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Market sentiment: Jittery. When global growth forecasts start to be adjusted downwards, at the same time as central banks warn of tighter monetary policy to come, investors in risk assets are liable to be a little nervous. Add to that mix the current implosion of Evergrande, the Chinese property developer with liabilities of $306 bn (equivalent to 2% of China’s GDP), another U.S debt ceiling crisis (however synthetic it feels), it is no wonder that global stock and credit markets began the week on the wrong foot. The VIX (‘fear gauge’ index is at 26, its highest in four months.
But this is far from a ‘perfect storm’, for two reasons. Which help explain why Asian and European stocks have bounced back today.
First, from the macro-economic perspective, some of the worries appear contradictory. The persistence of Covid-19 is leading to weaker growth than had been anticipated. And along with tighter monetary policy from the Fed and the ECB, this will help contain and -from next year- reverse inflation. So it seems counter-intuitive to worry about Covid-19, Fed tightening and at the same time the risk of inflation becoming an ‘embedded’ problem. Equally, if Congress’ reluctance to nod through the Biden fiscal stimulus packages leads to reductions in their size, the economic stimulus effect will be lower but so will inflation.
Second, stock markets are protected by what has become known as ‘tina’, or ‘there is no alternative’. With inflation at a decade-high in many developed economies, yet bank interest rates still at record lows and bond yields still negative in large parts of the developed world, investors are short of options.
Equities offer a positive yield, and some protection against inflation if companies can pass on rising input costs to their customers. The dividend yield on the S&P 500 is currently 1.28%. Better than the zero on offer from a dollar current account, and the 0.23% on the 2 years U.S Treasury. A 0.25% interest rate hike from the U.S Fed in early 2022, which appears to be a consensus view, will alter the maths. But not by much. And if that comes about because of inflation fears, the same inflation will push up company dividends. Meanwhile, in the U.K, the dividend yield on the FTSE100 is 3.5%, compared to a 0.26% yield on the 2-year gilt.
Higher input costs appear to be passed on to consumers. The jury is still out as to whether the current wave of inflation is just a passing phase, or the start of a long-term problem if it becomes embedded in wage growth and expectations. However, it does not -so far- appear to be eating into companies margins, suggesting that rising input prices are being passed on to customers. This supports the ‘equities as a hedge against inflation’ argument. The financial data company Factset recently looked at recent earnings announcements from S&P500 companies and found that estimated profit margins for the calendar year 2021 are -on average- now higher than the same estimates were in June.
Is Evergrande a global problem? Probably not. The heavily indebted Chinese property developer has fallen victim to new, tighter rules over the amount of leverage that such companies can take on. The Chinese government has warned that Evergrande interest payments will not be able to be made, suggesting that debt investors -as well as equity investors- will share in the pain of the companies implosion. While Chinese, Hong Kong and indeed global stock market investors fear that this will have a knock-on effect on Chinese banks, global materials suppliers, and the Chinese and Hong Kong real estate markets, there appears to be a market consensus that such fears are probably overdone.
The Evergrande debacle has been much anticipated, as the government tries to control the housing market which it blames for rising inequality. The authorities in China have plenty of fiscal and easing tools they can use to ‘prime’ the economy, to boost demand elsewhere and prevent a broad sell-off in the housing market. It will be presented -domestically- as part of a much needed cleaning up of an important part of the country’s economy, in the name of ‘shared prosperity. Indeed, if it helps reduce house price inflation it will promote consumption in other sectors of the economy.
The Fed meets on Thursday. Expectations were growing that the Fed would begin tapering its $120bn a month quantitative easing program in December and start raising interest rates early next year. Thursday’s Fed announcement is likely to be a little more dovish, with perhaps more ‘ifs’ and ‘buts’ attached to their forward guidance. This reflects clear evidence that the U.S economy has now passed ‘peak growth’, in part because of the lingering effect of Covid-19 and supply-side problems (whether labour or materials). If stock market investors have a friend in tina, tina has a friend in the Fed (thanks John Authors of Bloomberg for that line!)