Higher Volatility But No Change in Outlook
October 11, 2021
The S&P 500 has more than doubled in 18 months without any significant corrections until September, when market sentiment turned negative. Investors suddenly turned their attention to Chinese property developer Evergrande’s default, to the debt ceiling debate in the U.S. and to soaring energy prices in Europe. Despite the negative news the global equity market ‘only’ corrected by 4.2%, effectively giving up the gains from July and August, which means that the market was almost flat for the third quarter. For the year, the global equity market is still in solid positive territory.
Global Growth Slowing From Really High Levels
Looking forward, it is important to keep two things in mind: global growth might have peaked, but at very high levels. According to Bloomberg consensus estimates, real GDP in the G7 countries rose by 6.0% in Q3, down from 6.8% in Q2. G7 growth is expected to soften to 4.9% in Q4, mainly reflecting somewhat softer growth in Europe following a strong third quarter which saw real GDP expand by more than 9% in the UK and the euro area. Not all countries have reached peak growth. Japan is projected to see faster growth in Q4, with GDP rising by 3.8% compared to 1.6% in Q3. Canadian growth should pick up from 4.5% in Q3 to 5.8% in Q4. Australia’s economy is projected to grow by 7.4% in Q4 after having contracted by 10.7% in Q3. Chinese growth is also expected to accelerate to 5.9% in Q4 from 2.6% in Q3.
Global economic growth should remain at a healthy level in 2022. G7 economies are expected to grow at 4.1%, well above their long-term average. Usually when growth peaks, investors start to worry that a recession is around the corner. Given that growth is coming down from exceptionally high levels, we don’t think this is a major risk at the moment.
Second, earnings expectations have outpaced the strong market returns this year, which means stock valuations have come down. For global equities, the story remains one of fundamentals. Relative performance across regions has been driven by earnings expectations. The U.S. and Europe have seen year-forward earnings expectations increase 29% year-to-date, outpacing even the strong market returns, causing valuations to fall.
A Correction Around the Corner?
It is impossible to predict whether the market will correct further in the short-term. As we mentioned in previous Monthly Views, the market is likely to become more volatile when the economic recovery starts to slow. But even as the global economic growth rate slows, economic growth is still at healthy levels. The level of inflation most countries are experiencing will actually help to boost nominal economic growth in the short-term. The simple conclusion is to continue to favor investing in stocks. Although admittedly, the risk-reward profile for equities is not as appealing as it was last year.
In a way, the current market conditions resemble the late 1990s. The strong performance of large tech stocks is something we have seen before. However, 20 years ago the stock market was way bubblier compared to today and investors at the time were much more euphoric. Currently, investor sentiment is quite negative with many investors doubtful that this recovery can continue. Another important difference is that the tech leaders have more solid businesses than their peers in the late 1990s, and their valuations are not as extreme. Moreover, the Fed is not ready to tighten policy anytime soon and the business-cycle expansion is still young. All of this means that it is way too early to turn cautious on stocks.
On the positive side, we see a number of positive ‘risks’ that the market seems to be ignoring at the moment.
- Growth in Europe and Asia is likely to remain strong and could even surprise to the upside.
- The Q3 corporate earnings season is about to start and although earning growth will likely slow, earnings can still surprise to the upside.
- China could successfully manage the Evergrande implosion, while at the same time announce monetary and fiscal stimulus to boost the economy.
- Biden infrastructure plans could get approved before year-end, and possibly with lower tax increases than currently feared.
- The Biden administration could relax some of the Trump-era tariffs on Chinese goods.
All these potential ‘risks’ would be positive for equity markets.
Monetary Policy: Is Tapering Tightening?
As the impact of the pandemic slows down, central banks are starting to dial back monetary support. Norway and New Zealand became the first major developed economies to hike rates. Other central banks are looking to normalize policy. The Bank of Canada has cut its asset purchases in half. The Reserve Bank of Australia has begun tapering asset purchases. The Swedish Riksbank has indicated that it will end asset purchases this year. The Fed will likely formally announce the tapering of asset purchases in November, while the Bank of England’s latest round of QE expansion will expire in December.
The prospect of Fed tapering has stoked worries of a replay of the 2013 Taper Tantrum. We think these worries are overstated. For one thing, tapering is not the same thing as tightening. The Fed will still be adding to the size of its balance sheet, it will simply be doing so at a diminished pace. Thus, tapering implies a slower pace of easing rather than tightening, an important distinction.
U.S. – China
U.S. President Joe Biden and his Chinese counterpart Xi Jinping had a long phone call last month, the significance of which should not be ignored. This by no means reverses the geostrategic rivalry between the two countries, but it marks a pragmatic turn in Biden’s China policy from his earlier hawkish stance. The China-U.S. rivalry is structural, but the Trump tariff strategy has mainly hurt U.S. consumers and businesses, not Chinese trade, and it makes sense for there to be an adjustment. There are rising odds that the tariffs the two countries imposed on each other could be reduced, which would provide much-needed relief for both economies.
In addition, we believe overseas-listed Chinese stocks have overly discounted the regulatory risks, which presents a potential buying opportunity. International investors have been cutting their exposure to China because of the regulatory risk. However, in our view, investors would not want to exclude China in a globally diversified portfolio as it is the second-largest economy in the world that is growing at twice the pace of the global average with a rapidly expanding middle class consumer sector.
Contrary to popular perception, the Chinese government has not launched an indiscriminate attack on tech companies. If anything, heightened geopolitical tensions have made it more important than ever for China to support its tech sector. Rather, what the government has done is restrain companies that it either perceives as working against the national interest (e.g., addictive video game makers and expensive after-school tutoring companies) or that have too much sway over the public. Private tech companies in sectors such as semiconductors or clean energy continue to receive government support.
A plausible outcome is that China’s leading consumer-oriented internet companies will go out of their way to pledge allegiance to the Communist Party. If that were to happen, the Chinese government may allow them to operate normally, recognizing the fact that it is easier to monitor a few large internet companies than many small ones. Therefore, it is likely that the selloff in Chinese tech companies is overdone and has created buying opportunities. President Xi Jinping is fully aware of the importance of Chinese private tech companies in the ongoing China-U.S. strategic competition. In recent weeks, the Chinese government has come out on various occasions to reassure investors that Beijing’s pro-growth and pro-small business policy is unchanged.
Chinese Stimulus on the Way
The turmoil surrounding Evergrande, one of China’s largest property developers, has sparked fears that China is experiencing its own “Lehman moment.” Such worries are probably misplaced. The Chinese government has enough control over the domestic financial system to keep systemic risks in check. In order to mitigate the risks on economic growth, the Ministry of Finance has expressed its intention to ramp up fiscal spending by increasing local government bond issuance. As of the end of August, local governments had used up only 50% of their annual debt issuance quota, compared to 77% at the same time last year and 93% in 2019. Increased bond issuance will allow local governments to increase spending.
Higher Bond Yields
Treasury yields have moved up since the September Fed meeting. The market narrative of a “hawkish surprise” does not make much sense to us. The yield curve usually flattens after a central bank delivers a hawkish surprise. That is what happened following the June FOMC meeting. This time around, the 2Y-10Y curve actually steepened, which could mean that bond yields are rising as the bond market is expecting to see strong economic growth ahead. Given that our base case scenario is that global growth will remain solidly above trend over the next 12 months, we expect bond yields globally to keep rising slowly but surely. The rise in bond yields also reflects the realization that the pandemic-induced rise in inflation may be a bit stickier than previously believed.
The 10-year Treasury yield has already risen halfway to our 2022 target of 1.8%. Any further upward move is likely to be more gradual. That means that we expect pressure on stocks because of higher yields to diminish. Equities often suffer volatility when bond yields rise. However, history suggests that as long as yields do not rise enough to imperil the economy, stocks usually end up recovering and reaching new highs.
A New Super Cycle In Metals?
China consumes over half the world’s industrial metals. That is the reason that the Chinese economy tends to drive metals prices. There is a strong correlation between the Chinese credit impulse and industrial metals prices. If Chinese credit growth picks up over the coming months, this should support metals. Aside from iron ore, it is quite striking that most metals prices have remained firm this year even as China has cut back imports. Copper prices are up 45% year-over-year despite the fact that Chinese imports of copper are down 40% during this period.
As in the early 2000s, the combination of a multi-year period of underinvestment in new mining capacity and new sources of demand could set the stage for an extended bull market in metals. The shift to electric vehicles will boost demand for many metals. The typical electric vehicle uses four times as much copper as a typical gasoline-powered vehicle.
Gold prices tend to correlate closely with real interest rates. This is not surprising since the real yield can be regarded as the “opportunity cost” of holding a yield-less asset such as gold. What is somewhat surprising is that gold prices have fallen more than one would have expected based on the evolution of real yields. The US 10-year TIPS yield is only slightly higher than where it was in early August 2020, when the price of gold reached $2,067 per ounce.
One reason for this year’s weakness in gold prices could be the shift in investor interest from gold to cryptocurrencies. Both gold and Bitcoin are seen as “fiat money hedges.” The risk for cryptocurrencies is that tighter regulation could cause some funds to flow back into gold. Nevertheless, with real yields likely to edge higher over the coming years, the upside for gold prices is limited. That is why we favor a diversified approach when investing in commodities as we have in our Inflation Hedge Commodity Strategy.
Portfolio Positioning
The economic recovery is generally evolving in line with our expectations, which means that we have positioned our portfolios in a way that can perform well in the current circumstances. We are comfortable with our core holdings and the current tilts we have in our portfolios. This means a tilt towards financials and real estate, as well as a position in base commodities. In fixed income, we continue to keep duration short and focus on investment-grade credit and emerging markets government bonds, which offer a much higher yield.
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.
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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.
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.
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