The More We See, the Less We Know

No wonder investors are showing signs of concern with more demand for protection against downside risks than appetite for betting on unexpected upside. Worrying news on global risks are top of mind this morning — from China’s faltering Evergrande property giant to rising gas prices in Europe, and the transatlantic rift with France. As new economic data are released, the mystery about where the economy is headed seems to deepen rather than be clarified. Prices and payroll data last week supported the idea of a summer lull in the recovery. Inflation undershot expectations, although still high. Consumer confidence dipped on one measure in the US in August and crept up only slightly according to the University of Michigan release last Friday. But August retail sales data released the previous day showed spending recovering unexpectedly sharply from July, rising by 0.7 percent over the month. Sales have pushed beyond pre-pandemic levels in all major economies, with the strength in the US standing out. Still, markets that for months have brushed off bad news and celebrated the positive have become more worried this month. Growing investor angst about China continues to roil its equity markets. These are uncertain times politically as well as for the global economy. French President Macron’s unprecedented decision to recall his Ambassador from the US (and Australia) was an immediate, angry response to the US negotiating a deal — in secret — to sell its nuclear powered submarines to Australia, thus scuppering a French sale. But the French move — and the US action that triggered it — illustrated a broader tectonic shift in global alliances as the US focus shifts to China, and the desire to shore up strength in the Asia-Pacific. The transatlantic partnership enshrined in NATO is no longer the dominant factor in US foreign policy — even if relations with France are mended soon, as they likely will be at least on the surface.
Observations and takeaways for investors:
Central Banks Under the Microscope

Many hope this week’s Federal Reserve meeting will shine a light on what to expect going forward. The top news will be any remarks on tapering asset purchases. Look for a hint on timing — likely starting at the end of this year — and process — finishing purchases in mid-2022. So far, Fed Chair Jerome Powell has managed to lay out an increasingly solid path for tapering without triggering a 2013-style tantrum. Markets can predict the likely size of the Fed’s balance sheet next summer when this round of asset purchases — or QE — is expected to come to an end. The unwinding of the Fed’s corporate bond holdings announced in June has been proceeding uneventfully. 

Perhaps more important than any move on tapering will be the Fed’s new economic forecasts, in particular the “dot plot” showing where the central bankers see interest rates going over the period ahead. After all, it is today’s low interest rates — and the prospect of “lower for longer” — that have mainly powered inflows into equities. Fixed income markets have offered little to no upside for investors, making it increasingly difficult for even the most risk averse institutional investors to invest with a more traditional 60-40 allocation to stocks and bonds. That, together with the boost to retail investing from pandemic-induced cash savings, have led to record inflows into stocks. 

With US equities at near-record valuations and economic data painting such a mixed picture, the market struggled to regain traction this past week. The S&P 500 and NASDAQ Composite each declined by half a percent and have had losses of 2 percent and 1.4 percent, respectively, month-to-date. Energy sector stocks performed well last week on the back of stronger oil prices, but most other sectors were down. Weakness was most pronounced in sectors including materials, utilities and industrials where the rapid surge in natural gas prices threatens profit margins.

Europe’s severe natural gas shortage poses a major threat and the Euro Stoxx 50 shed 1.2 percent last week and is down 1.8 percent for the month. Higher energy prices, feeding into the higher electricity prices that no consumer likes, are troubling European politicians and adding pressure for completion of the controversial Nord Stream 2 pipeline from Russia. One reason for the surge in prices shows how difficult it will be to wean the world off fossil fuels: a lack of wind in the North Sea. Renewable and clean energy — whether wind or solar — cannot yet provide assured continuity or security of supply. Of course, the climate change that we are already seeing — with extraordinary floods and heat waves in Europe and the US — poses its own immediate challenge to energy supply with downed power lines and flooded power stations. 

Businesses as well as consumers are reacting to the European gas price hike, with its impact spreading through the supply chain. Norwegian chemical company Yara International announced a pullback in ammonia production due to soaring natural gas prices. Such a move has far-reaching effects along the supply chain including in fertilizer manufacturing and production of CO2 needed for meat production. Last Thursday reports indicated that 60 percent of the UK’s supply of CO2 had been cut and the country’s meat supply was perhaps just a week away from significant issues.

Bank of America’s latest monthly survey of fund managers was quite telling of investors’ current state of mind. In short, it portrayed a very dour mood. Of the 232 fund managers surveyed, only 13 percent are expecting an improvement in the global economy. Optimism for corporate profits has also tanked with just 12 percent of fund managers expecting improvement versus 41 percent just a month earlier. With such pessimism, one might find it surprising that global equities are not down more, but many investors appear to be maintaining risk despite their reservations. According to the BOA survey, investors have been maintaining overweights to cyclicals and European stocks relative to history, and cash levels are still not particularly high — an average of 4.3 percent.

In June, when the Fed forecasts were last updated, the economic outlook was stronger than it had looked in the spring and inflation was well above forecast. As a result, Fed expectations of a rates hike moved forward, with a majority of Fed policymakers seeing one — or even two — taking place before the end of 2023. Seven of the 18 Fed policymakers even shifted their expectations of a first hike into 2022. The puzzle for central bankers now: economic growth and employment are looking weaker than expected in early summer, but inflation is still far above the Fed’s target. A drumbeat of calls to raise the inflation target is unlikely to move the Fed, just a year after reaffirming the 2 percent as the main anchor in its more relaxed regime of average inflation targeting.

But even those who support the Fed’s easy money stance acknowledge that inflation is set to exceed the 2 percent target for longer than expected. Supply chain dynamics are proving more complex than anticipated. From empty container ships looking for cargo a year ago, demand for shipping has now pushed the price to send a 40 foot container from Shanghai to Los Angeles nearly nine times higher than in December of 2019. That in turn will raise prices more generally — until capacity is rebuilt and demand adjusts. In the meantime, economists remain just as divided on how much to worry about inflation. Both sides took last week’s US consumer price data as reinforcement for their views. Hawks who fear that high and rising inflation will become embedded in expectations and behavior, notably Democrat and former Treasury Secretary Lawrence Summers, pointed to the spread of higher prices beyond the narrow sectors initially affected by supply constraints, such as lumber and autos. Others noted that some earlier price increases were being reversed and that the month on month rise in August was the lowest for six months. “Team Transitory” as Summers last week referred to those at the Fed and elsewhere who believe that longer-term inflation will come down over time will take some convincing that Summers is right. Supply chain disruptions, as we wrote last week, may take time to unravel but businesses and suppliers will respond to the price signals and adjust to meet demand. Temporary high inflation can smooth that adjustment process. In the meantime, the Fed’s cautious and steady approach, and explicit focus on both parts of its mandate, including full employment, recognizes how costly the aftermath of the Great Recession was, with an underpowered economy, slow recovery and many months of high unemployment. 

Fiscal Policy: the Main Game in Town

For all the attention on the Federal Reserve, the real game changer in the pandemic recession — and the wild card right now — is the government’s fiscal policy. The enormous boost to spending in 2020 and early 2021 distinguished the US from other countries — in a good way. Central banks around the world eased up in the face of the pandemic. And governments in most advanced economies put fiscal support in place, to help businesses and individuals hit by the sudden lockdown and plunge in activity. But the size of the American spending, and range of programs, stood out. Last week, we learned how much this helped to reduce poverty in America. The Census Bureau reported that the poverty rate before government intervention would have risen last year — an unusual and troubling development, but unsurprising in light of the pandemic. Instead of increasing, however, when taking government programs into effect the percentage of Americans living in poverty fell from 11.7 in 2019 to 9.1 percent. The combination of stimulus checks, higher unemployment benefits and other support measures boosted family incomes and improved life for millions.

What has captured less attention is that this fiscal boost in the US is now being reversed. The series of spending bills under Presidents Trump and Biden provided a fiscal impulse of some 5 to 15 percent to the economy. The ending of extended unemployment benefits and stimulus payments means that fiscal policy is now having a negative impact on the economy, reducing US GDP growth by 2.8 percentage points at an annual rate in the second quarter of 2021. As Congress wrestles with the huge budget and infrastructure packages, opponents of the price tag worry about inflation and the debt. A new book by economic historian Barry Eichengreen puts the debt concerns into a two hundred year context, arguing: 

“The ability of governments to issue debt has played a critical role in addressing emergencies ― from wars and pandemics to economic and financial crises, as well as in funding essential public goods and services such as transportation, education, and healthcare. In these ways, the capacity to issue debt has been integral to state building and state survival. Transactions in public debt securities have also contributed to the development of private financial markets and, through this channel, to modern economic growth.” 

Eichengreen and his co-authors caution that in good times it makes sense for governments to make fiscal space.

China: More Mystery to Unpack

There are hopes that China may turn to fiscal tools to boost its economy now. The recent recovery in Chinese equities came to a stop last week as investors reacted to the ever-deteriorating news around China’s second largest property developer, Evergrande. Some in the Western press have interpreted Evergrande’s default as a source of systemic risk akin to Lehman Brothers’ collapse. The situation is more nuanced however, in part because the Chinese government, while keen to deleverage the country’s property sector, also feels the pressure to get involved. Authorities have provided liquidity injections and taken steps to aid buyers and suppliers. Regional measures, such as Shanghai’s recently released proposal for market-oriented pricing, are a reminder to the market of the government’s potential support. Chinese property developers are trading at record low valuations with big stock selloffs, but policy headwinds ensure it will be some time before we see a meaningful structural rerating story.
The bad news for Chinese markets was not limited to the Evergrande saga. Disappointing data on retail sales growth, industrial production and fixed-asset investment growth all contributed to the malaise. All signs point to a softening in the economy and the repercussions were felt across other emerging markets, including Brazil. Iron ore miner Vale sold off by more than 10 percent last week. Slow Chinese growth is not the only negative externality for emerging markets. Inflation, specifically food inflation driven by China’s insatiable demand for food commodities is increasingly becoming a serious issue for central banks across the developing world. It’s even having potential political ramifications for calcified regimes like the one occupying the Kremlin, as this weekend’s parliamentary election results show. 

On the positive side, the public health picture is increasingly better across emerging markets as access and administration of vaccines becomes widespread. The ASEAN region in particular stands to benefit from the “reopening trade” that others experienced earlier this year. The promise of ASEAN is far greater than a return to the pre-pandemic status quo. Embedded demographic challenges in North Asia have the potential to materially transform the economic landscape of South Asia. China’s remarkable emergence as an economic superpower over the last 20 years was driven by a young, skilled and seemingly inexhaustible labor force. Now, the legacy of the country’s one-child policy as well as the passage of time leaves China with a rapidly aging population. The young labor pools of Indonesia, the Philippines, Thailand and Vietnam stand ready to step in. Timing may also be beneficial as domestic issues in China (regulatory oversight of tech businesses), ongoing geopolitical tensions between China and the US (and Taiwan) and the impending peak of the IT earnings cycle are all prompting investors to revisit their North Asia allocations, at least in the short run.

Coronavirus Recession was short — but its half life may be longer than we hoped

Extraordinary government support held up the global economy during the pandemic and can limit the post-recession costs of continued unemployment and income loss. But Covid-19 itself is lingering for longer — and may never quite go away. That is leading governments to change their responses. In the Asia Pacific, low tolerance of the virus has kept the death toll far below that in Europe and the Americas. But it has also led to severe and frequent lockdowns, most recently leading to factory closures in China’s industrial south after a traveler from Singapore imported infection. Opposition to lockdowns has led to civil disturbance in Australia. Gradually, it is becoming clear that control rather than elimination of Covid-19 is the best future. That means vaccinations, as well as masks, distancing and other “non-pharmaceutical interventions.” Countries from China, Japan to Brazil have made extraordinary strides this summer in vaccinating their populations. 

In the US, by contrast, strong and politicized resistance to vaccines is holding up recovery. One notable statistic: the seven day average of Covid-19 deaths — and infections — is now ten times higher than it was in June. Perhaps not surprising that President Biden lost patience and ordered vaccinations for many workers. But the Administration’s vaccine push has been muddied with confusing communications and disagreements with experts. The president’s push for booster shots may have made some vaccine skeptics more reluctant to get an initial shot. And last Friday’s decision against boosters by the Food and Drug Administration (FDA) has undermined the Administration’s credibility.

September marked the return to the office, post-Covid-19, for many firms. In many countries, including the UK and much of continental Europe, office life is returning to something closer to normal — albeit including vaccination passes and masks. But the Delta surge in the US may have dented consumer confidence — although not consumers’ eagerness to spend. It has also made some businesses start to invest in the necessary infrastructure for interim hybrid work. We share the view that a hybrid work mode that includes working from the office as well as from home will become more common. It may surprise some that in Washington, DC, staff members at the international institutions of the World Bank and IMF, whose jobs require them to travel to emerging and low income countries to assist them, have voted with their feet, and chosen to stay home. In New York, many CEOs are insisting on office attendance in addition to outside gatherings, retreats and other ways to bring employees together. While property companies had been feeling the absence of people in midtown this seems likely to change as companies set up formal policies to ensure a safe return to work. A measure of office occupancy compiled by Kastle Systems indicates that New York City commercial property is about 19.5 percent occupied as of September 8th (latest available). While this is five percentage points lower than its recent peak in mid-July, and below its pre-pandemic rate of 98.9 percent occupied, it masks the creative ways companies are finding to still collaborate in person. The highest occupancy rates are in Texas metropolitan areas (mid 40s), with the lowest in San Francisco (less than 19 percent). Office relaunches, hybrid work and other solutions for a return to work have driven sub-letting activity higher as well. 
RockCreek Update
Afsaneh was named to the Forbes 50 over 50 Investment List, along with Senator Elizabeth Warren, The World Bank Chief Economist Carmen Reinhart and Lael Brainard, Governor on the Board of the Federal Reserve.

Today kicks off Climate Week NYC, events and discussions on the most pressing climate issues taking place alongside the UN General Assembly. RockCreek will be participating in events related to climate week, including discussions on new schemes related to Europe’s energy future. Look out for more details.

Team RockCreek

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