By the FÉRIQUE Fund Management Investment team
A headwind that we identified in the second quarter did indeed prove to be significant in the third: China’s slowing economy and its impact on the demand for commodities detracted from the performance of the Canadian market and also that of emerging markets. In the case of emerging markets, however, it was above all the surprise regulatory tightening by the Chinese authorities that had the most impact.Printable version (pdf)
|U.S. equities (CA$)|
|MSCI Asia Pacific (all countries)||▼2.1||▲0.1|
|MSCI World (excl. Canada)||▲2.5||▲12.6|
|MSCI Emerging Markets||▼5.9||▼1.6|
|Interest rates %
|EUR / CAD||0.68||▼0.7%||▲5.3%|
|JPY / CAD||87.80||▼2.0%||▲8.1%|
|USD / CAD||0.78||▼2.8%||▼0.1%|
Even though most investors are already familiar with the Chinese government’s iron grip on the market, recent months have provided stark reminders that China has
a different kind of capitalism. As for our comments that the successful vaccination campaign could lead to an upturn in some industries, such as hotels, the rebound was delayed by the spread of the Delta
variant but still began to materialize late in the quarter.
As for the bond market, our expectations proved to be correct: credit spreads narrowed somewhat and government interest rates rose only slightly from their June level, even though the inflation data were well above target.
Over all, the third-quarter performance isn’t one for the history books; but, if we pay attention, it can help us better understand where the markets stand and where they are likely to take us by year-end.
|Net of fees returns as of September 30, 2021 (%)|
|Q3-2021||YTD||1 year||3 years||5 years||10 years|
|Aggressive Growth Portfolio
|Short Term Income
|Global Sustainable Development Bond
|Globally Diversified Income
|Canadian Dividend Equity
|Emerging Markets Equity
|World Dividend Equity
|Global Sustainable Development Equity
|Global Innovation Equity
Even though the return on bonds was low during the period, we can still find reasons to be pleased. One of the risks was that the inflation data, which continue to inch upward, would trigger panic among investors. Instead, we saw a moderate steepening of the yield curve, which will prove to be profitable over the long term because of higher current yields.
The market continued to agree with the central banks’ assertion that inflation will be transitory. A common method used to assess whether inflation is likely to become problematic is to compare consumers’ shortand medium-term inflation expectations. The table below shows the changes in this indicator:
As we can see, the uptick in short-term expectations has not yet spread onto a longer-term horizon. We can therefore conclude that the ingredients for a self-sustaining inflationary dynamic are not yet present.
This explains, among other things, why the steepening of the yield curve remains relatively modest and why the central banks are being patient when it comes to monetary tightening.
Although desirable in the long run, the gradual return to higher interest rates is a drag on shorter-term performance. With this in mind, it’s worth remembering that the merits of exposure to a particular asset class aren’t limited to the potential return. Combining weakly correlated assets helps create a better-performing portfolio whose overall volatility is lower than the sum of the volatility of its assets taken separately.
If interest rates continue to rise gradually, the low return on bonds will be offset by a solid stock market performance. The yield curve’s upward trend is desirable because it provides the bond market with the vigour it will need to perform well when the stock markets begin to weaken. The outlook is modest for bonds; but given the difficulty of predicting exactly when the stock market will correct, it’s preferable to maintain some exposure to them.
During a quarter of disappointing returns, developed countries outperformed emerging markets. The hope that emerging markets will rebound once they catch up with their inoculation rates has been supplanted by the impact of regulatory tightening in China.
Despite a bumpy upward trend for the oil price, the energy sector did very well outside North America. It finished the quarter in a solid first place in Europe, Asia and emerging markets, returning more than 10% in each region.
Changes in the crude oil price in the third quarter
Given the Canadian stock market’s stellar performance in the first half, the expectations for the third quarter were more modest. The slowdown in Chinese demand for commodities also created a headwind. Additional gains would have to come from other sectors, especially consumer discretionary. The spread of the Delta variant, however, interrupted the momentum of the industries benefiting from the end of the lockdowns and, with the closure of schools and daycare centres, detracted from overall productivity. The spread of the new variant had an adverse impact during the quarter, but this effect should eventually reverse itself.
Even though the Canadian stock market has been the top performer in our universe1 since the start of the year, all it did was tread water in the third quarter, returning -0.1%, as measured by the MSCI Canada Index.
The impact of the Chinese slowdown is expected to be felt until year-end. China’s central bank seems comfortable with the effects of the monetary tightening it embarked on earlier in the year and is increasingly critical of foreign monetary authorities for maintaining an excessively accommodative policy.
Even though the increase in the oil price is due mainly to the OPEC+ production policy, it is positive for the performance of the Canadian market. Without having being major, the market’s recent pause will also help, now that the election is behind us. The outlook for the domestic market is once again moderately attractive.
The end of the quarter was also difficult south of the border. As measured by the MSCI USA Index, the market’s 2.7% return in Canadian dollar was due primarily to the loonie’s depreciation against the greenback, rather than the return in local currency. As for the economy, the positive impact that the end of stimulus programs was expected to have on the labour shortage has still not materialized. Moreover, the political impasse over the debt ceiling fuelled uncertainty and undermined the market’s shorter-term performance.
In terms of sector returns, the differences were less pronounced than elsewhere in the world. The U.S. market received positive contributions from sectors that included financials, utilities and health care. Conversely, industrials, materials and energy subtracted the most value.
Forecasters still expect that matching the unemployed with job openings will stimulate the U.S. economy; but it seems we will have to be patient and wait until the accumulated savings run out and people are forced to go back to work. We will also be looking at the shopping season, which includes Thanksgiving and the holidays, to see whether it has an impact. If the lead-up to this spending spree does not see any changes in the U.S. employment data, we can start to conclude that the pandemic has caused a permanent shock.
In a scenario where the Fed gradually tightens monetary conditions and political polarization continues to impede the functioning of institutions and the latest vaccination efforts, the U.S. market will lose some of its relative attractiveness, given its current valuation. With global growth remaining above potential, markets with greater exposure to cyclical stocks could outperform the U.S. market between now and year-end.
Global equities again recorded results that varied from one region to the next. With the exception of the energy sector, which did very well everywhere, and to a lesser extent the financial sector, Europe again outperformed Asia and emerging markets. Asia came in second but with a negative return. Investors wondering why emerging markets recorded the worst performance should note that China, the epicentre of the problems with its regulatory tightening and the collapse of Evergrande, has a considerable weight2 in the emerging index. Moreover, the Evergrande crisis also affected the Brazilian market, given that it is a major supplier of the resources required for property development.
The MSCI Europe Index ended the quarter with a return of 0.8% in Canadian dollars, while the MSCI All Countries Asia Pacific Index returned -2.1% and the MSCI Emerging Markets Index returned -5.9%.Outlook and issues
Looking on the positive side, we see that emerging markets and Asia have made a great deal of progress with their vaccination efforts. For example, India can now administer an average of more than seven million injections a day. This increase has reduced the significant gap between these regions and Europe and North America.
Moreover, China’s new regulatory measures are not expected to create another dramatic shock wave. The market has largely priced in the repercussions of the government’s objective: to ensure sound and equitable development in the country. Limiting the energy disaster of cryptocurrency mining, addressing the scourge of cyber addiction and ensuring affordable access to education are measures that should pay off in the long run, even if the approach may seem extreme.
The expected catch-up vis-à-vis the developed markets could occur at the end of the year, assuming, of course, that Evergrande’s liquidity problems and overindebtedness do not have a domino effect.
The problems facing Evergrande are a reflection of the structural challenges afflicting the overindebted Chinese economy. The local authorities are aware of the situation and have been struggling for years to resolve it. The Chinese government’s priorities are clear, however, and it has tremendous means of achieving them. The government also guided the direction of the country’s real estate market early in 2016: houses are to be lived in, not used for speculation. It may choose not to rescue the real estate giant, preferring a short-term economic shock to persistent excess corporate debt.
Another potential risk is the appearance of a new variant. At present, the Delta variant is by far the most widespread, and the vaccines currently available are all effective against it. Given the vaccination rate reached in many parts of the world, as well as the countries where it continues to rise, the probability that a new variant will spread to the point of slowing the economy again is therefore rather low.
Percentage of cases caused by the Delta variant
Here we are heading into the homestretch. So far this year, investors have enjoyed a fairly high level of comfort in terms of the market outlook. The performance has generally been solid, but we are entering a somewhat uncertain phase. Signs of a slowdown are appearing; even so, we should bear in mind that growth is expected to remain high beyond 2022.
In a context where central banks are tightening gradually and inflation is still not signalling that it could turn into a self-reinforcing spiral, the conditions are right for the stock markets to end the year on a high note. Cyclical stocks, especially the consumer discretionary sector, could finally put up a nice rally. From the geographic standpoint, emerging markets may be able to take advantage of the cyclical momentum as well as higher rates of vaccination to make up some of their valuation gap in relation to the developed countries. Developments in China will obviously play a key role.
The environment will remain challenging for fixed income. Despite stable corporate risk premiums and the buffer they provide, the total return on the bond market will inevitably reflect the capital losses caused by rising sovereign interest rates. In summary, the consensus is that the attractive stock market returns will continue until year-end. The risk factors we have identified, while not high, are reminders that it is better to stay diversified and focus on the long term to avoid unpleasant surprises.
Enjoy the fall season!
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