August 2021
Developed equity markets rose during July. U.S. stocks led the way with a gain of 2.4%. Developed international markets notched a 0.8% return. The headlines in July came out of emerging markets, more specifically China. Emerging-market stocks fell 6.9% in July, which was one of their worst relative returns versus developed markets on record. China was the driver behind the poor returns—thanks to a 13.8% drawdown in the MSCI China Index.
Chinese equities started off the year strong with a gain of nearly 20% into mid-February. However, since then Chinese equities have fallen nearly 27% on well-documented regulatory actions against a number of firms. The pain has been even worse in the technology sector—with many stalwart Chinese tech stocks (like Alibaba Group Holding and Tencent Holdings) down 30%–40% from their highs. The for-profit tutoring firms (New Oriental Education & Technology Group and TAL Education) were the worst hit given the government turned them into non-profit companies almost overnight.
We continue to speak with managers of our active strategies to get a better understanding of the landscape and what actions they may be taking in portfolios. So far, actions run the gamut from opportunistic purchases to outright sales of Chinese stocks. There isn’t a black-and-white right or wrong action for managers. A lot of it comes down to their philosophy, process, portfolio construction, and risk tolerance. For managers that are extremely risk sensitive and whose process necessitates the ability to quantify risk, the right move for them could very well be to exit (or substantially reduce) until more facts are known. Another manager might handicap different scenarios and think probabilistically—and so holding or adding to Chinese stocks might be the right decision for that manager.
What is clear is that all our managers are actively evaluating their exposure to China. Considering the developments, investors may want to adjust downward their expected returns for Chinese equities, and given China’s weight in emerging markets, the expected return for emerging market equities in general. In our asset class analysis for emerging markets, we have and continue to use assumptions we consider to be sufficiently conservative. We will continue to share our thoughts as we this matter develops.
In the fixed-income markets, interest rates have steadily fallen since peaking in March. The 10-year Treasury rate dropped from 1.45% at the end of June to 1.24% at month close. This was a positive for government and high-grade bonds in general, resulting in a 0.8% gain for U.S. core bonds. However, credit spreads widened modestly in July and our flexible bond funds, while gaining, still underperformed as they generally have more credit risk.
Toward the end of July, the Federal Reserve issued its FOMC statement. Earlier this year, inflation worries were all the rage and interest rates were climbing. By contrast, current conventional wisdom is that there is not much to worry about as yields slide. The reverse in interest rate movements seems to confirm that most observers think the U.S. Federal Reserve will be able steer the recovery toward a steady, post-pandemic future. They will likely provide enough support via low interest rates and asset purchases to prevent setbacks but reduce the accommodation just in time to prevent inflationary pressures from getting out of hand.
Given all the uncertainties that currently abound, from the fast-spreading Delta variant to political changes, it seems quite plausible we might be in for some similarly wild episodes in coming months. Vigilant patience certainly seems like a good stance to take against such a backdrop. And, not just for central bankers, but for investors too.
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