Quarterly investment review
Risky assets’ quarter
Risky assets have experienced varying degrees of success in Q3. The reopening of economies has been hampered and the economic recovery has stalled. After hitting records, the US stock market consolidated in the wake of the Chinese real estate developer Evergrande default.
Back to the job market in the United States
The unemployment rate in the United States keeps dropping. After laying off more than 20 million workers in 2020, US companies are still hiring and struggling to find skilled workers. After peaking at over 15% in March 20212, the unemployment rate fell to 5.20%. However, it remains well above its prevailing level just before the pandemic at 3.5%.
Earlier in the year, employers hoped to see the workforce return as early as September, in part because of the end of the payment of subsidized unemployment benefits for 12 million beneficiaries, as well as the reopening of schools.
Instead, the economy slowed in September due to an increase in infections linked to the Delta variant. Some workers prefer not to return physically at work. Schools and daycares have also been forced to send scores of children home to quarantine, which has made the task more difficult. for many parents to consider jobs outside the home.
Oil prices continued to hit new post-pandemic highs
Global growth is expected to be around 6.0% this year and 4.5% next year.
Long-term interest rates in the United States and in Europe continued in their downward trend started in April before rebounding in early August on the eve of the announcement by the US Federal Reserve of its wish to reduce the amount of its monthly bond purchases.
The equity markets stalled. The S&P500, the flagship index of the New York Stock Exchange, set a new high at the end of August at more than 4,500 points. It consolidated in September and is back to late June levels. It still shows an increase of over 15% since the start of the year. As interest rates hiked, the technological sector suffered big profit takings.
Gold did not show a clear trend, as industrial metal prices contracted following the Evergrande story and the risks of slowing Chinese demand. The price of oil continues to advance, it appreciated by + 4.5% over the quarter to reach $79 per barrel, gas prices have soared by almost 60%.
Currencies – Quarterly performance
In the wake of a less accommodative central bank, the USD appreciated strongly against all currencies, both from developed and emerging countries.
Bonds – Quarterly performance
Chinese government bonds continue to exhibit a clear decorrelation with those of developed countries. High Yield continues to perform well, while emerging hard currency bonds continue to experience massive outflows.
Equities – Quarterly performance
Quarter without a big momentum in developed markets, after reaching new all-time highs in the US market in the summer. Asian emerging markets are not catching up interests.
Commodities – Quarterly performance
Gas was the big winner during this period, as industrial metals were penalized by the Chinese economic slowdown.
Global manufacturing prices spike higher amid supply constraints
Manufacturing input costs rose at an accelerated rate in September, increasing at one of the sharpest rates seen over the past decade as supply shortages were exacerbated by ever-higher shipping costs. Demand growth cooled, however, alleviating some of the upward pressure on prices, linked in part to less companies building safety stocks compared to earlier in the year. Worldwide manufacturers reported a steepening rate of input price inflation in September, linked primarily to ongoing shortages of components and higher shipping prices.
Price pressures lift higher
The JPMorgan Global Manufacturing PMI, showed average factory input prices rising at the third-fastest rate recorded over the past decade, the rate of increase accelerating from August to equal that seen in July though fall slightly short of May’s recent peak.
The rise in costs was first and foremost again linked to suppliers being able to hike prices amid widespread shortages, creating a sellers’ market for many inputs from electronics components through to basic raw materials used for construction industry products. Average suppliers’ delivery times continued to lengthen globally at a rate unprecedented in almost a quarter of a century of survey data, exceeded only by those recorded in the prior three months, underscoring the unparalleled supply chain delays being recorded in recent months as a result of the pandemic.
Not only has the pandemic seen surging demand for many goods, the health crisis and associated lockdown measures has seen production of components and logistical capacity hit hard, with the recent Delta variant placing additional pressure on production capabilities in many important export-oriented Asian economies in particular, notably China, where manufacturing output has now fallen for two successive months .
Elevated macroeconomy volatility
Macro volatility will continue in the aftermath of the pandemic. Growth will converge from 2022 towards its long-term potential, while inflation will be resilient above Western central banks’ targets. Decoupling between the G7 and China will intensify. The containment of China’s housing crisis will require a significant easing of its economic policy. The generous valuation of most assets, the surge in commodities and real estate, the financial leverage represents potential vulnerability in times of macro and economic policy transitioning.
Volatile Macro/Geo-politic will challenge, but not derail the Asset Price Inflation regime.
We consider three secular disruptors. 1) Climate – rapid – changes, which impose hectic transitions towards green (er) economies. This will fuel large investment packages, but also higher inflation, new regulations, corporate requirements, and taxes. Europe is leading the charge. 2) Technology. The relentless shift towards digitalization has a long-lasting impact on labor markets. 3) High Inequalities generate more labor friendly policies to regain a higher share of GDP.
Stagflation fears are taking root. Rising inflation fears have irritated markets and fueled changes in assets’ correlation. The volatility of negative real rates, the global mushrooming of stricter regulation, and perspectives of (US) higher taxes add to uncertainty. The decrease of risk appetite favors a stronger USD. Further strength would accentuate drying-up of investable liquidity and upset risky assets.
Stagflation fears should dissipate by year-end. Supportive financial conditions will continue in H1 2022.
Global investment framework remains relatively supportive, though less so.
The almighty USD
The QE tapering will happen in November and a first rate hike in S2 2022 accordingly to the median Fed forecasts. That would coincide with a pickup in cyclical inflation, as opposed to the transitory lift we have seen this year from the combination of base effects and supply disruptions. Clearly, the Fed is looking ahead to a reacceleration in growth in 2022.
While a S2 2022 rate hike would not be shocking at this point, it still looks too early. According to historical forecasts, both the Fed and markets failed to predict the first rate hike in the right timing. Investors have usually been more hawkish than the FOMC, this time is the opposite and could cause a big shift in positioning.
Furthermore, the Fed central tendency terminal expected rate, still according to dots, is quite high at 2.5% compared to other central banks foreseeable rates paths. That divergence in policy rates between the Fed and other funding central banks like the ECB, BoJ, and SNB in the coming years will drive USD outperformance.
While the pandemic purchases will moderate, the overall ECB QE envelope will remain unchanged at €1850bn until March 2022 at least. The ECB intents to maintain favorable financing conditions to perpetuate the recovery narrative. Therefore, the central bank will consider pandemic purchases transitioning into the Asset Purchase Program. Although headline inflation risks testing 13-year highs, the ECB will look through short term price spikes, especially as core prices are expected to remain relatively well contained. Alongside expansionary fiscal policy will favor persistently low interest rates, and as a result, a weaker EUR in 2022. This will be the main support for the USD.
Solid credit performance
Rating performance is improving in the corporate sector. The number of issuer upgrades exceeded downgrades in 2021. Most of them are not reversals of rating actions taken in 2020. Last year was a record deterioration in corporate ratings, with the highest number of downgrades in 20 years or 20% of the universe, and with 7% of issuers downgraded by multiple notches. However, as pandemic-related restrictions have relaxed and as many economies return to growth, the most severe credit pressures have abated. Positive ratings actions have started to rise. The ratio of corporate upgrades to downgrades in developed markets is 1.3x in 2021, while the balance is almost neutral in emerging markets.
This dynamic is well spread across the bond universe. The number of potential fallen angels (issuer leaving the investment grade space to the high yield) has begun to shrink, and potential rising stars (the opposite way) continue to climb.
The 2022 US High Yield bond default rate will reach 1.0%, down from 2.5%-3.5% original projection, according to Fitch. This will result in just a 7% cumulative default rate for 2020-2022, well below the 22% registered during the 2008-2010 global financial crisis. These forecasts coupled with a very low near-term maturity wall and continuing improvement in fundamentals remain supportive for low credit spreads, even more as refunding remains easy.
Even if defaults risks are lows, the overall HY market is offering the largest negative real yield in history and more than 80% of the US HY market is yielding below the CPI. Higher government yields will not derail credit market, the amount of debt to roll-over in the next 2/3 years is manageable. Even with improving fundamentals credit spreads remain at unattractive levels
Supportive year-end seasonality
Since August, some investors have been worried about a significant stock market correction due to unfavorable seasonality (statistics) in August, September and the first two weeks of October, and expectations of smaller injections of liquidity from central banks. As observed recently, rising interest rates are still shaking the stock markets as they challenge stock valuations. Investors may be more worried now, because the origin of the latest hike is more inflation fears and potential cuts in central bank liquidity than expectations of an economic recovery.
Stagflation risks are mounting
In the short term, the market has to integrate a possible new paradigm with the return of inflation and the implication of a reduction in liquidity by central banks. Added to this is the brawl in the US Congress over stimulus plans and the debt ceiling, as well as the real estate problems (Evergrande) in China.
In the medium to long term, we remain positive on equities and believe that investors will look beyond this current period of acute disruption.
The positive arguments for 2022-2023 are:
• A gradual normalization of world trade and less pressure on supply.
• Massive restocking, with new demand coming from the energy transition and 5G (involving the use of new applications).
• An acceleration in demand thanks to the savings accumulated during the pandemic and the return of a normalized supply for clients/households.
• US and Chinese budget plans (forthcoming).
• Green investments, with perhaps more visibility after COP26.
• Investments dedicated to increasing production capacities (semiconductors) and new production capacities (electric vehicles, batteries, etc.)
The emerging zone should continue to underperform in a period of Sino-US confrontations – technological, commercial, geopolitical, financial -, questioning the globalization, the strengthening of the dollar and higher US interest rates.
Geopolitics is a source od stress
Geopolitics is becoming more complex, such as the rapprochement of Russia towards OPEC (Saudi Arabia) to control oil prices or Russian pressure on Europe with gas to make the Nord Stream 2 pipeline (Gazprom) indispensable, a great tool for Russian soft power. Gazprom is the only company that Europe can turn to in case of urgent need for gas and the International Energy Agency calls on Russia to ensure sufficient storage for the next winter season. We have to wait until the end of the year for the exploitation of Nord Stream 2 and Russian gas will therefore have to pass through Ukraine, which Russia does not facilitate due to the tense UkrainianRussian relations and international sanctions against it.
Gas and coal prices are skyrocketing. Demand for gas is picking up sharply in a context of an economic rebound, while inventories are at their lowest. Weather phenomena, several breakdowns (in Norway in particular), the Covid and a global maintenance delay on the installations during the year 2020 have contributed to the slowdown in global supply. China is caught off guard – one could even say that it is facing an energy crisis -and must ration electricity consumption.
Metals have clear different drivers
In precious and semi-precious metals, production of platinum and palladium for catalytic converters has declined along with that of cars due to the shortage of semiconductors.
The next few years will be marked by a structural increase in demand for metals and a weak supply response. Investments in new mines are slowing down because the profitability of projects is no longer guaranteed due to (geo) political, climatic and legal risks.
Precious metals are not sought after, gold and silver, as absolute protection, but as decorrelated diversification in a portfolio. Their prices moves with US interest rates and/ or the dollar. Gold is a financial asset that can protect in the event of a financial (debt) or monetary crisis. This is not the case today. If rates go down, it favors stocks, if rates go up, it favors bonds. However, a negative real interest rate regime is good environment for gold and offers cheap protection in a diversified portfolio.
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