The 3rd quarter ended up being largely uneventful in terms of returns, but we saw a pickup in volatility in late September and broad price declines — as renewed fear crept into credit markets about possible contagion related to the collapse of Evergrande, a Chinese property developer.
For the quarter, the S&P 500 rose 0.58%, oil declined 0.27% and gold dropped 1.07%. Bonds were flat. Not surprisingly emerging market equities were down 8.28%, mostly on the heels of the Evergrande headlines. Evergrande defaulted on its interest payments recently. The question that we have about Evergrande is that since Chinese property stocks have been in decline for four years, could it be that the panic around its headline represents a major low for emerging markets? Markets tend to bottom out on extremely negative news and sentiment.
As we saw from the Evergrande news, developments in China have an impact on US investors. Indicators in China have been signaling slowing growth in the Chinese economy for a long time – factors such as electricity output and industrial production have been trending down since 2003 and retail sales since 2011. Slowing growth is a big challenge to any highly indebted system, which is a big reason that China and emerging markets have underperformed US equities since 2011. Not that the US isn’t highly indebted as well, but we do have deeper and more liquid capital markets and the world’s reserve currency. So, US assets (especially index funds) can be generally more attractive to global investors.
Ten months after the first covid vaccines became available, 3.5 billion people or 45% of the world population have received at least one shot. At this point, everyone in developed economies who wants a vaccine has been able to get one. Vaccine availability in many emerging markets has been a problem, but it is improving rapidly. Moreover, new medications are on the way. Merck announced a breakthrough pill that lowers the risk of covid hospitalization by 50%. Globally, the number of daily new cases has declined from 650,000 in August to 450,000 today. This has allowed most countries to loosen lockdown measures.
With the global economy set to rebound, the concern has shifted to central banks tightening their monetary policies. As we saw in 2000, 2008 and 2018, tightening monetary policy can negatively affect investment prices. We do not worry as much as others do, because we believe the Federal Reserve will move very slowly and cautiously to not upset markets. Furthermore, there is a difference between ‘tightening’ monetary policy and tapering, or slowing, the $120 billion monthly bond purchase that the Fed is making.
The Fed is not likely to hike rates until late 2022 or early 2023, and that is if and only if asset prices do not decline significantly and inflation does not become excessively painful (our base case assumption) between now and then. If those prove true, it will take another year or two beyond any interest rate increase to impact economic activity and asset prices. When the Fed started hiking rates off the zero level in late 2015, it took three years for those rate hikes to hit asset prices and force the Fed to reverse course and drive rates back to zero.
The case for equities over bonds remains strong. We see the recent rise in bond yields partly a result of a recent decline in covid cases (markets projecting more economic growth) along with the likelihood that inflation may be a bit stickier than previously believed. Bond yields will likely continue to rise with less Treasury bond buying by the Fed and the combination of massive fiscal expansion (increased borrowing/bond supply from the Treasury) and higher-than-normal inflation.
With microscopic yields in cash and bonds and the prospect for higher rates going forward, there is no real alternative to earn real returns other than in equities. With the pickup in global growth, cyclical equity sectors will likely outperform. With a shortage of industrial capacity from semiconductors to autos, industrial stocks stand to benefit from increased capital spending. Materials and energy stocks will gain from strong commodity prices and a weaker dollar.
Value stocks, which we own, do best during periods of strong global growth and a weak dollar. Tech shares, which we generally avoid since they are insanely priced, usually struggle in a rising yield environment. Value stocks, at present, are also three standard deviations cheap based on a composite valuation measure that looks at P/E ratios, price-to-book ratios and dividend yields (see chart on next page), so it’s where the money is likely to be made going forward.
There may be some consternation and market volatility over any political infighting about the debt ceiling deadline in December, but we will look to take advantage of such volatility and purchase investments that we have wanted to own at more attractive long-term prices.
We did not make many changes in the third quarter because not much has changed. We are certainly living in a period of high prices (and high risk) in growth sectors inflated by easy credit markets. Today’s easy credit has been underwritten by the Federal Reserve. Accordingly, and to protect downside, we own investments that have been out of favor for one reason or another, so we believe that our portfolio does not carry near the risk level that most other advisors’ portfolios do. Most advisors focus on not underperforming rather than assessing the risk and return profile of the investments they make.
We hope that you are enjoying your fall so far and we extend our sincerest gratitude to you for considering Highgate to help you with your investments. Please know that we work hard every day to make high quality decisions and that we strive to deliver a superior client experience.
We can be reached at 303-968-1230, or by email at firstname.lastname@example.org and are happy to perform a no-obligation portfolio evaluation for you.