Fortunately, unfortunately

The third quarter brought both highs and lows for markets. The U.S. equity market made multiple record highs while Chinese equity markets were hit by a swath of new regulations and concerns about stability in the property market. Meanwhile, U.S. politicians are still wrangling over stimulus measures and risk another government shutdown. But more importantly, a combination of rising inflation expectations and falling growth expectations fueled the stagflation debate in markets.

Against all this, equity markets managed to hold up over the quarter. Ultimately, investors seem to still believe that even with a moderation in growth, recession risks are very low and the earnings outlook will support equity markets into year end and next year.

Equity investors may also be taking some solace from the fact that COVID-19 will have less of an impact on the economic outlook as case numbers from the latest wave have peaked, vaccination rates are rising, and more countries are shifting away from elimination strategies that should allow for broader economic reopening.

The challenge to equity markets is from rising bond yields. The fast move in government bond yields late in September weighed on those parts of the market most highly valued. Higher interest rates means applying a larger discount to future earnings, making companies and sectors with very high forward price-to-earnings multiples less attractive. Rising inflation expectations are increasing the nominal yields on bonds and we expect this to continue but at a more gradual pace than was experienced in September.

Despite the surge in inflation in recent months, central banks are prepared to look past supply disruptions and maintain the narrative of “transitory” inflation. South Korea and Norway have hiked interest rates during the quarter and the Reserve Bank of New Zealand followed suit in early October. The U.S. Federal Reserve (Fed) has paved the way to start tapering its bond purchase program, possibly in November, and for a faster pace of rate hikes once tapering ends. However, the Reserve Bank of Australia remains committed to its elongated taper and to not raising rates until 2024, a view that will be increasingly challenged by markets.

The healthy position of both household and corporate balance sheets means that spending should increase as economies reopen. Constraints in both the energy market and in global supply chains will also start to remedy themselves in the coming months. This should mean that today’s high rates of inflation will start to moderate, but that inflation will remain higher in this cycle than it did in the previous one. This is a material change for investors who may have become used to a persistently low inflation environment. 

Economy:

• The Australian economy expanded by 0.7% quarter-over-quarter in the second quarter and by 9.6% year-over-year (y/y), putting the absolute level of GDP 1.6% above the pre-COVID-19 peak at the end of 2019. However, the outlook for the fourth quarter will be impacted by the ongoing restrictions in New South Wales and Victoria.
• The housing market has been remarkably resilient even as COVID-19 restrictions limited activity. Residential building approvals rebounded in August, up 6.8% month-over-month (m/m). House price growth was a smaller 1.8% m/m in August but the pace of price gains has been very healthy with prices up 18.3% y/y.
  (GTM AUS page 10, 11)
• The labour market has been another bright spot over the quarter despite broad and severe restrictions in place across the country. The decline in employment levels was larger than expected at 146,000, but the unemployment rate materially better at 4.5%. There are mixed signals from the labour market as workers have stopped looking for jobs, but even as they return the unemployment rate is not expected to spike.
  (GTM AUS page 8)
• Global economic momentum may be starting to stabilize. The Global Purchasing Managers’ Index for manufacturing was unchanged in September and the pace of decline in this indicator across many developed economies slowed and even increased for some emerging markets.
  (GTM AUS page 16)
• The other outlier for markets is U.S. politics. The government has managed to pass a continuing resolution to keep the government open past the end of September (the end of their financial year) but still has the debt ceiling to deal with as well as the passage of the physical infrastructure (USD 1.2trillion) and social infrastructure (USD 3.5trillion) bills to negotiate. The U.S. government will likely reach an 11^th hour agreement on the debt ceiling as they have in the past, but it is a narrow path to traverse and likely to add to market nerves in the coming weeks.

Equities:

• The ASX 200 was up 1.7% in the third quarter, beating U.S. and European markets which returned 0.6% but behind the 5.3% return for Japan. Asian markets were heavily impacted from fallout from the Chinese property sector as the Asia ex-Japan index fell 8.4% over the quarter (local currency returns).
  (GTM AUS page 33)
• Locally, the energy sector made the biggest move, gaining 7.6% on the quarter, followed by industrials (5.9%) and financials (4.0%). The only sector in the red for the quarter was materials, falling by 13.3% as iron ore prices fell in line with weaker expected steel demand linked to fallout from the Chinese property sector (price returns only). 
• Broadly, the weakness in equities running into the end of the third quarter can be attributed to a combination of inflation fears, moderating economic growth, and a more hawkish shift in policy tone from many of the world’s largest central banks. This places strain on historically high equity valuations, but also adds to the rotation in markets towards value and cyclical sectors, which are relatively more attractive and tend to outperform as yields rise.
  (GTM AUS page 36)
• The negative news regarding China was unrelenting in the third quarter. A changing regulatory environment designed to achieve long run “common prosperity” goals unnerved markets but was compounded by fallout from overleveraged companies in the property sector and the threat of contagion to the broader financial system. However, the risk of a systemic crisis appears limited given government incentives to contain the situation.  

Fixed income:

• Global bond yields saw a material rise over September as inflation expectations rose and rate hike expectations from the Fed were brought forward. However, yields are only up marginally from where they ended in June. Over the quarter, U.S. 10-year yield rose 8bps to 1.53% while the Australian 10-year bond yield was actually down 4bps to 1.49% over the same period.
  (GTM AUS page 51, 54, 55)
• Investment grade credit spreads remain very narrow.
  (GTM AUS page 52)  

Currencies and commodities:

• Supply disruptions and a combination of new policy measures to reduce greenhouse gas emissions generated what has been called “greenflation”.
• Weaker supply of natural gas and thermal coal put upward pressure on prices over the quarter. The price of Brent Crude Oil rose to USD 79 / bbl even as the growth outlook moderated, and China released stockpiles from its Strategic Petroleum Reserve.
  (GTM AUS page 64)
• Meanwhile, the price of iron collapsed from USD 247 / Mt to USD 120 / Mt by the end of September on the back of slowing steel demand in China from not only the property sector, but also from lowering output to meet decarbonisation targets.
  (GTM AUS page 65)
• The U.S. dollar index was supported over the quarter thanks to the hawkish shift from the Fed. The Australian dollar depreciated by 3.8% against the U.S. dollar in 3Q 2021. The currency settled into a new trading range between 0.72 and 0.74 to the U.S. dollar.