In the face of a rapid spread of the delta variant, with daily Covid case numbers up almost 80% in July from June levels, concerns about the sustainability of growth re-emerged. While the spread of the variant is global, its impact falls disproportionately on the developing world, where the vaccine roll-out is much slower than in the developed world and the room for policy support is more limited. The imposition of renewed restrictions in many countries, notably across Asia, raises the prospect of delays in the economic recovery underway and a slower rate of growth ahead. Markets reacted by driving down yields on bonds: the US 10 year Treasury bond yield fell to 1.22% by the end of July, a drop of 25bps in a month, continuing the sharp falls seen in Q2. All of the fall in July was accounted for by a drop in real yields, from -0.87% at the end of June to -1.18% at the end of July, levels rarely seen in history, and which seem unsustainable in the absence of much sharper falls in growth and inflation than currently expected.
The result was a very strong month for bond markets generally, with US Treasuries returning +1.3%, Euro government bonds +1.8%, UK gilts +2.8%, and US Treasury inflation-linked bonds +2.8%, while inequities, growth, and quality stocks moved higher with tech and healthcare leading the way while ‘reflation trade’ stocks lagged. As might be expected under these circumstances, the US market, with its higher weighting towards growth stocks, led the way, up 2.3%. Asian markets lagged, with Japan down 2.2%, but the biggest falls came in emerging markets, with the global EM index down 6.7% in the month, leaving it flat over the year to date, compared with a gain of 15% in the MSCI World index of developed markets.
While the renewed spread of Covid across Asia and other parts of the developing world has become a significant short-term headwind to emerging markets, it was the dramatic further tightening of regulations on the private corporate sector in China which most shook investors. The first warning signs of a regulatory clampdown came late last year with the abrupt cancellation of the IPO of Ant Group, the Alibaba affiliate. This was followed by a series of sanctions and tightened regulations on China’s big tech and internet-oriented companies, including Alibaba, Tencent, Meituan, and ride-hailing firm Didi (timed to perfection, two days after its listing in the US). But the hammer blow came in late July with the overnight crackdown on the after-school tutoring industry, making it a non-profit activity barred from foreign participation. Shares in this sizeable sector listed overseas had been falling sharply from mid-February, along with the big tech companies, but collapsed by 70-80% in two days in late July, taking China’s market with them as investors reacted to the impaired profitability and heightened risk of further crackdowns. The MSCI China index, which has a high weight in China’s offshore listed companies through variable interest entities, a structure that has given Chinese companies access to foreign capital without explicit formal approval from China’s regulators, fell by 14% in July, and 30% from its February peak. Hong Kong followed, down 10% in July, but the more domestically oriented index, Shanghai Composite, held up better, down 5% in the month and 8% from its February peak.
Given the size and global importance of China’s economy and the stock market, these developments raise serious concerns. Understanding the rationale behind the crackdown is difficult given the opaque and abrupt way in which decisions are taken and communicated in China. The country is not alone in recognizing that regulatory oversight has not kept pace with the extraordinary growth, reach, and influence of its online sector, but other factors including anti-trust, abuse of market power, data protection, national security, cybersecurity, financial stability, socio-economic and geopolitical factors all seem to have played a part.
We do not believe that China is intent on destroying its global leadership ambitions in technology nor in threatening its thriving private sector, its access to international capital markets, and the internationalization of its currency and asset markets. But the clampdown is a timely reminder of the pre-eminence of the Chinese Communist Party (CCP) in all aspects of life in China, and
despite decades of liberalising reforms and a remarkably innovative private sector, their model of state capitalism has inherent risks that are not found elsewhere. With its centennial anniversary upon us and under the leadership of President Xi, it appears the CCP is becoming bolder in asserting its clout, whether that means over-riding its legal obligations like Hong Kong’s Basic
Law, its de facto constitution, or draconian domestic action with severe financial consequences to rein in private sector practices which risk undermining central control.
In our view, this does not make China uninvestable, as some commentators fear, but it does mean that the discount applied to Chinese securities should be sufficiently large to recognise the uncertainties and risks. Appropriately valued and sized, investments in China offer relatively high, albeit slowing, growth opportunities, and periodic sell-offs such as those of the past six months create a longer-term buying window.
Earlier this year, investors’ biggest worry was the prospect of a surge in inflation as economies reopened. In the event, inflation came in substantially above expectations – the June headline CPI in the US was 5.4% year-on-year and core CPI 4.5%, the fastest since 1991, yet markets were unmoved. Ten-year inflation expectations have remained anchored around the 2.3-2.4% area, the consensus view shares the narrative of central banks that the rise is transitory, bond yields have fallen sharply, and we are probably now at peak inflation levels as base effects fall away and peak levels of pent-up demand are reached. However, we are mindful of the wide range of companies pointing to supply chain constraints, shortages of materials, and input price rises, and still see a risk of a test of the Fed’s resolve if inflation remains materially above target with an impact on wage rises and inflation expectations.
It is clear, though, that all the major central banks will keep monetary policy very loose for a considerable time. The Fed is likely to begin to reduce its huge asset purchase programme before year-end, but this is being well flagged and interest rate rises are a long way off, while the ECB has moved to an asymmetric inflation target of 2%, giving it room to allow inflation to move above target for a period, and has no interest rate rise insight for years. A combination of highly accommodative monetary policy and continuing fiscal support underpins growth prospects for this year and next, albeit at lower levels than the immediate post-pandemic recovery surge, but still a strong tailwind for corporate earnings.
We, therefore, remain broadly constructive about risk assets. Given the strength of equity markets over the past year, returns are likely to be harder to come by in the very short term. The recent surge in Covid cases presents short term headwinds to growth but vaccines now clearly show the route out of the pandemic, and financial conditions will remain very easy. This is likely to underpin a long market cycle and we believe that patience and true diversification will be well rewarded in the year ahead.