Monday digest
Posted 19 October 2021
Overview: Have we passed the peak of supply disruption?
As petrol availability returned even to London’s suburbs, and temperatures outside rose again, so it seemed did global stock markets. Despite broader UK news flow still very much on the gloomy side, last week saw stock markets around the world turning positive for October, driving diversified investment portfolios back above where they had started the month. This begs the question: are we already past the point of peak supply chain disruption, or have market participants spotted other developments on the horizon that make them more comfortable with what looks like being a largely disappointing end to the year? On the first point, it is a possibility, but not a certainty, and with UK retail trade representatives whipping up fears over no toys for Christmas, there is clearly a chance the UK at least will work itself into another period of panic buying. The more important points in our view, however, are around China, and the first Q3 corporate earnings reports coming out of the US.
Regarding China, there have been persistent fears that its political leadership was failing to grasp the seriousness of the threat on domestic financial stability from property developer Evergrande going under, and a wider slowing of the economy because of increasingly frequent power cuts. On both issues last week, we saw the type of decisive action that investors have come to expect from Chinese policymakers over the past decade. First, the electricity price cap was removed for all heavy industrial users, like aluminium smelters and steel mills, which is expected to ease the China-specific energy crisis at the expense of those heavy industries. This is seen as a much lower price to the economy overall than the damage sudden power cuts inflict on all businesses. Second, Beijing delivered a very decisive acknowledgement of the risk arising from the financial troubles of Evergrande, while at the same time stating the situation was “controllable” and contagion “unlikely to spread”. Following the heavy sell-off in the Chinese sub-investment grade bond market last Monday, this could become the ‘do-whatever-it-takes’ moment for this testing episode in the Chinese financial sector.
To be frank, while the issues and concerns of the past weeks around a slowing of the economy on the back of the supply chain constraints have not suddenly disappeared, market participants may be coming around to accepting that the overall cycle remains on track for more expansion through 2022. That does not mean to say it will be plain sailing in markets from here to the end of the year. Of course, short-term selloffs on specific bad news (like unwelcome central bank statements) remain a distinct possibility. But in terms of general market sentiment, it does feel as if a page has been turned and markets are once again looking ahead with some degree of optimism.
Inflation – home and away
The Bank of England (BoE) now expects inflation to hit 4% or more by the end of the year. And while some of this comes from sharp wage increases in understaffed industries (like much-needed lorry drivers, who have reportedly seen wages rise as much as 15% this year) most people’s incomes have not risen nearly as much. The BoE reports that typical pay settlements are around 2-3% higher than a year ago. With prices rising and taxes set to increase, the average Briton has seen their real income fall. Similar trends can be seen in the US and Europe. Global supply shortages have pushed up prices but without a comparable increase in short-term growth prospects, meaning many consumers and businesses will see themselves as worse-off – putting a dampener on demand. These fears have been heightened by media talk of 1970s style ‘stagflation’, where prices continue to rise despite low growth. If that came true, it would mean an end to the post-pandemic growth cycle before it properly began.
We do not expect that to happen. Admittedly, some of the positivity from January seems overly optimistic now. The slower-than-anticipated unwind of supply constraints, and concerns over the Delta variant, mean the rough patch will likely spill over into the fourth quarter. However, these problems are unlikely to persist into the medium term, given global production resources for goods are merely ‘out of kilter’. For the cycle as a whole, underlying fundamentals remain strong. Household balance sheets are in good shape, supported by surplus savings built up during lockdowns, which will help households to absorb temporary price rises in energy and food. The three major central banks – the US Federal Reserve (Fed), European Central Bank and Bank of Japan, are unlikely to raise interest rates into the current cost inflation shock, even if some of the Fed’s representatives have sounded a bit more nervous about the persistence of inflation. The underlying reasoning is that tighter policy would drive down demand but do little to counter supply constraint-driven price pressures. The lower labour participation rate could push up wages over the medium-term, but we are still waiting on labour market tightness to feed through into increased consumer confidence/consumption and business investment.
In the meantime, spiking global inflation makes things difficult for emerging markets (EMs). EM central banks do not have the luxury of waiting out the inflationary storm like their DM counterparts. Many have had to tighten monetary policy this year, choking off growth while their economies are still reeling from Delta outbreaks. A loosening of global supply problems will be crucial for EM prospects, alleviating cost pressures and allowing policymakers to ease conditions. If global activity improves and the Fed maintains its loose monetary stance, we should also see downward pressure on the US dollar – a factor that almost always benefits EMs.
Q3 corporate earnings: rays of hope or shadows of doubt?
Corporate earnings season began last week, and despite the notable cooldown in global economic activity, analyst expectations are nevertheless upbeat. Earnings-per-share (EPS) for the S&P 500 is predicted to have grown 27% year-on-year for July to September, while the STOXX 600 – Europe’s benchmark equity index – is on course for 59.7% growth for the whole of 2021. As usual, investors can only gain so much information from corporate results. More important are the outlook statements and guidance on future earnings that give a more up-to-date picture of corporate health. This is particularly important as heavy supply constraints, rising prices and a dampening of growth, ratcheting up fears of a difficult winter ahead.
Outlook statements can give a good idea of how companies are coping with supply constraints and cost pressures. On this front, businesses overall appear to be managing quite well. That might seem contradictory, but analysts at Goldman Sachs put it down to three factors: (1) companies with high operational gearing (those whose fixed costs are a large proportion of overall costs) do well during economic recoveries as growth offsets cost pressures; (2) businesses often have a greater ability to pass costs on when supply pressures build rapidly; and (3) high excess savings among consumers from last year give companies an even greater ability to pass costs down. These factors bode well for businesses as we head into an uncertain end of the year. Costs are rising fast, but pricing power is high while background financing conditions are supportive.
Speaking of which, financial companies fared very well over Q3, and those positive results are in line with the cyclical rotation that excited investors earlier this year. Banks perform better when the yield curve (the difference in yield between long-term and short-term government bonds) steepens, as they can take deposits at the short end and lend at the long end. That tends to happen further through an economic cycle, when the recovery has matured, and growth has settled into a more stable pattern. Also supporting this is the performance of energy companies and – to a lesser extent – materials companies (here high raw material costs can be a challenge). Fuel shortages have been well-publicised, but wider commodity prices have also risen. Some commodities are benefitting from structural shifts to do with the world’s green transition. But we can certainly see a strong cyclical boost to demand and economic activity too. Recent fears over the Delta variant and weakening global demand (in the face of spiralling cost pressures) have put the cyclical positivity in doubt. But we see these problems as a bump along the recovery road, rather than an end to it.