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Investment Outlook Q4 2021

05th November, 2021

As we head for year-end, the economic recovery from the Covid-19 recession faces threats from rising Covid rates, inflationary pressures and an energy crisis. Company earnings on the other hand continue to rebound and surprise positively. What does this mean for the recovery?

Introduction

For most of 2021, investors have been focused on the progress of the recovery from the Covid-19-induced global recession and the likely reaction of central banks to any pickup in inflationary pressures. With the exception of China, the recovery has proceeded more or less as expected since the vaccination programmes started earlier this year. A China slowdown would normally elicit a bout of risk aversion among investors. Perhaps the difference this time is that it is central government policies that are stifling growth, and these can be eased or reversed by diktat if necessary (see below).

Covid management

The vaccination rollouts were expected to allow consumers and businesses to get back to normal activity, thereby driving the economic recovery. We pointed out last quarter that there was a reassuring disconnect between Covid-19 case levels in the UK and hospitalisations. With the further lifting of restrictions and the onset of winter, UK Covid rates have continued to rise and hospitals are coming under pressure once again. It seems like a matter of time before the UK will have to reintroduce some basic protocols to contain the rise in infections. These do not need to impact economic activity to anything like the degree that they have in the past. There is a lesson here about the pace of easing for other countries that are behind the UK in lifting restrictions.

Inflation everywhere

Investors began to revise upwards their economic forecasts for 2021 as soon as the world’s central banks and governments underwrote the global economy with a flood of liquidity and fiscal support last year. Those forecasts have been rising steadily over the past 18 months.

What has not been appreciated is the degree to which industrial shutdowns in 2020 have resulted in a clear-out of stocks of everything from base metals to semiconductors. Just-in-time inventory management has developed to a point where societies going into lockdown halted production of many of the world’s essential items. Restarting production amid shortages of labour and bottlenecks at ports is proving to be a painful process. As a result, the recovery from Covid has run head-first into supply chain bottlenecks, leading to a bout of inflation. On top of this, inadequate stocks of heating fuel as winter approaches have led to severe disruptions to global energy markets and sharply higher prices, particularly in Europe.

As we move through the current earnings reporting season, investors are focused on comments from company management about the likely progression of inflation. For the moment, the Federal Reserve and European Central Bank have reiterated their view that the price rises are temporary and will abate as supply disruptions ease. While both central banks are expected to reduce their purchases of bonds in the coming weeks, the threat of interest rate increases remains a 2023 phenomenon according to a majority of economists.

Meanwhile some of the largest unions in Europe, notably in Germany, are not waiting to see if current trends abate. They are seeking wage hikes to compensate for the higher cost of living. For the moment, this potential for a wage-cost spiral is not on the agenda of either of these central banks.

China’s own goals

China’s third-quarter GDP growth was lower than expected at 4.9% - down from 8% in Q2. Unusually, the current deceleration has largely been the result of official policy rather than external factors. Whether it be the deepening woes in the property sector, the disruption in the supply of power to industries or the closure of ports to exporters and importers, Beijing has had a hand in increasing the pressure on activity.

The property slump should be of particular concern to Beijing as it represents as much as a quarter of Chinese economic activity. Back in 2020, the Chinese authorities began a process of limiting the leverage within the property sector. The so-called “three red lines” were thresholds on financial metrics that were intended to limit the growth of developers with poor financial ratios. Within a year, one of the country’s largest developers, Evergrande, was struggling to meet its debt obligations and drawing focus onto a sector whose true debt levels are obscured by off-balance sheet exposures.

China’s developers are now frozen out of the funding markets that they need to meet their obligations to clients. Investors are increasingly expecting the authorities to underwrite a sector that has become a major driver of economic activity.

The power shortages in China have undoubtedly been driven by Beijing’s long-term environmental goals. The recent floods in vital coal mining areas in the east of the country have made things worse. However, Beijing’s policy of capping electricity prices to consumers in the face of rapidly rising fuel costs to suppliers has resulted in lower supply. The reaction so far has been to request energy-intensive industries to curtail output, which in turn impacts growth.

Since the original coronavirus outbreak in Wuhan, China has adopted a zero-Covid policy, closing ports for weeks on end following just a handful of positive cases. In August a terminal at the world’s third-busiest port was shut following one positive Covid case. Should the authorities maintain this policy into wintertime, this would likely exacerbate the global supply disruptions.

China’s policymakers will be busy over the next few months fighting fires that are, to some extent, of their own making. Investors will be watching closely for changes in policy that may alleviate some of the concerns of financial markets.

Faith in the recovery

In our second-quarter outlook we wrote about investors' recent preference for stocks which had performed best during lockdowns. They were stocks that could maintain profitability during an economic downturn and are represented within our model by the Persistence pillar. That change in investor preference might have been signalling concern about the growth recovery. However, as markets corrected during September and early October and global equities, as represented by the MSCI World Index, fell by some 5.6%, most measures of quality underperformed.

Our model of quality contains the four pillars of Profitability, Persistence, Protection and People. The People pillar ranks companies on how their management allocate capital among the various options available to them. Companies that buy back shares, pay dividends to shareholders, or avoid accumulating debt are ranked highest based on our metrics.

During the September drawdown it was the People pillar which fared best within our model. This pillar has tended to outperform when economies are recovering. It now seems to us that investors may have interpreted the fall in bond yields at the time of our last update as a reflection of a stalling recovery and that these concerns have waned somewhat in recent weeks. The current progress of the earnings season would support this assessment.

Conclusion

The recovery from the Covid-19 recession is being buffeted by supply chain problems and a lack of labour, resulting in a bout of inflation and upwards pressure on wages. These factors will linger well into 2023. Our analysis of equity market behaviour suggests that investors continue to believe in the recovery. This is being borne out in the current earnings season as company profits continue to surprise on the upside. 

We maintain an active approach to investment. When building equity portfolios, we prefer to focus on investing in profitable companies that deliver consistent results in the long run and allocate capital wisely. That approach is expressed through our investment process, which uses a quantamental approach to identify quality companies with ESG integrated throughout the process.

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