As the end of the year approaches, investors are entering a traditionally auspicious season for equities. This time, though, we believe there is reason to be more cautious.
For one, we’ve enjoyed an unusual summer party, given that summer months are typically a weak season for equity markets. The party peaked on US Labor Day, and we now think the usual fourth-quarter equity-market strength may fail to materialize.
Furthermore, the US Federal Reserve (Fed) has expressed its intention to start tapering its USD 120 billion monthly purchases from November this year, probably by USD 15 billion a month. This means that, although markets remain firmly supported through the generous provision of liquidity, it is inevitable that the huge pool of policy support will shrink. Guessing what this will mean for investors is difficult, but we expect somewhat higher interest rates to have a dampening effect on the current ebullient ‘buy any dip’ sentiment.
Also, we believe that the other engine, that has driven stocks to all-time highs – namely, earnings – may well sputter in the fourth quarter. Input price pressure is hitting both industrial and consumer companies’ profit margins. This is illustrated by the gap between producer price indices (PPIs), which reflect input prices, and consumer price indices (CPIs), which reflect output prices. Table 1 shows the latest statistics for selected countries.
Meanwhile, the strong upward revisions to earnings forecasts seen over the past year seem bound to gradually fade. The upward momentum in earnings-outlook revisions has continued to be strong across the world, with only two downgrades for every three upgrades. We haven’t seen such numbers since 2004. However, our view is that this trend is unlikely to be sustained, as we see slower economic growth and margin pressure ahead.
The inflation debate continues to rage, with expert views ranging from it being a ‘transitory phenomenon’ to ‘stagflation’. Regardless of which view prevails, investors may soon find themselves stuck between a rock and a hard place. If inflation were to fall back in the coming months, companies would likely take the margin hit. But if inflationary pressures persist, investors would probably face headwinds from higher rates, to which growth stocks are especially vulnerable.
Regardless of which view prevails on inflation, investors may soon find themselves stuck between a rock and a hard place
Growth stocks now account for a large portion of market capitalization-weighted indices, and this level of concentration worries us. The US generates about 20% of the world’s gross domestic product, but accounts for 60% of the MSCI AC World Index. Within the US, about 25% of the S&P 500 Index is made up of six big tech stocks. Should your portfolio carry that much concentration risk, especially with many retail investors, robo-advisors and even pension funds charmed by cheap exchange-traded funds?
One really has to wonder whether these products still offer sufficient diversification. We’re happy to point out that at Robeco we still run active portfolios based on fundamentals!
We are getting used to China, the world’s second-biggest economy, making headlines. The China market has been weak so far this year, after the broad regulatory crackdown on some of its most popular segments. We are now confronted by the “common prosperity” mantra, a term first used by Mao Zedong in the 1950s, that may sound too ‘socialist’ to many ’capitalist’ investors. Internet, media, and property, in particular, have been in regulators’ crosshairs.
Internet has too much data, and property has too much debt. Both are seen as contributing to inequality and pose a risk to economic stability. However, we want to emphasize that this doesn’t mean that private enterprises are no longer allowed to make a profit. It has always been an element of our investment process in China to invest with a government tailwind. From that perspective, it is encouraging to see the Chinese government’s strong drive to cut the country’s carbon emissions.
It is good to see China move from quantity to quality growth targets, and sectors that can contribute remain strong market favorites. Overall, however, we think this is likely to drive valuation multiples lower for Chinese stocks, as too much profit will not be seen as politically correct. Foreign investors, who have continued to accumulate positions over the last twelve months, may well reduce positions in the fourth quarter, with too much political noise a deterrent.
This quarter, we will be heading into the winter season again, and will therefore need some heating. And as much as we are trying to get away from fossil fuels, and as quickly as possible, we will burn a lot of oil and gas again. After having risen sharply for over a decade, US production levels have fallen by 20% since the onset of the Covid-19 pandemic. With demand rising again and supply constrained, gas prices have risen dramatically. Utilities will struggle to pass this on to consumers.
China’s recent power crunch shows what can happen if rigid CO2 targets are set. Many provinces simply shut down coal-fired power plants to meet targets. More generally, firms in environmentally sensitive sectors are under pressure to contain investments, so supply is failing to follow demand in many areas. This is also the case, for example, for semiconductors, where it takes a long time for a new factory to get regulatory approvals.
Environmental inflation may become a new phenomenon. Will democratic governments succeed in getting their voters to accept this?
Environmental inflation may become a new phenomenon. Will democratic governments succeed in getting their voters to accept this?
As for the Covid-19 pandemic, the market has been moving from ‘stay-at-home’ plays to ‘reopening’ plays, with the ups and downs depending on infection numbers. The world is now divided between the countries that try to eradicate Covid-19 entirely and those that adapt to living with an endemic disease. The former are mostly located in Asia, China, and Australia, in particular, while most of us are living in the liberal latter.
In both cases, the evolution of vaccination rates will be crucial, though it is clear that even vaccinated people can fall sick and spread the virus, albeit in a milder form. However, in the specific case of China, which currently has very low natural immunity to the virus, Covid-19 remains a big risk and means borders will likely stay closed for longer. That said, the country’s domestic economy is big enough now, and can afford to do that.
In conclusion, we have turned more cautious on the macroeconomic and the earnings front. For now, this does have a large impact on our near-term outlook, especially for emerging markets, which have historically been more sensitive to tighter US monetary policy. That said, we will closely monitor corporate earnings outlook comments and the ongoing inflation debate over the coming weeks.
If your presents can be shipped on time, then I hope you will enjoy a peaceful Christmas to ponder over another remarkable year in equity markets.
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