Summer surprises

In short

• Consumer spending drives global GDP growth, and recent data suggests that consumers are shifting their spending patterns once again due to inflation and COVID-19
• Stocks continue to trade higher against a backdrop of moderating economic data and stretched valuations
• Economic growth in China driven by increasing household wealth has been the basis for investment for decades. New policies to distribute that wealth could cool the demand for Chinese stocks in the short term.

With the summer months fading into the rearview mirror, investors are beginning to focus on what the next few months could bring in terms of the global economy, and in turn, the capital markets. While it is sometimes difficult to determine where the bears are hiding out, engagement in a more nuanced discussion of what the next phase of the equity market rally could look like yields just as many questions as answers. Reliance on a playbook written prior to the pandemic could prove as ineffective as referencing one from prior to the financial crisis, as there are likely to be permanent shifts in the way we work and live for the next several years. Creating comparisons with economic activity and valuations from 2019 could paint a much different picture than the one we should be considering, which remains in many ways unfinished.

What is clear is that the heavy reliance on a consumer spending rebound as the foundation for economic enthusiasm could put the equity markets at risk in the next several months. Economic data released in the month of August certainly cast doubt on the sustainability of the pace of the spending uptick against the backdrop of the Delta variant. The University of Michigan consumer sentiment index fell to 70.2 in its preliminary August reading, which marks a significant decline from July’s 81.2 print and a result well below the consensus expectation for an increase to 81.3. The reading was at levels not seen since 2011, and the month-over-month decline harkens back to those experienced during the financial crisis and the height of the pandemic last year. While the decline is due in part to the surge in COVID-19 cases, July’s CPI reading came in at +5.4% year-over-year, with Core CPI up +4.3%, slightly slower than June, but still representing a meaningful increase.

It's not just sentiment that is being weighed down by Delta and higher prices. Retail sales fell by -1.1% month-over-month during the month of July, significantly worse than the slight decline of -0.3% anticipated. Declines came in the form of lower demand for autos, clothing and sporting goods, and while the transition back to services spending will likely occur, the pace of that rotation may be hindered by another wave of COVID-19 in the northern states during the next several months.

Manufacturing data continues to moderate reflecting a normalizing economic rebound. U.S. IHS Markit flash manufacturing PMI fell from 63.4 to 61.2, led by a deceleration in new order growth and employment, as companies indicated that constraints on all inputs including labor are inhibiting stronger growth. Euro flash composite PMI also declined during the month, dropping to 59.5 from 60.2 in July, as did China’s manufacturing PMI, which dropped from 50.4 in July to 50.1 in August. Overall, the surveys reflect continued supply chain pressures and choppy demand for new orders which could in turn be driven by variability in the availability and pricing of inputs. As such, inflation will continue to impact services and manufacturing demand, and with PPI coming in up +7.8% year-over-year, consumer price inflation is unlikely to slow meaningfully in the next several months.

Yet, it appears that the Federal Reserve is looking past these data points and focusing squarely on employment. While the FOMC often uses the Jackson Hole symposium, held last month, as a jumping-off point for new policies and/or approaches to monetary policy, this year Chairman Jerome Powell essentially reiterated the messaging that has remained consistent through much of the year. Powell focused his comments on the dual mandate, citing the need for continued improvement in employment to match the progress made towards (and technically past) the Fed’s inflation target. He made it a point to differentiate bond purchases and interest rates as separate monetary policy tools, and admitted that, while tapering of bond purchases will occur late this year or early next year, the decision to raise rates will be very much data dependent.

The biggest piece of data to support the Fed’s current stance is the non-farm payrolls report, which came in well below expectations for the month of August. After solid June and July reports, in which the economy added an upwardly revised +962k and +1.043M, respectively, the August report showed an increase of only +235k versus expectations for a +720k bump. The biggest surprise within the report was the lack of hiring in leisure and hospitality in the month, as these jobs had represented a big part of the increase in the previous months, and were expected to continue to gain steam as the reopening continued. The unemployment rate declined to 5.2%, in line with expectations, but the participation rate remains stuck at 61.7%, still well off its 63.2% high prior to the pandemic. Wages are creeping higher, up +4.3% year-over-year, and a meaningful number of job openings represents the potential for increased hiring over the next several months. It remains to be seen if the current mismatch between jobs and job seekers is transitory or if job seekers are looking for something outside of these industries.

Equity market returns were better-than-expected in the month of August. While many expected a bit of choppiness as earnings season ended and the Fed kicked off its Jackson Hole symposium, instead risk assets held the reins and delivered a solid month across the board. The S&P 500 closed the month up +3.04%, led by the interesting sector combination of financials, technology and utilities; consumer discretionary, energy and real estate stocks lagged. Small caps stocks underperformed large caps modestly, gaining +2.24%, but showed strength to close out the month – perhaps setting the stage for outperformance this fall. Outside of the U.S. emerging markets stocks, particularly outside of China, performed well, while international developed names were the relative laggard, gaining only +1.76% for the month. Bonds were mostly down, save for high yield corporate issues, as the 10 Year Treasury yield closed the month at 1.30%, up slightly from July’s close of 1.24%. Commodities were also down slightly.

In focus: China challenges

Coming into this year, economists and investors were expecting a sharp rebound in economic growth, which began last summer, to continue globally with major consumer markets such as China poised to experience an even stronger rebound. Couple that tailwind with attractive equity valuations and a U.S. dollar that could remain range bound based on the Fed’s plodding pace towards interest rate hikes, and many investors were considering increasing allocations to emerging markets, and China in particular.

Fast forward to today, and the outlook at least in the short to mid-term appears cloudier – at least for investors. Investors have received a pointed reminder that the Chinese government is a Communist one, and that at any time it can enact policies that could potentially harm the business interests of companies operating in the country. Over the last several months, Premier Xi Jinping has led a charge on several fronts to rein in perceived business excesses, such as in the financial services industry, or pursue policies that create a more equitable distribution of wealth in the country – dubbed “Common Prosperity”.

Xi’s predecessor, Hu Jintao, acknowledged the inequity early in his term and put into motion efforts to provide financial support and incentives to the rural poor to pursue alternative enterprises that could support socioeconomic mobility and higher levels of per capita income consistent with the fundamental idea of an egalitarian society outlined by Mao Zedong. Xi’s policies under the new “Common Prosperity” mandate go much further than these policies, however, and are designed to support a narrowing of the wealth gap by actively encouraging redistribution through changes in taxes, enhanced social programs, wage adjustments and incentives for charitable acts, to name a few.

It is not just these new measures that are causing investors pause, however. The crackdown on for-profit education policies as well as plans to curb the rising costs of health care, as well as the adoption of new rules for overtime work are already in motion. Also on the horizon are significant changes regarding data privacy, financial products and potentially gaming that could impact companies operating in those industries.

All of these forces are likely to act as an overhang on publicly traded Chinese stocks in the near to mid-term. The longer term impact of the Chinese Communist Party’s efforts remains to be seen, but the re-rating that has occurred in Chinese stocks over the last several months is not without merit. The landscape could change dramatically over time, and while it is unlikely that the growth trajectory of the Chinese economy will be fundamentally altered, the lack of transparency makes it difficult to underwrite the full risk at a company level in the near term. As such, investors have been trimming their exposure to China, particularly through ETFs and mutual funds, and thus the pressure on widely held, large cap Chinese company stocks will be even greater than perhaps some of the smaller names. Our view is that emerging markets, and China, are solid long term opportunities, but we are cautious on the idea of increasing our exposure to take advantage of the recent weakness prior to the November meeting of the Standing Committee of the National People’s Congress.

What we’re watching

With the summer months behind us, attention has begun to shift to what 2022 will bring – and an even greater focus on the sustainability of the current bull market in equities.

The Fed continues to differentiate between the taper and tightening at every opportunity and this nuance represents an important factor for equity investors. Maximum employment and target inflation represent the Fed’s dual mandate and as long as employment remains below its pre-pandemic levels, the Fed should be the focus.