Happy fall to everyone. It’s my favorite time year. It always has been, even before pumpkin spiced lattes and all things flannel came in vogue. As the cool weather sets in, we hope that you have a great fall and holiday season.
The third quarter gave us no shortage of things to consider: market volatility, rising interest rates, a good ol’ fashioned government debt ceiling showdown, a floundering infrastructure package, defaulting developers, haywire supply chains…lots of stuff to ponder, far too much to get to here. We will give a market update and some thoughts on a couple of these issues. As always, if you have questions feel free to reach out.
The S&P 500 eked out a small gain for the quarter of 0.2%. During July and August, the market continued its upward climb with the S&P hitting a new high at the beginning of September. It was not to last though. Rising treasury rates and the specter of inflation spooked investors and the market quickly dropped 5%. Elsewhere in the world, rising energy costs and aggressive regulatory measures implemented by China pressured global markets. The foreign traded Chinese stock market, and other major markets suffered corrections, with many of their indices falling more than 10%.
It was good to see the market take at least another breather. It’s basically been on a non-stop upward climb since the Federal Reserve announced in March 2020 their intention to purchase $120 billion in US debt every month. The economic recovery from the initial COVID lockdowns has been robust, but many argue the main driver behind the continued market gains is the Federal Reserve’s asset purchases. The liquidity those purchases provide appear to have been necessary to avoid an economic collapse during the height of the lockdowns but at this point we might be getting too much of a good thing. The famed economist/professor, Mohamed El-Erian, recently remarked in a Financial Times article:
For their part, investors should recognize that the enormous beneficial impact on asset prices of prolonged central bank yield repression comes with a consequential possibility of collateral damage and unintended consequences. Indeed, they need only look at how hard it has become to find the type of reliable diversifiers that help underpin the old portfolio mix of return potential and risk mitigation[i].
One impact of additional liquidity and low interest rates has been consistently rising asset prices, such as we have witnessed in the stock market, bond market, real estate market, and just about almost every financial instrument. Many of these markets have hit all-time highs recently and, as we remarked in our last commentary, stock valuations are high on a historical basis by almost every metric. When the Federal Reserve tapers their asset purchases, which they will likely do in the near future, a part of the support for high asset prices will be removed and the market will be forced to stand on its own.
The unintended consequences of the Federal Reserve’s actions may play out over a long period of time. For instance, pushing asset prices to historical highs may mean we have to endure a subsequent long period of low returns. If you want to know what this might look like, Bank of America’s (BofA) research arm releases a chart forecasting 10-year returns (see right). One nice feature of this graph is they include their track-record since 1990 and, importantly, they’ve been in the ballpark of actual returns most of the time. As of now, they have the market, as defined by the S&P 500, pegged at an annualized negative rate of return over the next 10 years. GMO, an institutional investor, publishes a similar analysis, estimating forward returns for the next 7 years[ii]. Theirs, shown below, presents an even less rosy picture (an important side note…they present it in “real return” meaning, return minus inflation).
These estimates are not prophetic, but they are informative. The process BofA and GMO use for these estimates examines forward economic growth potential and assumes a reversion to the mean of investment returns, earnings per share growth, profit margins, and valuations. In simpler terms, if the US market is to repeat the performance of the last decade, it will have to buck historical trends or tap into some new channel of economic growth. Possible? Yes. Probable? No.
Looking back at the last 10 years, it is hard to fathom an extended period where the S&P 500 doesn’t perform exceptionally well, but history has shown there can be long periods of low to no growth in developed stock markets. For example, the United Kingdom’s FTSE 100 index is today just slightly above the value it was in 1999, i.e., last century. I was wearing Reebok Pumps and Starter brand hats when Japan’s Nikkei 225 Index hit its high-water mark in 1989. We could site several well-reasoned explanations for those paltry returns but they both start with the same over-arching factor…valuations. 1999 was the height of the dotcom boom when tech companies were selling at ridiculous multiples. 1989 was the height of the Japan craze where markets had assumed that Japanese companies had discovered the secret sauce to perpetual growth (sound familiar?)[iii]. Even the S&P 500 has had these periods. If you refer to the graph from B of A, the 10 year forward returns for the S&P 500 from 1998, 1999, and 2000 were negative. With current market valuations, me might be staring down a similar period.
This doesn’t mean we need to run for the hills, go all to cash, or bury our head in the sand. There are many of different paths the market can take, even if performance isn’t what it has been. We are not suggesting “crash and burn” is inevitable. In fact, the current market could continue to be supported for some time. If S&P 500 earnings grow robustly like many predict, valuations will be more reasonable, though still a long way from historical norms. Also, “the market” is more diverse than most people think. The S&P 500 performed poorly in the first decade of the 21st century but there were pockets of domestic equities that did well and many foreign markets, like emerging markets, had strong performance. We believe similar pockets of more reasonably priced assets exist today.
Chinese Regulatory Crackdown
Much of the market turmoil experienced in the third quarter was stimulated by developments in China. The Chinese Communist Party (CCP) has taken several regulatory actions over the last year aimed at reducing big tech influence, shifting capital investment to different industries, eliminating the inflating costs of private tutoring, reducing carbon emissions (or more accurately stated, reducing reliance on fossil fuel imports), and reigning in overextended debt in the construction development sector. These actions have reverberated across markets as corporate profitability in some sectors has been directly impacted or, as in the case with the private tutoring industry, eliminated (private tutoring companies now must be not-for-profits). In addition, Evergrande, the country’s largest and most indebted real estate developer, is on the verge of collapse. They have missed several note payments to their bondholders and further note defaults look likely.
Unraveling the decisions of the CCP – their motivations and the long-term impacts – is difficult, to say the least. Some of the world’s most successful investors have contrasting points of view regarding China. For instance, Ray Dalio says that investments in China can’t be avoided and should be embraced. In contrast, George Soros has labeled China as un-investible. Some have labeled Evergrande as China’s “Lehman moment.” Others see it as a small hiccup on the road to fix structural problems and promote Xi’s “Common Prosperity” doctrine.
Diverse opinions concerning China is nothing new. For the last two decades, we’ve been reading about the impending collapse of the Chinese economy while at the same time reading about China’s eventual assumption as the world’s greatest super-power. The reality is probably somewhere between those extremes. It is the second largest economy in the world and the largest by population. The country has experienced unprecedented economic growth during the last 30 years. The development of a large – and growing – middle class has created opportunities for growing corporate revenue. We also tend to view China not just the through the lens of the CCP. The corporations we own equity in support the life and livelihood of thousands, likely millions, of Chinese families.
In our view, recent events don’t change that over-arching outlook. We certainly don’t like the regulatory actions taken by the CCP (we believe in the superiority of a free market society. Also, we see some of these actions as discouraging entrepreneurship, productivity improvements, and innovation) but we see the intended utility of them. We also recognize that whatever the CCP does, it will be in the best long-term interest of the CCP. The timing of these regulatory changes is with purpose. It comes at a time when the country is benefiting from the re-emergence of the global economy. GDP growth was 18% in Q1 and just under 8% in Q2. This is a time where some short-term economic pain can be taken in favor of longer-term goals. But the recent regulatory actions do impact the risk profile of the country. The actions of the CCP have caused a lot of market volatility and have in some specific cases (private tutoring companies) destroyed wealth. In recognition of these increased risks, we are diversifying more broadly across Asia.
Inflation – Energy Prices Soar
Inflation continues to be at the center of debate and concern across markets. In July and August, inflation remained at over 5%. September results had not yet been released at the time of this writing, but inflation is expected to be lower (we’ve heard that before) as there are signs that many of the largest inflation contributors, such as airline fares, hotel fees, and used car prices, had decreased. However, the supply bottlenecks contributing to inflation don’t appear to be loosening up. In fact, they might be getting worse. We continue to have faith in supply side economics: as prices increase, purchasing will slow and this will help bring equilibrium back to the supply chain. That process may be a bit of a grind, and take some time, as the global economy muddles through an unprecedented whiplash of demand.
More concerning as of late is the recent surge in energy prices. Power shortages are acute in China and India right now. Warm weather and the strong economic recovery have pushed energy demand to an all-time high. In addition, the central Chinese government is pressuring its provinces to reduce their carbon dioxide emissions, a difficult task for a country reliant on coal for 70% of its energy generation. The nation has started rationing power and forcing day-long factory closures. With winter around the corner, China and India are both looking to liquified natural gas (LNG) imports to help fill the gap. Unfortunately, Europe also relies on LNG imports for much of its energy production and, in this global economy, increased demand in Asia – along with other factors – is pushing the price of natural gas to all-time highs across the globe.
The price of crude oil has also been increasing, recently rising to a 7 year high. Oil may be seen as the red headed step-child of energy generation but that child is still the main breadwinner for the family. Oil, along with its other carbon emitting siblings, can also be stored or produced at varying rates to adapt to variability in energy demands. In contrast, wind production and solar conversion can’t be ramped up during, for instance, hotter or colder days when energy consumption peaks. Renewables also present a problem when mother nature decides not to behave herself. For example, the share of electricity provided by renewables in the United Kingdom dropped in the spring of 2021 from the year prior because there was less wind and fewer sunny days. Texas, of all places, also had to deal with this reality last winter when an ice storm froze wind turbines across the state. The cold snap had pushed up energy consumption and decreased energy output at the same time. With colder weather just around the corner in the northern hemisphere, energy demands will increase and already stretched power grids will have to increasingly rely on carbon emitting sources of energy.
Oil producers seem loath to meet this increased demand with increased production. The Organization of the Petroleum Exporting Countries (OPEC) is unwilling to increase their production beyond the already outlined planned increases. US energy producers have largely shifted towards a capital model that focuses on paying out cash to shareholders in the form dividends and share buybacks instead of reinvesting for growth. That is unlikely to change as the political climate makes the regulatory risk of investing in expanded production too high to entice companies and shareholders. Bottom line: be ready to pay higher prices at the pump and write bigger checks for your heating bills this winter.
Looking out to the longer-term, this same story of energy shortages is likely to play out time and again over the coming years as the world attempts to shift away from carbon emitting sources of energy. Governments will be toeing the line between reducing their carbon emissions and keeping people warm, fed, and traveling at a reasonable cost. One has to look no further than the US, whose administration is pressing OPEC to increase production while at the same time taking regulatory steps to reduce domestic production and transportation. Traditional energy producers are looking less willing to play the game. Rolling power outages and spikes in energy costs are probably here for some time. Some will call it growing pains. Others will call it self-inflicted foolishness. Either way, oil and natural gas aren’t going away, and the price is likely to go up in the near term. We will all be paying more at the pump but the energy positions in our portfolios should fare well. We will continue to look for opportunities to invest capital at an acceptable level of risk.Blake
[i] https://www.ft.com/content/225cb41f-2cfc-42de-9066-d0ce86a2fed7
[ii] https://www.gmo.com/americas/research-library/gmo-7-year-asset-class-forecast-august-2021/
[iii] https://www.ft.com/content/99a8158d-d08c-4de9-9712-2301b9497779