Please see investment bulletin below from Brooks Macdonald received yesterday – 30/09/2021
What has happened
Equities bounced back slightly yesterday as global government bond yields found a new level. Both US and European equities saw muted gains, led by some of the more defensive subsectors such as food & beverages and utilities.
US Shutdown
Majority Leader Schumer said overnight that Senators had reached an agreement to introduce, and pass, a stopgap funding measure that would fund the government until the start of December. This bill will be voted on by the Senate today before moving over to the House of Representatives in short order as Congress looks to avert a shutdown at the end of today. The thornier issue remains the debt ceiling and bipartisan agreement there looks unlikely. In a sign of possible movement, House Speaker Pelosi said that the House would vote on the bipartisan physical infrastructure bill today which suggests sufficient cross-party support to pass the bill. This is despite progressive Democrats saying they would hold up the physical infrastructure bill until they could vote on this package alongside the wider social infrastructure bill. Progressive Democrats fear they would lose a key bargaining chip in this situation so should the $550bn package pass, we could see a fairly imminent watering down of the $3.5tn social package.
Focus on the UK
Despite growing expectations that the UK might raise rates at the end of this year or the start of 2022, sterling has been suffering. Yesterday saw sterling back to levels (versus the US dollar) that were last seen in December last year at the height of the Brexit deadline worries, as investors fear further disruptions over energy and fuel supplies. Markets are still trying to weigh up whether inflation expectations should be higher, due to higher energy prices in the short to medium term, or lower as investors price in lower consumer demand from higher prices for essentials and rising interest rates. This uncertainty is creating a fresh reason for international investors to avoid sterling for the short term.
What does Brooks Macdonald think
Arguably, at the start of September the market was overly complacent in the face of the risk of sustained inflation. September’s moves show a pricing in of two risks, one that inflation could be stickier and two that central banks may be more fearful of inflation expectations than tighter policy which could hamper growth. Whilst the signs still point to the current inflationary pressures being transitory, the markets at the end of September more accurately reflect the risks of the investor consensus being wrong.
Please continue to check back for our latest blog posts and updates.
Please see below for one of AJ Bell’s latest articles received by us today 30/09/2021:
The second largest Latin American economy enjoys a big trade surplus with the US.
Mexico is the second largest economy in Latin America and its proximity to the economic juggernaut that is the US has helped support strong growth, with some intervening ups and downs, over the course of the last two decades.
In its interim report on the economic outlook in September 2021 the OECD lifted its growth forecast for Mexico for 2021 from 5% to 6.3% and for 2022 from 3.2% to 3.4%. The government led by Mexican president Andres Manuel Lopez Obrador has also recently announced plans to address tax issues and ease austerity measures in its latest budget to support the economy.
Like many countries Mexico is having to tackle the issue of inflation, with its central bank among several in emerging markets to increase interest rates in recent months to address the problem of rising prices.
In June consultants at Deloitte noted the role exports were playing in Mexico’s economic rebound: ‘The bold recovery of the American economy is bolstering Mexican exports to its northern neighbour. The trade balance saw a surplus of $26.6 billion, or 2.4% of GDP, in 2020, the highest level recorded since data became available in 1993.
‘In March 2021, exports grew 31% year over year to reach $43 billion, the largest expansion in almost a decade. This growth was driven by machinery and metal manufacturing, which expanded 6.6%; electronics and professional equipment also registered expansions of 21.3% and 14.5%, respectively.’
Please continue to utilise these blogs and expert insights to keep your own holistic view of the market up to date.
Please see below Brewin Dolphin’s latest market summary, which was received late yesterday (28/09/2021) afternoon:
As you can see from the above, markets remained subdued last week as China’s Evergrande property business situation continued. The FTSE 100 had a better week than others as the Bank of England kept interest rates at 0.10%.
The US has signalled that rate hikes over there could come sooner than expected. This is something to monitor.
As stated last week, the negative sentiment towards China at the moment is likely to present buying opportunities in Chinese Equities.
Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.
Please see below article received from Legal & General yesterday afternoon, which provides a global market update and eases concern with regards to supply chain issues and inflation.
Don’t worry (much) about supply chains
Industrial companies are talking a lot about issues with their supply chains. But they haven’t taken the opportunity to change their guidance or deliver profit warnings. And market reaction to their comments was relatively muted.
We had a few companies with early quarter-ends give a flavour of what to expect from the rest of the reporting season. Of those early reporters, 74% beat analyst estimates and 80% outperformed the market the day after their results were released. Their figures cover a slightly different period than Q3, and while the sample is small, it looks somewhere between normal and better than average.
It also suggests that the disappointments from companies like FedEx*, Adobe* and Nike* may get the most attention but are not the norm.
There is clearly an impact on earnings from the supply chain bottlenecks, but so far it seems that the impact:
1.
is manageable for most companies
2.
can be covered with their earnings buffer by most companies
3.
is well anticipated and priced by the market
Bottom line: Indications so far are that we are heading for a fairly normal earnings season, which has little impact on markets at the aggregate level.
Germany’s election
Germans went to the polls on Sunday and granted the Social Democrats (SPD) a narrow victory, with almost 26% of the vote. Their leader, Olaf Scholz, said he had won a mandate to form the nation’s next government. Support for outgoing chancellor Angela Merkel’s CDU/CSU appears to have plunged to a historic low of 24%. The Greens secured almost 15% of the vote.
This will only mark the start of what will likely become lengthy coalition negotiations. Last time, this took a record six months, and this year’s prospect of a 3-party coalition across the political spectrum feels like a recipe for long rather than short negotiations.
There would have been really only one properly market-moving scenario: a left-wing, red-red-green government – but the Left party appears to have fallen just under the 5% hurdle.
The SPD and Greens had previously made it clear that they were leaning towards a more centrist, “traffic light” coalition with the Liberals (FDP), who won almost 12% of the vote.
Emerging market equities – what are we waiting for?
It’s easy to be bearish on emerging market equities amid double trouble from regulatory and growth risks. Increasing regulation in China across many industries is hitting the outlook for profits, and the uncertainty over the extent and duration of the crackdown means investors require an additional discount on top of their future earnings base case. At the same time, economic growth has slowed in tandem with the delta outbreak, and we expect an underwhelming rebound in Q4 as temporary regional lockdowns are likely to be required for some time. Then there’s the spillover from Evergrande’s* problems to the important property sector. Those are all drivers behind our below-consensus growth forecasts.
But equity markets have reacted…a lot.
The correction in Chinese equities (H-shares, not A-shares) is now one of the biggest in recent history. The HSCEI index is around 30% off its February peak, making it the third largest drawdown over the past decade. Emerging market equities have also been affected, having trailed developed markets by 20%, the third largest underperformance over the past 15 years.
Sentiment has turned very bearish. In an extreme reversal, emerging market equities have gone from everyone’s favourite long at the start of the year, in sell-side outlooks and investor surveys, to being the least popular in the latest fund manager survey since their low in 2016.
Valuations paint a similar picture. Relative to developed markets, emerging market equities are as cheap across many multiples as they have been in well over 10 years. Some of that clearly reflects falling earnings expectations, but earnings estimates have some way further to fall before catching up with what prices have already reflected.
Some of this sounds like a bull case in the making, but regulatory uncertainty and our below-consensus growth outlook are some of the factors holding us back — for now, at least. Nevertheless, we are watching a number of potential catalysts and signposts that could change our position:
•
President Xi or the Chinese government make a commitment to the private sector — and tech companies in particular.
•
Decreased sensitivity to regulatory news flow. We have seen some evidence of this in tech, but the price reaction to new sectors being targeted – e.g. casinos — remains severe.
•
A-shares selling off. The pain has so far been concentrated in H-shares. A-shares joining in the correction would be a sign of markets pricing the growth slowdown as much as the regulation theme, and a sign of domestic capitulation.
•
A larger-than-expected policy response to a slowdown. We expect policymakers to be slower than in the past in responding to stumbling growth, but evidence to the contrary would be a very positive catalyst.
•
Indications that our growth forecasts are too pessimistic and growth rebounds faster than we expect.
•
Vaccination convergence. Emerging market vaccinations are catching up with developed markets.
Bottom line: Emerging markets and China equities are becoming more interesting in some ways, but given our macro views, we believe it’s too early to buy.
We will continue to publish relevant content and news throughout the coming Autumn weeks, so please check in with us again soon.
Please find below an article from AJBell Investcentre, received Sunday afternoon, exploring whether food prices could be a source of inflation.
“If music be the food of love, then play on; give me excess of it that, surfeiting, the appetite may sicken and so die,” is a very famous line spoken by The Duke of Orsino, in Shakespeare’s Twelfth Night.
Investors may or may not care for the work of the Immortal Bard. But they will be interested – even concerned – to ascertain whether food prices will be the source of a sustained bout of inflation and one which may do damage to consumers’ ability and desire to spend.
Central bankers will want to know too, in case inflation forces their hand and requires a tightening of monetary policy in the form of a tapering of Quantitative Easing and higher interest rates.
“The United Nations’ FAO Food Price Index requires attention. The benchmark, which spans key agricultural materials such as cereals, vegetable oils, meat, dairy products and sugar, is up 33% year-on-year. That is the fastest rate since 2011.”
In this context, the United Nations’ FAO Food Price Index requires attention. The benchmark, which spans key agricultural materials such as cereals, vegetable oils, meat, dairy products and sugar, is up 33% year-on-year. That is the fastest rate since 2011.
Global food prices are surging
Source: Food and Agricultural Organisation of the United Nations
History play
“There do seem to be some one-off factors involved in the food price surge. These range from global shipping and port bottlenecks, to a shortage of truck drivers, to bad weather in countries such as Brazil, where drought and then unseasonal frost is badly affecting supply of oranges and coffee to the global market.”
No doubt central bankers, to defend their view that the current spike in inflation is ‘transitory,’ will be keen to point out some of the factors involved in the food price surge. These could range from global shipping and port bottlenecks, to a shortage of truck drivers, to bad weather in countries such as Brazil, where drought and then unseasonal frost is badly affecting supply of oranges and coffee to the global market.
But even the comparison against two years ago, before the pandemic struck in 2020, shows a 36% increase, so the current surge may not just be the result of a (low) base effect, even allowing for the role of these one-off factors.
In many cases, the best cure for high prices of a product is high prices, as they either choke off demand or encourage additional supply. The latter may happen in time, if the weather helps, but it is not easy for people to stop eating, as they need their daily calorific intake. (In this context investors may need to keep an eye on the political situation too. Food shortages and soaring prices helped to spark the Arab Spring protests and uprisings in 2011, the Chinese Tiananmen Square protests in 1989 and before that the Russian and French Revolutions of 1917 and 1789).
There appear to be some grounds for arguing that food prices are fuelling the current spike in inflation on both sides of the Atlantic, even if the UK CPIH inflation basket has a weighting of just 8.9% toward food and soft drinks (with a further 10.4% weighting toward alcohol, tobacco and restaurants and hotels), and the US equivalent weighting is 7.6% (with a further 6.2% from eating out and 1.6% from alcohol and tobacco). These weightings reduce food’s overall influence and that helps to explain why the UK headline rate of inflation is 3.2% and America’s 5.4%, along with how grocers and suppliers decide to handle cost increases, either by passing them or taking the margin hit themselves.
Rising global food prices may be nudging UK inflation higher…
Source: Food and Agricultural Organisation of the United Nations, Office for National Statistics
…and they could be fuelling US inflation too
Source: Food and Agricultural Organisation of the United Nations, US Bureau of Labor Statistics
Emerging problem
It may be of little comfort to consumers that the way in which baskets of goods are constructed to measure inflation is limiting the impact of rising food prices. Leave the economists’ desks behind and get out in the real world and this issue matters, especially to those who are less well off and where a greater percentage of income is spent on life’s essentials.
“The apparent correlation between the cost of foodstuffs and an indicator inflation may explain why emerging markets such as Brazil, Russia and Mexico are leading the charge when it comes to interest rates rises in 2021.”
Emerging markets are a case in point. It is possible to argue that food prices are a much bigger issue, if the apparent correlation between the cost of foodstuffs and an indicator inflation surprises is any guide. It is therefore no wonder that emerging markets such as Brazil, Russia and Mexico are leading the charge when it comes to interest rates rises in 2021. According to www.cbrates.com, there have been 52 individual hikes to borrowing costs around the world this year and all but two (first moves from Iceland and South Korea) have come from emerging markets.
Rising food prices are a big issue in emerging markets
Source: Food and Agricultural Organisation of the United Nations, Refinitiv data
End game
It may well be that the weather comes to the rescue and the combination of rising supply, an end to shipping chaos and 2021’s higher base for comparison means that food price inflation (and price rises more generally) ease in 2022, to the relief of investors and central bankers alike. But caution is needed. If consumers start to accept higher prices, and get higher wages so they can pay them, inflation can become entrenched.
Inflation came in three waves in the 1970s
Source: Office for National Statistics, FRED – St. Louis Federal Reserve database
“There were three distinct waves of inflation in the 1970s and the last one was the worst of all.”
There were three distinct waves of inflation in the 1970s and the last one was the worst of all. Only then did the Paul Volcker-led Federal Reserve and the UK’s Conservative government set about dealing with inflation by jacking up interest rates to double-digit levels, something that neither consumers nor financial markets will want to see in a hurry.
Past performance is not a guide to future performance and some investments need to be held for the long term.AuthorProfile Picture
Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.
Please see the below article that we received from fund managers Quilter Investors yesterday afternoon:
With climate-related risks and environmental challenges seemingly at the forefront of investors’ minds, it’s important that all those involved in the investment industry adopt a broad approach when assessing the major risks facing corporate sustainability today. This should include human rights abuses and forced labour and corruption, as risks to corporate sustainability affect not only shareholders and bondholders but also other stakeholder groups including customers, suppliers and employees.
The UN Global Compact is one of the many tools that can help investors assess threats to sustainable business across the companies in which they invest.
The UN Global Compact – what is it?
Launched in 2000, the UN Global Compact is the world’s largest corporate sustainability initiative aimed at promoting corporate sustainability and encouraging innovative solutions and partnerships through 10 guiding principles.
The UN Global Compact supports companies in responsibly aligning their strategies and operations, in addition to helping them to advance broader societal change, through initiatives such as the UN Sustainable Development Goals.
It also sits alongside the Organisation for Economic Co-operation and Development (OECD) Guidelines for Multinational Enterprises, which is another voluntary initiative to support sustainable business.
The UN Global Compact’s principle-based framework is broadly split into four key areas – human rights, labour, environment and anti-corruption – to help guide businesses in their activities in these areas. The framework is derived from numerous international declarations for companies and countries, such as the Universal Declaration of Human Rights and the Rio Declaration on Environment and Development.
The 10 Principles
Human Rights
Principle 1: Businesses should support and respect the protection of internationally proclaimed human rights.
Principle 2: Businesses should make sure that they are not complicit in human rights abuses.
Labour Standards
Principle 3: Businesses should uphold the freedom of association and the effective recognition of the right to collective bargaining.
Principle 4: Businesses should uphold the elimination of all forms of forced and compulsory labour.
Principle 5: Businesses should support the effective abolition of child labour.
Principle 6: Businesses should uphold the elimination of discrimination in respect of employment and occupation.
Environment
Principle 7: Businesses should support a precautionary approach to environmental challenges.
Principle 8: Businesses should undertake initiatives to promote greater environmental responsibility.
Principle 9: Businesses should encourage the development and diffusion of environmentally-friendly technologies.
Anti-corruption
Principle 10: Businesses should work against corruption in all its forms, including extortion and bribery.
Protection of human rights
Principles one and two relate to the importance of businesses to both support the protection of human rights and ensure that they are not complicit in human rights abuses.
A company that may be deemed to be in violation of the human rights principles could have revenue exposure to jurisdictions or authoritarian governments where human rights abuses are prevalent.
These companies are frequently flagged across emerging markets. For instance, an Indian port infrastructure company was flagged for being in violation of the principles given its financial ties to the Myanmar military.
However, a violation of the principles can be more explicit than this. For example, an Asian engineering and construction company was recently deemed to be non-compliant following a collapsed dam in Laos resulting in fatalities and the displacement of local communities.
Human rights is one of the main areas where investors can see which companies violate the UN Global Compact. It poses a higher risk across sectors such as aerospace and defence where businesses may be involved in the manufacture of controversial weapons.
The UN Global Compact is one of the many tools that can help investors assess threats to sustainable business across the companies in which they invest.
Labour best practice
Principles three, four, five and six are concerned with how sustainable businesses should uphold the effective recognition of the right to collective bargaining, eradicate all forms of forced (including child) labour and eliminate occupational discrimination.
Companies tend to fall foul of these principles less commonly. Following an investigation by Norway’s Council on Ethics, the forced labour risk has been particularly high in the Middle East over recent years. Migrant workers coming from India, Pakistan and Nepal face little hope of paying off the debt they owe to ‘recruitment agencies’ who have charged workers a fee for access to jobs in countries such as Qatar and the UAE.
As a result, there has recently been significant reputational damage to companies allegedly practicing forced labour in the Middle East.
Environmental responsibility
Principles seven, eight and nine provide guidance on how businesses should consider the negative impact of environmental damage, as well as the cost to a company’s reputation should a negative environmental event occur.
The principles also encourage investment in research and development around the long-term benefits of environmentally-friendly technologies.
Companies that are commonly deemed to be in violation of the environmental principles operate across the materials and utilities sectors.
For instance, an Indonesian aluminium business was found to be non-compliant given its interests in a mine that uses riverine tailings disposal (using rivers for mine waste disposal), a practice banned in many countries due to its severe environmental impacts.
Only four mines in the world engage in riverine tailings disposal, and in the case of this business, the mine in question has impacted one of the world’s most bio-diverse regions, Lorentz National Park, a UNESCO World Heritage Site.
Anti-corruption guidance
Principle 10 targets corruption in all forms, including extortion and bribery. The financial services sector is a particularly high-risk area of the market for exposure to corruption, specifically in relation to failings in anti-money laundering procedures.
Money laundering scandals have thrown the spotlight on the major Nordic banks in recent years, particularly those with exposure to the Baltic region, which has been beset by allegations of financial crime.
Our Comments
We have written about these UN Global Compact Principles in the past.
This is one of the key ESG processes that investment managers use to form their ESG screening process in relation to sustainable investments.
These principles are the foundation for investment firms who wish to bring ESG on board within their investments.
The main 2 methods of screening that investment managers use to assess whether or not the companies they choose to invest in are considered compatible with the 10 principles are positive and negative screening. Some firms go above and beyond this and look deeper, some use a combination of both.
Positive Screening is Investment in sectors, companies or projects selected for positive ESG performance in comparison to industry peers. This involves selecting firms that show examples of environmentally friendly and socially responsible business practices. This also includes avoiding companies that do not meet certain ESG performance thresholds.
Negative Screening is the exclusion from a fund or certain sectors or companies involved in activities deemed unacceptable or controversial (e.g. tobacco, arms, gambling etc). This involves avoiding companies that create negative impacts considered incompatible with the UN Global Compact Principles.
Just using these screening methods isn’t enough to ‘change the world’ so to say. It’s important that fund managers engage with the firms they are investing in, to challenge their practices to move them further along the ESG journey and ensure they are adhering to the UN principles.
ESG investing is still a new world, however, since we first started talking about it over a year ago, the ESG landscape has already moved forward, and fast.
We have more of our clients now engaging and starting the discussions around ESG and sustainable investing.
Interestingly, we listened to a compliance update earlier this week from our compliance partners, Paradigm. In this update there was a comment made that the view from MSCI is that they believe that clients will have to opt out of ESG investing in the future, rather than opt in, as they do now.
This supports the view we have had for a while now, that ESG investing will become the new normal.
Please see below the Brooks MacDonald Daily Investment Bulletin received by us yesterday, 22/09/2021:
What has happened
European indices posted strong gains yesterday, offsetting much of Monday’s weakness, however US bourses performed less well remaining mostly flat from Monday’s close.
Evergrande
Whilst Evergrande has been at the centre of the financial world this week, Chinese markets have been on holiday. When the equity markets opened for trading this morning shares dipped however the People’s Bank of China injected CNY 90bn of liquidity into the system to steady investor nerves. Reports are suggesting that Evergrande will make the domestic coupon payment due tomorrow however there has been no word yet as to payments on the foreign dollar denominated bond. The interest payments due on bank loans at the start of the week are reportedly yet to be paid so plenty of moving parts to this story. Expectations are pointing to a restructuring orchestrated by Chinese authorities and for the government to allow Evergrande itself to default but to take steps to ensure there isn’t extensive contagion into either Chinese property prices or the property investment sector.
US Infrastructure
The bipartisan $500bn physical infrastructure bill that passed the Senate vote but was held up in the House is now said to be moving to a House vote on Monday. This has less to do with any movement on the broader ‘social infrastructure’ bill but more to do with the proximity of the debt ceiling which is now demanding the focus of Democrats and the White House. Should the Republicans not support the government funding bills the White House will be forced to use budget reconciliation to pass the bills. Given there are procedural limits on the number of reconciliation bills in a Congress year, this risks Democrats having to hastily incorporate the least contentious parts of the $3.5 trillion social infrastructure bill, effectively watering down the size and scope quite considerably.
What does Brooks Macdonald think At 7pm UK time we will receive the latest policy statement from the Federal Reserve followed by a press conference by the Fed Chair. Expectations are for the bank to continue to guide to tapering this year but with the caveat that the economy must remain on track for the central bank to pull the taper trigger. This optionality will be important for market sentiment as if the Fed leaves a delay of taper on the table, even if it’s likely they won’t use it, this will provide a release valve for market concerns over the coming months.
Please continue to utilise these blogs and expert insights to keep your own holistic view of the market up to date.
Please see below Brewin Dolphin’s latest market summary, which was received late yesterday (21/09/2021) afternoon:
As you can see from the above, markets suffered losses last week. China also suffered large losses last week due to the Evergrande property business situation. Inflation and supply chains remain an ongoing issue, but hopefully these are just transitory trends.
Negative sentiment towards China at the moment is likely to present buying opportunities in Chinese Equities.
Please continue to check our Blog content for advice and planning issues and the latest investment, markets and economic updates from leading investment houses.
The impending default or restructuring of Evergrande, China’s second-biggest property developer, dominated China’s news last week. Please see below article received from Legal and General yesterday afternoon, which discusses the effects of this on the broader market.
Localised, so far
Evergrande accounts for 6.5% of liabilities in China’s property sector, and its sales make up roughly 10% of all property transactions in the country. Evergrande could therefore pose a systemic risk, but so far stress in the financial sector has been localised. Interbank spreads are not elevated and the renminbi has held up well.
After a string of incidents that have given equity investors concerns about China – such as regulation of tech, education and casinos – its stock market has slipped behind international peers, but over a longer-term perspective it remains close to recent highs.
Evergrande’s problems could still affect the broader economy beyond the financial channel. People are no longer buying off-plan properties from the company; if this feeds through to Evergrande’s building activity, it could leave a noticeable impact on GDP. August property sales and starts were already in contractionary territory, and GDP is under pressure from Covid-19 outbreaks and lockdowns.
We believe the authorities have the levers to steady the ship, however, and will do so soon. This would likely involve a liquidity provision via a reserve requirement ratio (RRR) cut, fine-tuning of property financing policies, and measures to ensure Evergrande can continue its regular operations.
There is a manageable path forward, in our view, but China’s history of managing delicate situations in financial markets is not unblemished, so this remains a risk to watch in the weeks ahead.
Blockages but not stoppages
The release of the Federal Reserve’s Beige Book earlier this month led to discussion about the effects of supply-chain disruptions on corporate earnings. Last week’s Goldman Sachs US Industrials conference was an opportunity to hear directly from the companies in the middle of the supply-chain issues.
Five things caught our eye:
1. Overall, there was a very consistent message across companies. All are dealing with supply-chain challenges, but all are also talking about strong demand and a growing order backlog, which bodes well for 2022.
2. There is no uniform picture of the disruptions across individual companies and sub-sectors. Some are reporting supply-chain issues getting better than they were in the second quarter; others are seeing things deteriorate. It really seems to depend on your very specific sub-sector.
3. Pricing-power optimism is high. That matches the strong pricing-power sentiment evident in other data sources, and suggests most companies think they can pass on higher input costs if needed.
4. Companies did not take the opportunity to guide lower or to issue a profit warning, so they seem confident they can hit third-quarter numbers despite supply-chain issues.
5. There was a muted market reaction to all the supply-chain commentary. Most stocks were down over the week, but that’s not materially different from the wider market. The comments didn’t shock investors, so expectations for the third quarter appear to have largely adjusted.
It’s too early to sound the all-clear on that front, as there are clear blockages, but it seems there are no economy-wide stoppages, which we believe makes for a good start to the traditional ‘profit warning’ season.
Currency market at a standstill
One of our currency traders told us last week that she has been seeing the same spot levels in developed currency markets for months now. It’s not that we love volatility, but there is a lack of action in the currency space. Idea generation is easier when prices are on the move as momentum traders will enforce the trend up to the point where positioning and sentiment become stretched, and a contrarian approach starts to look more promising.
We know volatility is low across financial markets, reflected in the realised volatility of assets and implied volatility in option markets having dropped sharply since the pandemic peak in March last year. But where equity volatility (e.g. the VIX index) and bond volatility (e.g. the MOVE index) have recently moved more sideways, currency volatility in developed markets continues to grind lower (e.g. the CVIX index).
The impact on prices of this low-volatility environment is quite different too. It’s a boon to equity markets, with one market after another reaching new all-time highs; a blessing for credit issuers keeping spreads historically tight; and a godsend to bondholders, with longer-end yields reversing much of the sharp increase from earlier this year despite high inflation prints. Stable spreads and yields may sound dull, but they allow fixed-income investors to continue earning that credit spread and capture the rolldown of longer-dated bonds.
In currencies, things are different. Carry is almost non-existent with interest-rate differentials at a historical bottom, while spot prices have stopped moving. To quantify our trader’s observation, we calculated the average distance between today’s spot price and the six-month trailing average across all 45 developed crosses. That average is just 1%, close to its lowest point over 20 years, which illustrates that developed currency markets are stuck.
We don’t have many active currency positions open and don’t take much risk in this asset class at the moment. It’s tempting to chase smaller and smaller movements, but in our view it wouldn’t be good portfolio management and so we prefer to be patient and wait for bigger opportunities to come.
We will continue to publish relevant content and news as we head into Autumn in the UK.
Please see the below article from Invesco received over the weekend:
The economic success of China presents appealing investment opportunities in a broad range of sectors. Not only that, but efforts to loosen the reigns have enabled much easier access to its financial markets.
But how can investors gain exposure to China? Most international investors do so via a multi-country portfolio or index, however we believe this may not provide the best exposures, given China’s economic rise, strong risk- adjusted returns (see Table 1), and unique opportunities. Our view is that investors should consider a standalone China allocation.
In our view, China is an exceptional emerging market
Though it’s classified as an emerging market, we believe China warrants its own allocation. Its equity market is the second largest in the world – well ahead of the third largest, Japan, which is only around 40% of China’s size. Japan is already treated as a distinct asset class.
China’s GDP is now higher than that GDP of India, Russia, Africa, and Latin America combined, and we believe it’ll continue to deliver premium growth going forward. The COVID-19 crisis has served to strength China’s economic leadership (Figure 1). Thanks to effective containment, it has managed to emerge strongly from the pandemic. Real GDP expanded +2.3% year-on-year in 2020 – the only major economy globally that delivered positive growth. Economic activities were strong entering 2021, benefiting from continued recovery in both domestic and external demand. This contrasts with other emerging markets whose outlooks remain clouded by uncertainties surrounding the pandemic.
Figure 1. China is expected to deliver premium GDP growth over the world
In our view, the Chinese economy is poised for long-term structural growth. The strengths we see from a broad range of economic indicators will likely continue. China is also repositioning its growth drivers towards consumption and services, which are already the largest contributors to GDP growth. We expect its consumption market to hit US$17 trillion by 2030, supported by an expanding middle class and sustained income growth. Policy support is expected to be strong given consumption’s strategic importance to the government’s long-term growth plan. These can enable China to generate sustained expansion going forward and to remain the largest driver of global growth.
Historic appealing risk-adjusted returns
China’s strong economic prospects have been reflected in its equity market performance (Figure2). We compared the return and risk profile of Chinese equities and Emerging Markets ex-China equities on a five-year basis. Chinese equities delivered a much higher annualized return, and even after adjusting for risk, they offered a premium over Emerging Markets ex-China equities (Table 1).
Figure 2. Equity market performance of China relative to EM (April 2016=100)
Position into the future
China’s importance in the MSCI EM index has risen in recent years. Its index weight has increased to around 40% now from below 25% five years ago. We expect its index weight to keep rising given faster economic growth and further A share inclusion. Over the past 20 years, we’ve seen the return correlation between China and Emerging Markets structurally rising to around 0.9 from 0.6 (Chart 3). Once China’s weight exceeds a certain threshold, we believe emerging market equities could become almost indistinguishable from China alone.
Figure 3. Historic return correlation between China and EM
A dedicated China allocation could make it easier for investors to capture the entire opportunity set in China, discover new names as well as alpha sources.
Unique domestic opportunities
The growth of the Chinese economy means that there are now more than 5,500 competitive Chinese enterprises, across a broad range of sectors, listed across mainland China, Hong Kong, and the US. We believe they provide a large selection of alpha sources for investors to choose from when constructing their portfolios.
Compared to other emerging markets (except Taiwan and Korea) that remain dominated by traditional growth sectors, the communication services, consumer discretionary and healthcare sectors together account for above 60% of the MSCI China Index. They make up just 17% of the MSCI EM ex-China index (Chart 4).
In our view, this is another compelling argument for a dedicated China allocation. Given the structural changes the pandemic has made to the way we work and live, it provides investors with the chance to position for the future.
Figure 4. China may offer abundant investment opportunities in structural growth sectors that have been strengthened by COVID-19
What factors could challenge our views?
Pushback 1: COVID-19 will have long-lasting impact on employment and income growth in China
As consumption becomes more important to its economic growth, there’s a concern as to whether China can generate the employment and income growth needed to support ongoing strength in domestic consumption. Considering the uncertainty caused by COVID-19, this is valid.
In fact, the government’s surveyed unemployment rate rose to +6.2% in February last year and urban households only saw an increase of +0.5% in their disposal income in the first quarter. These data points are however improving as the economy recovers.
Unemployment rate fell to +5.1% in April this year. On the income side, growth also picked up to +12.2% in the first quarter of 2021.1 We expect further improvement in 2021 as economic activities are on track for normalization.
Long-term, the government continues to focus on the quality of growth rather than quantity. Employment is being prioritised in various policy decisions – with the goal of promoting and stabilising it.
Meanwhile, income inequality is on top of the policy makers’ agendas as well. China released its new Five-Year Plan this year and there is strong emphasis on social welfare and improving income equality in the document.
Challenge 2: Geopolitical tensions with the US will derail its long-term growth
Our team believes the geopolitical tensions with the US will be an ongoing topic. This is in line with many investors’ views. That said, we don’t expect this tension to derail China’s long-term economic progression.
Our view is that it’s worth investing in China, even with the ongoing tensions. It’s large and expanding domestic market is a valuable feature of its economy allowing it to enjoy unique economic and business cycles. These cycles rely on its domestic strength, helping to shield it from geopolitical complications. On a corporate
level, Chinese companies derive over 90% of their revenues from the domestic market and less than 5% from the US.2
Challenge 3: ESG standards are low in China
ESG development is gaining traction in China. An upward trend in disclosure rates of environmental, social and governance indicators is gradually catching up with global and regional standards.
During the United Nations General Assembly last year, China also pledged to reach carbon neutrality by 2060. We believe this ambitious commitment exemplifies China’s desire to pursue long-term sustainable growth and will propel the wave of ESG development going forward.
Regulators are a powerful force in China, which should drive further improvement in ESG disclosures among Chinese companies. The China Securities Regulatory Commission (CSRC) is expected to publish guidelines for mandatory corporate disclosure on ESG issues soon. We believe continued financial liberalization to attract more foreign investors will also drive ESG development in China. Increased focus on ESG by international investors should lead to rising awareness and improvements in ESG practices.
Conclusion
It’s for these reasons that we believe investors should consider a dedicated China allocation. Besides premium growth, the country may also offer the benefits of abundant, attractive investment opportunities. Its investment universe is deep and diverse and thanks to structural growth, may provide investors with ample compelling opportunities.
We believe investors can consider adopting an all-share approach when investing in Chinese equities. This means selecting opportunities irrespective of listing locations. Both onshore and offshore Chinese markets have unique listed companies and together, they represent the complete opportunity set for investors. We believe investors can look to experienced managers to make the best stock selection choices.
We have various views on China, please see Friday’s blog about Alibaba and Apple and regulatory scrutiny. From my point of view I think it’s a time for ‘Active’ fund management in China and the region.
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