Weekly Market Update - 21/09/21

The week that was

Markets ended the week in negative territory again last week. While investor sentiment is weakening and there seemed to be plenty for investors to worry about, there is also a lot of chatter about ‘buying the dip’ and flows into equities remain at record highs. So far, it is a very small dip (markets are down 2% from all-time highs earlier this month) and remain up 10-20% for this year and 10% since pre-COVID (or 30% and 40% in the case of Japan and the US respectively).

Friday was nevertheless volatile and interesting with European markets falling quite precipitously to end the weak down 2%. The US followed a similar path, but it was perhaps the small spike in bond yields late in afternoon US trading which has had many commentators question the reflexive "bad news = lower rates = good news for stocks" pattern that investors have gotten used to. Ahead of the US Fed’s monthly meeting this week (where they may or may not ‘talk about tapering’) there was a lot of mixed economic data. Inflation survey expectations remain high but observed inflation appeared to ebb. Consumer sentiment has been hit by Delta but US retail sales reported last week were unexpectedly high. US jobs shortages continue unabated while claims for unemployment benefits rose. Adding to the noise was the expiry of three important market options (stock options, stock index futures and stock index options) on Friday, the so-called triple-witching that happens at the end of every quarter.

Commodity markets were also mixed though there were 2 clear outliers - energy was up and metals, barring supply constrained aluminium, were down. This was also reflected in stock performance with most global sectors down one or two percent. Oil stocks up strongly and materials stocks down another 4% here and abroad. Australia did get some stock specific respite with local REITs, healthcare and IT stocks performing well, seemingly as investors rotated into these sectors.

Last week, the real action was again in Asia. The Japanese market consolidated its gains and was the best performing market around the world. However, the headlines were dominated by events in China, where the market was down 3% due to the impending bankruptcy of property group Evergrande. This also dragged South Korea, Hong Kong, Taiwan and other countries in the Chinese sphere.

While government bond yields ended up where they were at the beginning of the week, market implied inflation rates actually decreased throughout the week. This represents a moderate tightening as real (after inflation) long-term rates became slightly less negative. For 10-year government debt this implies real interest rates of -0.99% from -1.08% a week ago and -1.12% two weeks ago. While these seem like very small movements, this is probably creating a headwind for markets beneath the surface, pointing to why a more significant normalisation of interest rates would undermine asset prices and why the US Fed and other central banks are treading so carefully.

What we're watching this week

Economists and policy makers seem to be settling on some kind of a consensus ‘muddle through’ view of economic growth, inflation and rates into next year. It is worth noting that just a few months ago the scenario analysis between Bidenomic reflation and secular stagnation was wide open. This consensus sounds comforting but actually presents significant portfolio risks. If one of those scenarios does start to look like more likely, it is now much less ‘priced-in’. That is one of the reasons we are formally extending our economic scenario analysis to asset class returns over shorter periods than we might otherwise do (eg: one year). For now, the probabilities of a melt-up scenario are finely balanced against the melt-down scenario, and the probabilities of both are receding but that could change quickly if the data gets less noisy, one way or the other. On top of that, October is statistically the most volatile month of the year, so with markets at all time highs it seems like a good time to be considering all possibilities.

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