QUARTER IN REVIEW
Q3 was decisively less risk-on for markets. The global equity market (MSCI ACWI) gave back some gains but is still up +11% ytd. There was wide divergence between markets, notably emerging markets are down. Safe havens like US bonds and gold are also down for the year.
Figure 1 Global Markets
Global economic conditions and outlook remain constructive on balance. The OECD expects global GDP to continue rising into Q4 2022, shown below. That’s well within the duration of historical expansions. However, as noted last quarter, the rate of growth has moderated, and there are several issues worth watching in the months ahead.
Figure 2 GDP Forecasts
First, inflation in the US remains elevated, headline CPI levitates around 5%. This is despite capitulation in commodity prices like lumber and iron. The Fed, during its September FOMC meeting, recognized inflation was now “elevated.” That does not negate the Fed’s position on “transitory” inflation, but it does tell us what to expect from the Central Bank. To the Fed’s credit, it has consistently telegraphed its intentions to taper first and raise rates second.
Figure 3 US Inflation Rate
The Fed is now ready to begin tapering (reduce stimulus), no surprise. The problem is nobody knows the timing of Fed moves with certainty. Should the Fed taper or raise rates sooner (or more aggressively) than expected, that could rattle markets at best and thwart the expansion at worst.
Where inflation heads in the coming months will be crucial to Fed action. If inflation comes in low, reinforcing the transient narrative, that could prevent aggressive Fed moves and increase its credibility, showing it is in control and knows what it is doing. It would also reduce market anxiety which could give risk assets a booster shot in the arm to rally further.
Second, watch global economic activity levels as they provide insight into future growth. The Global Composite PMI (a measure of worldwide economic activity) produced by IHS Markit and JP Morgan has registered a series of declines from a peak in May of this year. While PMI levels above 50 still reflect expansion, activity has clearly fallen.
Figure 4: Global Composite PMI
The reasons for the pullback are debatable, however, it is probably not a coincidence that May coincided with the current surge in the Delta variant. The optimistic viewpoint is recent weakness can be written off as another side effect of COVID that too shall pass. The pessimistic view is 2021 was an economic head-fake and worsening contraction leads to a double-dip recession.
The third is China. The global sell-off in risk assets during September was, at least in part, tied to various concerns brewing in China. They included an acute slowdown in economic activity, a government crackdown on private enterprise, and the ongoing disaster that is Evergrande. After a remarkable rebound from the pandemic, Chinese economic activity quickly moderated.
Figure 5 China Industrial Production
The failure of Evergrande, China’s largest real estate developer, could mark a tipping point for China which was already facing an “uneven and unstable” recovery. As the world’s second-largest economy and a bellwether of post-pandemic growth, an unorderly unwind of Evergrande and China slipping into contraction could stop the global economic train in its tracks.
For the record, I don’t know what happens next with inflation, Evergrande, or the economy. The best any of us can do is watch carefully and pay attention to what the data are telling us. As of now, the story is one of moderating growth. What happens next will depend on the path of inflation, economic activity, and China, among other things, all of which are worth watching closely in the months ahead.
Despite the obvious concerns and rising risks, our baseline scenario based on current economic and market conditions is still marginally positive. Barring a negative shock (like China imploding), the path of least resistance is continued expansion, even if moderating. As such we maintain our current allocation with a modest overweight to risk assets.
However, as we move deeper into the business cycle risk assets will likely experience higher volatility than earlier in the recovery. The global equity market rally of the past 15 months basically moved in one direction. That initial sharp rebound (where markets only go up) is behind us.
Anyone rattled by the stock market moves in September should brace themselves. The reality is the S&P 500 has not pulled back by more than -5% in 2021. Historically, pullbacks of at least -10% happen about once a year. In addition, the standard deviation for the S&P over the past year was only about ~14%. Longer-term that value is closer to ~20%. The point is we’ve enjoyed a relative calm that is unlikely to persist.
Within global equities, we continue to prefer foreign markets relative to the US. Last quarter I pointed out foreign markets lagged the US in several aspects including vaccinations, economic recovery, and equity market returns. This quarter I’ll add that within foreign markets, emerging markets look particularly attractive.
Figure 6 Global Equity Markets
Last month I wrote China’s equity market pullback could be a longer-term opportunity, however, there are also obvious near-term risks. Those country-specific risks could be abated through broader EM exposure, which in aggregate, still looks relatively attractive versus developed markets (something I will elaborate on in a later note).
THE BOTTOM LINE
Q3 was less aggressively risk-on than the first half of the year, however, risk assets are still solidly up and to the right YTD. As I have been commenting over the past year, upward is the path of least resistance for risk assets given supportive economic and market conditions. Conditions don’t need to be perfect (they rarely are), just relatively better than worse and good enough.
Heading into Q4, our baseline expectation is a continuation and more of the same. But several risks could upend expectations including high inflation, weak economic activity, and disorder in China (not to mention any number of unforeseen macro shocks). Although we do not know for certain what to expect, we can and will maintain careful vigilance and adjust as conditions change.
As we enter the 2021 holiday season I want to express my sincere gratitude and appreciation for all those who support BCM. Clients, family, and friends alike, your continued trust and confidence are what keep us pushing to grow and improve every day. From all of us at BCM, thank you and we wish you the very best over the holidays!
Victor K. Lai, CFA