Investment Markets Update – 4th October 2021 Jilly Mann
The last few weeks have, at times, felt like a constant wall of worry for global stock markets with fuel shortages, the Evergrande fallout and inflation concerns. In reality, we don’t feel that the situation is actually as negative as perhaps it is being portrayed to be. There is one big unknown in the world of geopolitics which could undermine everything, but for those factors within investors’ control, there are some positive signs for the rest of 2021 and certainly into 2022. In this update we cover the following:
– The “big unknown”
– Semiconductors, China and the rest of the world
– Japan and the demise of Prime Minister Suga
– The UK, the FTSE, Brexit and the emergence from the pandemic
– Our allocation to the US
– Inflation, interest rates and tapering
– Commodities, COPS26 and ESG
The “big unknown”
Let’s start with the “big unknown”. Since our last update, the world has been rocked by the Taliban taking control of Afghanistan. This is in itself didn’t move stock markets, however, the geopolitical positioning in the aftermath has contributed to the unspoken feel of new Cold War divisions across the globe. How China, Russia, Iran and North Korea, to name but four of the states who butt up against the US, responded to the unsettling atmosphere within Afghanistan was quite telling and did little to dispel fears of increased tension within both politics and trade. The latter aspect is the key. As a Schroder US fund manager said to us last week, the rest of the world tend to view China as a customer, whereas the US view China as a competitor.
This theme picks up the thread from my last update and it is not to say that US and China relations are doomed, but if tensions further increase, then global stock markets generally will all suffer as a result and it won’t be a case of picking specific markets who will remain unaffected, our view is that everything would look quite messy for a period of time. Hence why we deem this the “big unknown”.
Semiconductors, China and the rest of the world
Allied to this story is one of the world’s most owned stocks; Taiwan Semiconductor (TSMC). Almost all self-respecting Asian, Emerging Market and Global fund managers own this stock as one of their top ten holdings. TSMC is the world’s largest foundry and key producer of chips for Apple Inc, smart technology such as tablets and phones, parking sensors and auto emission reduction technology. TSMC is in the middle of a power struggle between Japan, China and the US. All of whom are heavily reliant on TSMC to produce chips for their domestic markets and all of whom are attempting to lure TSMC to set up factories in their respective countries. The US have already agreed a TSMC plant in Arizona and Japan are in discussions for a plant in Tokyo. However, TSMC has inadvertently found itself in the middle of this global political power struggle.
There remains the threat of Chinese invasion in Taiwan and if that happens, it would likely have a significant impact on exports from TSMC. The Coronavirus has already seen auto plants across Europe lobbying Government to increase supplies from TSMC to reignite supply chains which were struggling to cope with demand, especially for hybrid and pure electric vehicles. China have also poached key staff from TSMC to develop their own semiconductor supplies. Perhaps TSMC finds itself in a privileged position whereby no country can afford to have too negative an impact on the business, but it is a good example of a stock and scenario that we keep a close eye on.
As we discuss specific stocks, we should consider Evergrande. The chaos around Evergrande shares has been the single biggest mover of stock markets in recent weeks. Evergrande Real Estate is one part of a broader Evergrande Group, backed by one of the richest businessmen in Asia (or at least he was). Evergrande Real Estate was one of the biggest beneficiaries of the Chinese property boom. They built their expansion on easy credit, so they quickly became asset poor and debt heavy ($300 billion). For a long time, the Chinese property sector overheating has been deemed a threat to Chinese stocks, but with a focus largely on Chinese technology firms within most mainstream Chinese investment funds, our investors have more insulation from the fallout should the property bubble burst. That said, when the Chinese authorities started to introduce their reforms last year to control the amount of debt owed by Real Estate developers, Evergrande had to take desperate measures to cover their debts.
Evergrande started to offer major discounts on its properties in return for some immediate capital injection. Sadly, this resulted in two main outcomes. Firstly, many of the properties which investors were putting down deposits on still haven’t yet seen construction commence and so those individuals are at risk of losing their deposits. Secondly, Evergrande are not in a position to repay the interest on their debts, which has resulted in their share price plummeting and the rating of their associated bonds fall to Junk status (i.e. at risk of default).
This all sounds critical and the market has reacted nervously to the continuing newsflow around Evergrande, however, the story needs some context. The context won’t stop the markets continuing to jerk downwards until the story concludes, but those movements are finite and with every piece of negative news, the markets are quickly picking up much of the loss and registering positive returns in the following days. This will continue for a while yet and so investors need to be prepared for this. It is a situation affecting global markets and not just Asia or China.
In terms of what China are doing about this, well Evergrande aren’t too big to fail and actually they wouldn’t be the biggest default or failure the markets have seen. Yes, it is uncomfortable and it sounds a warning claxon to other Chinese real estate firms, but if the worst happened and the company fails entirely, it won’t be catastrophic and markets would recover relatively quickly. As we so often say, markets don’t like uncertainty and unfortunately the decidedly opaque actions China are taking to resolve this matter serves to exacerbate the uncertainty.
China’s reforms which are sweeping at the moment and affecting all major companies and industries are designed to look after the working classes. China aren’t so concerned about the billionaires and those who are well off and making a good living, they are concerned about making sure the working classes have fairness and equality. They may not go about it in a way that sits easy with the West, but domestically much of the reform is aimed at this objective. So, in terms of Evergrande, the authorities do not want people to lose their deposits and be penniless as a result. We have already seen State Owned Enterprises within China start to buy up stock from Evergrande. China haven’t directly stepped in to bail Evergrande out, but they are using their mechanisms to commence the process behind the scenes. Whether they go the whole way and rescue it all is perhaps unlikely as that would contradict their reforms. They couldn’t realistically impose restrictions on debt and taxes to big business and then just bail them out when they fail as a result, but they will do enough to ensure that the working classes aren’t brought down by these entities.
We reduced our China exposure a few weeks ago, as well as reducing our Emerging Market and Asia exposure at the same time. Any uncertainty in China affects the broader Asia region, Japan apart and so we took the view that whilst this plays out, we will reduce initially and then continue to assess the situation with further shifts in our allocation expected in the coming days. If uncertainty persists, then we are looking at increasing our exposure to natural resources and Western developed markets over the Emerging/Asia world.
Japan and the demise of Prime Minister Suga
Japan is worthy of a mention. On the 3rd September 2021, Yoshihide Suga announced he was to step down as Prime Minister. The decision followed sinking support levels amidst criticism of his handling of the Coronavirus pandemic. Whilst Japan had seemingly done a fairly good job of containing the pandemic in the early stages, the Tokyo Olympics stirred local angst as the Games coincided with the spread of the Delta variant in Japan and rising infection rates. Japan’s General Election is due in November 2021 and retaining Prime Minister Suga was becoming a headwind for the ruling Liberal Democratic Party (LDP) and so the decision was made for him to step down.
The chart above shows the performance since the start of August 2021 of the JPM Japan fund, a fund we owned successfully through parts of 2020. The chart clearly shows that as rumours of Prime Minister Suga’s departure were brewing in late August, stock market performance was rallying and took off when the official announcement was made. We looked at this market and questioned whether we should be buying back into Japanese equities, however, we held off as we weren’t convinced that the momentum would be sustained. As the chart shows, positive momentum reached a peak in mid September, but has fallen away again since then, possibly amidst the realisation that Japan now has a real decision to make about its political future, but possibly also due to broader global market concerns.
The UK, the FTSE, Brexit and the emergence from the pandemic
Looking at the UK, September was a relatively gloomy month for the FTSE indices. The FTSE 100 was hit by Chinese Evergrande concerns and energy price issues, whilst the FTSE 250 saw some of its component stocks take relatively big hits. AO World is one such FTSE 250 example whereby the online electrical retailer saw shares fall by 18% amidst warnings of global driver shortages and supply chain issues, all caused by the aftermath of the Covid pandemic. The business has still reported improved UK sales, up by 6%, in the six months to 30th September 2021, but warnings from management had a knock on effect to other such stocks, Currys as an example. In the FTSE 100, it is not unusual for shares in Lloyds Banking Group for example to register daily losses of around 3% at the moment. Inflationary issues across Europe are weighing heavy on the UK market and contributing to the movements we are seeing in the financial and resources sectors.
The charts below show the performance of some of our core UK equity holdings for the year to date. The general trend for these assets has been positive and they have outperformed both the FTSE 100 (yellow line) and FTSE 250 (grey line) by some margin, although September was a difficult period.
Our present allocation is more heavily weighted towards small cap and FTSE 250 holdings, we have less in FTSE 100 stocks. This has been a deliberate approach as we feel that longer term there is more scope within sub FTSE 100 stocks for growth, especially in inflationary conditions and with the focus being on domestic markets rather than the impact of movements in the US Dollar or overseas concerns. We still believe this to be the case despite short term performance in September.
We commented a while ago that we hadn’t yet seen the fallout from the Brexit vote, as the pandemic had delayed the true impact of leaving the EU. We are now starting to see a combination of Covid passport/vaccination woes allied to a dearth of workers resulting in the present fuel tanker issues. The fuel shortage in the UK isn’t solely down to Brexit, but it is a key contributory factor, as it is with the shortage of workers in the leisure and catering space. Factor in the forthcoming Budget and potentially the start of tax rises, together with the cessation of furlough arrangements in the UK and we sense that the next couple of months could be relatively choppy for UK markets. We may well be in the eye of both a domestic and international storm, where we almost lead the world in austere budgetary planning post pandemic. How markets react to that could be quite indicative for the rest of the globe as they too start to taper the financial support applied to get through the pandemic.
We are looking at potentially reducing our UK weighting a little, although we are still very positive on UK stocks and their valuations relative to global stocks. We still believe that small to mid-cap holdings in the UK offer very attractive upside, but we just need to be mindful of these external factors and how much they may or may not weigh on UK markets.
We do need to get used to a more volatile environment for global stock markets, including the UK. In many ways, these sorts of conditions are ideal for stock pickers and investors trying to apply a logical argument to buy good quality companies that can benefit from current conditions, rather than everything going up or down in unison, but it requires some patience and ability to ride out a week or more of something other than continuous daily positive returns in order to achieve the longer term outcome.
Our allocation to the US
Moving on from the UK to the US, we are looking to increase our US exposure by introducing the Schroder US Mid Cap fund to our portfolios. This fund complements our existing US allocation in the form of the Baillie Gifford American and Premier Miton US Smaller Companies funds. There isn’t much flash about the Schroder fund, certainly not in the way that say Baillie Gifford invests in cutting edge US technology stocks. The fund manager is from New York, but lives in a small town outside the City and is acutely aware that the small, independent shops he used to frequent have all shut down in the wake of US policy throughout the pandemic. In the same way that in the UK, we have experienced the inequality of independent greetings card shops having to close whilst supermarkets selling greetings cards remain open, the exact same scenario has played out in the US via Walmart as but one example. This is quite refreshing to hear from a US fund manager, because too often you don’t sense that they have a feel for what is happening on the ground.
The table above shows the correlation between our US holdings. The higher the correlation (i.e. the numbers in the blue boxes) the more likely the funds are to perform similarly in different market conditions. The Schroder US Mid Cap fund is only half correlated (the green box) to the Baillie Gifford American fund, which means that in different market conditions, one could expect quite different performance outcomes, which is positive when building a robust (and eggs in different baskets) investment strategy.
In much the same way in which many UK firms are flush with cash at the moment, having built up reserves through the pandemic, the same is true in the US and the fund has always had a focus on investing in businesses without debt on the balance sheet. The manager sees opportunities in areas which were decimated prior to the pandemic. For example, they believe that we will continue to see migration away from cities and a push towards more flexible working practices, with demand for suburban and rural housing increasing. They also think first time buyers will be forced to buy outside of cities due to rising prices. As a result, they own stocks which operate in the modular housing industry, where parts of the house are prefabricated away from building sites and then transported there. They see these businesses benefitting from the labour shortages we are seeing in the construction sector at present, as it’s less labour intensive to put together a prefab property. This industry was decimated by the housing bubble pre financial crisis, with poor quality borrowers often buying this type of home, so it’s been a slow recovery since then, but they feel there is a long growth runway ahead for this industry. This isn’t a flash investment opportunity, but makes a lot of sense when targeting that segment of society who have struggled to get by through the pandemic and will certainly fall short of minimum deposit requirements for mortgages etc.
Inflation, interest rates and tapering
Looking at inflation and the tapering of covid support across the globe, there are two schools of thought. One that inflation is transitory and therefore, only a temporary issue and the other that it is here to stay. Recent discussions with JPM and Schroder have concluded that in the US certain aspects of the economy are inflationary and shall remain inflated, wages and rent are key areas which are therefore less transitory and here to stay. Keeping in mind that rental inflation makes up 40% of the core US inflation figure, it becomes clear that sweeping statements on inflation aren’t so easy to make.
In the UK, the Bank of England considered raising interest rates before commencing tapering of the Government asset buying in December 2021, but have thus far held off as they watch the fallout from the end of the furlough scheme. In reality, they are unlikely to raise rates ahead of December, but the fact that they have considered it has been a headwind for UK markets.
The US should have begun to taper their economic support well before now and as has just been indicated by Jerome Powell, Chair of the Federal Reserve, it will now be introduced imminently and rolled out with more haste than previously anticipated. Keep in mind that Jerome Powell is seeking nomination for a new term as Chair of the Federal Reserve in early 2022 and so 2021 has been frustrating to watch. His speeches hold a lot of weight, but this year has felt more like a charade to keep the new President onside to win his vote for 2022, before more decisive action taking place in 2022. That uncertainty over what the Fed Chair actually means when he speaks has not sat well with markets. We are almost through that period now and Powell is almost certain to be in post for another term, so we can expect a different strategy from here.
The overall feeling remains that inflation may rise in the immediate term, but interest rates will remain stubbornly low even factoring in rises. Any interest rate rises will be small and incremental.
In terms of the bond market, Janus Henderson, who we invest much of our fixed income allocation with, expect 2021 to be a case of riding out the inflation story with 2022 potentially seeing a reverse inflation environment which could be very positive for bond markets. Inflation levels this year have been high coming off the back of artificial lows at the height of the pandemic, those levels will reverse next year as markets adopt something more normal and feasibly this could result in zero or negative inflation rates. This isn’t the headline story at the moment, but if past trends are considered, with the aftermath of the Global Financial Crisis being a key benchmark, then Treasury yields may well fall from here as a general trend, albeit accounting for a small initial uptick whilst markets settled down. There have been no defaults in the US bond market for the last two months in spite of heightened market volatility and this is also supporting markets at the present time.
The key factor from the bond market is that structural change is disinflationary and the pandemic has undoubtedly led to structural change in the way many of us now live. The only thing that could throw this theory off is if we see a sudden downturn in global momentum or recovery from the pandemic. This could lead to further reflation trades, such as we saw in late 2020/early 2021. If this were to happen then perhaps inflation becomes a much more protracted issue, but for now the bond market is generally signalling a positive outlook for 2022, as we ride out the remainder of 2021.
Commodities, COPS26 and ESG
Finally on to commodities. The upcoming COP26 2021 United Nations Climate Change Conference in Glasgow will see China, the US, the UK and global nations come to agree to further agree progress towards climate change zero carbon targets. In line with previous global climate change agreements, China has closed 20-25% of its coal plants. The difficulty for China is now that the closure of coal plants has led to a spike in gas prices, because they cannot generate enough energy to keep up with the demand required as they recover from the pandemic.
The chart below from Schroders and the Lantau Group demonstrates that most provinces in China are currently in the midst of power rationing. The grey provinces are the ones without any rationing at all at present, whilst red and gold are under rationing conditions.
How long China can hold out without reopening these plants to ease supply/demand pressures and improve conditions for the working classes is questionable, but it feels like gas prices will remain high for some time to come if they stick to the Climate Change agreement.
In terms of the copper price which is up over 18% year to date, there is four times the amount of copper needed to make electric cars than traditional fuel cars. With the move towards electric and hybrid vehicles continuing, there is no reason for the copper price to fall from here, especially when one considers how much copper is required for chips that power smart technology as well.
If we look at the performance of the Liontrust Sustainable Future Global Growth fund since the start of 2020, we can see that it has outperformed the MSCI World All Cap index by around 20%. The MSCI World All Cap Index reflects all stocks across the globe, both mainstream and ethically minded stocks. This outperformance is noteworthy over such a difficult time period and further demonstrates that sustainable investing does not necessarily result in reduced returns, hence its weighting across all of our portfolios. That said the Brent Crude Oil spot price is up over 63% year to date and so we are looking at increasing our exposure to all types of energy sources in portfolios.
We attended an investment conference last week where every fund manager referenced ESG (Environmental, Social and Corporate Governance) as a key factor when planning their funds. Sadly, we only regard a handful of those managers as really incorporating ESG factors truly within their processes. It is has become a regulatory requirement for managers to demonstrate their ESG credentials when investing, even in the most esoteric investment types and this has diminished the quality of those who genuinely manage from an ESG perspective.
It is our job to sort the wheat from the chaff in this regard, but to give a good example of where the lines can blur is a new Artemis fund, the Positive Future fund. It is new to Artemis, but has been run within Aegon, the manager’s previous fund house, for some years. The key researcher on the fund is a known expert ESG analyst and so has genuine ESG pedigree. The issue is interpreting the fund. It isn’t solely about the headline issue of climate change, it is about stocks which improve conditions and environments. Potentially new ways of managing diabetes, state of the art helmets which reduce brain injuries, technology to improve hearing loss and meat free vegan food producers. Amongst the holdings, there are undoubtedly stocks which reduce carbon and which improve future quality of life and our footprint on the globe, but it isn’t a traditional ethical investment strategy. As COP26 will further highlight the need to hasten carbon reduction, these type of strategies will become more prevalent to ally purely “green” holdings and it is something which we are mindful of when building strategies that can be future-proofed.
Overall, we are aware that August and September have been a little less straightforward for investors, however, we are continuing to make changes to the portfolios and will continue to do so over the coming weeks. We do feel that there is some temporary noise affecting markets at the moment and so, whilst we have acted swiftly throughout the pandemic, we are conscious of not acting too swiftly at the risk of prematurely selling assets that we see a positive long term story for once short term noise dies down.