to the spread of the Delta variant. Thanks to the effectiveness of vaccines, it is unlikely that the delta variant will have a long-lasting impact on economic activity in advanced economies, but it does have the potential to cause temporary reintroduction of some pandemic restrictions.
Growth concerns are especially visible in the bond markets. After climbing to 1.74% in March, the US 10-year Treasury yield has fallen back to 1.30%. Notwithstanding these concerns, the U.S. equity markets seem to be hitting record levels month after month. However, there is a bit of a hidden market correction going on, disguised by the continued surge in the main indices, led by a few mega-cap growth stocks. In other words, although most stocks have actually been correcting, the equity indexes are so dominated by FAANGM that the overall performance of the popular averages has been distorted by these mega-cap stocks. Underneath the continued advance in the S&P 500 and the NASDAQ, most stocks are below their 52-week highs, some significantly so. The Value Line Arithmetic Index, which is a simple weighted average of some 1700 listed stocks fell 7% between mid-June and late July. Meanwhile, the Russell 2000 is down about 7% from its March highs.
No Longer Crazy Rich
We are currently in the middle of Q2 earnings season and so far, many companies have surprised with better-than-expected earnings and topline revenues. With over 80% of S&P 500 Index companies that have reported showing above-consensus earnings and revenues, the corporate profit backdrop remains quite positive. The average forward price-earnings ratio of the S&P 500 Index is now 22 compared to 27 earlier in the year, which is not an unreasonable valuation in the current low-interest environment. In other words, the market has in a way corrected without falling.
However, investor sentiment remains subdued with many investors still expecting a larger correction at any time. From a contrary point of view, this supports our view that equity markets can continue to advance, although it is likely we will see different parts of the market perform at different times. If U.S. Treasury yields start climbing again, big cap growth stocks likely underperform while financials and healthcare could outperform again.
Meanwhile, the sell-off in the China tech sector was clearly not hidden and has created value in the Asian market as the sell-off has been indiscriminate, and not every company’s profitability prospects have been impacted by the regulatory crackdown.
Inflation Data
This week we will have the July Consumer Price Index (CPI) inflation data. The expectations for month over month are 0.5% for overall and 0.4% for core. If those numbers are surpassed significantly, Jay Powell and the Fed will have to “capitulate” and set an announcement for tapering. These numbers will also have political consequences, as higher prices are influencing public opinion. If they come out as expected or lower, the Fed can maintain its “temporary” inflation story.
We have mentioned before that we believe that the current inflation spike is transitory. Only time will tell, but we think it is extremely unlikely that the recent rate of price increases can or will be sustained. The large jump in price levels has been very narrowly based and mainly reflects relative price shocks stemming from the chip shortage and economic re-opening.
Stripping out the impact of the chip shortage and temporary factors relating to economic reopening, the core components of CPI inflation have stayed remarkably stable, at around 1.75%. In other words, the Fed has still not been able to lift the core rate above 2%. There is no way that the surge in used car prices, which accounts for 32% of the recent spike in core CPI inflation, can continue. Since April, used car prices have risen roughly 10% per month. At this rate, used cars would become more expensive than new cars.
The combination of a slowing world economy, a stronger dollar, an easing chip crunch, and continued renormalization of the world economy could lead to a surprise decline in inflation and possibly even mild deflation in 2022. This means the Fed may not be able to raise rates for quite some time, even if policymakers would want to.
Our view remains that U.S. inflation is likely to cool after the summer, which would allow the Fed to maintain a highly dovish policy stance for the foreseeable future, which will remain a positive for equity markets.
More Fiscal Support in the U.S.
The U.S. Senate approved President Biden’s $1 trillion infrastructure plan, of which only USD 550 billion in new spending, which will have a limited impact on economic growth in the coming years.
Democrats are likely to use the reconciliation process to both raise the debt ceiling and pass President Biden’s $3.5 trillion American Jobs and Families Plan. Meanwhile, much of the fiscal stimulus that has already been approved has yet to make its way through to the economy. U.S. households are sitting on about $2.5 trillion in excess savings, about half of which stems from increased government transfers.
Euro Area Economy: Reasons for Optimism
Outside the US, fiscal policy will remain supportive. All 27 EU countries ratified the €750 billion Next Generation EU fund (NGEU) on May 28th and have recently started first distributions. The allocations from the fund for southern European countries are relatively large and most of the money will be spent on public investment projects with high fiscal multipliers.
Large economic imbalances and the damaging double-dip recession resulted in very weak euro area economic performance over the last decade. Periphery euro area countries were forced to undergo strict fiscal austerity measures following the sovereign debt crisis. This resulted in a fall in real euro area government consumption from the second half of 2010 until 2013 during the double-dip recession, worsening already poor growth conditions. The Next Generation EU stimulus package will allow governments to positively contribute to economic growth over the coming years. This should allow the region to enjoy a more robust and durable expansion this decade.
We expect upside growth surprises in the years ahead, as opposed to the prevailing downbeat market expectations. Euro area core consumer price inflation has rebounded but remains subdued. We expect core inflation to begin trending gradually higher over the next 12-24 months. This also makes us more positive on the Euro versus the U.S. dollar and potentially on Euro area equities.
What’s Going on in China?
Beijing’s regulatory crackdown on the country’s for-profit education institutions in July triggered a massive sell-off in both the domestic stock market and Chinese stocks listed on Hong Kong and overseas exchanges. Chinese stocks were already under pressure in the last few months from a slowing economy and earlier regulatory actions on Didi and Alibaba. However, the latest regulatory action has accelerated the sell-off across the board. Although the education-tech sector is a relatively small sub-sector, the fact that the Chinese government ordered it to become non-profit without clear warning has created a market confidence crisis. And this comes on top of the Didi investigation and the cancellation of the ANT Financial IPO last year.
The sell-off in Chinese shares has undoubtedly created value but regulatory uncertainty will mean that the required risk premium on Chinese stocks is now higher. Nevertheless, we think the business case for many of China’s leading companies is still solid and we expect that Q2 earnings, which most companies will report in the next few weeks, will prove to be strong.
The uncertainty surrounding Chinese tech firms will remain high in the near term, but we doubt Beijing’s crackdown will fundamentally undermine these companies’ growth outlook. More than ever, China needs its domestic companies in the technological competition with the U.S., and it is highly unlikely that Beijing will risk suffocating its own tech champions. China still offers one of the most exciting growth opportunities for tech companies globally.
Bond Markets
U.S. Treasury yields have come down since peaking in March, which means that bond markets performed relatively well in the past four months, recouping some of the losses incurred in bond markets during the first quarter of the year.
Having said that, we expect bond yields to move higher again in the coming months, which means that returns will be quite low this year overall.
Portfolio Positioning
In our core equity portfolios, we have built a balance between growth and value as we see value in consumer tech but also in financials and healthcare sectors.
The overweight to Chinese domestic stocks has not hurt the portfolio as much as might be expected because the sell-off has been concentrated in large Chinese tech stocks with listings outside of China. Our portfolios, where possible, are positioned toward companies listed domestically, which are owned by Chinese retail investors and already undergo a much more stringent regulatory review before listing.
In the fixed income part of the portfolio, we keep duration short and we remain positive on emerging market debt.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.
* Investments in commodities may have greater volatility than investments in traditional securities, particularly if the instruments involve leverage. The value of commodity-linked derivative instruments may be affected by changes in overall market movements, commodity index volatility, changes in interest rates or factors affecting a particular industry or commodity, such as drought, floods, weather, livestock disease, embargoes, tariffs and international economic, political and regulatory developments. Use of leveraged commodity-linked derivatives creates an opportunity for increased return but, at the same time, creates the possibility for greater loss.
Investing internationally carries additional risks such as differences in financial reporting, currency exchange risk, as well as economic and political risk unique to the specific country. This may result in greater share price volatility. Shares, when sold, may be worth more or less than their original cost.
The Standard & Poor’s 500 (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. It is a market value weighted index with each stock’s weight in the index proportionate to its market value.
Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
Indices are unmanaged and investors cannot invest directly in an index. Unless otherwise noted, performance of indices do not account for any fees, commissions or other expenses that would be incurred. Returns do not include reinvested dividends.