August was another strong month for developed equity markets. It was in fact the seventh consecutive positive month for the S&P 500 index, up nearly 4% in pound sterling terms for the month. China was again a laggard, with the CSI300 broadly unchanged on the month as ongoing regulatory changes and Covid-19 related manufacturing shutdowns dampened market enthusiasm. The more tech focused Hang Seng China Enterprises Index only fell by half a percent on the month. These two markets are still down roughly 7% and 14.7% respectively on the year in local currency terms.
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Four issues have been dominating the concerns of investors. They are, in no specific order: The Fed and the prospect of it tapering its asset purchases, the spread of the Delta variant and its impact on economic activity, China’s new “common prosperity” focus and of course, inflation. Three of these four concerns impact one another as inflation and the continued effects of the pandemic certainly influence the thinking at the Fed. It is difficult to generalise about China and there have been gloomy prognostications for over a decade, but recent policy moves, and internal debt dynamics are worth thinking about.
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Fed Chairman Powell was clear in his speech at the Jackson Hole Economic Symposium that a reduction in the size of asset purchases should not be mistaken with tightening of monetary policy. Nor should it be seen as a signal that the Fed was going to embark on a rate hiking cycle. He again emphasised that the recent rise in inflation (five months in a row of headline CPI over 2.5% and three months in a row at 5% or higher) was transitory and cited specific factors (used car prices for instance) that were having an undue impact on inflation. He acknowledged that the Fed’s inflation goals were being met and that while there was progress on their other objective (full employment), there was still a long way to go and that the labour statistics do not fully capture the true degree of unemployment in the economy. He stated that any plan to taper asset purchases would be well telegraphed to the markets in advance. The general expectation is that a formal announcement may be made in November (with perhaps a hint at the September FOMC meeting) and implementation beginning in December or January of 2022. It is expected to be a gradual and predictable process with most market participants thinking the Fed’s current pace of $120 billion a month in purchases ($80 billion in treasuries and $40 billion in mortgage-backed securities) would be reduced by $15 billion a month. Will this kind of announcement unnerve the equity markets? Possibly, but we would expect any negative reaction to be short lived, as the Fed is likely to be a long way away from raising interest rates. The bond market is likely to react, and we could see longer term yields drift back up towards 1.75-2.00% but it will be a gradual move and may require some talk of tapering by the ECB and the BOE as well.
If we turn to inflation, we have just seen the Eurozone post its highest headline number in over a decade, registering 3% inflation for August (after July’s 2.2%). The ECB’s interpretation of this is much like the Fed’s, in that they view this jump as transitory due to base effects from lower VAT rates in Germany last summer and a surge in energy prices when compared to a year ago. There is also evidence that Covid related supply shortages in a variety of industries are producing price hikes globally. The central banks are prepared to look through this and for the moment so are the fixed income markets. However, given how low yields are, (negative real rates of return on many fixed income securities) it is hard from a risk and return point of view to justify a large weight in fixed income in one’s portfolio. Given this, we retain our preference for shorter duration.
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We have all been surprised by the continued impact of the Covid pandemic. Even with the vaccination of most of the population in the developed world we are still seeing outbreaks in many places (particularly in vaccine averse parts of the US) leading to the re-imposition of some restrictions. More importantly, the
slow progress in vaccinations in the developing world is leading to not only human suffering but also social distancing restrictions that are reducing manufacturing output and leading to global supply chain issues, shortages and price hikes. Here again the major central banks are very aware of these issues. The lingering impact of the virus will encourage them to go very slowly in removing monetary accommodation. Also, there is very little appetite on the part of the public in the highly vaccinated developed world to accept a return to the kind of restrictions put in place last year. The UK model of learning to live with the virus is likely to be the one followed. International travel and returning to office for work are still challenged but more vaccinations and the addition of booster shots will probably aid in overcoming these problems.
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This leaves us with China, never an easy place to make confident statements about. The government’s regulatory crackdown on their tech giants has grabbed all the headlines and certainly impacted their share prices. Nevertheless, the more important development from a growth and perhaps financial markets impact is the ongoing deflation of the real estate credit boom. The poster child is China Evergrande, the largest and most indebted of China’s property developers. They appear to be heading for default and bankruptcy. The share price has fallen from a high of HKD 32.00 per share to below HKD 4.00 over the past four years. They have nearly RMB 600 billion (c. £60 billion) in debt outstanding, it was nearer RMB 1 trillion in 2017. There are also concerns that there are hundreds of billions in off balance sheet debt as well. Evergrande feasted off the super abundant availability of credit in the Chinese economy, piling debt upon debt, often taking out loans to pay the interest on existing debt.
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They were not alone in this practice and critics of China have been pointing this out for a decade. The government has just had to organise (in fact demand) a bailout of Huarong, the state-owned entity which buys bad bank loans (of which there are many to choose from). The Chinese authorities have been attempting to slowly deflate this credit bubble without substantially damaging growth. That is getting more difficult. The authorities are taking a different route with China Evergrande, don’t be surprised if foreign creditors get hurt in a restructuring. The losses are going to show up and impact activity. Don’t be fooled by the recent bounce in some Chinese stocks.
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What is ahead of us? The August unemployment figures just released for the US give Powell and the other doves on the FOMC more reason to be slow to taper. Yet remember tapering isn’t tightening and there is no appetite amongst central banks to deliberately slow economic activity by raising interest rates. Inflation will likely stay high as the Delta variant provoked supply shortages are not going away quickly. We may start asking ourselves when does transitory inflation turn into permanent inflation? Investors should also keep an eye on developments in China, the authorities there don’t care about what impact their policies have on foreign financial markets and foreign investors. In the absence of a financial accident in China or a return to lockdown polices to combat the delta variant the slow and steady stock market melt-up will continue.

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