August 2021 Monthly Market Commentary: Post-Covid recovery largely on track despite regulatory and political headwinds
14 September 2021
MARKET CONTEXT:Post-Covid recovery largely on track despite regulatory and political headwinds
Global Macro: The proportion of vaccinated people continues to rise around the world while the number of deaths is decreasing rapidly despite the Delta variant. The global economy is normalizing with key unemployment figures improving, albeit not yet at pre-pandemic levels. Expected growth for 2021 remains strong, led by China (+8.5%; vs US +6.5%, Europe +5.1%, Asia +7.1%). We also note corporate earnings have beaten expectations in major economies. As anticipated, inflation appears to be transitory, with China’s annual inflation rate at 0.8% in August, below market consensus (1.0%), thus easing the pressure on central banks to hike their short-term rates. As such, we expect short-term interest rates to remain near zero in the West and close to 2.20% in China. Nonetheless, with inflation twice as high as pre-Covid levels and a solid global economic recovery, we believe central banks in major economic blocs will start reducing their bond purchasing programs within the next 12 months, thus allowing long-term rates to increase. However, we think the rise will be moderate as governments in the US and Europe have seen their budget deficit skyrocket following the roll-out of costly stimulus measures to keep their economy on track during the pandemic and thus cannot afford to let long-term rates rise too much as it would increase the cost of servicing their debt.
Based on our econometric model, over the next 12 months, we expect to see the 10-year US Treasury yield within the [1.2%; 2.0%] range, the 10-year German Bund yield within [-0.4%; +0.2%], and the 10-year Chinese government bond yield within [2.8%; 3.2%]. On one hand, the Fed and ECB are trying to find a way to taper their bond buying programs without scaring the market; on the other hand, many large pension funds would place buying orders if the 10-year US Treasury yield approached 2% and the Bund yield became positive, which would lower the upside pressure on long-term interest rates. On the equity side, we expect the environment to remain favorable for global stock markets until the end of the year as central banks maintain their accommodative monetary policy and earnings continue to rise. We are positive on Chinese equities as a large risk premium is already priced in to reflect the country’s increased regulatory oversight in sectors within the digital transformation space. The government’s policy is pro-growth, banks’ reserve requirement ratio (RRR) is expected to be eased, and local government bond issuances are planned to increase substantially by year end. Overall, the Chinese economy is expected to be the fastest growing among major economies, both in 2021 (+8.5%) and 2022 (+6.5%). On the currency side, despite the Chinese equity sell-off this summer, USDRMB was unable to appreciate and stay above the 6.50 resistance level. Based on our econometric model, we believe the US dollar will continue its secular bearish trend, on the back of the US twin deficit and global de-dollarization trend, while expecting the renminbi to be supported by China’s strong economic growth. We expect EURUSD to remain relatively stable within the [1.16; 1.24] range.
Equity:Month to date the S&P 500, Euro Stoxx 50, and Nikkei 225 gained 3.0%, 2.6%, and 3.0%, respectively, against a positive backdrop for global equities; by contrast, the Hang Seng Index edged down 0.3% as investors remained prudent following China’s recent regulatory tightening. Fixed Income: The 10-year US yield rose 6bps in August to 1.30%, while Emerging Market government bonds (+0.7% in USD; +0.6% in local currencies) and High-yield corporate bonds (+0.5% in USD; +0.2% in EUR) all increased. Currencies:The greenback appreciated against other major currencies amid market expectations of tightening measures from the Fed: EUR -0.8%, AUD -1.4%, CNY -0.2%; safe-haven JPY -0.5%, CHF -1.3%. Commodities:After an initial sell-off in early August, gold recovered and ended the month flattish (+0.1%); oil prices fell 7.4% due to concerns over a slower demand recovery as the Delta variant progressed.
Covid-19:New waves of infections caused by stronger Covid variants could result in new restrictions and lockdown measures around the world, with a strong negative impact on the economic growth outlook, although higher vaccination rates would limit the risk.
China’s regulatory tightening: Following the implementation of stricter regulations in both the tech and education sectors, Chinese regulators may target other industries, which would further impact financial markets.
Rising long-term interest rates: We expect central banks to start reducing cash injections and tapering their bond purchasing programs within the next 12 months, which will result in higher interest rates and downward pressure on equity valuations. Meanwhile, investors are requiring higher yields to compensate for the risk of governments’ ballooning debt.
US tech bubble & high US equity valuations:Tech stocks remain under pressure, given the highest valuations since the dot-com era and high market concentration, while the Biden administration is expected to take a much stronger stance on the tax and anti-trust treatment of tech companies.
US-China tensions: US-China trade frictions remain strong, with increasing tension around Taiwan and the South China Sea. In addition, the US is maintaining pressure on Chinese companies listed on US stock exchanges by implementing stricter rules targeting Chinese firms.
Hedged bond income portfolios: As interest rates will likely trade in a range over the next 12 months, we highlight the importance of receiving positive carry (income from bonds or money markets) in fixed income portfolios with bond capital gains contributing less to fixed income portfolio returns. As the next move for rates is most likely on the upside, reflecting bond buying tapering from central banks, partial hedging of bond portfolios will be key to optimizing risk-adjusted returns.
Chinese equities: The Chinese stock market has underperformed Western equities by c.40% this year amid US-China tensions and increased Chinese regulation on tech firms, with Chinese tech stocks plunging c.40% since January. However, we think the downside risk from here is moderate as the Chinese market started to rebound and US hedge funds and asset managers are building long positions again. The Chinese government and PBoC are preparing a substantial stimulus to keep the economy growing as we exit the pandemic. As there will be increased volatility till year end in the Chinese equity market due to a series of announcements aiming to further regulate the digital sectors, we believe it is paramount to gain exposure progressively via a medium-term ramp-up.
Oil & Gas: The energy sector is a major beneficiary of the global recovery, while long-term anticipated oil demand remains robust. Moreover, we expect energy companies to resume share buybacks and dividend payments, which would be a catalyst for their share price.
Financials: We believe the financial sector will benefit from higher yields and a steeper yield curve when long-term interest rates eventually rise, but also from stronger growth via a reduction in nonperforming loans and the positive impact from lower loan provisions on earnings revisions. This would be positive for both the banking and the insurance sectors, where valuations continue to look attractive. We think stocks of well-capitalized quality banks in the US, Europe, Hong Kong, and Japan will pay above-market dividend yields following their central bank’s green light.
Chinese Yuan:The RMB reflects the forward growth of the Chinese economy and the increase in global trade and investments in RMB. The yuan is also becoming an important reserve currency for central banks and financial institutions, underpinned by China’s strong economic fundamentals: a large positive commercial balance, growing domestic consumption, and much higher interest rates than in Western economies. Moreover, China became the number one country in the world for Foreign Direct Investments in 2020 according to the UN, with growing inflows from investors buying Chinese stocks, bonds, and hard assets contributing to the strengthening of the renminbi and consolidating its role as a major trade currency.
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