Signs of an impending shift in global monetary conditions, reflecting a more hawkish view of inflationary expectations by central bankers, left financial markets on a nervous footing at the end of the quarter under review. A reversal in the direction of sovereign debt yields during the period’s latter stages left (investment grade) bond benchmarks flat or lower and mainstream global equity indices little changed, as the Dollar advanced to a 12-month high. Concerns over the possible wider impact of corporate distress in the Chinese residential property sector, a sharp spike in domestic energy prices and continued supply chain disruptions also proved unsettling. The markets’ movements took place against a backdrop of economic data that indicated a moderate slowing in the pace of the global economy’s strong post-lockdown rebound. While the Covid-19 pandemic continues to affect large parts of the world and impact our day-to-day lives in a myriad of ways, the continued roll-out and success of vaccine programmes, particularly in the West, means that its influence on financial markets has very much diminished.
Given the generally negative tone and focus of the financial media’s coverage, one might be forgiven for thinking that the quarter under review was a horror show for equity investors. While it is entirely fair to say that it was a testing time in Asian and emerging markets, the headline returns from broad (developed market) global benchmarks did not bear that out.
Equity Market Indices
|Index||Q3 2021||Year to date|
|MSCI World ($)||-0.35%||11.77%|
|MSCI World (EUR)||2.04%||18.09%|
|MSCI World (£)||2.16%||13.35%|
|MSCI World (local ccy)||0.24%||13.56%|
|S&P 500 ($)||0.23%||14.68%|
|FTSE UK All Share (£)||1.10%||10.49%|
|MSCI Europe ex-UK (EUR)||0.28%||13.84%|
|Japan Topix (¥)||4.46%||12.49%|
|MSCI Asia ex-Japan ($)||-9.95%||-4.96%|
|MSCI Emerging Markets ($)||-8.84%||-2.96%|
|MSCI Emerging Markets (EUR)||-6.65%||2.53%|
|MSCI Emerging Markets (£)||-6.55%||-1.59%|
To some extent, movements in developed markets reflected the pattern of economic data relative to consensus forecasts; as ever, the closely-watched Purchasing Managers (PMI) surveys – in particular, those in the US – were a key driver. After a faltering start, stronger than expected figures saw the MSCI World Index 5% ahead in early September, before a reversal during the period’s later stages left the benchmark only marginally higher. Importantly, although they surprised (marginally) on the downside, were lower than the preceding numbers and some way off recent peak readings, the most recent (September) prints for US and Eurozone composite PMIs of 55.0 and 56.2 indicate healthy levels of expansionary activity across both manufacturing and service sectors, as indeed does the corresponding index of 54.9 for the UK.
The shift in investor sentiment and markets’ direction also coincided with a significant change in the narrative from Western central bankers, whose comments and forecasts suggest that the likely timetable for the tapering of asset purchase programmes and eventual interest rate rises had shortened. While it is difficult to escape the conclusion that the primary reason for the new monetary outlook is the persistence of what were previously assessed (downplayed?) as transitory inflation pressures, it is also worth remembering that the growth element of central banks’ mandates remains very much in place. One could therefore argue that any changes in policy are only likely to take place as long as the health of the economies in question is not meaningfully compromised. Nevertheless, the task of managing the balance of these two potentially conflicting considerations does suggest an increased risk of disruption to markets posed by policy error and we remain on a heightened level of alert for any signs thereof.
Citigroup Global Inflation Surprise Index
As highlighted earlier and evidenced by the table above, there was a sharp divergence between the performance of broad emerging market indices and their developed equivalents. A series of announcements from the Chinese government signalling a crackdown on companies’ handling of online data triggered heavy losses in the share prices of mega-cap internet stocks that account for a sizeable chunk of the domestic and global EM benchmarks. Markets in the wider Asian region were dragged down by a surge in negative sentiment. Data from the Chinese economy was also a contributory factor: having begun its recovery from the initial effects of the Covid pandemic several months ahead of the West, activity has (inevitably) moderated from the initial “growth spurt” to more normalised levels. The most recent PMIs, from both official and unofficial sources, which are marginally either side of the 50 mark that signifies the divide between expansion and contraction, reflect this. Adding to the already downbeat picture was the news that Evergrande, a large and highly leveraged Chinese property company, was facing collapse. With estimates of the company’s debt as high as USD300 billion (!), concerns over the possibility of a systemic event, the effects of which were felt beyond the country’s borders were understandable, but happily have so far proved wide of the mark. Recent actions by the Beijing authorities suggest that this remains the case.
Given the confluence of negative news flow, the performance of equity markets over the quarter under review is, on reflection, entirely understandable and we would further argue that a pause in their upward trajectory is both healthy and positive for their medium-term prospects. With latest and forecast aggregate earnings putting the MSCI All Companies World Index on current and forward price/earnings ratios of 22.1 and 17.5 respectively (implying 26% growth in earnings over the next 12 months), broad market valuations, though by no means cheap within a historic context, are meaningfully below their Q1 highs and, we suggest, in keeping with the current phase of the economic cycle. Thus, while it’s likely that the prevailing uncertainty and associated jitters over the inflationary outlook will persist in the short-term, we remain comfortable with the level and mix of equity exposure within our models.
MSCI World vs MSCI Emerging Markets
Source: FE Analytics 31.12.2020 – 30.09.2021
For the most part, the net changes in core sovereign bonds provided no clues as to their sizeable movements during the quarter, which began with yields declining to levels last seen in February, reflecting concerns over the spread of the Covid-19 Delta variant and its potential impact on the opening of economies. By the first week of August, the reflation trade was largely forgotten and ten-year benchmark bonds in the US Treasury, German Bund and UK Gilt markets were, respectively, 30, 29 and 21 basis points (bps) below their opening marks. As is so often the case, the first signs of a shift in market momentum were seen within the fixed income space. After an initial jump and partial retracement, bond yields headed higher over the remainder of the period, leaving the ten-year Treasury and Bunds only marginally changed at 1.49% (+2bps) and -0.20% (-1bps) at the end of September. By contrast, the corresponding Gilt broke out of its six-month trading range and closed out at a 28-month high of 1.02%, up 30bps, to leave the Bloomberg Barclays UK Government (<1 year) Index more than 5% below its peak and down 1.91% for the quarter (vs +.09% and -0.11% for the corresponding US and German measures).
10 year UK Gilt yield
Continued strong demand for corporate bonds ensured that investment grade credit spreads remained relatively stable at the very bottom of historic ranges, with the yield premium on US BBB-rated paper just 3bps higher at 107bps. There was, however, evidence of some volatility in the high yield market: after hitting an all-time low of 217bps a week into the period’s first week, the aggregate spread on the Bloomberg Barclays US HY Index backed up as far as 295bps during August before tightening to end the period at 255bps, (+27bps). We continue to monitor this part of the credit markets closely as a key indicator of investor sentiment and market direction.
As we have highlighted many times, although mainstream fixed income assets offer relatively little in the way of absolute value (and given the recent rise in inflation, even less so in real terms), there is ample evidence that the flexible approach and tools available to our preferred core managers and the specialist nature of those with whom they are combined offer strong protection from unfavourable changes in bond markets’ direction. As such, their presence continues to provide scope for positive returns and useful diversification within portfolios.
After fluctuating in and out of positive territory for much of the quarter, a rally in the Dollar during the closing weeks lifted the trade-weighted DXY Spot Index to a one-year high, up 1.94% in Index terms and having appreciated against every one of the 16 other major currencies listed by Bloomberg. Echoing the movements and relative performance in other asset classes, EM currencies were the biggest laggards, with the Brazilian Real down a hefty 8.70%, and the South African Rand 5.27% lower in USD terms. Among so-called hard currencies, Sterling was a notable loser, reflecting the individual headwinds faced by the post-Brexit UK economy, in the form of labour shortages and supply chain issues, over and above those prevailing elsewhere.
DXY Spot Index
Within the wider FX universe, the small number of (modest) winners in USD terms, which included the Indonesian Rupiah (+1.31%), Russian Rouble (+0.54%), Chinese Renminbi (+0.19%) and Indian Rupee (+0.12%), again hinted at the potentially favourable opportunity set provided by EM currencies that a number of specialist macro-oriented managers are often keen to highlight during meetings, commentaries and presentations. While it is a regular topic of discussion and remains on our watch list as a possible dedicated allocation, exposure within portfolios is currently confined to a small proportion of our chosen core strategic bond fund holdings.
Commodity markets commanded a greater than usual level of attention over the period thanks to huge movements in prices of Natural Gas, the trigger for which is a combination of factors that represent and, for once, justify the use of that clichéd phrase, a perfect storm.
In addition to an already tight energy market created by a recovery-driven 4% rise in estimated annual global electricity usage, a sharp increase in demand for Liquified Natural Gas from China has further tilted its balance. There, coal-fired power has been curtailed by a mix of environmental restrictions and the cessation of shipments from number one supplier Australia due to a trade dispute, in addition to which, an unusually hot and dry summer has drastically reduced hydro-electric generation. Nearer to home meanwhile, a lack of wind (!) that has drastically reduced the supply from a source that now produces almost a quarter of UK electricity has further exacerbated market pressures. The upshot, depending upon the mechanism and point of delivery, has resulted in gas price increases of between two and five times over recent months
Europe NG $ per mbtu
This huge rise in input costs has been seriously disruptive in a wide variety of seemingly separate, but in reality closely inter-related, industries. In just one of many examples, reduced output by fertilizer companies, from whom carbon dioxide is a major by-product, has hit meat and fizzy drink production, for which CO2 is a key requirement. Which, thanks to the extraordinarily interconnected and time-critical nature of global supply chains, explains why somebody switching on an air-conditioning unit in suburban Guangzhou means that the local butcher isn’t able to make so many of his best-selling sausages and there is a shortage of mixers to go into our G&Ts.
Although oil price movements were comparatively modest when compared to those described above, gains of 2.12% in the front-month contracts of West Texas Intermediate and 8.21% in Brent Crude (which hit a 6 ½ year high) added to the markets’ inflation jitters. Away from the energy space there were sizeable (weather-related) rises in Cotton (+24.62%) and Coffee (+19.41%l) and Aluminium (+12.94% – a big energy user). Among the components of the Refinitiv CRB Commodity Index, double-digit gainers outnumbered losers by two to one, contributing to the benchmark’s 7.28% increase. The Rogers Ex-Energy Index was up 0.97%.
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