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- Global stock and bond markets have faltered recently, with inflation worries and the China crackdown influencing returns. That said, longer-term returns are still very healthy overall.
- A few bright spots exist, including energy companies and Japanese stocks.
- Emerging markets are among the biggest laggards, with Chinese technology companies falling heavily.
- Looking ahead, the supportive environment is evolving quickly and requires a watchful eye. We are broadly positioned for a continuation of the economic recovery, although we retain a defensive ballast.
Most major developed markets maintained their positive trajectory in the September quarter despite pulling back in the month of September itself as a variety of risks from moderating economic growth, supply disruptions, rising inflation and contagion risk from one of China’s largest property developers spooked investors. The MSCI World Ex-Australia NR Index finished the quarter slightly up at 0.6%, in local currency terms. This saw 12-month returns in the order of 29.0%, with some markets, notably key indices in the U.S., hitting all-time highs mid-quarter. In Australian dollar terms, quarterly returns were 4.0% due to the falling Australian dollar, however, currency movements detracted slightly from 12-month returns (+27.8%) for unhedged investors.
Sector performance was mixed, though returns between sectors were not as wide as we’ve seen previously. Financials (+3.0%), Energy (2.4%), and Technology (1.67%) were the strongest performers in the MSCI World Index (all measured in local currency terms). Over 12 months, Energy was by far the highest performing sector, returning 67.7% in local currency terms, followed by Financials which returned 52.1% in local currency terms. Supporting the enormous returns seen in global energy was a 91.7% return in Brent Crude over the 12 months ending September 30 2021 as we near the 12 month anniversary of the covid vaccine being approved in November 2020, which saw one of the biggest rallies in value stocks seen in recent history.
U.S. shares ended the quarter relatively flat with a 0.58% return in local currency terms, a positive outcome overall considering the S&P500 retreated -4.6% in September. The Federal Reserve provided more guidance around the reduction in quantitative easing, saying that it may happen as soon as November with purchases set to end by around the middle of next year. Over 12 months, U.S. shares returned 30.0% in local currency terms, broadly consistent with other major developed markets. Europe ex-UK and the U.K returned 0.2% and 2.2% in local currency terms, respectively. Consistent with the U.S., central banks in these regions provided similar guidance around the reduction of quantitative easing.
Interestingly, the ECB stressed they were not tapering asset purchases down to zero. Japan was the standout performer in the quarter, returning 5.3% in local currency terms, with major news coming in the form of a new leadership announcement. Prime minister Yoshihide Suga announced he would be stepping down from leadership of the Liberal Democratic Party with his successor, Fumio Kishida, taking the helm.
Australian shares broadly reflected global themes. The energy sector led the way for the quarter (+8.00%) given the strength in a number of commodity prices, followed by Telecommunication Services (+7.64%) and Industrials (+6.28%)
Key stats (ASX 200) (12-month returns in brackets): +1.7% (+30.6%).
Bond yields softened over the quarter (the U.S. 10-year bond yield finished the quarter around 1.45%), given concerns around the sustainability of the current economic momentum as the Delta variant surges. This saw gains in the global benchmark index. The real story here is all about inflation and whether it is transitory or structural. This is a major point of contention among bond investors, creating heightened volatility in this space through 2021
Key stats in local currency terms, (12-month returns in brackets): Australia: +0.3% (-1.5%); Global: +0.05% (-0.8%).
Global property & infrastructure
Domestic and global listed infrastructure performed relatively well, as economies began to reopen. However, returns from global listed property were more muted.
Key stats (in local currency terms) (12-month returns in brackets): Australian listed property: +4.8% (+30.7%); Global listed property: -0.2% (+29.1%); Global listed infrastructure: +2.7% (+21.1%).
The US dollar appreciated slightly against most major currencies, though this wasn’t without some volatility – mid-quarter especially. This was on the back of more hawkish comments from the Federal Reserve and inflation, which appears to be more persistent than perhaps initially thought by the market.
Changes to the Balanced Portfolio over the September quarter
- The fund further reduced its exposure to risk assets rotating into Australian and Global Bonds taking profits from Australian and International equities.
- In International equities, profits were taken in Energy, Financials, Mexico and general Emerging Markets. Within Australia, we reduced our bank's overweight position to underweight in a bid to reduce the overall Australian equities exposure. As noted last quarter, we see Australian equity valuations are less attractive than 2020 on the back of strong performance.
- We initiated a U.S. Consumer Staples position in July 2021, consisting of several well-known companies. This position brings a more defensive tilt to the equity portfolio.
- As always, we are seeking to remain opportunistic and focus on segments of the market with embedded value whilst being considerate of valuations which in a number of developed markets that are expensive relative to history
Positioning & Outlook
The global rally in asset prices has faltered in recent times. While some equity markets continue to post modest gains, the total return backdrop has paled compared to recent memory, with emerging markets a particular sore point. Thus far, it is more akin to a stumble than a fall, with year-to-date returns still strong and the post-pandemic recovery intact. Several factors are at play, but the two prominent influences are 1) inflation fears, and 2) the China regulatory crackdown.
Inflation fears have been with us for most of 2021 yet continue to be regarded as the biggest tail risk—potentially derailing both equities and bonds. More recently, this has included central bank dialogue around a gradual tapering of its loose monetary conditions. While some see the inflation increase as being driven by a rebound from depressed prices in 2020 (the so called “base rate” effect) and temporary supply-chain issues, others point to massive fiscal and monetary stimulus contributing to a structural increase in inflation. The reopening of businesses is another contributor, although this has lost some steam as the delta variant creates economic challenges.
The combination of rising inflation worries and central bank tapering translates into rising bond yields. This was perhaps the most noteworthy financial market move late in the third quarter of 2021, influencing the returns of both stocks and bonds.
For equities, a rise in bond yields typically equates to downward pressure on stock prices—all else being equal—and that’s exactly what we saw in the third quarter. The obvious exception was energy companies, which saw another meaningful return boost, supported by higher commodity prices. Japan was another rare bright spot. To the downside, we saw a remarkable shift in Chinese technology companies and the potential bankruptcy of a large real estate developer, Evergrande. This Chinese weakness carried contagion fears, bringing down the entire emerging market basket and practically wiping the gains year-to-date. Small-cap stocks also fell late in the quarter, giving back some of their lead over large-cap stocks in the past year.
For bonds, inflation fears are driving yields higher and have helped inflation-protected bonds outperform. On the other hand, nominal government bonds have failed to offset equity risk recently, generally posting modest negative returns. Longer-dated government bonds are now down meaningfully year-to-date, while emerging market bonds in local currency are also down. Higher-quality corporate bonds are generally doing better and broadly flat, despite a rise in volatility. Currency moves are the final piece of the puzzle, where we have seen recent strength in safe-haven currencies like the U.S. dollar.
Broadly expensive equity markets lead to stock selection being particularly important. We look for investments that continue to appeal and believe are key to contributing to your portfolio returns over the longer term. To that end, we have sought investments whose valuations are relatively attractive, including European energy. We have also added non-cyclical companies that should prove resilient if economic growth falters or higher inflation and interest rates eventuate. Among these are US consumer companies and Japanese industrials.
The Balanced fund maintains a healthy cash holding which offers a buffer against equity market pull backs while providing the resources to take advantage of asset price weakness which offers attractive long-term expected returns.
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