Wayfarer Quarterly Commentary: Q3 2021

Macro

Shortages were the main theme of the quarter be it the ongoing semiconductor saga, staff, ships or even latterly, energy. No negative prices for oil at the moment! European front month gas prices are six times what they were last year at this time! Silicon metal prices are up 300% since the start of August – higher solar panel prices here we come.

These shortages occurred despite the UK Pingdemic, the pervasive Delta wave and a natural peaking in the second derivative of economic rebound following reopening.

Central Bank definitions of transitory inflation are being refined monthly in respect to both magnitude and duration and Central Banks are talking more openly about tapering Quantitative Easing and even raising interest rates.

The natural slowdown in growth was accentuated by the above shortages and indeed the breadth of shortages is likely to mean that the length of the economic recovery is likely to be extended rather than truncated.

The Norges Bank became the first G10 Central Bank to raise rates whist the UK enacted a budget that raised taxes on individuals and corporates alike. These are the first small steps to moving the largesse that saw the developed world through Covid. More such steps will follow in the West. The East did less stimulus in the first place and is also ahead in removing such, although Covid resurgences have tempered such moves.

China suffered from said resurgence and its zero tolerance approach resulted in lockdowns of several major cities and key ports with obvious knock on effects to economic activity. This will rebound as the latest outbreak is brought under control.

Markets

Beijing grabbed the headlines during the quarter via a series of regulatory actions that impinged upon the growth and margin outlook for the internet behemoths and went as far as to outlaw profitability in segments of the under eighteen private education sector. The mega rich, be they corporates or individuals, were also ‘encouraged’ to donate more of their wealth to social causes. On top of this the crackdown on the Chinese housing sector which began last Autumn looks set to claim a headline victim with property giant Evergrande virtually certain to see its debt restructured in the near future as it is struggling to pay obligations as they come due. Estimates of debt outstanding approach $300 billion. However, consensus has it that the Chinese Authorities will engineer a managed work out to prevent contagion to the legion of small suppliers and financial players who are owed money. The authorities have long experience in enacting such work outs.

During July the breadth on the S&P 500 (% of stocks participating in stock market move) reached its lowest level since 1999. For the quarter most equity indices experienced their first negative return since Q1 2020.

After having its best month since 2016 in June, Sterling spent the most of the third quarter on the defensive as the Pingdemic and related slowing of activity combined with the general waning of risk appetite took the shine off its lustre. The dollar gained somewhat against most currencies considered positively correlated to economic growth as it benefited from its defensive characteristics.

The commodity complex took a hammering early in the quarter after being the star performer earlier in the year. Lumber and Iron Ore have both fallen over 50% from their peaks of Late Spring/Early Summer and the Energy complex also sold off considerably before staging a spectacular recovery in September during which European Natural Gas prices surged to all-time highs whilst Brent Crude rose 8.41%. The early fall was mostly down to weaker Chinese growth numbers (caused mainly by Covid related lockdowns as well as regulatory moves) whilst shortages caused the big move up in Energy Prices.

Developed countries bond yields had a wild ride during the quarter as they dropped precipitously from the June Federal Open Market Committee meeting until late August. They then increased rapidly through September as investors once again reappraised when the Federal Reserve will start to taper and increase rates. Consequently, by the end of the quarter, yields were modestly above where they started.

Chart 1. US Ten Year Bond Yields in Q3

Source; Marketwatch

We should highlight that bond yields have displayed much more volatility, on both the upside and downside, over the last two years than they have done over most of history. This is likely to continue unless authorities take the extreme move of suspending market economics by actually capping yields (a few commentators are already talking about this possibility). Given that equity prices are much more sensitive to bond yields these days, then this increased bond volatility will likely cause a similar spike in equity volatility.

Table 1. Performance of assets in Q3 (all figures in base currency)

Activity & Positioning

We have previously written that whilst we are optimistic on the medium to long term economic outlook, we were concerned about the prospect for a pullback in financial markets where some valuations had become stretched relative to history, the technical situation was looking vulnerable and government regulation/action could serve to dampen enthusiasm. We raised cash accordingly in the March to June period. This came to pass, particularly in Asia so we bought back the Invesco Asia we had previously sold and added to Jupiter Japan. We also bought some Nomura Dynamic Global Bond fund as this provides a yield uplift to the models yet will benefit if short term interest rates rise (as we believe will happen).

We reduced some exposure to our long standing favourite Montanaro UK Equity Income after a very strong run which saw its valuations rise to close to all time peaks.

Table 2. Portfolio activity during Q3

As the chart below demonstrates, whilst several asset classes are expensive in a historic context, the situation is by no means uniform and we can see further upside in several areas from here.

Chart 2. Not everything is expensive

The areas we are invested in are likely beneficiaries of economic activity beginning to normalise and indeed provide some insulation from increased regulatory activity and an environment where both inflation interest rates are a bit higher than was expected in the recent past.

Outlook

Although Policymakers and investors are reluctantly embracing inflation that is higher for longer and therefore accepting that tapering and even interest rate rises are closer on the horizon than originally anticipated, consensus still calls for low growth and low inflation to return relatively soon.

As we have articulated before, our research points to several fundamental changes being in place compared to the decade preceding Covid which imply that this consensus will be severely challenged. These include much more expansionary fiscal policy, a curbing of migration and shorter, more regionally heterogeneous supply chains. Each of those individually challenge prior deflationary forces. Together they do so considerably.

On a shorter timeframe each of Chinese Monetary Policy, Fiscal policy and Regulation should become less of a drag from here (and at least the first two should become more supportive).

This will help offset the incrementally less stimulative policy in the West, particularly the US and UK. Indeed, most of Asia should benefit directly from an improving Chinese outlook.

We should also bear in mind that the shortages referred to above mean there is still a lot of pent up demand left to be satisfied and that such shortages have served to lengthen the economic cycle, not shorten it as some imply.

In a similar vein the vast excess cash reserves built up by Western households over the last twenty one months remains largely untouched, providing further underpinning for consumer spending.

We are well on our way to recovering from the economic shocks of the pandemic. However, we are not fully there yet and as furloughs and direct payments from governments to households end and mobility increases further, we will see currently unanticipated issues arise. As this will occur concurrent with a gradual withdrawal of monetary largesse then it is likely financial market volatility will increase, in spite of a positive medium term macro environment.

We are not scared of such and stand by to invest more as opportunities present themselves because we think we are only one year into what is likely to be a multi-year economic expansion that will be different in tone to the prior decade.

Given activity will pick up as shortages and Covid flare ups are brought under control we expect further progress in equities over the medium term, albeit amidst heightened volatility.