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Monthly Wrap: August 2021

Global share markets remained resilient in August against a backdrop of coronavirus headlines and volatility in China, writes Senior Investment Manager George Lin.

       Written by George Lin
Senior Investment Manager | Colonial First State
   

Global share markets remained resilient in August, despite the concern surrounding Chinese regulatory action in Asian share markets, as well as the delta variant of coronavirus dominating headlines and driving new case numbers globally. Over the month, global economic data pointed to a divergence in activity across key developed economies, while in Australia, reporting season yielded generally positive results despite uncertainty on companies’ outlooks for the future. By month’s end, the ASX 300 was up 2.06% while the Australia Dollar (AUD) traded at 73.09 US cents.

Key economic developments

Over the month, the delta variant of coronavirus continued to drive case numbers in several countries – including New Zealand, which had been hailed as the most successful country in containing the pandemic in 2020. The spread in Australia showed little sign of abating, with New South Wales exceeding 1,000 cases a day and extending its lockdown to the end of September. Elsewhere, the US, UK and Western Europe also saw increases in new cases. However, these countries (with higher proportions of their populations vaccinated), have largely avoided imposing significant lockdowns and have relied instead on increasing vaccination coverage, softer measures such as mask mandates, and voluntary social-distancing to manage the latest surge.

Over the month, global economic data diverged across several developed economies. For instance, while the manufacturing sectors in the US and Europe continued to expand (albeit at a slower pace), the Chinese manufacturing sector was teetering on the brink of recession. The services sector is still expanding for major economies despite the increase in new coronavirus cases. However, the pace of the expansion in the services sectors for both China and the US seems to be slowing.

Source: Factset
Source: Factset

In the US, the labour market continued to improve. Employment increased in July, marking the third consecutive month of strong growth, while the unemployment rate fell to 5.4%. While this is higher than the pre-pandemic level of 3.5%, several indicators point to ongoing growth in employment. Firstly, there are currently more than 10 million job openings in the US. Secondly, the scheduled re-opening of schools in September as well as the expiration of unemployment benefit programs in a number of states are expected to ease labour supply constraints and drive growth in the jobs market.

In other economic developments, the run of higher inflation continued in the US. July CPI increased by 0.47% month-on-month, which is slightly better than market expectations and also lower than the 0.9% change for the previous month. However, headline inflation is still running at around 4.28% year-on-year, with core CPI inflation of 4.23% year-on-year. Other indicators have also pointed to persistently strong inflation pressures with a modest slowdown.

Source: Factset
Source: Factset

Australian economic data released over August began to reflect the negative impact of the lockdowns. Consumer confidence fell sharply, with New South Wales unsurprisingly seeing the largest decline. Retail trade fell by 2.7% in July – the second monthly decline. New South Wales and Victoria, the two states most impacted by lockdowns, led the fall in retail spending. The level of business confidence also fell, with the NAB Business Confidence Index falling to -7.87, which is the first negative reading since September 2020. The level of employment – a lagging indicator – has held up reasonably well so far, with the unemployment rate declining from 5% to 4.6% in July. However, the fall was driven by a sharp decline in the participation rate from 66.2% to 66%. The number of job advertisements, which is a leading indicator of labour markets, fell slightly in August – pointing to further weakness in the Australian job market over the coming months.

Source: Factset
Source: Factset

Despite the deteriorating economic outlook, the Reserve Bank of Australia (RBA) surprised financial markets by reaffirming its commitment to begin reducing the size of its asset purchase program in September. However, the minutes from the August meeting stated that the asset purchase program “will continue to be reviewed in light of economic conditions and the health situation, and their implications for the expected progress towards full employment and the inflation targets”. The RBA’s decision is clearly data-dependent, and financial markets expect the decision will be deferred given the significant deterioration in economic outlook since the RBA board met in early August.

In China, there are further signs of an economic slowdown. After a strong recovery in 2020, a number of leading economic indicators including retail sales, industrial production and fixed asset investment have declined markedly over recent months. This is partly a reflection of China’s pursuit of a less expansionary mix of policies as the negative effect of the pandemic faded. The Chinese government started to ease policy, with the People’s Bank of China lowering the Reserve Requirement Ratio (RRR) by 0.5% in July. However, the measures are modest so far. Credit data disappointed in July – with M2 growth slowing unexpectedly and total social financing (a closely monitored measure of the availability of finance in the Chinese economy) falling over the month.

Source: Factset

Key market developments

After large declines in recent months, global bond yields edged higher in August – with 10-year US bond yields closing at 1.30% (or around 7 basis points higher than a month ago). While persistently high US inflation is causing some concerns for bond investors, this has been offset by the downside risks driven by the delta variant and Chinese political and economic developments.

Share markets were strong considering the negative headlines. US share markets reached new highs – with S&P 500 rising 2.9% and NASDAQ rising by an even stronger 3.7%. Chinese share markets stabilised somewhat after earlier volatility for Chinese internet and education stocks. The size of the correction in Chinese internet stocks was staggering, especially in the context of a strong bull market for shares. For context, several major Chinese internet stocks declined by around 50% compared to their peaks in early 2021.

Table 1: Chinese internet stocks – decline from peak prices (as at 31 August 2021)
  Tencent Alibaba Meituan JD.com
Fall from peak (%) 37.2 46.2 44.8 26.5
Source: Factset
 
 

From an Australian perspective, the ASX 300 rose 2.06%. A significant development for markets over the month was the large fall in the price of iron ore – our single largest commodity export. A combination of weaker Chinese economic data and China’s action to lower commodity prices have driven down iron ore spot prices in China by close to 27% since their peak in early July.

Source: Factset
Source: Factset
Source: Factset

Looking ahead

The global economy remains on an uneven path to recovery, with accommodative monetary policy supporting the prices of financial assets. At this time, there is preference for growth assets over defensive assets despite the more diminished returns potential for assets like shares. However, the downside risk to markets has undoubtedly increased since early June.

One source of increased risk is the delta variant of coronavirus. Our base case remains that the variant may lead to a somewhat slower, more drawn out and volatile global economic recovery without an outright double dip. Key western economies with higher vaccination rates will persist with re-opening their economies since most governments are unwilling (for social and economic reasons) to go back into lockdown. Countries like Australia and Japan will likely catch up with the US, UK and Europe over the next six months and join the “live with the virus” camp. Even with higher vaccination rates, China presents a unique situation. Given the importance of the Chinese economy to the broader world economy as both a consumer and a global manufacturing bases, China’s zero-tolerance approach to the pandemic will likely contribute to inflationary pressures as supply chain issues persist.

As a result of the lockdowns in Australia, Australian GDP will most likely contract in the September quarter. Forecasts vary greatly, with the most pessimistic outlooks calling for a quarterly decline of more than 3%. While demand will recover when the lockdowns are lifted, there is an increasing risk that the strength of the recovery may be weaker given the prolonged nature of the lockdowns – especially in Greater Sydney.

Another source of risk is the economic and political developments emerging within China. While authorities have toned down some of the harsh rhetoric against stocks in a bid to reassure investors, the regulatory drive has not just continued – it has accelerated. For example, over the month, new restrictions on internet gaming for teenagers were announced, while the Chinese press targeted (among many subjects) the local liquor and wine industry, as well as the entertainment industry for inappropriate behaviours. Finally, the state media has heavily promoted the term “common prosperity”, after the tenth Central Finance and Economic Committee Meeting of the Chinese Communist Party emphasised the theme and called for steady advancement of this long-term goal. The policy aim is to address China’s massive income inequality, but the policy implications are unclear and have caused much debate among investors. In the context of the current Chinese political environment, it is difficult to ascertain the extent of this redistribution of income and the way it will impact specific industry sectors.

The last and possibly most discussed risk to financial markets is US central bank monetary policy and the impact of higher-than-expected US inflation. Markets fully expect a reduction in the size of the Federal Reserve’s (the Fed) asset purchase program, to be announced before the end of 2021 and implemented in early 2022. As long as this tapering is gradual, which the Fed has hinted it will be, the impact on markets will likely be manageable. The key risk is that US inflation turns out to be more persistent and higher than the Fed’s current expectations – thereby forcing it to taper more aggressively than expected. A number of indicators are pointing in this direction but, with a generally dovish Federal Open Market Committee, this is most likely a 2022 risk.

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