Monday digest

Posted 6 September 2021

Overview: politics and policy sitting at the head of the table
Equity markets (North America and Europe) began September in an upbeat mood, but this was tempered last Friday by the disappointing jobs report. The US economy created just 235,000 jobs in August, a steep decline on the 1.1 million generated in July, and short of economist expectations by more than half a million. The numbers appear to confirm that the US economy is still in a repair phase, potentially shelving US Federal Reserve plans to withdraw stimulus for the foreseeable future.

Meanwhile, in Europe, hawkish European Central Bank (ECB) members were busy positioning themselves for this week’s policy meeting. Their debate will focus on tapering the ECB’s own Pandemic Emergency Purchase Programme (PEPP). We note that the PEPP is currently limited to EUR 1.85 trillion, so is not as open-ended as the Fed’s initiative. Europe, of course, has another significant event to look forward to. In three weeks, Germans will go to the polls, and the outcome of this year’s federal elections could not be more open. For the past 16 years under Chancellor Angela Merkel, the biggest question facing the German electorate was which party would become the coalition junior partner. This time it looks like three parties will form the next government, with several combinations available. The accepted wisdom is that the Green Party is likely to be part of the coalition, especially if the Social Democratic Party of Germany (SPD) refuses to team up with the Christian Democratic Union (CDU), again. This means smaller parties may end up playing the role of kingmakers. Negotiations are likely to be drawn out well beyond the results day, but much of the pre-election sabre rattling should give way to pragmatism. There may be a knee-jerk short-term market reaction that then gives way to ‘business as usual’ as coalition negotiations play out. But as was clear with the Brexit result and the Trump tax cuts, policies do make an impact as they slowly feed into the economy.

China’s regulatory drive has been relentless in recent months, and the crackdown continued this week. Authorities summoned the most prominent members of ride-hailing platforms – such as Didi and Meituan – and warned them that unfair customer and employee practices needed improvement. The overall stock market impact was muted though, most likely as price-earnings ratios are already relatively depressed, and markets are starting to get used to the meaning of China’s “common prosperity” drive. But arguably the most surprising political development of last week was the resignation of Japan’s Prime Minister Yoshihide Suga, over the government’s COVID handling. Two former foreign ministers are in the race to replace him. Equity markets viewed this as a positive, calculating that it would increase the chances of additional fiscal stimulus. This may just bring us back to our opening thoughts – just as peak growth momentum wanes, policy stimulus is getting withdrawn, even if it is from exceptional levels. The business cycle will surely continue, but the transition phase can prove tricky, especially for markets with elevated valuations.

August market review: plenty for markets to think about
Looking back, August was a decidedly mixed month. While the lifting of restrictions and rapid vaccination programmes seemed to give the public a much-needed boost, the equally rapid spread of the Delta variant caused great concern and dampened the optimism built up in the spring. Global equities climbed for a seventh consecutive month, with the MSCI World index posting a 3.6% gain in sterling terms. But this was partly down to currency effects after sterling dropped in value against its major peers. In US dollar terms, global equities climbed a more modest 2.5%, showing steady, if unspectacular, returns.

Economic data was strong in the developed world. The restrictions that hampered activity for over a year continued to fade, supporting the strong recovery seen earlier in the year. Non-farm payrolls released at the beginning of the month showed the US economy added 943,000 jobs in July, the strongest figure in 11 months. Wage growth and inflation both strengthened too, adding to widespread reports of labour and supply shortages. The UK posted similarly strong jobs data, with employment intentions and vacancies at record highs. Europe had a slower opening process than Britain or the US, and was therefore behind in growth terms. But August’s data showed businesses are confident and inflation is strong.

These are all positive signs, but they are ultimately backwards looking. More current data – business confidence surveys – shows the global economy coming off the boil. Purchasing managers indices (PMIs) were less positive in the US and UK, suggesting we have passed peak growth. Europe seems to be at its peak now. This effectively confirms what investors already knew: the global recovery is strong but no longer improving. The added complication is the spread of the Delta variant, particularly now in emerging markets, where low vaccination rates make many countries vulnerable. When you combine these factors with the recent policy drama in China, investors could be forgiven for being nervous.

All in all, August delivered little to shock capital markets. There are certainly positive signs out there, but a turning over of growth, and the latest twist in the pandemic, could make things difficult for the rest of the year. Markets have upside left to find, but we are prepared for more choppiness ahead.

Germany’s benchmark stock market gets a much-needed makeover
From mid-September, Germany’s Dax will expand from 30 constituents to 40, with the old guard being joined by the next ten largest German companies by market capitalisation. The list is likely to include established names like Airbus and Porsche, as well as newer firms such as Hello Fresh and Zalando. Discussions on how to revitalise Germany’s leading index have been continuing for some time, and with so few constituents, the credibility of Dax was badly hurt by the collapse of Wirecard in 2020 – forcing index owners Deutsche Börse to launch a consultation on what needed to change.

Wirecard’s collapse prompted soul searching in Germany’s financial centres, but investors have long had complaints about the Dax. At just 30 companies, Germany’s main benchmark has fewer members than those of France, Italy and Spain – and less than a third of the FTSE 100. That is despite the German economy being comfortably the biggest in Europe. That narrow range of stocks makes the Dax much less reliable as an indicator of the German corporate culture. Together with lax governance standards, the index had been very susceptible to the troubles of individual companies – as Wirecard amply demonstrated. More companies, and greater standards, should therefore make it a better reflection of Germany. The inclusion of smaller companies is another positive in this regard. An index too focused on established companies can fail to capture the growth and dynamism that mid- to small-cap businesses bring. And, given that markets have rewarded growth so handsomely in recent years, Deutsche Börse will be eager to benefit from it.

There is a danger in overstating these changes, and Deutsche Börse has been criticised for not going far enough. The governance standards being asked of potential new entrants are hardly stringent, and many of the touted new Dax members are subsidiaries or spin-offs of existing companies. For example, Siemens Healthineers, a recent spin-off of existing Dax 30 member Siemens, is likely to be added. Equally, Porsche SE owns a majority stake in Volkswagen, and the Mercedes spin-off into Daimler Trucks could also make an entrance. So, some Dax family members will already know each other quite well. That said, including smaller spin-offs is still better than not including them, and it gives more variety to the index.

We can still draw positives. Tracking the Dax will reflect better the corporate base in Germany. The fact that the index will rebalance twice a year will also make it more attractive, as it means the index can incorporate performance changes more quickly. And, of course, in theory, smaller growth companies are meant to deliver superior returns. All of this is to say that the equity reshuffle is ultimately just a small step for German investing. Membership is expanding and entry rules are being updated, but the current milestone is neither the beginning nor the end of Germany’s financial modernisation.