Delta fails to dampen equity markets

The Harbour Investment Outlook summarises recent market developments, what we are monitoring closely and our key views on the outlook for fixed income and equity markets.

Friday, October 15th 2021, 8:28AM

Key points

The MSCI All Country World (global shares) Index fell 4.3% (in USD) in September, though was down a more modest 1.4% over the quarter.
The news that one of China’s largest property developers, Evergrande, was facing imminent default caused jitters within the market, with many worried about potential contagion. Evergrande’s troubles came to the forefront following tighter restrictions on property developers’ balance sheets.
Broader Chinese economic momentum has continued to stall with Beijing prioritising structural reforms over growth.
Bond yields rose over the month, the New Zealand 10-year bond yield increased by 0.27% to 2.09%, while the US 10-year bond yield climbed 0.18% to 1.49%. This contributed to declines for major New Zealand and global bond indices.

Key developments

Global equity markets fell sharply over the month, delivering a modest fall over the quarter. Investors reacted negatively to disruption in China’s property market, a rise in bond yields as the US Federal Reserve (Fed) looks to reduce stimulus, concern over the US debt ceiling, the impact of shortages (supply chain disruptions and energy) and ongoing COVID delta disruption. With the US Fed confirming a tapering path, higher bond yields triggered a rotation from growth to cyclical stocks. This saw the MSCI All Country World Value sub-index outperform its growth counterpart by 2% over the month. For context, the value index outperformed by 5% when we saw a sharp increase in yields in March this year.

Despite the current mobility restrictions, New Zealand remains different to many other countries with very little spare capacity and broad-based inflation pressures. The NZIER Quarterly Survey of Business Opinion (QSBO) showed capacity utilisation increased to all-time highs in Q3. Beneficiary numbers suggest the unemployment rate remains close to 4% and data soon to be released is likely to show annual inflation increased to 4% in Q3 – double the midpoint of the Reserve Bank of New Zealand’s (RBNZ) target range. This strong economic momentum has seen the market price in an official cash rate (OCR) of 1.5% in February 2023, a faster tightening cycle than many other developed economies.

In Australia, lockdowns are weighing on economic activity. The Australian economy is likely to contract 3 - 4% in Q3 due to lockdowns, and only partially rebound in Q4. Job losses were much higher than expected in August and labour force participation dropped as job prospects worsened. The Reserve Bank of Australia (RBA) followed through with its promise to taper QE purchases from $5bn/week to $4bn and committed to this purchase pace until at least mid-February from previously indicating purchases would be reviewed again in mid-November.

Globally, most countries have successfully reduced the spread of the highly infectious delta strain via a combination of vaccines and increased mobility restrictions. However, the world’s growth leaders have been hurt in the process. The US likely grew at annualised pace of 3 - 4% in Q3, vs. estimates of more than 6% a month ago. China’s zero-tolerance elimination strategy means the economy is likely to have contracted slightly in Q3. Fortunately, better-than-expected euro area activity means the global economy should still grow by about 6% this year, well above potential and consistent with reducing spare capacity. Global growth will be slower next year, at around 4.5%; this is still a healthy rate of annual growth for the world economy relative to the pre-COVID pace of around 3%.

What to watch

Inflation: Transitory? Global inflation has been surprisingly high and will likely prove more persistent than previously thought. Citibank’s global inflation surprise index is at all-time highs. US annual core inflation increased to a three-decade high of 3.6% and the euro area equivalent increased to 1.9% - the highest level since 2008. More is likely to come with European gas supply disruption resulting in a large increase in energy prices recently. In the US, a net 62% of US firms reported paying higher prices for inputs in September and, with global goods inventories historically low, it may take until the middle of next year before global supply chains normalise.

Market outlook and positioning

Investors face a ‘wall of investment worry’ in the near term with COVID outbreaks hitting supply chains and confidence, deflation of Chinese property markets triggering systemic failure concerns (and higher equity risk premiums), energy shortages adding fuel to inflation concerns and central banks unwinding ultra-stimulatory monetary policy settings - all of which are highlighting full valuations in some parts of the equity market.

However, there is support to ‘climb the wall of worry’. Re-opening with increasing vaccination rates may reduce near-term inflation pressures as the community gets back to work. Earnings volatility may reduce as supply chain pressures wane and as businesses incur less closing/re-opening disruption on operations and earnings. While earnings uncertainty may currently be high, several near-term earnings headwinds may dissipate to be replaced by a longer-term tail wind from COVID-forced business changes. And while interest rates are increasing, they are likely to remain on the easier side of historical levels for some time, supporting returns for longer duration (payback of returns) assets including equities.

Within equity growth portfolios, our strategy remains to ‘cut through the noise’ and build diversified, resilient portfolios, predicated on secular trends. While the portfolio invests in selected cyclical growth stocks with pricing power, we continue to focus active investment on a mix of quality sustainable growth stocks supported by secular thematics including digitisation (internet of everything, big data everywhere, ecommerce, automation, and robotics), demographic change, urbanisation, rapid medical advancements and the rise of sustainability. Given full market valuations, we remain selective and nimble. While, in the near term, equity market valuations may be constrained by the risk of higher bond yields and potentially higher equity premiums, in our view, equity markets will ‘climb the wall of investment worry’ driven by earnings that continue to beat modest expectations.

Within fixed interest portfolios, we have been of the view for some time that inflation risks remain to the upside and while inflation expectations have increased over this period, benefitting portfolio returns, we still believe upside risks remain. Indeed, existing tightness in global labour markets and surging prices across the global energy sector (oil, natural gas, electricity) are more alarming now than they have been for years. However, in New Zealand, we are also shifting to a different COVID-19 existence, and this brings greater uncertainties to the economy. We may experience weaker growth but higher inflation at the same time, making for a difficult decision-making environment for the RBNZ. Balancing these risks, we expect the RBNZ to steadily move the OCR towards a neutral level of 1.75-2.00% over the next 12-18 months.

Within the Active Growth Fund, our strategy within the portfolio has been to trim exposure to areas of the market which are likely to be sensitive to the path of interest rates in the short term. This has seen us modestly increase cash levels within the Fund. The Fund has continued to invest in companies supported by secular thematics, more recently we have extended this to private as well as public markets, recognizing the trend of companies remaining private for longer. Given relatively full equity market valuations, we remain selective and nimble.

Within the Income Fund, the main change to Fund strategy during September led to a reduction in our equity allocation from 33% to 29%, a move that we consider to be moderate rather than aggressive. The neutral position is 32%. We currently have a more cautious view. Firstly, the strong performance we enjoyed in August took the market to levels where good earnings news was more fully reflected in prices. Secondly, headwinds have been building. These include fresh concerns within global supply chains, notably across the energy sector and not just in Europe. It is also becoming more evident that labour is a constraint across the world, as many firms in New Zealand are also experiencing. In addition, central banks are moving steadily towards reducing policy support, with reduction in quantitative easing (QE) in Europe and the US in the pipeline, while some central banks are hiking interest rates.

This does not constitute advice to any person. www.harbourasset.co.nz/disclaimer

Tags: Harbour Asset Management