Monthly Market Update — October 2021
This month’s newsletter looks at some of the key issues facing markets and recent asset class performance.
The main points are as follows:
Markets have once again stumbled in what is often a seasonally weak time of the year.
This time fears are centred around higher inflation leading to higher interest rates.
Up to now, the market agreed with Central Banks that inflation will be temporary.
This view is now changing as persistently higher prices are being recorded.
We see this as a big deal. Central Banks may need to raise interest rates sooner than expected.
Times with increasing uncertainty such as now see us focus on diversification, quality, and liquidity.
The US S&P500 Index has once again lived up to its seasonal reputation as markets stumble into the end of the September quarter. The September month return of -4.75% is however much better when compared to previous experiences. The 9/11 attacks in September 2001 (-8.2%), the Dotcom crash in September 2002 (-11.0%), and the Global Financial Crisis in September 2008 (-9.1%).
The reason for the weakness is that the market has once again turned its attention to the list of worries. Some of the items on the list are new, whilst others are not so new. On the not so new list is the potential US Government shutdown, US debt ceiling talks, and the inflation outlook. The latter perhaps becoming much more problematic as inflation is proving to be “not so transitory”. This leads into to the new worries which is a growing energy crisis across many parts of the world including Europe and China. Not quite the challenge China needs as its economy is slowing and it attempts to coordinate a soft landing of its property market.
There are significant challenges facing the global economy and the tools used by Central Banks may do little to solve these challenges. Cheap money will not lower input costs for businesses, it will exacerbate them. Cheap money will do little to solve the energy crisis, especially in the short run. Apparent to us is the facts have changed. The debate over renewable energy is about to become a lot more complex. Global trade relationships are becoming much more important as supply shortages abound.
At this stage, the list of unanswered questions is growing. Will businesses pass higher costs onto their customers (inflation). Will businesses absorb higher costs and sacrifice profits? How will China navigate its short-term challenges? How fast will Central Banks remove stimulus? When and how fast will interest rates rise? Whilst these uncertainties hang around, investors are likely to be reluctant to pay any premium to be invested.
In this newsletter, we discuss share market performance as cheap money is removed. Volatility should increase, but unlikely to cause a financial crisis. We also discuss the growth concerns coming out of China which we view as more permanent than temporary. Linked to this is the Iron Ore price which has halved since May.
Times with increasing uncertainty such as these see us increase portfolio resilience. The focus is to be well-diversified, positioning for not just one but several probable outcomes, and investing only in high quality and highly liquid investments.
Peak liquidity could see peak valuations.
On historical valuation grounds, share markets are expensive with little reason to move higher. Dividend yields are low, Price/Earnings and Price/Forward Earnings are high, and Price/Book values are high.
But one thing is different this time. Interest rates are low and according to Central Banks are likely to remain low for some time. This makes cash and many fixed-income investments unattractive for long term investors.
Some of the greatest booms started when interest rates were low. As outlined in the above chart, the US S&P500 entered a multiyear bull market when interest rates were low (green areas) and remained strong even as interest rates gradually moved higher (blue areas).
The trouble occurred when interest rates were elevated becoming more restrictive on growth. The severity of the subsequent downturns generally depended on the size of any bubble built on cheap money. Whether it be technology stocks in 2000 and real estate in 2008.
We are in a similar situation today with interest rates at record low levels further supercharged with massive stimulus measures. Hardly surprising to see a boom in share markets.
Central Banks are now gearing up to start the withdrawal of stimulus. The remainder of 2021 is likely to see major Central Banks announce their plans to wind back stimulus programmes (taper).
This is a path the US Fed has been on before. If the future is like the past, we would expect tapering to slow share market appreciation and cause higher volatility compared to the last few months.
In our view tapering on its own is unlikely to cause another financial crisis. Tapering is however necessary to avoid another full-blown bubble created on cheap money.
Challenging this orderly exit from existing stimulus programmes is that inflation remains in check giving Central Banks time to gradually exit and then slowly raise interest rates. This is however becoming a bigger challenge.
We would argue that the tapering of liquidity (cheap money) may see investors slowly shift their focus to good old fashioned valuation metrics once again.
Shifting gears to Slowing Growth.
Central Banks have provided share markets with much-needed certainty over the past 18-months. This is evident in not only the rapid recovery but the low levels of share market volatility.
Have we however now reached an inflection point? Asset prices are reflective of a strong earnings outlook at a time when Central Banks are to slow the printing presses. Are cracks about to start showing?
The last month saw several Wallstreet banks downgrade US growth expectations. COVID-19 Delta being the reason cited, but this should be temporary so nothing to see here. The slowdown in the US economy is coming at a time when inflation remains stubbornly elevated.
Outside of the US, China is having growth challenges of its own. The growth slowdown seemingly far deeper than the impact of COVID-19 Delta. Regulatory reform is impacting several sectors with the property sector being the most significant.
How China reacts to this uncertainty is critical. Will authorities allow Evergrande’s creditors to suffer significant losses or will they step in. China prides itself on stability and control and a failure of this size would be one of the biggest challenges faced by Xi Jinping. The new common prosperity drive in China seems unrelenting and how far Beijing is willing to go immensely uncertain.
In the face of these challenges, the future does look slightly different to the past. We do however balance this against still cautious Central Banks, who acknowledge the fragility of the global economy.
With still elevated share markets this is a good time to think about portfolio risk levels. Riding through any possible short-term volatility is key.
Longer term we still see many positives and therefore remain broadly diversified across both attacking investments (stocks) and defensive investments (bonds).
Record high in May, then a 50% decline, where to next for iron ore?
Since peaking at a record high of US$230/t in May spot iron ore prices have halved to current levels of about US$110/t in the space of four months.
A decline in Chinese steel production and weaker demand outlook is to blame as Chinese authorities have imposed output caps to improve its environmental credentials. Clearer skies are particularly sought after as next February’s Beijing Winter Olympic Games approaches. Tighter property sector regulations are also leading to lower housing construction activity.
China is by far the world’s largest consumer of iron ore, accounting for about 70% of the 1,500 MT pa seaborne market. We therefore regard the Chinese administration’s policy changes as a “big deal” for iron ore markets.]
The market is predominately supplied by Australia’s Big 3 (RIO, BHP & FMG) and Brazil’s Vale.
Supply and demand fundamentals suggest that in any commodity market, the price is dictated by the highest-cost or marginal supplier. This is the one that would stop mining if the price were to fall, leaving the market short of supply.
Currently, the highest-cost producers are Chinese many of which require US$90-100/t prices to remain profitable. This tells us that the dizzy heights reached earlier this year were not sustainable and prices are now better reflecting market fundamentals.
Vale is ramping up its production capacity and the potential for competing supplies from other regions (eg. Africa) should see lower cost production enter the market in the coming years, further pressuring iron ore prices.
Future Chinese policy and demand remains a swing factor and is difficult to predict. Further complicating matters are ongoing China-Australia diplomatic tensions which may have repercussions for Australian exports.
Equity market analysts (and Australian treasury officials) are forecasting the iron ore price to dip further towards ~US$65-80/t over the next 1-2 years.
The good news is that Australian production is highly competitive, sitting at the lower end of the global cost curve as shown in the graphic below. BHP and RIO for instance have production costs of around US$25-30/t including royalties.
This is positive for Australia’s iron ore miners’ ability to withstand price cycles, albeit profits are expected to decline from current record levels. Iron ore made up 70% of BHP’s FY2020-21 earnings, RIO (76%) and FMG (100%).
On the stock market, the combined ASX200 index weighting of BHP/RIO/FMG is about 9%. Australian index equity ETFs are therefore not directly over exposed to this sector.
Investors wishing to take a contrarian view (believing the selloff is overdone) can obtain concentrated exposure to BHP/RIO/FMG (~50% weighting) through the SPDR S&P/ASX 200 Resources Fund (ASX: OZR) or BetaShares Australian Resources Sector ETF (ASX: QRE).
Australian Equities
The S&P/ASX200 Index posted a -1.85% return for the month of September resulting in a still healthy +30.56% return over the last 12-months.
Top-performing sector was the Energy sector gaining +16.38% in September. Oil prices have reached 7-year highs seeing shares prices in Woodside Energy gaining +22.51% over the month.
The Materials sector was the weakest sector over the month giving back -12.09%. The weak Iron Ore price saw sector heavyweights BHP Billiton sliding -17.50% and Rio Tinto -10.62%
International equities
The MSCI All World Index gave back -4.15% over the month of September still up a healthy +28.82% over the last 12-months.
The strength of the last month seen in Japan with the S&P Japan500 Index gaining +2.57% after the news of Prime Minister Shinzo Abe’s resignation.
The S&P Europe350 Index gave back -4.70%, followed by the US S&P500 Index which gave back -4.65%, and the S&P Europe350 Index which gave back -4.70%.
The S&P Dow Jones Emerging Market Index gave back -3.44%. The weakness driven by the Chinese market. The S&P China500 Index down another -2.06% and now -21.84% since peaking in February.
Property and Infrastructure
Australian Property Index weakened -2.18% over the month of September with Global Listed Property (Hedged) retreating -5.52%.
Hedged Global Listed Infrastructure was more resilient giving back -0.54% over the month. The supply chain congestion amid continued economic reopening is positive for infrastructure assets.
Fixed income
The Bloomberg Australian Bond Index gave back -1.51% over the month as markets once again start pricing in the expectation of a higher future interest rates.
The 10-year Australian government bond yield is currently paying investors +1.48% per annum which is much higher +1.16% a month earlier.
GENERAL ADVICE WARNING
The advice contained within this document does not consider any person’s particular objectives, needs or financial situation. Before making a decision regarding the acquisition or disposal of a Financial Product, persons should assess whether the advice is appropriate to their objectives, needs or financial situation. Persons may wish to make their assessment themselves or seek the help of an adviser. No responsibility is taken for persons acting on the information within this document. Persons doing so, do so at their own risk. Before acquiring a financial product, a person should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.