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Quarterly Wrap: September 2021

While monetary policy and inflation remained ongoing influences on financial markets last quarter, concerns about developments in China escalated, explains George Lin.

       Written by George Lin
Senior Investment Manager | Colonial First State

Over the September quarter, many developed economies with high vaccination rates chose to “live with the virus” as they proceeded with re-opening their economies. Economic data was somewhat soft over the quarter, particularly in China where China Evergrande – a highly indebted property developer – began its descent into bankruptcy. Several central banks in the developed world began reducing their asset purchase programs as their economies continued their recoveries. And towards the end of September, bond yields rose while share markets were volatile – with large falls in Chinese stocks. By quarter’s end, the ASX 300 was up 1.8% while the Australian Dollar (AUD) traded at 72.2 US cents.

Key economic developments

Over the quarter, Asian countries which had previously been successful in controlling the first wave of coronavirus have since lagged the rest of the world with vaccinations and experienced sharp rises in new cases. Australia fell into this camp. Major developed economies, which began the quarter with high vaccination rates, chose to persist with re-opening their economies – relying on mask mandates, less intrusive and limited social-distancing measures, and vaccination programs to manage their outbreaks. The threshold for large-scale lockdowns in these economies is very high given the exorbitant economic and social costs of the lockdown in 2020. Consequently, the economic and financial market impacts of this wave of the pandemic will be more limited.

Global economic data was mildly disappointing. The Citi Economic Surprise Index, which measures economic data versus market expectations, turned negative in both the US and China. While this weakness is driven partly by markets’ highly optimistic expectations, it is also consistent with purchasing manager indices (PMI) which are historically good readings of economic activity. In particular, China’s services PMI has fallen below 50 (a level which indicates activity in the sector is contracting) and has also deteriorated in the US, while China’s manufacturing PMI was last teetering at around 50, which confirmed other data which suggested some softening in the level of activity.

Citi economic surprise index
Source: Factset
PMI manufacturing graph
Source: Factset
PMI services graph
Source: Factset

China

A significant development over the September quarter was the sharp deterioration in China’s economic conditions and outlook. There are several dimensions to this. A key driver is the aggressive re-assertion of the Chinese Communist Party’s (CCP) role in both economic and social spheres. After a concerted media campaign against Chinese internet giants, a number of strict regulatory measures against their business practises were announced. Those were followed by the effective purge of various celebrities whom the CCP considered undesirable, as well as the “voluntary donations” of massive amounts of money to various charitable causes by Chinese tech tycoons, and ominous signs that heavy-handed regulation or re-structuring will be imposed on a number of other sectors, such as Macau gaming and Hong Kong property developments.

A second key development is the almost inevitable bankruptcy of China Evergrande, a large and highly leveraged property developer with up to USD $350 billion in liabilities. The Chinese government has been concerned about high property prices and speculation in the property sector, and has aggressively tightened regulations since mid-2020. While equating Evergrande to Lehman Brothers (during the Global Financial Crisis) is an exaggeration, the developer does pose a risk to some Chinese financial institutions and its demise will likely further weaken building activities, a key contributor to growth, and consumer confidence in China. Chinese economic data reflected this weakening economic environment: fixed asset investment, industrial production and retail spending all fell over the quarter. In particular, the large decline in retail sales from 8.5% year-on-year (yoy) in July to 2.5% in August has caused some alarm.

Finally, an energy shortage engulfed many Chinese provinces, including several coastal provinces which are significant manufacturing hubs, in the last two weeks of September. While periodic electricity outage is not uncommon in China, the scale and duration of the current shortage is unusually large. This energy crunch is likely to have a strong negative impact on short term Chinese economic growth.

China major economic indicators graph
Source: Factset

United States

US economic data indicated a deceleration in economic growth, from a brisk to a slower but still respectable pace. After experiencing strong growth from May to July, non-farm employment growth unexpectedly slowed to 235,000 roles in August. However, the number of job openings in the US continued to grow, with a record of 10.9 million job openings in August. Other labour market indicators such as wage growth and a survey of employers’ intentions to hire also point to continuing strength in the demand for labour. Taken together, the slowdown in employment growth most likely reflects a combination of the delta variant affecting the pace of hiring in face-to-face service sectors and supply side constraints in the US economy.

Change in US non farm employment graph
Source: Factset
US number of job openings graph
Source: Factset

US consumer price index (CPI) remained at a stubborn level consistently higher than the US Federal Reserve’s (the Fed) target of between 2–3%. Headline CPI inflation reached a peak of 5.32% yoy in June before easing to 5.2% in August. Similarly, core CPI inflation – which excludes volatile items such as food and energy – peaked at 4.45% yoy in June and eased to 3.98% in August. While markets were encouraged by the fall in annual inflation, there is much uncertainty surrounding the extent and persistence of the fall given that the drivers of the rise and fall in US CPI involve volatile items whose prices have been distorted by the pandemic. For example, used car prices rose sharply in June and July and then fell by a 1.5% in August, while air ticket prices fell by 9.1% month-on-month.

US CPI inflation
Source: Factset

Australia

Australian economic data released over the September quarter largely reflected the negative impacts of the lockdowns. Retail trade fell for three consecutive months as consumer confidence declined. Unsurprisingly, the fall was worst in NSW and Victoria, and sales from face-to-face interactive industries fell the most. The decline in consumer confidence was matched by a deterioration in business confidence which fell into negative territory in July. Conversely, the unemployment rate has behaved surprisingly well to date, falling to 4.52% in August compared to 5.06% in May – the last month before lockdowns impacted the domestic economy. However, the key driver of a lower unemployment rate was a fall in the participation rate from 66.2% in May to 65.2% in August as discouraged workers left the labour force. The level of employment fell by around 110,000 from May to August, with the fall concentrated in August when employment declined by more than 146,000 roles. The employment figure is likely supported by various governments’ job assistance programs and likely understates the deterioration in the labour market due to the number of underemployed persons. Other leading indicators, such as the number of job advertisements, point to further deterioration in the job market.

Economists have steadily downgraded Gross Domestic Product (GDP) estimates for the quarter as the lockdowns were extended. Currently, the median expectation is a 3.4% fall in quarter-on-quarter GDP growth for the September quarter, followed by a 2.1% recovery in the December quarter.

AU employment & unemployment rate graph
Source: Factset
Anz job advertisements graph
Source: Factset
Monthly change in AU retail trade & consumer confidence graph
Source: Factset

Central banks started to taper

Several central banks, including the Reserve Bank of Australia (RBA), implemented or announced a “tapering” of their asset purchase programs, which were initiated in early 2020 in response to the pandemic. The RBA decided to proceed with tapering its bond purchases (from AUD$5 billion per week to AUD$4 billion per week) in September, while leaving the target cash rate unchanged at 0.10%. The decision, while well telegraphed in advance, was a mild surprise to financial markets as most economists had expected the RBA would defer tapering due to the lockdowns in NSW and Victoria. However, the central bank reiterated its intention to “not increase the cash rate until actual inflation is sustainably within the 2–3% target range” and noted that “the central scenario for the economy is that this condition will not be met before 2024”.

The European Central Bank (ECB) also announced a “moderately lower” pace of bond purchase in its Pan European Pandemic Relief Program (PEPP). Although there was no formal announcement on the magnitude of the reduction, press reports suggested the pace of bond purchase would fall to €60-70 billion per month compared to the current average of €79 billion per month.

While the Fed did not announce a tapering at its September meeting, it strongly hinted a formal announcement would be made in November. The meeting statement said that “if progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted”. Chairman Powell further commented that tapering could be announced “as soon as” the next meeting and hinted that the asset purchase program would likely end at around nine months after the start of tapering. The Fed also signalled that it was increasingly confident of the strength of the US economy and as a result, the forecasts on policy rates moved higher.

Key market developments

Global bond yields traded range-bounded for most of the quarter as investors focused on the impact of Delta, disappointing US economic data and Chinese economic concerns. US 10-year bond yields reached a low of 1.18% in early August, however, yields started to rise in the last two weeks of September as investors became more convinced that the economic impact of Delta would be limited – shifting their focus towards inflation and the possibility of a tapering by the Fed. US 10-year bond yields finished the quarter at 1.54%, while Australian 10-year bond yields closed at 1.48%.

10 year bond yield graph
Source: Factset
Main equity indices graph
Source: Factset

Share markets had a volatile but flat quarter, with most making small positive gains. The S&P 500 rose 0.2%. Euro STOXX rose 0.4% while ASX 300 rose 1.8%. The notable exception was Hong Kong’s Hang Seng Index, which fell by close to 14.8% over the quarter – driven by poor Chinese economic data, concerns about China Evergrande and Chinese regulatory risks. During this time, the Chinese government either announced tighter regulations or stroked speculation about tighter regulations against private education, Chinese internet giants, Macau gaming stocks and Hong Kong property developers. The impact on share prices for stocks in those sectors was devastating, as reflected in the table below on major Chinese internet stock prices.
 

Table 1: Chinese internet stocks – share price performance as at 30 September 2021
  Tencent Alibaba Meituan JD.com
Fall from peak (%) 39.8 53.7 45.7 32.1
3 month change (%) -21.0 -35.4 -23.0 -7.3
Source: Factset
 
 

Another casualty of poor Chinese economic data has been the price of iron ore, Australia’s most significant export commodity. After reaching a peak of US$218 per tonne in mid-May, the iron ore price has fallen by around 43% to around US$120 per tonne by the end of September.

Iron ore spot price graph
Source: Factset

Forward-looking views

While US monetary policy and higher-than-expected US inflation remain ongoing influences on financial markets, what markets seem to be most concerned about at this time is the fall-out from China Evergrande, as well as the shorter-term economic outlook and the longer-term political and economic environment in China.

Despite media rhetoric, China Evergrande is not a “Lehman Brothers moment” for the Chinese economy – even if it does pose serious challenges to the country’s already weakening residential property market. The most likely scenario for China Evergrande is a state-supervised re-structuring, under which the government will try to protect the approximately 1.5 million Chinese households that have already fully or partially paid for their still-to-be completed residential units. The main debt providers of China Evergrande (the various Chinese banks) will have to write-off most of their loans, either explicitly or implicitly. However, since pretty much all major Chinese banks are owned by various levels of government, they will effectively be bailed out by taxpayers. Not exactly positive news for investors, but most likely not catastrophic to the Chinese financial system stability either. Foreign investors, who own around USD$20 billion in bonds, will likely discover they don’t rank high on the assistance priority list of Beijing. Overall, China Evergrande will likely exacerbate the economic slowdown in China, but will not cause a complete meltdown in the financial system.

The energy shortage, which is clearly having an impact on economic activity, is another short-term risk to the Chinese economy. Sell-side economists have already reduced China’s GDP growth forecasts for 2021 by as much as 1%. This is at least a short-term drag on economic growth, especially in terms of industrial production. The one positive from those problems is that Chinese authorities are now more likely to adopt more accommodative fiscal and monetary policies over the next 12 months in order to ensure a stable environment for the Winter Olympic Games in early 2022 and the 20th Congress of the Chinese Communist Party (CCP) in late 2022. In summary, a slowdown in economic growth – not a crash – is still the most likely outcome. So while there is a negative view on the short-term Chinese economic outlook, it is not overly pessimistic.

Finally, there are mounting concerns about the longer-term political and economic outlook for China. The concerted regulatory measures targeting various industries accelerated in September. While there are legitimate competition and social equity issues in all cases, it is simplistic to brush off the government’s changes as regulatory-driven. President Xi seems to have a vision for China – from both a social and economic perspective. The state media has made this clear by heavily promoting the term “common prosperity” in recent times. The policy aim is to address China’s massive income inequality, but the policy implications are unclear. What is clear is the CCP’s move to exert greater control in all aspects of Chinese society. The extent to which this will “crowd out” the private sector, reduce future economic growth and diminish the attractiveness of Chinese financial assets is unclear at this time.

Looking ahead, there may be greater volatility in share markets and higher bond yields in key developed markets. The rally in global share markets has come under some pressure over recent weeks. While this could continue during the December quarter, overall, any share market correction should be more of a medium-term, technical correction rather than the end of the share market rally all together. Given that the Fed is still likely around 12 months away from increasing the cash rate, if investors adopt a “buy the dip mentality” this may limit the size of any market correction.

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