After seven consecutive months of gains, global equities fell by 4.3% in September (the MSCI AC World index in US dollar terms), cropping their year-to-date growth to 9.8%. While emerging market equities posted a similar loss (-4.2% for the MSCI Emerging Markets index in USD), their decline from the end of 2020 (-3.0%) is due to specific headwinds that have stymied Asian markets in particular in recent weeks.
Two factors can help explain recent pressure on equities.
On the one hand, there are China-related concerns, specifically over the ability of a major Chinese property developer to overcome massive debt problems, and more generally over country’s economy. Should this large builder default, financial markets face contagion via the broader real estate market and a hit to household confidence.
Meanwhile, the latest business surveys and data on industrial production and retail sales suggest that GDP growth will slow in Q3 as a result of the renewed outbreak of Covid-19 during the summer and Beijing’s regulatory tightening in many sectors. Liquidity injections by the People’s Bank of China may have helped to avoid even greater financial market turbulence, even if the authorities’ future intentions remain unclear.
On the other hand, long-term bond yields have risen on the back of an apparently less accommodative stance at several major central banks. Investors worry that rising interest rates could call into question the high equity valuations.
How tough will the Fed be on inflation?
There appears to be some confusion in the markets, though, over the likely course of the US Federal Reserve. Some policymakers see a need to raise interest rates as early as next year now that the economy is recovering, while others feel any rate rises should start later given that employment has still not fully bounced back from the shutdowns.
While central bankers at the Fed may have agreed on pre-announcing the end of Covid-related emergency support for the economy (known as tapering) later this year, the debate about raising rates has only just begun.
Is the ECB on a similar path?
It has indicated that it will adopt a moderately slower pace of asset purchases under the pandemic emergency purchase programme. Financing conditions have remained favourable, clearing the way for some tapering at a time when growth expectations – for 2021 – and inflation forecasts for the next few years have been revised upwards. The PEPP scheme is due to end in March 2022.
The ECB has not communicated yet on the future of its other asset purchase programme – known as the APP. Discussions in the governing council on the future of asset purchases are likely to be lively. Several council members have distanced themselves from the inflation forecasts released in September. They consider these to be too low and would favour less central bank largesse.
Overall, it appears the ECB’s scenario remains one of temporarily higher inflation due to the imbalances between demand and supply. However, the upside risks highlighted by some council members are more of a focus for observers than the reassuring words of ECB President Christine Lagarde.
More generally, with central bankers beginning to talk about persistent supply bottlenecks, investors have revised their inflation expectations upwards. This was also fuelled by the rise in commodity prices, particularly energy prices. The oil price has risen by 9.5% from the end of August, reaching a year-high.
Japanese equities stand out
Within developed markets, Japanese equities outperformed, with the Nikkei 225 index up by 4.9%, after Yoshihide Suga’s surprise decision to relinquish his position as prime minister. For investors, the move paves the way both for greater stability in the majority party and for additional support measures. Fumio Kishida’s subsequent appointment as prime minister reinforced expectations of continuity.
In the US, the rise in long-term bond yields held back equities. The S&P 500 fell by 4.8% from the end of August. In the eurozone, the drop (-3.5% for the EURO STOXX 50) was cushioned by financials, which are expected to profit from the steepening yield curve.
Globally, two sectors escaped the downturn: Energy and banks. The biggest declines were in basic materials, amid global growth concerns and supply shortages, and broad technology.
Are the markets right to be edgy?
The renewed nervousness in markets can be explained by specific factors such as the regulatory tightening and property market situation in China and anticipated changes to US monetary policy. The jitters also reflect more fundamental concerns: The assumption of a rapid return to ‘normal life’ through mass vaccination was called into question by the widespread impact of the Delta variant of Covid.
The effects of the Delta wave have been mainly on the supply side. Many sectors are suffering from a lack of raw materials, component shortages (such as semiconductors) and, in some cases, difficulties in recruiting qualified employees.
There are complicating factors. On the one hand, GDP growth in China has disappointed, leading investors to question the authorities’ ability and willingness to protect growth. On the other hand, some observers worry key interest rates may be raised earlier than expected.
We believe the ‘normalisation’ of monetary policies in the US and the eurozone will be prudent and gradual, but the more hawkish direction taken elsewhere is a concern.
Current conditions still favour equities since business activity should benefit as the bottlenecks dissipate. Government bonds are facing reduced support from central bank purchases in 2022. As a result, long-term yields should gradually rise to levels more in line with the macroeconomic fundamentals.