As we emerge from the shadow of the virus, the world is facing new challenges. We will need to confront a series of rolling supply shocks, a de-leveraging of the Chinese economy and a profound change in the industrial landscape as global climate commitments are realised.
We consider below how investment policy can respond and whether the remarkably sanguine reaction of world markets to date can realistically continue.
Such is the scale of the economic shock from COVID that the road back to economic normality will, necessarily, be a long one. Today’s global energy shortages and supply chain disruptions are the first of many aftershocks that we should expect in the years ahead. Indeed, we see a series of rolling supply shocks becoming almost the norm for world markets. The challenge for investors is all the greater, because of two other changes that will confront us, at much the same time. The first is the restructuring of the world’s energy infrastructure to meet today’s highly ambitious de-carbonisation targets – a task that arguably involves the biggest capital spending commitment since the reconstruction of Europe after World War II. The second is the unwinding of the massive leverage in the Chinese economy, after 20 years of exceptional growth.
In the face of such profound economic challenges it is all the more surprising that asset markets continue to behave so well. Following the short but extremely violent decline seen in the spring of 2020, global equity markets have rallied steadily, bond yields are broadly where they were on the eve of the crisis and the US dollar is almost unchanged from a year ago. Can financial markets remain immune to such deep economic change and, if not, how can investors attempt to future-proof their portfolios?
A Green Era energy squeeze
The first energy squeeze of the green era, as the Economist describes it, is already a global phenomenon. A worldwide shortage of gas and LNG supplies has driven power prices higher around the world. A hot summer in Asia and a strong post-COVID rebound in industrial production have lifted demand, while supply shortfalls from Russian gas pipelines have left European storage well below seasonal norms. Adding to electricity shortages have been lower wind speeds in Europe and the UK, which have curtailed generating capacity (and highlighted the intermittency of some renewables). China is facing particular problems, with at least 20 provinces already rationing electricity to industries to meet President Xi Jinping’s targets for energy efficiency and pollution reduction. Across the world the energy squeeze is driving up factory input costs, squeezing consumer incomes and lifting already high global inflation rates.
For policymakers there is no immediate solution – yes, carbon-intensive energy should be more expensive but without alternatives, price increases will tend to lift inflation with little immediate impact on supply. To boost the production of clean, base load electricity requires primarily more nuclear capacity and this will take many years to develop. Additional gas storage and battery capacity will help (we are investing in both of these, via alternative energy funds and through bonds issued to fund transmission and storage). In the short term though, expect today’s higher energy costs to be with us for some time yet. Fortunately, central banks have indicated that they will be more tolerant of inflation overshoots in their new policy guidelines – such forbearance may be needed sooner than many had hoped.
Gauging the impact of Chinese regulation
At the same time as the global energy squeeze risks higher inflation, China is facing a deflationary risk from the likely bankruptcy of its second largest property developer, Evergrande. The company is a vast enterprise with 123,000 employees and 3.8 million contractors, and accounts for 6.5% of all China’s property debt. Across the country, real estate represents at least 25% of the gross domestic product, with more than 75% of China’s wealth invested in housing - so contagion issues are very real. Evergrande though, is no Lehman’s - there is comparatively little international debt at risk, while Chinese banks can effectively be directed by the state to lend to and support the sector. The parallel may be nearer to Northern Rock or even Bear Stearns, where the authorities faced a real tension between the moral hazard of a bail-out, and the risks to financial stability of taking no action. Some measure of state support is likely in our view (we have already seen the Chinese central bank increase liquidity) because Evergrande’s problems are symptomatic of wider industry challenges. In particular, new regulatory standards introduced last year are forcing much needed de-leveraging - this is a laudable goal but as any policymaker will tell you, embarking on the rapid deflation of asset bubbles normally comes with meaningful risks to the wider economy.
This is not the only area where Chinese regulation is evolving fast. Other sectors, including cyberspace, gaming, after-school tutoring and fan-based culture, are all feeling the hand of government policy. The speed and determination are disorientating for investors in China, but the building of an overarching regulatory framework, where we more clearly know what Xi Jinping’s government really wants, will provide much needed clarity. Indeed, some of the regulation is long overdue, including the protection of user data, anti-trust regulation and the monitoring of algorithms that drive user engagement. As with the property sector, some of the goals are to be welcomed – but once again the speed and suddenness of implementation comes with many risks.
Back on Capitol Hill
Missing no opportunity to invent their own crisis, US politicians have been hard at work manufacturing one. Democratic leaders are essentially trying to guide two blockbuster spending bills (a $1 trillion bi-partisan infrastructure bill and a hotly debated $3.5 trillion healthcare, education and climate package), at the same time as feuding about who is responsible for lifting the debt limit. The Bipartisan Policy Center, a Washington think-tank, suggested that the US government could default on its obligations as soon as mid-October if the debt ceiling is not raised. In 2011, a similar crisis resulted in a downgrade of the US AAA rating (Standard and Poors), while as recently as 2019, under Donald Trump, the US Federal government saw its longest shut down in history (35 days). While a full default has less than a 10% likelihood, according to a recent call with Larry Summers (former director of the National Economic Council for President Obama), the showdown is intensifying and a spill over into financial markets in October is entirely possible.
Against a backdrop of these three key challenges, how should investors now respond, especially in the light of the remarkable asset price increases they have experienced over the last 18 months? Four key issues are driving our thinking:
- The Federal Reserve signalled at September’s FOMC meeting that it is ready to start reversing its pandemic-driven bond purchases (QE). Tapering could begin as soon as the November meeting and will likely take around six months to complete. The run rate over this period will still mean that the world’s central banks will purchase an additional $2 trillion of bonds – in other words monetary policy will remain exceptionally loose.
- Despite the challenges above, the global economy remains strong. We have trimmed our figures for world GDP growth from 6.1% to 5.7% this year and from 4.4% to 4% in 2022, but this is still a very robust trajectory. It is more than sufficient to underpin today’s sharply higher corporate earnings and ultimately dividends.
- Real yields from global bond markets are now close to 40-year lows – this in turn makes equity yields attractive even as market valuations climb.
- In the fight against COVID variants, today’s vaccines have been remarkably effective and, with the advent of booster doses, should be even more so. This is allowing Western economies to gradually re-open, while emerging world vaccination rates are finally climbing. China and increasingly India are running extraordinarily effective mass programmes.
So how can portfolios best meet these challenges?
So how should investors respond? First, the continuing pressure on global supply chains implies higher inflation for longer, so we will continue to reduce government bond holdings across portfolios. Second, we will remain modestly overweight equities on the back of still strong global growth and robust earnings and dividends (for more cautious target return accounts, we will deploy portfolio insurance when cost effective). Third, we will remain cautious for a while longer on emerging markets, while noting that in the longer term at least some of the regulatory agenda in China is to be welcomed. Fourth, despite recent price volatility, we will continue add to climate-related equities, renewable infrastructure funds and bonds issued to finance sharply rising decarbonisation costs. Finally, we won’t be afraid of holding higher than normal cash balances – yes, cash yields are effectively zero but today’s market challenges make short-term market setbacks highly likely. And, because although we hope for the best from Washington, we are aware that logical solutions can often take some time to prevail…