A few clouds over markets

September has turned a little darker for investors. China experienced a slowdown in growth momentum, exacerbated by uncertainties from property developers’ financial stresses and power outages. The Federal Reserve (Fed) is starting to settle its plan for reducing bond buying, and U.S. Treasuries (UST) sold off as a result. Energy prices rebounded on the back of supply disruptions. The path to “living with COVID-19” is a bumpy one with the pace of vaccination slowing down in the west. These factors have led to a modest correction in developed market equities. Some of these, such as the Fed’s policy and rising bond yields, have been expected. Others are more of a surprise. While this correction could have a bit more room to go, we still think the outlook for risk assets remains constructive going into 2022. 

Am I getting lumps of coal for Christmas?

Disruptions of the global supply chain continue, and this has triggered several channels of inflationary pressure. The natural gas shortages in Europe have led to a spike in prices, which could be particularly troublesome as winter arrives. For broader trade of goods, freight rates have already risen significantly in 2021, and the pandemic has lengthened shipping times further with reduced workforce at ports. This means importers in the U.S. and Europe would have to pay more and wait longer for the year-end holiday seasons. This rise in costs will either be absorbed along the supply chain, resulting in reduced profit, or consumers will have to pay for it. The latest round of power outages in China has added to the concern of not enough goods available to fill Christmas stockings, or other necessities, going into the year-end. 

A well-telegraphed policy move

Given the backdrop of inflationary pressure persisting going into the new year, the Fed and other central banks are still content with maintaining accommodative monetary policy. However, the Fed’s September Federal Open Market Committee (FOMC) meeting effectively pointed toward starting to roll back asset purchases, with an announcement expected in the November meeting and actual reduction starting in December. Of course, there could still be changes if the economy suffers some unexpected shocks. The overall message is that the economy has recovered sufficiently for the Fed to start removing these extraordinary measures. The updated FOMC Summary of Economic Projections has also seen more members predicting the first hike to come in 2022. 

In addition to watching the Fed, the U.S. economy is also looking at Congress to see if it will pass the USD 1.5trillion bipartisan infrastructure package and the USD 3.5trillion 2022 budget plan. It will also need to raise the debt ceiling for the federal government to continue to meet its financial obligations.

As a result of the Fed policy change and the increase in UST supply, the 10-year UST yield rose to above 1.5% for the first time since June. We believe that this trend is likely to continue for the next 12 to 18 months given the possibility of fiscal deficits staying high on the back of the various spending plans, as well as a reduction in demand from the Fed via its quantitative easing program. 

China faces more economic challenges

The immediate economic outlook is becoming more challenging. Economic momentum was already slowing in the summer due to the normalization of monetary and fiscal policy in the first half of 2021, as well as sporadic outbreaks of COVID-19 in some cities, leading to a  slowdown in consumer spending growth. In September, two new concerns emerged. First was the potential financial stress relating to property developers. The tightening measures to limit residential property price gains has cooled activities in the real estate market. Investors are increasingly concerned that companies with high leverage will not have sufficient cash flow to service their debt. The Chinese authorities do not seem to have the appetite to rescue these developers financially. Yet, given the role of real estate and construction in the economy, they are expected to protect homebuyers and limit the possibility of defaults having an impact on the broader economy.

There were also a number of power outages across the country. This was partly due to the surge in coal prices leading power companies to cut back electricity production to limit financial losses, since electricity prices are fixed. Some provinces are also limiting power production in order to meet their greenhouse gas emission targets. This could have an impact on overall manufacturing output entering 4Q 2021, and some of this impact was already reflected in September’s manufacturing Purchasing Managers’ Index.

Given the economic slowdown, we expect both fiscal and monetary policy to turn more supportive in the near term. There is sufficient buffer for the central and local governments to issue more debt to fund economic activities. While reduction in policy rates or reserve requirements does not seem likely at this stage, the People’s Bank of China has already stepped up its liquidity injection in the financial system via open market operations.

Investment implications

We enter 4Q 2021 with a few more economic concerns. This could lead to more market volatility, especially in the U.S. where rich valuations offer limited buffers to disappointment. It is important for investors to focus on the long term, where two things are important. The global recovery path is still intact, albeit a bumpy one with significant regional variations. Even though central banks may have passed their most accommodative phase, the path of normalization will be long and gradual. This implies the ample liquidity situation should still be supportive of risk assets.

Our view on asset allocation over the next 6 to 12 months is largely unchanged. We are still cautious over fixed income given the prospects of higher UST yields and the subsequent negative price impact on bonds from duration. Global high yield debt and emerging market (EM) fixed income can still provide investors with high income. For Asian fixed income, investors have been quite sanguine in separating the Chinese developers from the rest of the Chinese fixed income and Asian high yield space. Active management continues to be crucial in this space.

On equities, a globally diversified allocation can capture the varying pace of recovery. The U.S. and Europe have led the way for much of this year. Japan is starting to catch up. This is partly due to the expectation that a new prime minister (Fumio Kishida) could step up government spending ahead of the next Lower House general elections, which will be held before the end of November. The global capex cycle recovery should continue to support Japanese corporate earnings.

For the rest of Asia, despite challenges facing China, investors are looking ahead to a higher level of vaccination, allowing governments to reopen their economies in a more sustainable way. While the latest outbreak in Singapore is denting this confidence to some extent, living with COVID-19 would be an option that more Asian governments could take more seriously. Overall, we believe Asian equities could have a greater potential to catch up in late 2021 and 2022. 

Global economy:

• The Fed has strongly hinted that the reduction of bond buying will occur before the end of 2021. We expect it to start in December and finish by summer 2022. While some FOMC members are expressing their expectation that the first policy rate hike will come in 2022, the overall path of policy rate tightening will still be very gradual. Meanwhile, the U.S. Congress is still debating over the size of the 2022 budget reconciliation bill, which is holding back the USD 1.5trillion infrastructure bill and the raising of the debt ceiling. 
  (GTMA P. 20, 21, 28)
• The slowing Chinese economy is being met with two new challenges. The cooling of the property market is adding to the liquidity stress of some property developers with weak balance sheets. Investors are monitoring the potential contagion impact since the government is unlikely to bail out these developers. Meanwhile, power blackouts are having an impact on production in a number of cities, brought on by a combination of the surge in coal prices and emission quotas. Both fiscal and monetary policies are expected to step up to stabilize growth momentum.
  (GTMA P. 6, 7)

Equities:

• September was a more difficult month for global equities given moderation in growth momentum and the concerns over China mentioned above. The S&P 500 and NASDAQ were down 4% and 5.2%, respectively. Europe was also down 4%. The rise in UST yields continues to support the outperformance of the value and cyclical sectors over the growth sector.
  (GTMA P. 31)
• Challenges with the Chinese economy and developers have had an impact on the Hong Kong market, with the Hang Seng Index and China Enterprise Index down 5.5% to 6% in the month. In contrast, the CSI 300 was flat in September. The more cautious sentiment out of the U.S. has also impacted the rest of Asia, with South Korea and Taiwan both down more than 5%. India and Indonesia are the exceptions, with small positive returns in the month, showing that the prospects of quantitative easing tapering are not necessarily a negative for these two markets.
  (GTMA P. 31, 37, 43)

Fixed income:

• The Fed pointing toward the start of slower asset purchases starting at the end of 2021 and the increase in net issuance of government bonds have lifted the 10-year UST yield toward 1.5%, the highest since June. Price pressures remaining elevated also contributed to the rise in government bond yields. The UST curve also steepened on the back of this. 
  (GTMA P. 55)
• The rise in UST yields negatively impacted the U.S. investment grade (IG) corporate debt benchmark more (-1%) compared with high yield (+0.2%), since the IG benchmark has higher duration and lower yield to protect against duration risk. U.S. corporate credit spreads remain largely unchanged despite the slower economic momentum. Concerns over Chinese real estate developers have impacted EM and Asia fixed income, with the high yield segment unsurprisingly underperforming in September. Select EM central banks opting to raise interest rates also pressured the EM sovereign debt market.
  (GTMA P. 51, 53, 54)

Other assets:

• The U.S. dollar rose 1.7% in September with higher government bond yields and a superior interest rate differential relative to other developed economies. In developed markets, the Australian dollar and New Zealand dollar experienced the largest depreciation in September since they are no longer the only markets with relatively high yields in government bonds. In Asia, the onshore Chinese yuan remained surprisingly resilient (+0.2% vs. the U.S. dollar) despite China’s economic challenges. The Thai baht, Korean won and Philippine peso saw the biggest drop against the U.S. dollar amongst Asian currencies.
  (GTMA P. 69, 70)
• Supply side issues raised oil prices in September. West Texas Intermediate crude rose 9.5% to USD 75 per barrel in the month. A pick up in seasonable demand as the northern hemisphere enters winter is also pushing up demand expectations. In contrast, rising yields have pressured gold to drop by more than 3%.
  (GTMA P. 72-74)