3rd Quarter, 2021
There is no immunity from inflation.
THE MARKETS
The major markets moved higher at the beginning of the third quarter buoyed by post pandemic euphoria and rising consumer and business confidence linked to successful vaccination programs and the gradual re-opening of the country. However, beginning in August, the markets gave back their advances as consumer and business confidence began to decline to levels not seen since February. As the quarter came to a close we saw more doubts unfolding about the sustainability of the recovery trajectory. Rapid sector rotation moved against the growth oriented technology and healthcare sectors, favoring the previously beleaguered energy and financial sectors.
Key concerns now arising were previously noted but largely ignored by the markets. They are the continued spread of the Delta variant, the misreading of inflationary expectations, and the decoupling of coordinated fiscal and monetary policy. Additionally Federal pandemic transfer payments have essentially ended and unemployment levels appear poised to rise.
Overseas markets are factoring in similar concerns, with particular attention focused on higher prices in dollar denominated energy markets, growing supply chain woes, recurring COVID-19 waves and real estate failures in China.
Major foreign currencies have recently declined about 4% against the U.S. dollar and some central banks have preempted the Federal Reserve in raising base rates. The cumulative effect is that pressure on nominal interest rates is rising globally, although bond yields remain negative on a real basis. The stage appears set for greater volatility and liquidity challenges as investors adjust their risk parameters.
THE ECONOMY
The trajectory of resurgent GDP growth that began earlier in the first quarter has begun to decline and will likely continue to lose momentum as pandemic denied consumption becomes satisfied and the realities of ongoing Covid-19 Delta variant related disruption begin to take hold.
While the U.S. and the G7 nations have achieved good results with COVID-19 vaccination programs, the politics of delivery and dissemination of conflicting advice have impeded the goal of herd immunity. As a result, we are well into the global Delta variant surge which has attacked the unvaccinated with tempest and fury, leaving very high mortality rates. As we enter the northern hemisphere winter season, general health levels will face the challenge of a new flu season and the possibility of new COVID-19 variants. Vaccination programs (including 2022 flu) must be re-emphasized to keep the overall rates moving to achieve herd immunity.
The expected longevity of the COVID-19 pandemic cycle was originally estimated to be 1,500 to 2,000 days. We are now somewhere near 600 days thus while we may have the upper hand in this war, the battle continues to rage and more challenges are likely to lie ahead.
The global economy has responded well to the successful achievements in public health and coordinated monetary and fiscal policies of accommodation. The economic and social disruption wreaked by COVID-19 is still being calculated and the so-called new norms are not yet fully understood. Until they are, economic growth will remain challenging and, in many cases, disappointing.
Key among social and economic challenges is inflation, for which there will never be immunity. The initial evidence of inflation was the result of supply chain disruption where shortages of critical goods and services almost immediately led to price increases. As the pandemic played out, officialdom took the view that inflation would prove transitory and would revert to a level that is 2% or less and thus remain tolerable. Now the meaning of “transitory” is being stretched, with inflation continuing to spread to many sectors of the global economy and at unexpected levels approaching 5% or more. Pandemic induced inflation is global and thus beyond the reach of any national monetary authority.
Inflation is a cancerous destroyer of capital, and the attempt to use arbitrary political power to control it only exacerbates the damage it inflicts. For example, in parts of Europe, some natural gas prices (expressed in dollars) have risen 500% in the past year. In France, President Macron has frozen the price of natural gas for 2022. Of the 500 companies in the S&P index, nearly half have publicly expressed concerns about inflation in materials and operating costs, the likely impact on profit margins, and their need to pass them on to consumers. A number of CEOs have stated the added costs are here to stay. The Federal Reserve’s position is that employment has not risen to where wage pressures are likely to be a factor in inflation. Anecdotal evidence suggests otherwise. Labor shortages in service industries such as food and transportation are not being cured by higher wages and signing bonuses. Individuals don’t want to work in sectors that remain pandemic challenged.
Looking ahead to 2022 and 2023, corporate profits and household incomes face increasing headwinds from broadening inflation that will increase wage demands. Cost of Living Adjustment (COLA) formulas will kick in, sending budget deficits higher. This in turn will force the Fed to face the challenge of normalizing interest rates as a response to the inflation born of nearly seven years of negative real interest rates.
INVESTMENT STRATEGY
Massive fiscal and monetary stimulus in early 2020 aimed at stemming economic freefall has achieved success in restoring economic growth and investor sentiment. When aligned with the parallel achievement of vaccine development, we now have an economic growth engine that is gaining traction, but which must adapt to a whole spectrum of new norms in order to achieve sustainability of real growth.
The resilience of the recovery has now reached the point where investors have begun to raise concerns and questions about the state of the economy and its continued ability to grow and at what rate. Key concerns include the outlook for further economic damage from COVID variants, policy changes regarding normalization of interest rates, the impact of inflation factors, government spending, corporate profit margins and market risk.
The confluence of any two or three of these variable concerns strongly suggests greater near term market volatility and a period of investor “risk off” which can bring about liquidity indigestion. As such we believe there is enough uncertainty at present to reduce equities that have appreciated beyond long term targets. Where there are known cash outlays planned for the next year, this is a good time to fund them by harvesting profit from outperforming stocks. Longer term fixed income investment opportunities are not yet present as real interest rates remain negative, and as a result, durations should be kept short.
A FEW THOUGHTS ABOUT CHINA AND WESTERN STYLE CAPITALISM
Having followed foreign investment in China since its infancy in the early 1990’s, we are mindful of the advice given by a wise man in Hong Kong: If you invest in China, always remember the primacy of the Chinese Communist Party. If government policy turns overnight, your investment may be worth 50 cents on the dollar before the sun rises.
China’s experiment with western style capitalism has served its economic development well over the last 25 years. It has become a global industrial and technology powerhouse, creating an educated and well-off middle class and allowing unfettered accumulation of private wealth among those with privileged access to the ruling class of the CCP.
When the power structure is largely dominated by a paramount leader, things do change and sometimes rather quickly. The Nixon-Kissinger overture to China is the likely basis for the China we have today as it paved the way for China to open up and to partake of the global benefits bestowed by capitalism. This was the choice of the then paramount leader and it represented a significant departure from the ruling class of Mao.
Zhou Enlai wanted the opening so as to have a seat at the global leadership table and his successor Deng saw the advantages that limited capitalism could bring and thus the story of inward investment begins. China’s long range goal has always been the reunification of its historic empire. In 1997 Hong Kong was handed over in a convoluted 25 year agreement of one country two systems, which was abrogated last year on the grounds of national security. Macau was quietly annexed and Taiwan remains on the pathway to annexation. With China it’s always a long game regardless of who is in power.
Now we have the reign of Xi Jinping who descends from a family of devout Maoists and who sees the successes of capitalism as property of the state. Xi spent the first term of his paramount leadership consolidating his position of power within the politburo and central committee. Now that he is secure in his position coming up to the 2022 CCP leadership Congress, he has undertaken several initiatives that bear the imprimatur of Mao in moving to take public corporations well into the CCP tent under the guise of “common prosperity” wherein the prosperity belongs to the people through the Party. His goal is well stated in remarks directed at Jack Ma at the time of the Ant IPO fiasco last year. “I can’t let you grow unless I can control you.” The foregoing posture recently has been broadened to include sweeping controls over corporate governance such as significant party representation of corporate boards to ensure adherence to the state before shareholders. Xi has now tightened the noose around strategic corporate sectors by asserting that they are quasi-public instrumentalities, thus financial returns to investors are in a dubious state. Overall, it is easy to conclude that in the present environment investing in Chinese stocks is not subject to traditional financial and risk analysis thus the doctrine of caveat emptor should be followed.