The most noteworthy event in September 2021 was probably the apparent collapse of Evergrande, one of the largest real estate companies in China, whose status is currently unknown. On Thursday, 16th September 2021, Evergrande issued a statement that it will not be able to repay the outstanding interest payments that day. Following this announcement, the financial market was in substantial stress. Equity markets all around the world lost a few percentage points and volatility spiked. Bond trading was under pressure as well, as Evergrande’s bonds were downgraded and frozen from trading. It sometimes was already referred to the next “Lehman Brothers” case. The volatility the stock has seen since is tremendous, as it lost nearly 80% in the first few days after the announcement. It seemed as though the situation had stabilized, but since not all due payments were paid on Friday, 24th September 2021, the status is unknown. If nothing else happens, which is highly unlikely, the company would enter a grace period following bankruptcy. There are three critical features involved in Evergrande. Firstly, China and Chinese people are heavily engaged with the company, as the company has sold many buildings already without having built them yet. A default would cause huge issues for the affected people. Secondly, many companies are frequently doing business with Evergrande, in particular construction, design and other suppliers, could also face bankruptcy alongside Evergrande. Lastly, the collapse of Evergrande would pose a substantial risk to the financial system of China. The latter one is in particular difficult, as the company has outstanding debt at more than 250 banks, which could put additional pressure on China’s ability to offer cheap debt, which is necessary to maintain growth level. Moreover, it does not make a China a more appealing place to invest for foreign investors, which were already on the decline since the recent developments
The macroeconomic environment will largely drive the market in H2 2021, which itself is based on significant degree how Covid-19 will evolve in the near future. With regards to the pandemic, the key questions are how the number of vaccinations evolve going forward, in particular as developed economies no longer have shortages of vaccines, but rather a declining number of people that want to get vaccinated. A crucial point is whether herd immunity can be achieved, either by being vaccinated or having had the virus. Another important point is how long the vaccine will last, as the cases of vaccinated people contracting the virus rises. Luckily, the symptoms seem to be minor. Probably even more important is whether new strains of the virus emerge that completely bypass vaccinations and essentially setting the world back to March 2020. The latter scenario seems less likely but should be considered to some degree. In a non-negative scenario, US inflation is likely to drop towards the end of the year with expectations around 3%. For the next years, it is expected that US inflation will remain between 2% and 3%, following the change in the FED’s inflation target of being 2% in the long-term instead of capping inflation at 2%. Thus, it is unlikely that inflation will drop below 2% for quite some time. In the EU, the inflation outlook is lower compared to the US, as the ECB expects inflation to rise to around 2.6% in Q4 2021. In 2022 and 2023, inflation is expected to remain around 1.5%. Furthermore, the FED and ECB also hinted at possibly putting more emphasis on employment instead of inflation going forward. This suggests gold being well positioned in the current market. As of July 2021, gold is almost back at its average in 2021 of $1800 per ounce. Despite being at a relatively high level historically, gold seems attractive with surging inflation and short-term interest rates being very close to 0%. Yet gold’s record high of more than $2000 per ounce lies back almost a year, at a point in which inflation was at 1% and not a concern for many. Since May 2021, inflows in gold ETFs are positive again albeit a bit sluggish. This is remarkable as previously, there were mostly only net outflows. Currently, the global gold AuM is at $214bn. Equities, in particular in the US, have experienced a great 2021, as shown in Figure 1. The S&P 500 is trading very close to its record high of around 4,450. During 2021, expectations for the S&P 500 level were adjusted multiple times. At the end of 2020, when the S&P 500 was 3,700, moderate expectations were around 3,900, while optimistic scenarios targeted 4,300. Yet, all those expectations were already surpassed in the low-interest rate environment, monetary stimulus and increased corporate earnings due to the recovery of the economy. Goldman Sachs has updated its target for the S&P 500 to 4,700 at the end of 2021. Contrarily, Chinese tech companies have suffered in July with the worst month since the financial crisis in 2008. Investors feared the crackdown of Chinese regulators on tech companies. Figure 2 shows valuations of Chinese companies listed in Hong Kong and in the US. Not only, are Chinese tech companies strongly undervalued compared to US tech stocks. Furthermore, Chinese tech companies listed in the US are even stronger undervalued, as very few even reach a multiple of 5, as shown in Figure 2.
Inflation has been among the most important concerns in 2021, after the world has been able to fight the virus to some degree after over a year and a variety of vaccines. The inflation concerns stem from two main sources, the increased liquidity provided from central bank interventions through quantitative easing and the stimulus packages from governments. These two major components are shown in Figures 1 and 2. The first figure shows the balance sheet of the federal reserve. Since Covid-19, the balance sheet has doubled to $8tn. Despite the increase being smaller on a relative basis compared to the global financial crisis, the absolute terms differ vastly. While during the global financial crisis in 2008, the balance sheet grew from $1tn to $2tn, which was seen as unprecedented and extremely large intervention, it is only a quarter of the interventions following the occurrence of Covid-19 in early 2020. This has several implications. It will substantially increase the liquidity provided to the financial market and if the balance sheet is reduced, it will likely cause more volatility, as it was the case at the end of 2018 when equity markets decreased substantially. This is under the assumption that Covid-19 is now and will remain at a stage it can be handled. The entire underlying assumption could change, if, for example, a new strain of Covid-19 would emerge that is resistant to the currently available vaccinations. Figure 2 shows the government stimulus packages provided to fight the economic impact of Covid-19, which has surpassed $10tn globally. Again, this provides additional liquidity to financial markets and there has not been a large wave of defaults, due to government guarantees and similar programs. It remains to be seen, how this evolves, once the government guarantees are withdrawn, which could trigger additional volatility in the market. These two indicators suggest that inflation is very likely to increase in the short-term with potentially long-term consequences. Furthermore, instead of only anticipating rising inflation, it started to effectively to show, as the US inflation rate in May has risen to 5% compared to only 1.4% in January 2021 and BoE’s Haldane has warns that inflation is expected to rise close to 4% in 2021. Figure 3 looks at inflation in recent years for selected US consumer goods and services, which have developed vastly different, even when disregarding the impact of Covid-19. For example, within the last twenty years, hospital services have doubled, whereas TVs have decreased by 90%. The overall inflation over this time frame was almost 55%. It seems to be the case that most industries that are substantially affected by the government have increased massively, whereas fewer regulatory inventions have led to decreasing prices of goods and services. However, this is not entirely objective, as three out of the four massively more affordable goods are tech related. For technological products and services, it is common that they are very expensive in the beginning but lose value very quickly and become cheap and widely accessible. In an environment, in which inflation is a huge concern, equities seem like a good way to hedge some of the inflation risk. But, its attractivity is limited, as stock markets have risen incredibly since the initial drawdown caused by Covid-19. The S&P 500, for example, is almost breaking its high on a daily basis with a high of 4,302 (as of 1st July 2021). This boom in the stock market, alongside the surge in valuations of mostly technology companies, has led to 5.2m new millionaires in 2020, as shown in Figure 4. Consequentially, equity hedge funds have done mostly very well last year, some (for example Long/Short US Equity Consumer, TMT, Healthcare) being up more than 60% in 2020. In 2021, the growth has slowed down, as our SMC Equity Strategy Index is up almost 6% as of May 2021. The best performing equity strategy is Equities US Activist Event Driven with a YTD of 26% in 2021.
Fed Wants Optionality - and that Is Bullish for Vol! by Aquila Markets
*Fed creates optionality around Yield Curve Control and its “now in doubt” September review – which by definition creates volatility
*We are watching with interest to see if USD higher / risk lower persists, but we do not think the “highs” are in
*We believe the market is yet to begin considering a potential sweep by the Dems – this is a core theme on the radar for the Autumn
Despite having been quite sanguine about the Fed, the golden rule of the Fed “creates” volatility worked once again. There is clearly pushback within the FOMC itself to Yield Curve Control, recognising the upside of entering into a policy that the market is defacto already following is limited. Instead, the Fed has created optionality for itself. Additionally, the market started to question whether the results of the Fed’s policy review would indeed be presented in September, where average inflation targeting – ie letting inflation run Hot – would be a core part.
The timing of such a big announcement is creating an issue for the Fed, given the election, the recovery and the situation with the virus. September we believe will be entering a period of max uncertainty on the those three issues, which makes commitment to long term plans hard to justify, and it may be the Fed it trying to – again – create optionality for itself by delaying until, let's say, December.
But given the correlations we have been highlighting between rates, equities, commodities (Gold is correlating strongly with TLT, for instance) and realised volatility, any sense that rates COULD go higher caused the spill lower in stocks, especially given the horrendous breadth in US equity leadership, weakness in Asian stocks and a stalling in European markets.