- The Delta wave is moving in the rear-view mirror with minimal economic impact across most countries. Global supply-chains are becoming the most important headwind to growth, most notably for Europe and China. But we continue to expect global growth to remain above trend into 2022.
- As the third-quarter earnings season kicks off, we are confident earnings momentum will remain solid, albeit decelerating from the record second-quarter pace. We will be closely monitoring how firms comment on input-cost pressures due to ongoing supply-chain and labour challenges.
- We think the negative impact from increasing global energy scarcity should leave Europe and Emerging Market (EM) countries in a relatively less favourable position over coming months as some shortages may intensify in coming weeks.
- We remain overweight of equities versus fixed-income as we transition to the mid-cycle phase of the cycle. We expect policy support to moderate, but that’s mostly a reflection of the healing economic backdrop.
Too Many Clouds Gather of Near-Term Economic and Market Outlook
Between mounting concerns regarding the rout of China’s real-estate tycoon, Evergrande, global supply chains, an endless fiscal debate in the U.S., a more hawkish U.S. Federal Reserve (Fed), and downward revisions to growth expectations, investors had little positive news in September and global equities ended their seven-month positive streak. One key positive development in September was regarding the virus as the Delta wave appears to have peaked with minimal impact on economic activity in most countries. As the third-quarter earnings season kicks-off, we are confident earnings momentum will remain solid, albeit decelerating from the record second-quarter pace. Particular attention will be paid to input-cost pressures and profit margins as firms cope with supply-chain and labour challenges. While we don’t think the Fed is about to do an old-fashioned policy tightening and jump on the interest-rate brakes, the healing of the economy means short-term interest rates will be moving toward rate hikes.
Global Markets: Equities lacking oxygen at the top
A wave of short-term headwinds shook off global equities (MSCI ACWI, -4.1%) from their top and sent them lower in September. After a challenging year-to-date performance, Japanese equities (Nikkei 225, +5.5%) were a rare bright spot last month as investors cheered the arrival of a new prime minister that promises to accelerate public spending to support economic growth. In the U.S., tech stocks (Nasdaq 100, -5.7%) lagged the broader benchmark (S&P 500, -4.7%) while small-caps (Russell 2000, -2.7%) outperformed. Canadian equities (S&P TSX, -2.2%) outperformed their global peers as rising oil prices gave a booster shot to the energy sector. European equities (Eurostoxx, – 3.4%) outperformed slightly despite mounting evidence of rising inflation and slowing growth in Europe. Finally, emerging market equities (MSCI EM, -4.0%) were once again dragged lower by negative news from China.
It took some time to get there, but the Fed signalled it was almost time to start reducing the pace of bond purchases, most likely starting in November, which helped send U.S. and Canadian bond yields higher during the month. After a few months stuck in a narrow range, the yield on Canada’s 10yr bond surged last month (1.51% from 1.22% in August). Increased concerns about energy supplies helped Western Texas Intermediate (WTI) oil prices reach their highest level since 2014 at $75.03/bbl (from $68.50/bbl). A hawkish Fed and a risk-off mood in global markets lifted the U.S. Dollar (+1.7%) in September, but the loonie retreated more modestly (-0.5%) as oil prices jumped (+9.5%). Finally, the VIX volatility index (23.1%, from 16.2%) rose as market anxiety increased, but the spike in implied volatility seemed more contained than the depth of the S&P 500 September drawdown.
Global Equity Factors: Surge in yields helps Value outperform
The surge in long-dated bond yields helped global Value (-3.0%) stocks outperform their global peers (MSCI ACWI, -4.1%) as financials and energy rallied. On the other end, Quality (-6.4%) and Growth (-5.7%) were hurt by the underperformance of rates-sensitive tech stocks. Other global equity factor style performed in line with global equities. We will be closely monitoring the upcoming earnings season to see which type of companies is experiencing the biggest challenges on their profit margins. We suspect guidance will sound more concerned about rising prices than earnings results, which means there will be greater scrutiny of the topic of inflation when firms discuss their outlook. Given their smaller and more fragile profit margins, Small-caps stocks could be the most vulnerable to a profit-margin squeeze from higher input costs (Chart 1). For the broader market, however, we think the strong demand should allow firms to pass-on higher costs to clients and thereby help maintain margins.
Chart 1: Profit Margins Showing Greater Pricing Power for U.S. Large Caps
The chart compares the profit margins of S&P 500, Nasdaq 100, Russell 2000 and European, Asia and Far-East equities since 2019. We see that Nasdaq 100 companies have stronger and more resilient profit margins, whereas Russell 2000 companies have more volatile and weaker profit margins. Source: Bloomberg, BMO Global Asset Management, as of October 5, 2021.
China: Bad to worse?
Default concerns over Evergrande, China’s second largest developer with liabilities of $300 billion, is the latest development that has plagued Chinese sentiment. For markets, the concerns are two-fold: whether the company’s downfall leads to global financial contagion, and how China’s growth outlook is impacted. On the former, we believe global systemic risk is low. The share of developer loans is under 8% and the Chinese banking sector is well-capitalized with non-performing loans at multi-year lows. But most importantly, the Chinese government has high incentives to prevent contagion ahead of their 20th Party Congress next year, and just as in the past, we expect targeted stimulus in response.
The implications to the broader economy, however, are more negative. The property sector, which accounts for 25% of China’s Gross Domestic Product (GDP), is already slowing on the back of prior tightening measures; lingering uncertainty over the fate of Evergrande and other developers could weigh further on home sales and housing starts. Spillover effects of a property sector slowdown to broader spending are meaningful as at least 70% of household wealth is housing. Slowing Chinese demand spells trouble for raw materials, with iron ore prices down 40% from their May peak while copper prices are seeing a more muted decline of 12% (Chart 2). In addition to new regulatory rules over private sector companies as part of the government’s Common Prosperity agenda, China’s slowing economic trajectory is likely to continue weighing on earnings.
Chart 2: China Slowdown Feeding Through to Commodity Prices
The chart compares Iron Ore and Copper prices in 2021. We see that the price of both base metals sharply into the month of May, but have since cooled, especially Iron Ore prices, which fell sharply as the Chinese economy slowed this summer. Source: Bloomberg, BMO Global Asset Management, as of October 6, 2021.
Outlook and Positioning: Pricing power to support earnings
Our portfolio positioning was largely unchanged last month as we remain optimistic about equities, especially versus Federal bonds. We were expecting equity markets to experience some volatility in September given all the risks events that were lined up, including a Fed decision and U.S. fiscal negotiations, and we raised our cash balances during the month to be better positioned to add to equities on dips. The main changes we implemented in our portfolios in September were to buy U.S. financials as a sector overweight prior to the Fed decision while we increased our allocation to U.S. equities late in the month as equities were selling off.
While we expect discussions around the U.S. debt ceiling to keep investors on their toes in coming weeks, these risks are short-term in nature. With a mid-term macro-outlook that remains favorable to equities, we continue to see dips in U.S. and Canadian equities as buying opportunities, especially if supply disruptions cause further selloffs to equities.
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