By Tim Sharp
The weak September seasonality of financial markets showed up again this year and the world remembered the 20th anniversary of the 9/11 bombings. Inflation has risen sharply in recent months and although the expectations are that rates in the developed world will be lower next year as many causes prove transitory, we believe it is likely that some prices, such as housing, will remain elevated, and further upward pressure from wages is also likely. It is probably true to say that the underlying trend in inflation is rising[i] assisted by the expectation that central banks will allow a period of above target price growth to run and the strong recovery of economies following the 2020 shutdowns.
The FOMC projections for PCE inflation see inflation ending the year at 4.2% before falling to 2.2% in 2022 and 2023 getting back to 2.1% in 2024[ii]. This underscores the belief that the current high levels will be transitory but shows less confidence in GDP growth being maintained. Looking at US breakeven rates the Fed would seem to be more confident in its inflation forecast than bond markets who price the 6-year breakeven rate at 2.51% well above the longer run projection of 2%[iii]. Markets had built up an apprehension over the Fed September meeting, but despite the frank press release outlining the change in the environment this fear dissipated without a serious threat to risk assets.
The reopening of economies has once more shone a light on persistent supply side disruptions and the risks to financial markets. The lockdown in Vietnam appears to have left Nike, amongst others, with major supply headaches, and the semi-conductor shortages have affected many industries most notably automobile production with the knock-on effect to the second-hand car market. Absolute Strategy Research (ASR) believe that the forced reshoring of supply chains would be a net negative for the global economy and the disruption to the global goods economy ongoing. Along with the rise in COVID cases this has caused many forecasts for global growth in the second half of the year to be downgraded, with the Fed itself lowering its US growth target for 2021 to 5.9% from 7% in June ii, which is also very similar to ASR’s global projection of 5.75% for this year[iv]. In our opinion, recent global PMI data has also pointed to decelerating growth, and we remain cautious of the likely weakening in the PMI data during the next couple of months may prove significant.
Having been the global engine for growth following the global financial crisis we feel China is now proving to be a drag on its region’s ability to recover and causing instability in both economic and geo-political terms. The credit tightening particularly in the property market has led to a slowing economy and the Evergrande saga that has played out over the past two weeks increased fears regarding the risk of contagion spooking investors. It is also clear that the Chinese government is also worried about the flow of data and money through certain sectors most notably technology and private education. The new data protection laws and regulations for internet companies have seen the tech sector shares weaken significantly as the legislature tries to rein in the power of popular internet platforms by standardizing datai. This process appears to be ongoing and its effect on global data gathering currently unknown but with deeper divisions of trust between China and western economies it is difficult to gauge how far the effects are likely to reach.
It is true to say that risk asset markets always seem to be climbing a wall of worry but there seems to have been a number of reasons to cause the additional anxiety in September including the rise of delta variant cases, the persistent rise in inflation, European gas price shock, Fed to start tapering QE, the easing of growth forecasts, continued strength of technology stocks, Evergrande contagion, US government default and shutdown, and the pressure on corporate tax rates to name but a few. However, until this week at least US 10yr Yields remained anchored below 1.40 and the dollar was once more a safe haven, turning TINA into TRINA – There Really Is No Alternative to equities at present despite a mainly negative month for both developed bonds and equities we believe. The S&P500 gave up 4.76% over the month while the more tech-heavy NASDAQ lost 5.31% leaving it negative over the course of the quarter. The Xetra DAX Index (-3.63%) and CAC 40 Index (-2.40%) followed the US lead while the already underperforming UK FTSE 100 finished the month down only 0.47% but still flat on the quarter. Japan showed some of its safe haven qualities with the Nikkei 225 index up 4.85% on the month against a weaker Yen versus the Dollar.
In the last few days, the US bond market has started to react to the surprisingly hawkish FOMC meeting with 10yr yields trading as high as 1.56% rising above its 100- and 200- day moving averages as the curve steepens once more. We feel UK MPC minutes have also been surprisingly hawkish forecasting CPI above 4% into Q2 22 with the Gilt market pricing in two hikes in 2022 with the first in the first quarter. The ten-year Gilt now nominally yields approximately 1%. It is looking increasingly likely that the BOE will take the interesting step of tightening rates before finishing QE. Furthermore, Norges Bank in Norway was the first central bank to raise policy rates by 25bps suggesting that Central Banks have made the first tentative steps to unwinding the accommodative environment that has supported markets for so long[v].
We believe this has been an important inflection point in the reopening of economies as markets consider the slowing growth forecasts for the second half of this year and the heightened risk of a correction in equity markets that comes with it. We still believe equities remain expensive in absolute terms but are still supported by their relative valuation to bonds and the strength of corporate earnings reporting over the past year. It is, therefore, unlikely that the medium-term risk overweight positioning will change but we feel it is likely that market volatility will rise as we enter the fourth quarter starting with the most volatile month in the calendar year – October. We have positioned ourselves for the reflation trade and the focus to move more towards Europe away from US growth stocks which has been undermined by the rotation back into Technology over the summer which was reversed as September came to a close. The S&P Growth Index lost 5.95% over the month versus -3.85% for the Value Index. As real rates become negative the search for real, long term growth prospects become stronger. However, rising inflation is a real headwind for growth stocks as it undermines future cashflows and potentially reduces revenue growth opportunities, so we expect the markets to come back round again. We still favour banks, financials, healthcare, and industrials in equity sectors, but our focus remains on alternative revenue streams to bonds and equities through collectives that are looking at real assets, structural growth opportunities, and the strength in IPO and M&A markets.
[i] ASR’s Investment Committee Briefing – September 2021
[ii] FOMC Summary of Economic projections – September 22, 2021
[iii] Bloomberg – Points of Return: The Tapir Cometh – John Authers – September 23, 2021
[iv] ASR Economics – Growing Pains – Dominic White – September 14, 2021
[v] Barclays – Global Macro Thoughts: A Rising Wall of Worry – September 28, 2021
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