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Chief Investment Officer's team, 01.08.2021
Last week it was all about the US Federal Reserve and China. The former concluded its July meeting with nothing new and nothing done on policy, a continuation of the dovish status quo supportive of financial assets, while the latter sent global shockwaves with its harsh regulatory crackdown. All of this was played against the backdrop of strong earnings in the major Western markets, which closed the five days through Friday with minor losses, caught in the tug of war of these opposing factors. Of course, concerns about the delta variant lurked in the background, but given low hospitalisation rates and no lockdowns, we think that in this summertime the virus is not playing a major role in driving returns. Come the fall or winter, it may be a different story, with more indoors life and lower temperatures increasing covid-related tail risks.
We maintain a procyclical tactical positioning in our portfolios, with emphasis in DM versus EM equities, although we think that by the end of the year the staggered recovery underway should see the EM take the growth baton. Expansion rates have just peaked in the US and should be close to peaking in Europe, leaving the developing countries as the next in line to be at the forefront of the recovery.
Investors will be looking forward to the Jackson Hole meeting in late August as the next venue where the Fed chair could provide some important insights into the tapering process, very much on schedule to be implemented early next year. Stay safe.
As much as unexpected, the Chinese regulatory offensive which last week shook domestic markets and global investors was harsher than the previous ones but represents indeed nothing new in the local landscape. Beijing has consistently been shaping the economy as per the ruling party’s objectives, starting years ago from the systemically important real estate sector, and then stepping into healthcare, information technology and lately for-profit, after-school tutoring. This could be dismissed as the footprint of an authoritarian regime as compared to an extremely liberal democracy like the United States. This misses the point. Our conclusion is that regulatory interventions in China are aimed at achieving longer term stability, hence sustainable growth, at the cost of shorter term, unavoidable pain. While in the United States “government is the problem”, as Ronald Reagan put it, in China it has, at least so far, provided solutions and managed to steer the whole socio-economic system in such a way that the country nowadays is a primary global power to be reckoned with. Hence, we would see Beijing stopping short of suffocating entire swaths of the economy with new regulations, as that would depress expansion rates and engender massive capital flights, ultimately running contrary the authorities’ very goals.
Families straining their balance sheets for supposedly best-in-class tutoring for their, often wise only one, kid’s future would have been standing in the way of having more than one child per family and ultimately also fostered inequality. The increasing of the population to spur growth and a more balanced development are goals ensuring longer-term stability, which the Chinese authorities have been obsessed with. The burden of the necessary redistribution to achieve the purpose has been borne by the education sector, de-facto killed and abruptly transformed from a high-flyer into a sort of utility-like space. Some international investors have been scared and are still selling out of the country’s markets, but the bulk of them should be sharing our same thoughts simply by looking both at Beijing’s track record and publicly declared purposes.
So, where does all of this leave us with our proemerging-market stance? Shorter term, most likely with more pain than gain. Investors will want to see two things before their concerns are allayed: the bulk of disruptive regulatory interventions behind them and the end to the current slow-down phase following the recent tightening. As for the former, we think that we should be quite close, unless Beijing makes a policy mistake by overstepping the mark; as for the latter, we would expect that by year-end new stimulus measures in the form of more fixed asset investments are announced. If internal consumption is growing too slowly and services-driven overseas demand cannot help Chinese manufacturers much, resorting to stimulus is the only option left for Beijing, again to avoid excessive imbalances.
Nothing new under the Chinese sun. “If the reforms are too fast there is chaos. If the reforms are too slow, there is stagnation”, as Cao Siyuan, the deceased architect of the first bankruptcy law in the country in the 1980s, once put it.
Fixed Income Update
Last week the Fed July meeting was concluded with very little in terms of new news. Rates policy was left unchanged, as well as the monthly asset purchase rate, and no update was provided about the timeline for the start of its tapering. With many pockets of the economy having more than fully recovered from the pandemic, it is surprising that Fed officials tie the future course of their policy to how the unemployment rate will be evolving. It is a known fact that the average monthly post-recession employment recovery rate has not changed much since the 1980s, so that one could today more or less project when full employment will be reached simply by extrapolating this rate into the future. Yet, this was the Fed’s decision, so that persistent accommodation still is in place. It all is happening in the face of rising inflationary pressures. Granted, price pressures related to supply bottlenecks will go, being by definition temporary. Yet, the ones from the incredible year-over-year expansion of the money supply, engineered by the Fed itself, will stay. Also, rising wages could well be a 2022 story with the US economy projected to sit above trend-growth throughout the year. For now, markets can enjoy the uber-easing and continue to ride the liquidity wave.
In spite of concerted monetary and fiscal stimulus, US long-dated Treasury yields dropped to new all-time lows, reaching on the 10-year tenor the level of -1.2%. This is not sending a reassuring message about the outlook. On the one hand it could be unabated Fed asset purchases compressing nominal yields with real rates following through, on the other it could be a signal of stagflation ahead. TIPS, Treasury-Inflation-ProtectedSecurities, would be telling us that inflation will still be there once growth has subsided. Only time will tell whether this is going to be the case. For now we can just acknowledge that US growth is already running below expectations, with US Q2 GDP disappointing - reported as slightly above 6% rather than above 8% as for previous forecasts - and US business confidence no longer in the upper-band of its historical range. The Chinese PMI for the month of July this morning printed dangerously close to the 50 threshold, suggesting a continuation to the slowdown phase which started late last year.
In summary, we cannot find any obvious catalysts for long-dated US Treasury yields to be rising from current levels, yet we maintain our year-end fair value for the yield on the 10-year note at 1.75%, considering by how much it is understating the US expansion, unless one contemplates the possibility of no growth for 2022.
It was all about results last week. Developed market earnings updates surprised to the upside on already high expectations, a shift from emerging markets which in the last decade led growth. For Q2, 55% companies in the Stoxx 600 that reported had EPS growth of +140% y/y and the 50% in the S&P 500 that reported +90%. Record profit growth but not record profit as expectations for the rest of 2021 and 2022 are high.
Global equities finished the week lower, but the month of July higher, with markets influenced by various factors: the spreading Delta variant, China's recent crackdown on overseas listed corporates and for-profit education companies, Q2 earnings, the Fed’s continuing accommodative policy and economic data around Q2 GDP releases. Year to date, developed market equity performance leads emerging markets by 15% with EM performance flat for the year, post a 14% fall in China’s main equity Index in July. The UAE and KSA were among the few markets with a positive week. Strong growth in UAE bank earnings buoyed by lower impairment charges, helped sentiment.
China stocks had a volatile week and the uncertainty could continue to weigh on performance. In the last few months there has been a regulatory crackdown on technology companies in the digital payment space (Ant) and those with large data banks, along with investigations into companies listing in the U.S. (Didi) and new regulations for profit making online education companies. While largely driven by data privacy concerns, the last is on reducing social pressure on the funding for tuition beyond school hours. Whilst China company fundamentals are attractive, with the main Index at low valuations and earnings growth in the 30%+ range, till there is clarity on what the regulatory authorities plan, we wouldn’t be bottom fishing. Over the long run, China is an important member of the world economy contributing to c.16% of global GDP. Our positioning continues to have a higher overweight to developed market equities and in the emerging market region whilst we maintain a small overweight, we have been neutral Asia since last month.
US tech companies which generate 60% of revenue from overseas are a contrast to China’s domestic focused tech giants and should see further traction post bumper revenue and earnings growth last quarter. However, forward guidance cannot be anything but cautionary as last quarter profits grew 90% for the big 5. The move to digital has continued even post- openings, a trend accelerated by the pandemic, but there to stay. Facebook reported a revenue increase of 56% and profit growth of 101% y/y driven by higher pricing on ads and its push into ecommerce. In spite of it being the target of government and user activism on use of its data and privacy concerns, monthly active users rose 7% y/y to 2.9 billion. Alphabet grew profits by 200% aided by digital ad sales and notable for Apple was its growth in emerging markets and China, with global paid subscriber accounts over 700 million. Amazon disappointed with lower guidance, though profits grew 50%. The more cyclical European market’s mining and energy companies Shell, Rio Tinto and Total Energies saw earnings grow by up to +200% y/y and more significantly increased dividends and buybacks.
Written By:Maurice Gravier Chief Investment Officer, [email protected]
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