Market Update: Eventful Back To School

The quiet days of a not-too sunny summer (unless you spent it along the Spanish or French Mediterranean coasts) seem long gone. Barring a few noticeable exceptions, summer months are generally quiet with the amplitude of daily market moves fairly benign. This idea is captured by measuring market volatility – or VIX. It is the most commonly used volatility index and it was at relatively low levels this summer (near-term low of 15.45 on August 13th) confirming the historical summer patterns. But it spiked to 25 (September 20th) and now is around 16. Higher volatility is generally a sign of a market searching for a clear direction. 

What can explain this lack of direction? 

Investors are generally trying to identify the dominant market theme for the months to come and adjust their portfolios accordingly. Due to Covid-19, very large fiscal packages were adopted by the main economies (US, Europe, China), and central banks have boosted liquidity, to stimulate the economy that went to a halt. We describe this as the “reflation trade”. To us, it started in December 2020 when US yields rose sharply that in turn benefited and benefited industries such as energy, materials and financials. From late-March onwards however, US yields have gone down again which drove another rotation in the market leadership from mostly the “old economy” back into visible growth benefiting sectors such as Technology. 

Since we’re back to school, we have been observing a tension between the repricing of the reflation trade (i.e. what worked during the first part of the year) and the attempt to price another regime, one of them being stagflation. All of this creates uncertainty which quite often translates into challenging market conditions for investors. 

What is stagflation and why could it roll the markets? 

Stagflation is often recognised as a period during which inflation is going up while economic output is stagnating or even contracting. Let’s have a look at inflation. Unless you have missed out the news, inflation has accelerated over the summer in many countries driven by higher energy prices (see our blog post on this very specific topic: What is inflation, and is it impacting you? (clim8invest.com), but also supply chain shortages (e.g. semiconductors). The most recent data point for US inflation is 5.4%, a level fairly constant since April 2021, but well above the target rate of 2%. When inflation is rising, Central Banks become more hawkish. In simple terms, they increase the cost of borrowing in an effort to “cool” the economy while reducing the liquidity (tapering), liquidity that was turbocharged in the first place to heal the economy from post-Covid shock. The Norwegian Central Bank was the first to hike interest rates amongst the G10 economies and the US Federal Reserve, like the UK Bank Of England, may rise earlier than initially anticipated, in 2022. 

But to be effectively in stagflation requires the economy to stall, right? 

That’s correct, and this is why every news which could dent economic growth prospects over the coming quarters will be particularly watched and analysed. In that context, two “events” shaked the markets since September 1st. 

• In China, Evergrande, one of the biggest and most indebted Chinese property developers, is on the verge of defaulting. A default is when a debtor cannot meet the scheduled maturity payment that was agreed upon with its creditors. Evergrande’s debt is denominated in US dollars and Chinese Yuan. Payments for the dollar-denominated debt have been missed already, rising the spectrum of a collapse, with the possibility of a contagion that could negatively impact global capital markets and negatively affect Chinese growth, and global growth. Supply chain shortages and higher energy prices were cited in the last reduction of growth forecasts by the International Monetary Fund for 2021. Yet, growth expectations remain well above the cycle average according to the Washington-based organisation with global growth in 2021 to average 5.9% and 4.9% in 2022. 

Right now, the prevailing consensus is that a potential collapse of Evergrande would be dealt with directly by Beijing authorities with contained overseas consequences. Besides, tapering has been well telegraphed in the US and in Europe to counter inflation. But those episodes taught us that every grain of sand that could derail the growth narrative will be associated with stagflation fears and maintain a higher volatility regime in the market. 

How have these developments impacted the performance of the main market indices? 

The most common equity benchmark (MSCI World) has been challenged since the beginning of September (September 1st to date down -0.23%, in GBP), while the decorrelation between bonds and equity was not that obvious as the most common fixed income benchmark (Bloomberg Barclays Global Aggregate Bond Index), dropped by 1.73% over the same time period, due to a global drop in yields fueled by more hawkish policies. Conversely, energy prices increased quite substantially, with oil prices up 16.24% and European Gas prices by a staggering 19.29%. 

Something on our view for the coming weeks?

We think it is way too premature to position portfolios for stagflation especially since growth expectations for next year are still well above the long-term average, still surfing the wave of fiscal and monetary measures announced late 2020/early 2021. As a result, we would be in the camp of the resumption of a mild reflation trade. However, it comes with stark differences relative to the beginning of the year: 1) inflation expectations are now well anchored in the market; 2) supply chain risks have emerged (equally they are better understood); 3) much higher energy prices are challenging certain businesses and customers.   

Besides, market expectations for 2022 corporate earnings in the US have never been so high, and imply 9.6% growth. The same pattern applies to Europe with 7.7% growth expected. Given all the identified risks, we believe there could be small negative revisions down the road. That’s why we remain very selective for now and look at strategies that can navigate between all the known unknowns. 

All sources from FE Analytics and FactSet. Data as of October 22nd. 

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