|Q3 2021||YTD 2021|
|Barclays US Agg Bond Index||0%||-1.6%|
The S&P 500 reached a new all time high at the start of September before dropping over 5%. Despite that drop, the market closed the quarter slightly positive and is up nearly 16% for the year. That leaves the US stock market at extremely high levels.
Treasury yields went up slightly during the quarter, resulting in a flat return for the US Aggregate bond index. The bond index remains negative for the year primarily due to the rise in interest rates during the early part of the year.
Headlines during the quarter were dominated by China’s regulatory crackdown and talk of central banks around the world tightening monetary policy. Both would seem to be headwinds for the market ahead but I think if problems from China started to spill into the rest of the world we’d see central banks retain their stimulative policy.
In my opinion, the bigger risk to markets came in the nearly parabolic move in selected energy prices during the quarter. Some analysts are predicting an impending energy crisis this winter. The spike in energy prices has not been met by any significant supply or capital spending and some countries are scrambling to ensure they will be properly supplied with energy this winter.
Global Central Banks tightening monetary policy
In response to the Covid pandemic, central banks around the world unleashed massive stimulus. The explosion in their balance sheets can be seen in the chart below:
Central banks are finally indicating that they will begin reversing their easy policies soon. The US Federal Reserve (the Fed) has been buying $120B in bonds each month for the past 18 months. Fed Chairman Jerome Powell stated on September 22 that the Fed may slow the pace of its purchases as soon as November. The Fed also announced projected interest rate increases greater than the market expected. While they’re only calling for a 1.75% rate by the end of 2024, the increased expectations caused Treasury yields to spike at the end of September.
Other central banks around the world either tightened monetary conditions during the quarter or signaled that they will soon. The European Central Bank is currently slowing its purchase program and the Bank of England and the Bank of Canada have signaled that they will tighten soon. Norway hiked its key rate last month and New Zealand just hiked its interest rate for the first time in 7 years.
Despite the tightening policies, central banks have uniformly stated that they will err on the side of providing too much support to the market. For instance, European Central Bank President Christine Lagarde recently stated, “The key challenge is to ensure that we do not overreact to transitory supply shocks.” She said policy “must remain focused on steering the economy safely out of the pandemic emergency.” Fed chair Powell has echoed her sentiment and has said he will be focusing on the data coming out in following weeks and months to determine if conditions are still right to begin tightening.
There was a seemingly never ending stream of negative news out of China during the quarter. China started by cracking down on private tutoring companies. These were ordered to restructure as non-profits, remove foreign investment, and put limitations on when they could tutor students. Publicly traded education companies saw their stocks tank and a number of companies declared bankruptcy.
In the beginning of July, China cracked down on ride-hailing app company Didi two days after it had its IPO on the New York Stock Exchange citing potential misuse of customer data. Chinese regulators forced the Company to stop signing up new users and removed its app from mobile stores. China later fined the company for antitrust violations and stationed government officials in Didi offices. Didi’s stock is down over 50%.
In August China imposed a three hour a week limit on videogames for minors under 18, hurting tech giant Tencent and other video game companies. Online gaming is now only available to minors from 8pm-9pm Friday-Sunday (and public holidays).
During the quarter, Tencent and Alibaba both announced they would be making ‘voluntary’ social aid contributions in excess of $15B each to help China achieve goals around sustainable societal innovations and ‘co-prosperity’ initiatives. Details were sparse and investors are still debating the ultimate impact of these ‘voluntary’ contributions but it’s clear that China is stepping up its oversight of their tech sector.
The biggest news out of China during the quarter was property developer Evergrande’s move toward bankruptcy. Evergrande is China’s most indebted property developer with an estimated $300B in obligations outstanding.
With real estate and related services making up a relatively massive 25% of China’s economy, any slowdown in this sector would have a significant impact on future GDP growth in China. Harvard economist Kenneth Rogoff says, “The problem is not just a single lender; it’s the whole Chinese growth model that is so dependent on producing real estate. It’s not a Lehman moment in that they get a financial crisis, but it could be just as painful if you look at the longer-term growth.”
Real estate makes up a disproportionate share of Chinese net worth compared to other markets such as the US and Japan. The following chart shows the value of real estate, stocks, and bonds in those three countries. Real estate makes up nearly 80% of China’s value.
Unfortunately China’s property also appears expensive as a multiple of income compared to other global cities:
The MSCI China Index has lost over 30% from its February high and many investors now call China uninvestable after all the recent government action.
ESG impact on energy and markets
ESG stands for Environmental, Social, and Governance. ESG standards have been adopted by a massive portion of the US market as they attempt to apply these non-financial factors as part of their analysis. A number of industries have essentially been black balled by the ESG movement, making access to financing more expensive and difficult to attain.
Aswath Damodoran, the ‘Dean of valuation’ and a finance professor at NYU, has called ESG the most overhyped and oversold concept in business. Damodoran recently stated ‘I believe that ESG is not just a mistake that will cost companies and investors money, while making the world worse off, but that it creates more harm than good for society.’
I think ESG is really just a marketing buzzword used to justify higher fees and gather assets by virtue signaling. However, it has had a very real impact on energy prices and the areas deemed not investable for ESG based investors. According to Crispin Odey, founder of London-based Odey Asset Management, “the ESG guys are causing terrible problems. They’re ensuring price rises are not met by supply.”
Hedge Fund manager Howard ‘Kuppy’ Kupperman says ESG = Energy Stops Growing. In his latest post Kupperman said, “I am increasingly convinced that we’re about to have a global energy crisis. Almost every day, we hear of a different policy plan to reduce energy production. We learn of new mandates, new taxes, more cancelled pipelines, more cancelled permits, and more penalties. What we don’t hear about is where the replacement energy comes from.”
That energy crisis he mentioned may already be upon us. China just ordered its top energy firms to secure supplies for this winter at all costs. Here’s a few charts showing the recent spikes in energy prices:
The energy picture is even scarier for Europe. Here’s a look at the European benchmark Natural gas price:
UK gas contracts for November delivery just surged 40% in a single day. The future is almost certain to include more carbon free and green energy. However, it’s going to take decades of carbon based energy production to sustain us through the transition to green energy. As Crispin Odey mentioned above, these price surges are not being met by an increase in supply. Energy producers are hesitant to invest in new production as it’s difficult to get financing, permits, etc. Coal miners have found it all but impossible to get bonded for new mine production as insurers don’t want to risk losing their ESG label by being involved with a dirty form of energy.
I think nuclear stands to be a real winner from all of this. Any country that is serious about carbon free energy production needs nuclear to be a significant part of their energy production mix. The sun doesn’t always shine and the wind doesn’t always blow.
I think this potential energy crisis is something to pay attention to going forward. Other things that would impact growth (such as problems out of China) would likely be met by stimulative central bank actions. Skyrocketing energy prices would be much more difficult to tackle.
The stock market and economy is at a potential turning point as we’re finally ending the period of massive fiscal and monetary stimulus from the Covid pandemic. Markets will increasingly face headwinds from central bank policies while also having to still work through increased inflation and supply chain issues. With US stocks still at extreme valuations, continued caution is needed by most investors.
Scott Caufield, CFA, CPA