Highlights:
· The jury is still out on whether near term inflation will turn out to be transitory or sustained. The Fed does, however, seem to be coming around to the notion that prices may stay inflated longer than they originally anticipated.
· COVID-19 continues to act as a headwind for the global economy, but seems unlikely to derail the economy again to the extent it did last year as vaccines get in to more arms each day across the world.
· A regulatory crackdown by the Chinese government and missed payments by some of China’s largest property developers spooked investors who fear it may cause a global financial contagion.
Commentary:
We dedicated last quarter’s commentary to the debate over whether the jump in year-over-year economic data was more likely to be transitory or sustained. While the Fed continues to insist that inflation is transitory, they have also been nudging up their outlook on core inflation every few months and are now showing a definitive willingness to start raising interest rates. At a minimum, the Fed seems to be acknowledging that supply-chain and inventory challenges are likely to last longer than they originally anticipated.
It has also become clearer that many companies are successfully passing on higher labor and materials costs to consumers. This is because the pandemic brought on a massive increase in demand for hard goods. Demand-driven price increases enable businesses to increase profits if they can produce the supply. The rub is that in order to supply more, business need to hire additional workers and have ready access to core materials. This isn’t typically an issue for businesses coming out of a recession, where unemployed workers are eager to find a job, and businesses that are reluctant to hire until they feel confident about consumer spending. This time around, due to the unique circumstances of the pandemic, consumer spending is robust and employers are anxious to hire, but workers aren’t willing or able to return. This would strongly imply that wages must increase in order to lure workers.
Accordingly, it is no surprise that the Fed lifted their inflation forecast for this year to 4.2%, which is more than twice the targeted level of 2%. However, Fed policymakers see the rate of inflation falling back to 2.2% in 2022 based on their working hypothesis that the global economy will return to normal as supply-chain disruptions caused by the pandemic work their way through the global economy. Ideally, the Fed would like to defer raising interest rates until inflation does recede closer to the 2% target level and the employment situation improves. Nevertheless, they also realize there is a possibility they will need to prematurely raise interest rates to cool inflation before the job market has fully recovered from the pandemic.
There is a school of thought that raising the inflation target could solve this dilemma and improve the long-term health of the economy. The theory goes that modestly higher and more stable inflation is likely to result in fewer and less severe recessions, which in turn should reduce the need for intervention such as central bank bond buying that can have a tendency to create asset bubbles. At the same time, raising the inflation target could arguably relieve the Fed of having to increase interest rates to tame inflation. Critics of raising the inflation target point out that, 1) inflation has been running under the Fed’s 2% target for the majority of the time period since the Great Recession, 2) raising the target now is akin to allowing the Fed to simply move the goal posts, creating a self-fulfilling upward cycle of expected inflation, and, 3) it’s unclear if say 3% inflation even meets the Fed’s mandate for stable prices.
The Delta variant is also throwing a wrench into the Fed’s plans for raising interest rates, as well as tapering bond purchases. It is unclear at this time what impact the Delta strain will ultimately have on consumer behavior, and the Fed has put on hold taking any actions until they have a clearer picture of its effect on consumer spending. Hopefully, the current trend will continue and the impact of this variant will be muted.
While the COVID-19 pandemic persists, its impact on the equity markets last quarter was relatively muted. Rather, it was China’s regulatory crackdown in July on publicly listed companies in the private tutoring, online financial services, internet-technology and other sectors that initially rattled investors. These crackdowns were interpreted as a potential indicator that China was beginning to decouple from the global market and especially from the U.S. market in particular. China later clarified that the intent was to address problems in these industries and help them grow in a proper manner with an emphasis on balancing development and security. This is part of China’s attempt to modernize its economy by lowering demographic inequality and promoting more sustainable, albeit possibly slower, GDP growth that is less dependent on financial leverage.
The most recent regulatory crackdown might have spooked investors, but it is consistent with China’s pursuit of economic growth over the last few decades. Relentlessly reforming the structure of its economy has allowed the country to become the second largest economy in the world in a relatively short period. Thus, it’s reasonable to believe that the most recent regulatory changes are not meant to slow growth, but rather to limit monopolies and improve data security and consumer privacy. If you believe this to be true, it is also reasonable to believe that China’s domestic policy objectives will continue to be devised around sensible political and economic goals that include the continued opening of its capital markets. Nevertheless, China indicated that in the future it would attempt to introduce new policies in a more cautious manner to give investors more time to digest new information and avoid market volatility.
The biggest concern for China’s economy now is its property market. A recent slowdown in housing sales appeared to put Evergrande, one of China’s largest real estate developers, with over $300 billion in liabilities, on the brink of insolvency. Investors are worried that the failure of Evergrande has the potential to set off a cycle of defaults among banks and other real estate companies. In fact, Fantasia Holdings, a Chinese developer of luxury apartments, missed a $315 million payment to lenders shortly following Evergrande’s missed payments of their own. Shortly thereafter, Chinese property developer Modern Land asked investors for permission to defer repaying a $250 million bond due later in October.
By some estimates, almost three-quarters of household wealth in China is tied to property. The loss of confidence in the property market could spill over and cause consumers to become gun shy about spending, further hurting the economy. Any intervention by the Chinese government to prevent this scenario from unfolding, by curbing debt for example, risks limiting overall economic growth.
Most economists agree that Chinese real estate has gotten expensive to the point of a bubble after one of the largest real estate booms in history. It is likely that China’s real estate bubble is larger than the real estate bubbles seen in Japan in the 1980s, the U.S.in the 2000s, or the longer-lasting unsustainable booms in European countries such as Ireland and Spain. All of those real estate bubbles eventually burst and had devastating consequences for their economies.
To this point, China has been able to stave off the bursting of its housing bubble. This is because, at least on the surface, China’s real estate bubble is different from the bubbles that eventually popped in Japan, the U.S. and Europe. For one, China’s economy is still growing more quickly than these economies were, even if the rate of growth has slowed in recent years. Second, China’s government has significant cash reserves and has established a precedent of doing whatever is necessary to avoid an economic crisis and social unrest. Third, the government has already taken steps to cool the housing market, such as restricting certain sales and home loans, which have slowed down price increases in recent years. These factors are likely not enough to overcompensate for years of too much construction and inflated prices, but the Chinese government will do everything in its power to try to navigate a soft landing to prevent a so-called “Lehman moment” in which a corporate collapse snowballs into a financial crisis.
Investors have and will likely continue to benefit from maintaining exposure to the world’s second largest economy, but recent events emphasize the ongoing political risks that are inherent in emerging markets. This is nothing new. Nor is it new that a diversified portfolio across geographies, market capitalization and investment style will always have asset classes that underperform on a relative basis to other asset classes in the portfolio during certain periods of time. Emerging markets have underperformed rather significantly relative to U.S. equities since the global equity market recovery that began in early 2009 on the heels of the U.S. financial crisis. This has resulted in emerging market equities trading at the most attractive valuations relative to U.S. equities in more than 15 years.
This does not mean a reversal is imminent, but we do believe there is a good chance that the next decade is unlikely to look like the last one. This, again, is not news. To quote Jack Bogle, the late founder of Vanguard, “It’s very difficult for any particular segment of the stock market to sustain superior performance. The watch word for our financial markets is, ‘reversion to the mean’ i.e. what goes up must come down, and it’s true more often than you can imagine.”
Urban Financial Advisory Corporation – October 2021