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Monthly Wrap: July 2021

In July, markets focused on the latest Coronavirus variant, economic data and share market volatility caused by escalating concerns around Chinese government regulation.

       Written by George Lin
Senior Investment Manager | Colonial First State

Last month, the delta variant of Coronavirus caused an increase in new cases in a number of countries, especially those with low vaccination rates – including Australia, which saw a number of cities go into lockdown. For a third consecutive month, US consumer price inflation surprised on the upside, while at the same time, bond yields defied expectations and plunged again. And across the world, Chinese share markets experienced a massive sell-off – with billions of dollars wiped from the market as concerns about the nature of government regulation escalated. By month’s end, the ASX 300 was up 1.1%, while the Australian Dollar (AUD) ended July at 0.7351 US cents.

Key economic developments

In July, the pandemic reared its head once again with a surge of delta variant cases. Countries with low vaccination rates struggled to contain delta. From an economic perspective, Australia is one of the countries most impacted. The situation in key developed economies with high vaccination rates was mixed. While those countries also experienced sharp rises in the number of new cases, they’ve been primarily relying on vaccination as the main tool to control the pandemic and seem reluctant to adopt new and severe restrictions except as a last resort. The UK is an interesting case study. With 55% of its population fully vaccinated and another 14% partially vaccinated, the UK removed all social restrictions. While this led to a sharp rise in new cases, case numbers started to fall by month’s end. This may be an indicator for how developed economies will live with the pandemic.

Source: Factset

The global economy continued its solid, but uneven recovery. Global manufacturing sectors have expanded at a healthy pace despite some softness in Chinese data, as reflected in the Manufacturing Index. But for financial markets, relative performance versus expectation matters more and in this regard, upside economic surprises (as measured by the Citi Economic Surprise Index) have diminished due to elevated expectations. In particular, Chinese economic surprises have turned negative and are now surprising investors on the downside.

The weakness in Chinese economic data has emerged as a serious concern for markets. This is partly due to China’s status as the first nation thought to have controlled the pandemic which, in turn, provides the rest of the world with somewhat of a roadmap to a post-pandemic environment. From this perspective, Chinese economic developments since the start of 2021 could be a cautionary tale. Chinese authorities tightened policy in late 2020 and after a very strong recovery from the pandemic, economic indicators have since turned south. Growth in retail sales and fixed asset investment peaked in March and have decelerated significantly. While part of this softening in data could be part of the normalisation process, the extent and speed of the correction alarmed investors and Chinese authorities. As a result, the People’s Bank of China lowered the Reserve Requirement Ratio (RRR) – a key policy instrument in controlling the growth of credit in the economy – on 14 July by 0.5% to 10%. This is the first reduction in the RRR since late 2019 and it led to speculation that other policy instruments such as key lending rates will also be relaxed to support the economic recovery.

Source: Factset

In the US, Consumer Price Inflation (CPI) surprised significantly on the upside for the third consecutive month. Headline CPI rose 0.9% month-on-month in June, while the yearly price rise increased to 5.4%, which was the highest level since August 2008. Furthermore, core CPI rose by 0.88% month-on-month in June – a stronger increase than consensus expectations of 0.4%, bringing the year-on-year reading to 4.5%. As in previous months, the sharpest increases are seen in the sectors with supply chain issues, such as new and used cars as well as industries benefiting from the economic re-opening, such as airlines, hotels and car rentals. Arguably, such price rises are transitory and should fade over time. However, other components in the CPI also show solid rises which are likely to be more structural. For example, Owner Equivalent Rent (or OER, a measure of how much money a property owner would have to pay in rent to be equivalent to their cost of ownership), already has a large 23.7% weight in the index and rose 0.32% month-on-month. The other concern was wage inflation as the US labour market improves. Non-farm employment rose by 850,000 in June and reversed the downward trend in employment growth, which started in December 2020. Other indicators are pointing to strong employment growth in the US.

Source: Factset

As economic growth consolidated, central banks began to reduce or withdraw their monetary stimuli. The Reserve Bank of New Zealand announced an end to its asset purchase program in July, almost a year earlier than expected. The Reserve Bank of Australia (RBA) also announced a reduction in its asset purchase program from $5 billion per week to $4 billion per week from September. However, the economic impact of the Sydney lockdown means the RBA may delay this tapering. And while the US Federal Reserve (the Fed) did not announce any changes to monetary policy at its July meeting, it further signalled that the US economic recovery is gathering momentum and is making progress towards the Fed’s goals. Currently, financial markets expect a tapering to start in the US in early 2022 with an announcement before the end of 2021.

Key market developments

Despite the stronger-than-expected US inflationary data, long-term bond yields in the US and in other developed markets defied conventional wisdom and fell significantly. US 10-year yields fell from 1.45% at the end of June to finish at 1.23% at the end of July. Australian 10-year bond yields fell even further from 1.53% to 1.18% as the various lockdowns escalated concerns about the economy. The unexpected fall in yields was driven by an unusual but powerful combination of drivers:

  1. Technical factors such as the Fed’s change to the bank leverage ratio which caused US banks to hold more government bonds.
  2. Marginally weaker economic data in the US.
  3. Concerns about the negative economic impact of the spread of the delta variant.

Share markets had a very mixed month. Major developed market indices delivered significantly different returns, ranging from -9.94% for the Hang Seng to 2.27% for S&P 500. The Hang Seng was affected by a savage sell-off in Chinese stocks towards the end of July. This was initially triggered by new regulations on the education sector – a large and very profitable sector in China – which effectively decimated the current business model of listed education stocks. This escalated investors’ concerns about regulatory risk and led to aggressive selling in other sectors, such as internet and property development, which have also been the subject of increased regulation over recent months. On the other end of the spectrum, falling bond yields and a generally positive earnings season proved very supportive to US stocks. Australian stocks were remarkably resilient in July, given the continuing flows of poor news on the lockdowns – with the ASX 300 rising 1.1%.

Another casualty of Coronavirus developments in Australia and concerns about the Chinese economy is the AUD, which started July at 75.1 US cents and ended the month at 73.5 US cents, compared to a high of around 77.9 US cents in early March.

Source: Factset
Source: Factset

Looking ahead

While a number of countries have been impacted by the delta variant, the ongoing re-opening of other developed economies has continued. Many of these countries have learned to live with Coronavirus and so it seems that the most likely impact of delta is to delay – but not totally derail – the global economic recovery.

The delta variant is a greater short-term concern for Australian financial markets due to the lockdown in Sydney. However, the RBA’s assessment of the economic impact reminds us that, based on past experience, with sufficient fiscal support ‘the economy bounces back quickly once outbreaks are contained and restrictions eased’. The most likely outcome is disappointing economic growth in the September quarter, followed by a sharp recovery. Australian financial markets may be more volatile but will likely look through the economic slowdown. Admittedly, there is a high degree of uncertainty and much will depend on the duration and severity of the lockdown in Sydney. A significant extension of the lockdown – say, until Christmas – will test market resilience.

The fall in bond yields seems overdone and bond yields in developed markets will likely resume a rising trend before the end of the year. Even if one accepts that US Gross Domestic Product growth and inflation will moderate in the coming quarters, US 10-year bond yields at around 1.25% is difficult to justify by economic fundamentals. However, the patchy nature of the global economic recovery and the high level of indebtedness around the world mean the peak in bond yields will likely be lower than in previous economic cycles.

The main medium-term question for investors remains the threat of inflation in the US and how the Fed will react to it. While US inflation is near its peak, there is a strong possibility that it will be more persistent and overshoot markets’ expectations over the next year. The Fed, under Chair Powell, is the most dovish Fed in history and will likely tolerate an overshoot. However, the message being telegraphed from its last two meetings is that there is still a limit in its tolerance for higher inflation.

There are mixed views on Chinese economic and market developments. While the signs of a Chinese economic slowdown are real, the political cycle means authorities will be desperate to maintain economic growth at a sufficiently high level. The Chinese Communist Party (CCP) will hold its 20th Party Congress and elect a new leadership team by the end of 2022. After successfully amending the Constitution to allow for a third term, President (and Chairman of the CCP) Xi Jinping will want to ensure a smooth transition to his new term, meaning there will be an even stronger-than-normal incentive to maintain social stability and economic growth.

However, there are some worrying, longer-term trends which raise legitimate question marks about China. The latest regulatory outlook is a sign that global investors are belatedly (and reluctantly) re-pricing the geopolitical risks of investing in China to a more realistic level. The regulatory moves on the education, internet and property sectors over the past 12 months are driven by a mix of concerns on competition, national security considerations (on big data), concerns to address inequality in society (property sector) and the CCP’s penchant for social engineering (education). But the rights of investors rank very low in China. The above changes also reflect President Xi’s distrust of markets and private enterprise, as well as his preference for re-consolidating power to the CCP.

So, what are the implications for investors? While there is a preference for shares over bonds at this point in the cycle, and while reflation trade remains intact for now, a lot of good news has already been priced in – meaning, equity investors should expect lower returns in the second half of 2021.

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