Q3 2021 Update

30 August 2021

Q3 2021 saw equity markets broadly track sideways. The main features were supply constraints, growing fears of stagflation, loosening COVID restrictions, concerns regarding China, and continued substantial capital flows into equities.

While a few countries remain in lockdown, most of the world is firmly past the Delta variant and adopting policies that treat COVID as an endemic. Most economic activity is opening back up, which has led to supply constraints, shortages and price spikes. The transitory inflation narrative is looking increasingly threadbare. How long can inflationary pressure be regarded as transitory?

Natural gas, coal and bulk shipping prices are at levels last seen in 2008 and oil prices are at multi-year highs. There is growing evidence of mounting wage inflation in critical sectors, most notably for HGV drivers in the UK. The consequence of a retreat from globalisation, if sustained, will give domestic workers more leverage. Slowing economic growth and rising prices have revived news stories from the 1970s. The term “stagflation” has been searched on Google 10x more in September than the average rate of the last decade.

Having retreated from the post-pandemic highs in March this year, Treasury yields have started to drift back up. However, for now, they remain some way below the forward expectation for inflation. Real interest rates remain negative and thus unlikely to halt the flow of capital into riskier asset classes, such as equities.

From now to the end of the year, there will be a seasonally strong level of US Treasury issuance. The usual political theatre of the US government debt ceiling management shouldn’t be significant. However, with a White House gaining a reputation for being clumsy, this cannot be taken for granted.

There has been growing unease regarding events in China. What started as a specific halt to the proposed IPO of Ant Financial a year ago has widened into a general crackdown on several sectors. The main political initiative is the pursuit of “common prosperity”, a Chinese version of “levelling up”. The rapid political redirection of resources has unsettled financial markets, with several high-profile investors now declaring China to be uninvestable. George Soros expressed surprise that the Chinese Communist Party could be, well, so communist.

While there is a debate about whether this leaves Chinese assets looking attractive or not, the bigger question is whether the Chinese housing crisis will spread. China could well add financial contagion to its long list of export successes. However, fear of a Chinese financial meltdown has been a long-time favourite stock market scare story. What is clear is that China faces many of the same problems as the West. They are just politically less constrained in taking action. By taking pre-emptive moves to mitigate financial distress and avoid social unrest, China will probably recover investor confidence at some stage.

Equity markets saw a bounce in the economically sensitive value stocks in Q1 this year, followed by a reaction back favouring growth names in Q2. In Q3, there was a more mixed performance, and most of the broad equity indices in the UK were flat to small down over the period. September saw a weaker trend with the notable exception of energy stocks.

Many commentators are pointing out that the stock market looks expensive, which, although technically correct, is an incomplete statement. There have been unprecedented flows into global equities as $ trillions of capital trapped in negatively yielding assets seeks higher returns. Market leadership is becoming increasingly narrow as investors avoid specific sectors (oil and gas because of ESG concerns), banks (credit risks), China (political risk). The chosen few sectors almost inevitably become expensive on traditional measures.

However, on most of these measures, the UK market looks relatively good value. The recent fall in the value of £ is only likely to increase overseas and private equity interest in our corporate assets.

The IPO market in the UK continues to operate at a cyclical high.

We continue to take a keen interest in meeting as many companies as possible. The count for September was 142.

However, while we remain positive on UK mid and small-cap stocks, we remain selective in our approach.

Written by Jeremy McKeown