A September slump put a pause on the global equity bull market. The S&P 500 Index dropped 4.7% for the month, developed international equities fell 2.9%, and emerging-market (EM) stocks dropped 4.0%. For the third quarter, the S&P 500 was up just 0.6%, MSCI EAFE was down 0.4%, and EM stocks declined 8.1%. For the year to date, the S&P 500 is up an impressive 15.9%, MSCI EAFE is up 8.3%, and the MSCI EM Index is down 1.2%.
The culprit behind EM stocks’ poor recent showing is China. The MSCI China Index was by far the worst-performing stock market in the third quarter, down 18.2%. For the year to date it is down 16.7%. (More on this below.) Chinese stocks comprise roughly 35% of the EM equity index.
Meanwhile, within the broad U.S. market, smaller-company stocks dropped 4.4%, and growth stocks beat value stocks for the second straight quarter. The financials sector was the top performer, but the energy, industrials, and materials sectors (all cyclically sensitive) were in the red. These style, sector, and factor performances reflect a somewhat more risk-averse investor mindset, consistent with the COVID-19-related economic growth slowdown during the quarter.
In the bond markets, the benchmark 10-year Treasury yield ended the quarter just a bit above where it began, at 1.53%. But it was a roller-coaster ride, with the yield plunging below 1.2% in early August, and then shooting back up in the last two weeks of September. For the quarter, the core bond index return was essentially flat, up 0.1%. Credit-sensitive bond segments outperformed core bonds, with the high-yield bond index gaining 0.9% and the floating-rate loan index up 1.1%. For the year to date, core bonds are down 1.6%, while high-yield bonds and floating-rate loans are up 4.6% and 4.4%, respectively.
Looking ahead to the rest of the year, as usual we won’t make any market predictions. We’ll only note that the fourth quarter is historically the strongest seasonal period for stocks. For example, according to Ned Davis Research (NDR), since 1970 the median fourth quarter return for the MSCI World Index is 4.4%, and it has registered a positive return for the quarter more than 75% of the time.
Portfolio Performance & Key Performance Drivers
Our active balanced portfolios slightly underperformed their benchmarks for the third quarter. The biggest detractor was our tactical exposure to EM stocks, which significantly underperformed other equity markets as well as core bonds. On the positive side, most of our actively managed/flexible bond funds beat the core bond benchmark.
In the rest of this commentary, we’ll walk through our current outlook for the financial markets. We’ll recap our portfolio positioning and performance expectations. And we’ll conclude with an update of our views on EM equities and China in light of the recent market headlines and regulatory developments there.
Financial Market Outlook
Over the next 12–24 months we see the strongest likelihood for continued positive returns for equity and credit markets (and “risk assets” in general), driven by continued economic and corporate earnings growth—albeit decelerating in the United States—and supported by still-accommodative monetary and fiscal policy—albeit less so in the United States.
This macro backdrop also suggests 10-year Treasury yields are likely to rise—although we don’t expect a sharp increase, which means a poor environment for core bond returns, both in absolute terms and relative to other asset classes and alternative strategies.
For the U.S. market, with valuations already near all-time highs, we see little room for valuation expansion. Earnings growth should therefore be the primary driver of U.S. equity returns. But as we discuss next, the U.S. market is also facing some near-term risks that could lead to a market correction (a roughly 10% market decline), but unlikely a bear market (20%+ decline).
Reasons for near-term caution on U.S. stocks…
1| A growth scare
Economic growth momentum in the United States and abroad decelerated in the third quarter. While some slowdown was to be expected coming off the extremely strong second quarter, the recent economic news has been generally worse than the consensus expected, as can be seen in the Citi Economic Surprise Indexes. And as the following chart from NDR shows, negative economic surprises are typically negative for stock market returns.
So far this year, the U.S. markets have remained resilient in the face of these disappointments. However, there comes a point where equity and other risk asset markets can no longer shrug off bad fundamental news. And this risk is heightened when growth expectations—and the valuations that reflect those expectations—are high. Put differently, the higher the expectations/valuations, the bigger the downside risk if those expectations are not met.
Throughout 2021, S&P 500 earnings repeatedly and spectacularly beat consensus expectations, driving the U.S. market index to one new high after another. But as is the nature of human behavior and financial market cycles, excessive (earnings) optimism ultimately sets the stage for (stock market) disappointment, as the following NDR chart shows.
So this is a key shorter-term U.S. market risk—one that we would put under the general heading of a “growth scare.” A “mid-cycle” market correction is fairly common during this phase of the economic and earnings cycles. There are any number of potential catalysts right now, although some are lower probability in our view than others. Some examples:
• There is a COVID-19 resurgence during the winter months that leads to reduced economic activity and investor pessimism/risk aversion.
• The fiscal growth drag from the expiration of pandemic support programs is more severe than expected.
• Washington political gridlock prevents passage of additional infrastructure spending that the market is already expecting.
• Corporate tax rate hikes are larger than expected and/or have a bigger impact on earnings than currently expected. On this point, we have seen estimates ranging from a four to seven percentage point hit to S&P 500 earnings growth in 2022 from higher corporate tax rates. But the market does not appear to have fully discounted this yet.
• A federal debt ceiling/Treasury default debacle causing a short-term but severe disruption.
• Systemic contagion from a China Evergrande debt default. Even absent an Evergrande contagion crisis, there could be a hit to China’s economic growth—and therefore global growth—due to China’s clampdown on its property/housing sector, which comprises a large share (~30%) of China GDP.
2| An Inflation Scare
A second type of market risk stems from an inflation shock. If incoming inflation data (e.g., wages, core inflation metrics, inflation expectations) strongly support the “non-transitory high inflation” argument, the market and Fed are likely to respond by pushing interest rates meaningfully higher. This would likely hurt investor sentiment and hit valuation multiples, particularly for the long-duration high-growth stocks that have been the primary beneficiary of the recent period of exceptionally low yields and low inflation, (e.g., the FAANG stocks, short for Facebook, Apple, Amazon, Netflix, and Google/Alphabet). Cyclical and value stocks could perform relatively well in this environment, but the tech-heavy S&P 500 would likely not.
It is also possible the Fed’s policy tightening response to an inflation scare would be so severe as to push the economy into recession. (Fed tightening cycles have historically been the primary catalyst for recessions. And most bear markets are associated with recessions.) This is the argument many Fed critics have been making: By already waiting too long to start tightening monetary policy, the Fed is brewing inflationary pressures and financial imbalances that will ultimately require an extremely aggressive tightening response, pushing the economy into a deeper recession than otherwise would have been the case.
But barring a recession, and given our base case that this global economic cycle still has legs, we would expect tighter-than-expected Fed policy to cause at worst a stock market correction—setting the stage for a further market rally rather than a full-on bear market.
We made no changes to our portfolio allocations in the third quarter. They remain well-diversified and balanced across a range of global asset classes, risk factor exposures, and investment strategies, each of which has different expected performance depending on the macro and market environment that unfolds.
We believe the portfolios are well positioned to generate relatively strong returns in our most likely baseline scenario of a continued global economic recovery with moderately rising interest rates and inflation and decelerating growth in the United States. But our balanced portfolios should also prove resilient in the event of a “left-tail” scenario (a negative scenario among potential outcomes), such as a growth or inflation scare as discussed above.
Overall, portfolios have (1) an overweight position to U.S. mid/small cap stocks, (2) a neutral position to EM stocks, (3) a modest underweight to core bonds in favor of flexible, shorter-duration, credit-oriented bond and emerging market funds, and (4) where appropriate, positions in lower-risk and diversifying alternative strategies.
An Update on Our Outlook for Emerging Markets & China
With China’s economy and financial markets in the headlines recently (e.g., the large property developer Evergrande’s looming default), and EM stocks’ strong performance earlier in the year having reversed, we wanted to provide a more in-depth update of our views on this important asset class.
We believe emerging markets broadly, and China specifically, offer unique risks and opportunities and will be an important diversifier and return-generator for client portfolios over the long term. As such, we want to have a strategic allocation to it that is large enough to have a meaningful portfolio impact. Barring a compelling tactical view, we stick to our strategic portfolio allocations (across all asset classes) and periodically rebalance to those target allocations. This lends valuable discipline to our investment process. It also is a measure of humility in that it acknowledges that markets are generally efficient in pricing in most risk factors over time and that the future is uncertain and unpredictable.
Moreover, the evidence is overwhelming that most investors detract from their long-term investment returns by overtrading their portfolio in response to short-term market gyrations or news flow. So, the key reasons why we have a strategic allocation to EM equities (and therefore China equities, which represent roughly 35% of the EM equity index) is diversification and gaining long-term access to a huge and important part of the global economy and investment opportunity set.
Despite specific EM risks and factoring in their lower expected earnings growth rate and lower quality versus the S&P 500, we believe EM stocks are quite cheap, as the following chart demonstrates.
In our view, it is likely that as the world emerges (again) from the COVID-19 pandemic we will see a reflationary growth cycle re-emerge that will be positive for both EM earnings and valuation multiples.
However, we have not yet decided not to rebalance our EM allocations as we were considering prior to China’s recent severe crackdowns against after-school tutoring companies. As a result, we are factoring in some moderation in our medium-term EM outlook due to recent regulatory changes, including property-related deleveraging, that are geared toward achieving China’s social goals (and clearly Chinese president Xi Jinping’s personal political goals as well).
Key Risk & Question
The biggest question mark or uncertainty for us right now relates to the Evergrande situation, which in our view highlights an incongruity: China’s goal to reduce income inequality and, at the same time, to also reduce the leverage and size of the property/housing sector of its economy. Unlike the for-profit education sector, the property/housing sector is a bigger problem in terms of both worsening inequality and how large it is as a share of China’s economy, accounting for roughly 30% of GDP and roughly 60% of household assets (estimates vary). (As a comparison, only about 25% of U.S. household assets are in property.) It raises the question: Can China achieve both goals at the same time?
While the answer remains uncertain, at this point the weight of the evidence we have been able to collect suggests it can.
First, the Evergrande debt problem specifically, and the entire property sector deleveraging, seems manageable. The majority of Chinese property developers meet the “three red lines” criteria China has laid out to mitigate systemic risks stemming from excessive property investment and speculation.
But it is increasingly clear Evergrande and a few others do not meet those red lines and are likely to default. China is trying to inflict losses on Evergrande’s private investors, and in turn reduce moral hazard (where investors assume the government will always bail them out in a crisis), without causing widespread financial contagion. Critically, the Chinese government stands ready to step in to manage and minimize widespread damage from the Evergrande default (an “orderly” default) given it is the majority owner of, and effectively controls, the financial system.
Second, it is unrealistic to believe that this problem or incongruity will be solved overnight. Very likely, China will de-lever the real estate sector slowly, in favor of other sectors it wants to grow and is championing. This is also creating investment opportunities that our active EM and international managers are looking to exploit.
Third, China’s government will be highly motivated to prevent a crisis stemming from a potentially disorderly decline in property prices, given the huge amount of household savings that reside in the property sector.
Of course, the risk is that China is not able to manage this balance well and there is a major financial crisis, a risk we have worried about in the past and do not ignore today despite our relatively optimistic view. Outside of a financial crisis, there is the medium- to longer-term risk that by clamping down on the huge property/housing sector, China’s overall economic growth is sharply curtailed beyond what the market is already expecting.
To conclude, we believe on balance the recent regulatory and property sector–related actions, if executed well, will lower systemic risk and likely result in a more sustainable growth path for China. On the regulatory side, thus far our discussions with managers suggest while there may be a hit to the long-term earnings power of some consumer-facing e-commerce companies, it will likely not be material. Meanwhile, their stock prices have already taken a big hit.
Most companies will comply with the new requirements and restrictions and move forward as it is good business, as long as the drive to meet social objectives is not taken so far as to damage long-term company profitability. We will continue to monitor this through our in-depth manager conversations and other sources, but widespread damage to private enterprise would not seem to be in China’s own long-term growth interests.
In sum, at present we are staying the course while looking for more clarity on the regulatory front. We are comfortable with our current position, though we are mindful of the risks from the ongoing deleveraging in the China property sector. We are actively analyzing these risks. If the evidence and our analysis suggest we should change our positioning, we will do so.
Most of this commentary has focused on our investment outlook over the short to medium term—the next few years. Our base case over this period remains relatively sanguine, as we expect the economic and earnings growth cycle, interest rates, and government policy to remain broadly supportive of equities and other risk-asset markets.
However, our longer-term outlook suggests we should be prepared for an extended period of lower absolute investment returns—certainly, in our base case, much lower for U.S. stock and core bond market indexes than the last five to 10 years. (The S&P 500 has gained 17% annualized over the past 10 years and core bonds are up 3% annualized.)
Absent significant further U.S. equity valuation expansion (higher price-to-earnings multiples), from already near-record-high levels, double-digit U.S. market annualized returns are extremely unlikely. What has driven larger-cap U.S. stock valuations to these record highs has been the decline in bond yields to all-time lows combined with above-trend earnings growth (largely due to the mega-cap tech/Internet leaders). Mathematically and economically, that is extremely unlikely, if not impossible, to repeat over the next five to 10 years, given where we are now starting from in terms of yields, profit margins, and earnings growth.
Nevertheless, in our medium-term “upside” scenario we estimate still-attractive upper-single-digit returns for U.S. stocks. And in our base case, while their absolute returns are uninspiring, we expect U.S. stocks to earn an adequate excess return premium above core bonds.
Meanwhile, expected returns for non-U.S. equities—EM equities in particular—remain absolutely and relatively attractive over a longer time horizon. But as we wrote at the end of our second quarter commentary—and as we experienced with EM stocks in the third quarter—equity investors should be prepared for a bumpy ride.
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