- Developed market shares were flat (in US dollar terms) in Q3. Declines in September erased prior gains. Emerging market equities underperformed amid a sell-off in China.
- Global sovereign bond yields were little changed in the quarter. The US Federal Reserve said it would soon slow the pace of asset purchases.
- Commodities gained with natural gas prices seeing a sharp spike.
- US Equities
US equities notched up a small positive return in Q3. Strong earnings had lifted US stocks in the run up to August, when the Federal Reserve (Fed) seemed to strike a dovish tone, confirming its hesitance to tighten policy too fast. However, growth and inflation concerns late in the quarter meant US equities retraced their steps in September.
The Fed stated in September that tapering of quantitative easing (i.e. a slowdown in the pace of asset purchases) will be announced at the November meeting, as expected, and will finish by mid-2022. Meanwhile, the fed funds rate projections now show a faster rate hiking schedule than they did in June. The median rate expectation for 2023 moved up to three hikes from two in June, with three additional hikes in 2024. Fed officials were evenly split 9-9 on a rate hike in 2022.
The shift comes in the context of revised real GDP growth – down to 5.9% for 2021 from the 7% growth estimated in the last meeting – while inflation has risen. The Fed now sees inflation running to 4.2% this year, above its previous estimate of 3.4%. The Fed raised its GDP projections for 2022 and 2023 to growth of 3.8% and 2.5%, respectively.
On a sector basis, financials and utilities outperformed. At the other end of the spectrum, industrials and materials struggled, although September’s sell-off hit almost all sectors. Energy was an exception, rising as supply constraints drove energy prices to 7year highs – particularly Brent crude.
Eurozone equities were flat in Q3. The energy sector was the strongest performer, as was information technology with semiconductor-related stocks seeing a robust advance. Consumer discretionary stocks were among the weakest for the quarter, with luxury goods companies under pressure amid suggestions that China could seek greater wealth redistribution, which could hit demand.
The quarter had started with gains amid a positive Q2 earnings season and ongoing economic recovery from the pandemic. The Delta variant of Covid-19 continued to spread but most large eurozone countries have now fully vaccinated around 75% of their adult population against the virus, enabling many restrictions on travel and other activities to be lifted.
However, as the period progressed, worries emerged over inflation due to supply chain bottlenecks and rising energy prices. Annual inflation in the eurozone was estimated at 3.4% in September, up from 3.0% in August and 2.2% in July. The European Central Bank said that it would tolerate any moderate and transitory overshoot of its 2.0% inflation target.
The end of the period saw a surge in power prices as a result of low gas supply and lack of wind over the summer, among other factors. High power prices should be positive for utility firms. However, the sector – particularly in southern Europe – is susceptible to political intervention as evidenced by announcements of price caps in Spain and other countries. The utilities sector was a laggard in the quarter.
Asian equities recorded a sharply negative return in the third quarter, largely driven by a significant sell off in China. This was partially due to concerns over the ability of property group Evergrande to service its debts. The Evergrande situation sparked global investor concerns over potential spill over risks.
Market concerns over inflation and the outlook for interest rates also dampened investor confidence during the quarter. China was the worst-performing index market, with sentiment towards the country also weakened by the government’s regulatory crackdown affecting the education and technology sectors. Power outages in China and the rationing of energy also spooked investors, hurting production of key commodities. The downside risks in China have significantly increased against a backdrop of slowing economic activity and concerns that recent regulatory policies will further weigh on growth.
India was the best-performing index market during the quarter and achieved a strongly positive performance as accommodative monetary policy and the easing of Covid-19 restrictions boosted investor sentiment. The Japanese equity market traded in a range through July and August before rising in September to record a total return of 5.2% for the quarter. Indonesia also achieved a positive return. Singapore was almost unchanged, while declines in Taiwan and the Philippines were modest compared with the falls seen in other index markets.
- Global bonds
US and European government yields were unchanged for the quarter as an initial decline reversed in September amid a hawkish shift from central banks and continuing inflationary pressure. The UK underperformed, with a significant rise in yields on increased expectations for monetary policy tightening.
The US 10-year Treasury yield finished at 1.49%, one basis point (bps) higher. Yields fell initially, as the rapid economic recovery appeared to be moderating. However, as the market’s focus turned to rising inflation and the prospect of the withdrawal of monetary policy support, yields rose back to similar levels seen at the beginning of the quarter. The Federal Reserve (Fed) became increasingly hawkish, suggesting that asset purchase tapering could start as early as November and that it could be wound up by mid-2022, earlier than expected.
The UK 10-year yield increased from 0.72% to 1.02%, with the move occurring in September. As with the Fed, there was evidence of a marked hawkish shift among Bank of England (BoE) policymakers, with a suggestion that rate rises might be warranted before the end of the year. Recent economic indicators came out worse than expected, while year-on-year consumer price inflation rose to 3.2% in August, the highest since 2012.
In Europe, the German 10-year yield was one basis point (bps) lower at -0.19%. Italy’s 10-year yield finished 4bps higher at 0.86%. Economic activity continued at a robust pace, the region benefiting from the release of pent-up demand, having come out of lockdowns relatively late. Eurozone inflation hit a decade high of 3.4% year-on-year in August.
The Bloomberg Commodity (BCOM) gained 5% in September, marking its 14th monthly gain over the prior 17 months and a fourth quarter in a row outperforming the S&P 500. It now stands at +29.1% YTD, which currently represents its largest annual gain since 1979 (42 years). Natural gas has gone parabolic with a quarterly gain of 61.5% and +134.9% YTD. WTI crude gained 2.11% for the quarter and +55% YTD, for its highest monthly close since 2014. A consortium of factors on both the supply and demand side are driving energy prices higher with seemingly little end in sight. The members of “OPEC+” maintained a historically high compliance rate to self-imposed production targets while easing COVID-19 cases around the globe in September bolstered the demand outlook for refined petroleum products.
In the US, crude production dropped due to the impact of the hurricane Ida, causing stockpiles to shrink. Inventories have actually declined across the world amid supply shortages and stronger-than-expected demand growth. Additionally, there was no progress on nuclear negotiations between the U.S. and Iran, and sanctions remained in place preventing Iran from selling oil on the global market. Crude has also been supported by the fact the energy sector has been rallying across the board. Scorching hot weather in parts of Europe caused demand for cooling to surge, which, in turn, increased natural gas demand by electric power plants, causing inventories to plummet. Meanwhile, gold posted a small loss in the third quarter as a firming dollar and rising interest rates helped offset still stubbornly elevated inflation metrics.
Markets Outlook for Q4
We believe economic growth expectations, valuations and quality are likely to be key areas in Q4 and into 2022. Where possible, we are targeting quality value and profitable growth while being cautious with our approach to deep value and aggressive growth.
This earnings season, markets will pay close attention to margins and whether companies have been able to pass on higher production costs. The US producer price index (PPI) increased 8.3% year-over-year (Y/Y) in August while the consumer price index (CPI) rose 5.3% Y/Y. This gap, the largest between these two inflation gauges in more than 40 years, indicates that corporate margins may come under pressure. Higher global shipping costs combined with higher wages are major factors to monitor continuously.
Should enough companies be able to pass on their higher input costs, consumer inflation could rise faster than expected, potentially bringing forward less accommodative Fed policy. Expectations for higher interest rates are a concern across the market, but particularly for high growth market segments. The yield environment has been a major factor in the recent valuation environment. Expectations for high future earnings are now discounted at a higher discount rate.
With the economy largely open, there is less anticipation and focus on a single idea. So, as we transition away from the reopening economy to the mid-cycle recovery, reduced economic growth expectations shift the focus from deep value towards quality value. Moving into the cooler months, focus is likely to remain on economic engagement and discretionary spending on services. Additionally, sustaining margins is likely to become increasingly important with inflation pressures expected to persist into mid-2022.
The implications from Evergrande Group’s potential failure – which has been the subject of intense speculation over the past few weeks – could be significant though heading into Q4. China’s real estate sector contributes 29% of its total GDP. As such there could be ramifications for Chinese financial markets and the economy, while there have been some concerns over wider contagion to other global markets.
After a blissful third quarter and in line with our outlook the US dollar has managed to eke out some gains over the summer months and especially in the last days of Q3. The current macroeconomic environment is favouring a continuation of this trend with the Federal Reserve expected to end its debt purchases by the middle of next year. The key for US dollar strength in the fourth quarter is: how long can it last?
There is no doubt that the currency market has some further repricing to do when it comes to the greenback – the Fed is widely expected to taper in November and the present conditions in the labor market will be closely watched. That said, the weight of these macroeconomic reports is greatly diminished, now that Chairman Powell communicated the intentions of the Fed to move at the next Fed meeting in the beginning of November.
In short, the actions of the US Federal Reserve are the key factor for US dollar and precious metals traders this quarter. Should the Fed manage to taper, in the face of a falling stock market, the US dollar could rally significantly from current levels and level off into the end of the quarter as other central banks start contemplating to reduce their monetary stimulus measures. If, however, the Fed flip flops, the FX market is likely to sell off US dollars aggressively and gold and silver should skyrocket, as the confidence in the US central bank’s ability to manage the economy declines materially.
While oil has had a great year so far, that’s not to say prices will continue rising, as the market is always forward-looking. Looking ahead, we see some potential obstacles that could derail the rally. So, we reckon that the risks are skewed to the downside for oil prices. Weakening economic growth in China and the fact they have tapped their strategic reserves indicate demand from the world’s largest oil importer is already getting soft. India is the world’s third largest oil importer and consumer, meaning that if the dollar rises against the rupee, it would hurt demand for oil and other commodities as the strength of USD would make imports even dearer. Supply bottlenecks could also undermine the economic recovery in more developed economies with the net result being potentially weaker demand growth for oil in the months.
This article was written by the Standard Investment Bank Global Markets Department.