Faster, Stronger, Higher
“Faster, Stronger, Higher” is the motto of the modern Olympic games. The Tokyo Olympics has added “Together” to this motto in the spirit of battling the COVID-19 pandemic. As we say goodbye to the Tokyo Olympics, “Faster, Stronger, Higher” could mean very different things to investors around the world, with considerable implications for the rest of this year.
Faster inflation and policy normalization?
Global inflation has picked up in 2Q 2021 on the back of higher energy prices and supply-side bottlenecks. In the U.S., used car prices surged as semiconductor shortages impacted new car production. Challenges in hiring workers have limited the capacity of the services sector as demand returned. With the Organization of the Petroleum Exporting Countries (OPEC) and Russia agreeing to increase production by 400,000 barrels per day each month between August 2021 and December 2022, energy prices should stabilize. This should at least statistically help to drive headline inflation back toward the Federal Reserve’s (Fed’s) target of 2% in 2022. For the supply-side bottlenecks, they should gradually ease over time as distortions in the job market and logistics return to normal. This supports the Fed’s recent view that the latest surge in inflation should be a temporary phenomenon.
Nonetheless, the ongoing economic recovery in the U.S. and other developed economies is allowing central banks to start planning for the exit of extraordinary policy measures to boost growth. The Bank of Canada has already started to pull back on asset purchases. The Fed hinted in its July Federal Open Market Committee (FOMC) meeting that the economy is making progress toward the central bank’s objectives. We believe it could start to reduce asset purchases as early as the end of 2021. The Fed’s Economic Policy Symposium in Jackson Hole on August 26 to 28 could provide more indication of its policy intention. The prospects of policy normalization make the recent decline in the U.S. Treasury (UST) yields difficult to explain. The falling real yields are not consistent with the strength of the U.S. economy, especially if U.S. President Joe Biden were able to go ahead with his USD 1trillion infrastructure bill given support from both Republicans and Democrats.
One of the variables for the Fed to consider is the latest round of outbreaks of the Delta variant. There has been a sharp rise in new infections in the U.S. and the UK but so far hospitalizations and deaths have been relatively low, especially amongst those who have been vaccinated. If this trend could continue in the coming one to two months, governments would have more confidence in keeping their economies open. This should also give other governments extra incentive to accelerate their vaccination programs in order to allow for greater sustainability in economic reopening.
Stronger policy regulation in China
The Chinese authorities have been addressing regulatory issues relating to the new economy and technology sector over the past year, from potential systemic risks from financial technology innovation to antitrust practices of e-commerce platforms and data privacy issues. On July 24, the Chinese government issued the “double reduction” policy, which aims to reduce homework and after-school tutorials for young children. The aggressiveness of the policy has led to a sharp sell-off in not only education-related companies, but also technology in general.
We believe that investor confidence could take some time to settle, but we maintain our view that China continues to offer ample investment opportunities to international investors. While fintech, e-commerce sector leaders, ride-sharing and education are facing regulatory headwinds, there are areas where policy tailwinds are plentiful. This includes semiconductor and software industries under the import substitution strategy. Greenhouse gas reduction is another area where multi-decade development has just started.
Higher corporate earnings
Alongside economic recovery, corporate earnings are also rebounding. At the time of writing, both the S&P 500 and Stoxx 600 are halfway through their 2Q 2021 earnings season. For the U.S., 90% of companies that have reported earnings have beaten market expectations. Market consensus on 2021 earnings per share (EPS) growth has been upgraded to 42.3% from 37.2% as of the start of July. Profit margin improvement has been the key to earnings growth in 2Q 2021, despite healthy revenue expansion. In Europe, 83% of companies that have reported 2Q 2021 financial results beat earnings consensus.
Not surprisingly, the cyclical sectors (consumer discretionary, financials, industrials, energy and materials) are enjoying the stronger earnings recovery, considering the damage they suffered last year during the pandemic. 2022 could be a year where the earnings environment normalizes, and the growth sector could start to outpace in earnings growth once more.
This continues to underpin our preference for equities for the rest of 2021 and beyond. The U.S. and Europe are enjoying the earnings tailwind, while Asia is still struggling with the outbreak, thus limiting their domestic demand recovery. Nonetheless, we expect a rise in vaccinations around the Asia region should help prepare for a more sustained reopening in 2022, which would help to lift corporate earnings beyond the export sector.
Putting everything together
The macroeconomic environment is still constructive for risk assets despite the recent drop in UST yields. We still see U.S. and Chinese equities to be core in any global equity allocation despite the recent policy adjustment in China. We would prefer to track the recovery progress, and Europe is likely to occupy the sweet spot alongside Asian exporters. For Asia and emerging markets to enjoy a more broad-based rally, the conditions for economic reopening, including a higher percentage of immunized population and establishing test and tracing systems, are needed.
For fixed income, short duration and high yield are still the key to balancing the management of duration risk with the generation of appropriate income and return for Asian investors. In addition to U.S. high yield corporate debt, Asian and emerging markets (EM) fixed income can also support this framework. However, some EM central banks have already started their rate hike cycles, such as Russia, Brazil and Hungary. At the corporate level, concerns over the Chinese real estate sector could persist, given the Chinese authorities’ determination to cool property prices. Hence, active selection is necessary to manage such risks.
- U.S. economic growth for 2Q 2021 came in weaker than expected at 6.5% on an annualized basis. Robust consumption recovery was offset by softer residential investment and inventory drawdown, reflecting the challenges from labor shortages and logistics disruptions. These are also factors that are contributing to inflationary pressure in the near term. Meanwhile, the Fed kept policy unchanged in its July FOMC meeting but hinted at reducing its asset purchases given the economy is making progress toward its policy objectives of price stability and full employment.
(GTMA P. 26, 27, 30)
- The global economy has seen a surge in COVID-19 infections, largely driven by the Delta variant. In the U.S. and the UK, the rise in new infections has not yet led to a significant rise in hospitalizations and deaths, especially amongst those who have been vaccinated. August is going to be crucial in observing whether this trend could continue, as governments can allow their economies to stay open even with rising infections if the medical system is able to cope. In Asia, the rate of vaccination needs to pick up significantly, especially in southeast Asia, in order for the governments to plan for a more comprehensive reopening of their services and tourism sectors.
(GTMA P. 24)
- Abrupt changes in the rules surrounding the education sector by Chinese authorities have prompted a sharp correction in the Chinese tech sector and the new economy, especially those listed in Hong Kong and the U.S. The Hang Seng China Enterprise Index lost 11.3% in July. The CSI 300 Index lost 5.3% in the month. It could take some time before investor confidence stabilizes, but there are sectors in the Chinese market that will continue to receive support from the authorities, such as software, semiconductor, and renewable energy.
(GTMA P. 32, 44)
- The U.S. market remains supported by firm economic data and earnings performance. The S&P 500 and Nasdaq were up 1% and 0.23%, respectively, both hitting record highs in the month. With half of the S&P 500 companies having reported earnings, 90% were able to exceed earnings estimates. For Europe (Stoxx 600), 73% of companies outperformed EPS expectations.
(GTMA P. 46-48)
- Despite another surge in inflation, ongoing economic recovery and the Fed hinting at reducing asset purchases, UST yields continue to grind lower. The 10-year yield fell below 1.3%. Real yields also declined despite the better growth, which suggests lower yields are driven by technical factors, such as capital flows and underlying demand for Treasuries, rather than economic fundamentals.
(GTMA P. 56, 58, 59)
- Lower Treasury yields have helped to boost returns of the higher quality segment of the credit market. The U.S. high grade corporate debt benchmark (+1.14%) outperformed high yield (+0.24%) due to longer duration. The high yield sector also saw a modest widening of credit spreads, which impacted their overall performance. For Asia, concerns over the financial health of Chinese real estate developers also led to a widening of credit spreads in high yield Asian corporate debt.
(GTMA P. 52, 54, 60, 62)
- Oil prices stabilized following the agreement by OPEC members to raise oil production by 400,000 barrels per day each month starting in August. This implies the demand recovery should be matched by a rise in production, which should help to rebuild inventory and limit further price increases. Having dipped below USD 70 per barrel (pb) after the agreement was reached, West Texas Intermediate Cushing oil prices returned to the USD 70 to 75 pb range.
(GTMA P. 73, 75)
- The drop in real Treasury yields gave gold a boost with the gold price returning to above USD 1,800 per ounce. However, given the upside risk to UST yields in months ahead, the outlook for gold continues to be challenging.
(GTMA P. 74)