Can’t take my eyes off this market!

Many investors have suffered their worst month of the year in September as volatility derailed portfolios. Initial third-quarter estimates from Asset Risk Consultants (ARC), which monitors some 250,000 portfolios operated by 117 firms, showed losses across its indices ranging from 1.4% at the cautious end of the risk spectrum to 1.7% at the higher end.

So, what has caused this and are managers expecting more of the same or will this be just a blip? The post-pandemic recovery stalled in September as a combination of factors damaged investor confidence. There remain on-going concerns around persistent inflation, signals that the tapering of stimulus measures may begin this year, troubled Chinese property giant Evergrande and the sharp rise in the price of natural gas leading to broader impacts on the real economy, which all served to push markets lower.

The September upheaval has cast a cloud over what had been a decent year up to that point.

Returns for many investors before this blip had largely been driven by a rebound in Covid-stressed sections of the market and a revival in what are known as ‘value stocks.’ However, asset classes such as commodities, real estate, inflation-linked bonds, and alternatives also contributed to the recovery.

Let’s look at the detail in some of these important sectors.

Bond yield spike

The sudden sharp spike in US Treasury yields at the end of September certainly spooked investors and fund managers. The 10-year benchmark shot up above 1.5% for the first time since June, resulting in the S&P 500 posting its worst weekly drop since February. The market questioned whether the spike was the consequence of a more hawkish tone from the Federal Reserve to counter the inflation threat, or simply the market playing catch-up following the Covid dislocation.

The Fed’s signals have been somewhat confused. It raised rate projections at last month’s meeting, even though it cut its forecast for economic growth. Investment teams will naturally expect bond yields to move higher if growth continues to pick up. Many observers subscribe to the notion if we see decent economic growth over the next couple of quarters, it would not be surprising to see the Fed raise its rate projections further. This should result in seeing safe-haven bond yields continue to edge higher.

Higher inflation numbers

The question of whether higher inflation is here to stay will continue to be debated by investment managers and their analyst teams across all markets. Many leading analysts suspect it remains temporary, albeit with some caveats.

As a function of the imbalances of the reopening of the global economy, with notable mismatches between supply and demand, examples of elevated price pressures might prove to be higher and last longer than expected. To smooth out this risk, managers might well take the approach to balance portfolios risk levels between growth, defensive, value and cyclical styles.

Commodity inflation remains the greatest concern of the moment. The latest Chinese economic data suggest that the world’s prime consumer of industrial metals and raw materials is losing its appetite. Yet, metal prices are in overdrive. Bloomberg’s industrial metals index, based on futures prices for aluminium, copper and the like, remains well below its high from the last commodity bull market, although it has now doubled since its low last year. If inflation is not ‘transitory’ as most of us would understand it, then, what can we say about the odds that it continues?

China crash

Recently, there have been significant regulatory measures introduced by the Chinese government. This regulatory crackdown, which wiped billions off the nation’s tech stocks, is yet another destabilising factor that hit markets in September. This was compounded by the debt crisis at Evergrande, leaving the Chinese property developer on the brink of collapse.

This double whammy created big questions for investment managers as to how much and where to allocate risk to Chinese markets. We can see from many market reports there has been a profound shift in China’s political and regulatory backdrop, which brings with it the potential for positive structural reform. However, this also introduces significant regulatory uncertainty and greater intervention by the Chinese state. Fund managers generally do not like government interference and certainly will be wary if this is the strategy the Chinese will follow.

Most managers have retained small positions in China, taking the view that regulatory change should ultimately enhance the nation’s long-term growth prospects. We will have to wait and see on that. In addition to the regulations, investments teams believe the rise of ESG investing and a consumption boom could create opportunities in China, where the big tech firms still have the potential to thrive. We cannot ignore companies like Alibaba and Tencent. They continue to have competitive advantages, profitable core business areas and high-growth subsidiaries. The view is they may also benefit from a shift towards greater consumption, while the regulatory crackdown ironically makes it more difficult for smaller firms to challenge them.

The search for value

Elsewhere, investment managers have taken some profits from US equities, feeling better value can be found elsewhere. We have also seen further reduction to UK exposure. In the early summer, there was a number of managers who marginally trimmed US exposure, where much of the recovery had taken place and where valuations look frothy, even accounting for the premium in the world’s largest economy.

We have also seen managers diversify non-US exposure, trimming the UK and redistributing this to Japan and Europe but, in doing so, leaving overall equity allocation unchanged. Core bonds continue to look unattractive for portfolio managers particularly when set against a backdrop of tightening monetary policy and inflation. Many managers think this will remain elevated over the medium term.

In general, portfolios have already reduced fixed income allocation with many not holding any conventional government bonds and favouring index-linked bonds and short-dated corporate credit/bonds. There is a picture emerging that many managers have a higher exposure to alternatives, especially high-quality absolute return funds and infrastructure.

There are plenty of other views out there, which I am attempting to get to grips with in the coming weeks and months. The point is that the debate gets much more complicated and the stakes grow much higher once we accept this inflationary episode is more than a transitory phenomenon.

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