Last week’s commentary started with the words ‘Global equities seem to have regained their poise’. Well, we spoke too soon as markets shortly resumed their decline, ending last week down 2.2% in local currency terms.
Global equities are now 4.0% below their early September high and we are not far off seeing a correction of 5%. As we have pointed out on several occasions, one typically sees such a decline twice a year but we have seen no such fall since last October.
So, the weakness is no big surprise but why exactly now? Evergrande, the Chinese property developer, was the initial cause. But fears that its collapse might lead to widespread financial contagion have eased, even if concerns over its longer-term impact on the property sector and the wider economy remain. Property accounts for as much as 28% of the Chinese economy. Only Spain has come close to a similar dependence and its property boom ended in tears.
Instead, the second leg of the correction has been triggered by the approach of monetary tightening and a whiff of stagflation. The initial reaction of bond markets to the recent moves by the Fed and Bank of England to bring forward their tightening plans was limited. However, government bond yields have subsequently continued to move higher, particularly in the UK where 10-year gilt yields have hit a 2.5 year high of 1%.
An abrupt move higher in bond yields often causes a brief period of indigestion for equity markets. But more importantly, we do not believe yields will move up fast enough or to high enough levels to cause equities significant longer-term problems.
Even though UK rates now look set to be raised early next year, they should still only be back to their pre-pandemic level of 0.75% by end-2023. As for US rates, they are expected to be at a similar level in two years’ time and less than half their level at the start of last year.
But how serious is the risk of stagflation which would imply an unpleasant combination of low growth, high inflation and more aggressive monetary tightening? Near term, the growth-inflation mix has taken a definite turn for the worse due to bottlenecks which are proving worse than expected. Supply shortages, rather than a lack of demand due to concerns over the Delta variant, appear to be the main reason for the slowdown in growth.
The bottlenecks have undoubtedly been exacerbated by Brexit but are far from unique to the UK. China for instance is now facing power shortages and oil prices are back up to $80 per barrel. A shortage of container ships, semiconductors and most important of all labour is hampering numerous industries worldwide and likely to remain a problem for months yet.
Fiscal policy is also now turning less supportive of growth. The furlough scheme and uplift to universal credit both ended in the UK last month. Meanwhile, in the US, enhanced unemployment benefits have also come to an end and the Democrats are struggling to agree on and pass into law their infrastructure and social spending packages.
Only in Germany is fiscal policy set to turn a tad more expansionary. Last week’s election saw the centre-left Social Democrats, rather than the incumbent centre-right Christian Democrats, gain the largest share of the vote. A coalition government still needs to be formed but should be somewhat less fiscally hard-nosed than its predecessor.
Despite these growing fiscal headwinds, we believe global growth will remain relatively strong over the coming year, buoyed by pent-up demand, pent-up savings and an eventual easing of the supply shortages.
On the inflation front, forecasts continue to be raised with the surge in energy prices set to prolong the spike in headline inflation. As for core inflation, which strips out food and energy and is the primary focus of central bankers, this also looks unlikely to fall back as quickly as once thought. US core inflation was unchanged in August at a 30-year high of 3.6%.
We still expect much of the spike in inflation will prove transitory – to use the current word of choice for central bankers – just not to the extent they do. Inflation looks set to remain a major source of debate and some source of concern for markets well into next year. All the same, talk of a return of stagflation looks overdone and we believe the environment remains supportive for further advances in equities, albeit considerably smaller than to those we have become accustomed.
Rupert Thompson
Chief Investment Officer