Weekly Market Update - 02/08/2021

The week that was

The financial news of the week was surprisingly aggressive regulatory action by the Chinese authorities targeted at education companies, some of which are listed and have attracted considerable investment from Western investors. This roiled not only Chinese tech companies in general (capping off a fairly torrid year to date for the sector) but Western tech companies as well (where there are also worries of a regulatory overhang). Later in the week, the Chinese government walked some of this back and sought to reassure overseas shareholders that they were not themselves the object of authoritarian ire. Chinese tech companies rebounded, although they remained down for July and in many cases for the year to date. In sharp contrast, large US tech companies like Microsoft, Apple and Amazon have had a bumper year for revenue, profits and share price movement. Although, this shine came off a little later in the week as they reported huge earnings numbers while intimating that these might also be difficult to repeat. This pretty much sums up the increasing dichotomy between the US and Chinese tech giants - one is priced for perfection (and faces valuation risk) while the other now appears very cheap (but faces difficult to quantify, but now well acknowledged, regulatory risk).

All of that meant most markets finished the week flat, apart from the Japanese market which suffered from the imposition of harder lock downs while belatedly hosting the 2020 Olympics, with the only real bright spot in terms of performance being gold (up almost 2%). Gold was similarly the standout performer in July (up 5%) while the US and Australian markets were up by 1% and 2% respectively due to their corresponding national champions (tech and iron ore). Most other markets were flat in July, apart from Japan and emerging markets (again mainly due to Chinese technology companies which are a large part of the universe).???????

Bond market volatility ticked up in July, but ultimately bellwether long term government bond yields ended up down around 0.2% (quite a big deal in this yield compressed market) and by even more in Australia. On the one hand, the slight moderation in the US Fed’s preferred inflation measure (the Personal Consumption Expenditures ‘Trimmed Mean’ released on Friday) will help the Fed credibly stay on course keeping rates so low. On the other hand, broader measures of inflation continue to surprise on the upside and Fed Chair Jerome Powell also admitted last week to being slightly perplexed at the continued slide downwards in long-term rates. That meant that government bond funds performed well (up 2% in July) despite such low yields, but perhaps more interestingly inflation linked bonds also performed similarly well as inflation exceptions ticked back up. Usually this would be bad news for nominal (fixed interest) government bonds, lending weight to the ‘technical’ explanation of current bond yields - too many investors (especially banks) must own and buy more of them, primarily for regulatory reasons.

Still, and at the risk of adding yet more ifs and buts in this noisy economic environment, most commodities (apart from safe haven gold) were fairly soft in July. This lends weight to the argument that rates are heading downwards due to plain old economic weakness caused by resurgent COVID cases around the world, and a global economy that is already approaching the second peak of its V-shaped recovery, and potentially rolling over. Soon, we may be talking about W shaped versus square root shaped recoveries. A bit clumsy perhaps, but you heard it here first.

What we'll be watching this week

With both fixed income US Treasury yields edging downwards but Treasury Inflation Protected yields falling by more,?market implied inflation rates rose.?So-called break-even inflation rates are the difference between the two yields, representing a level of expected inflation that implies bond holders would be indifferent holding either bond. Break-even rates tend not to be very predictive of inflation (especially when it moves around a lot) simply because no individual or the market in general has a crystal ball. It does, however, provide a reasonable gauge of what investors think inflation is going to be, most of the time. Last week was an extension of the dynamic we have seen since the onset of COVID. We have 2 thought pieces on this very unusual situation:

• The first looks at the medium to long-term economics of negative real rates, as some commentators suggest they may be here for a while. There is a popular thought that this is just evidence of continued secular stagnation - just look at Japan and Germany who have hit the zero bound and muddled along for some time. The difference is that both these economies have very low inflation so real rates were actually not negative. Modest (say 2-3%) or high inflation combined with ultra-low rates is a different kettle of fish with very different implications.
• The second looks at the more visceral effects on equity markets in the short-term of ultra-cheap money. We have to consider the implications for the efficiency of markets and active stock-picking.

Having spoken to many fund managers and economists last week, we are also keeping an eye on?the US versus China tech titans versus the rest,?given not only the recent volatility of Chinese stocks but the?recent earnings reports from the US. Put simply, if US tech earnings continue to grow at hitherto unprecedented rates of 10-15% per annum, then investors should expect decent, if unspectacular returns. If that doesn’t happen, we will look back and say it was obviously a bubble that anyone should have seen. Similarly, if the Chinese government starts to ease pressure on Chinese listed companies (especially those with foreign investors) and COVID eases elsewhere in Asia, this will look like a classic cyclical buying opportunity. If neither thing happens and the geopolitical environment worsens it will, equally obviously, look like in hindsight like the beginning of the end of the China super cycle. We think much of this is still unknowable and so we are taking an each-way bet.???????

This?earnings season?is perhaps more interesting than most, given the inflationary cross-currents and potential for a rolling over of economic growth. While last week’s flurry of US tech reports was always going to be the highlight, this week the focus shifts to a number of more industrial names in the US, Japan and Europe, as well as Alibaba (which is not expected to trumpet it’s success too loudly and instead will factor in short-term costs associated with increased monitoring requirements). Hopefully that is all priced in now. Closer to home, the Australian reporting season also starts in earnest this week and, as we have seen in the US, the focus is likely to be more on the outlook than recent earnings.????

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Integro Holdings (WA) Pty Ltd ABN 61 612 297 739 AFS Licence No. 489444

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