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Weekly investment update – Emerging markets miss out on equities and bonds surge

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Nathalie Benatia
 

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At first sight, the direction of financial markets in July might have come as a surprise: global equities posted their sixth consecutive monthly gain despite a steep drop in emerging market equities, while bond markets also recorded strong advances, again except for those in emerging markets.

Volatility spiked at times during July. Indeed, it hit its highest since early May and took equities from a historical peak to the lowest level in a month within the space of a week before they set another high towards month-end. Emerging market equities suffered from a persistent sell-off in Chinese stocks over the government’s regulatory clampdown on sectors ranging from ride hailing to gaming.

Economic growth – On an even keel

While markets worried that the economic recovery had peaked, the latest purchasing managers’ data – seen as a leading indicator of the direction of growth – did not signal a sharp slowdown. China’s PMI for July, typically also a proxy for wider emerging market growth, fell by 0.5 of a percentage point from the previous month, indicating that company activity had slowed down. Remaining at above 50, the indicator also signalled that overall economic expansion overall is continuing.

Exhibit 1 - Composite PMIs signal no sharp drop-off in activity

In the eurozone, business activity rose at its fastest rate in just over 15 years in July. At 59.8 in July, after 58.3 in June, the services sector PMI was at its highest since June 2006 and consistent with a sharp rate of activity growth.

US GDP growth was 6.5% annualised in Q2 after 6.3% in Q1 and fell short of expectations. While inventories and net exports contracted, personal spending on consumption and non-residential private investment grew strongly. GDP was above its pre-Covid peak. Thanks to massive fiscal and monetary stimulus, it is now back on its pre-Covid trend.

Exhibit 2 - Private consumption drives US GDP growth

Despite this economic progress, the US Federal Reserve has continued to indicate that there is still ‘some ground to cover’ before it will start reducing its pandemic support for the economy. Employment is still some seven million jobs below pre-Covid levels. Risks to the outlook remain, not least as Delta variant Covid cases rise.

Equities: Record-setting

July saw concern over slowing global growth offset by news of strong corporate earnings and still record-low interest rates. Markets were buoyed by optimism over the outlook for the US economy in the second half of 2021, even in the face of a pickup in Covid infections due to the more contagious Delta variant.

Some observers are pointing to the small chance of widespread lockdowns, while others have noted that although caseloads are rising rapidly, hospitalisations and fatalities are not.

US stocks recorded their sixth monthly rise in a row. The S&P 500 rose by more than 2%, while the tech-heavy NASDAQ and the Dow Jones added more than 1%.

There were all-time highs for European stocks as well, allowing them to record a sixth consecutive month of gains. Mid-caps, IT and dividend stocks led the market, while the energy sector lagged.

Asia takes a dip

In contrast, Asian equity indices had a poor month due to rising Covid cases across the region and concerns that a regulatory crackdown on tech businesses in China could slow already decelerating growth. This came on top of spreading Delta cases in the country and a softening land and property market. The developments clouded market sentiment across various regions.

Exhibit 3 - Emerging markets lag, particularly Asia EM and China

Japanese equities lost more than 2% on concerns about another coronavirus wave and its impact on the economic recovery. Investor worries over global economic growth not only drove down US Treasury yields, but also the US dollar, allowing the yen to strengthen. The break in what had been the yen’s weakening trend also roiled Japanese markets.

Tepid domestic data, concerns about growth in China and volatile oil prices – Japan imports some three quarters of its oil consumption – also weighed on the market.

We believe there are reasons to be somewhat cautious on equities despite the good recent earnings momentum and the continued support from central bank pandemic measures. Recent recoveries followed sell-offs on a modest scale rather than sharp retrenchments and dips have not attracted many more new buyers or more widespread buying. Recent gains look vulnerable to us.

Bonds: The rally rolls on

Yields fell as investors sought shelter in haven assets such as US Treasuries and Bunds, extending the rally by a third month.

In the US market Treasury, 2- and 10-year yields notched their biggest one-month drops in over a year (March 2020), even as the Federal Reserve’s preferred inflation gauge rose sharply in June for the fourth big gain in a row. However, June’s increase was smaller than forecasters had expected.

Investors still appear to be siding with the Fed, accepting its view that higher inflation is due to supply bottlenecks and shortages and that these should ease off as the recovery matures. Ironically, the pressure should also ease as a growth slowdown tamps demand.

Over the month, long-dated debt yields fell to around five-month lows.

What’s up with real yields?

Some investors appear to worry that very low real yields — which measure the returns investors can expect once inflation is taken into account — are warning of a (coming) sharp slowdown in growth as the more contagious Delta variant spreads, turning businesses and consumers cautious again.

Others have argued that market pricing has become too pessimistic, pointing to the US economy’s strong rebound, even if growth has now peaked.

A further explanation could be that continued large-scale bond buying by central banks is still holding down yields across the board – even yields that are adjusted for inflation that has seen high readings in the US, the UK and Europe. An end to this form of support for economies does not appear to be in sight any time soon.

The Fed, which has bought about USD 120 billion of bonds monthly throughout the pandemic to pin down borrowing costs for households and businesses, reiterated after its latest policy meeting that the economy was making ‘progress’, but it remained too early to tighten monetary policy. Any tapering of bond purchases could be delayed by a growth slowdown, which should support markets.

Elsewhere in bond markets, high-yield credit in USD, EUR and GBP had another good month, extending their run of gains by a seventh month. UK inflation-linked bonds were in the lead in the fixed income segment.

Gold was supported by the continued rise in inflation and the declines in real yields that have made it more attractive as an inflation hedge. Commodities more broadly were the best-performing asset class in July.

BOND MARKETS
10-year yields Monthly change 2021
US T-note 1.22 -25 31
JGB 0.02 -4 0
OAT -0.11 -23 23
Bund -0.46 -25 11
EQUITY MARKETS
Euro Stoxx 50 4089.3 0.6% 15.1%
Stoxx Europe 50 3555.8 1.2% 14.4%
Dow Jones 30 34935.5 1.3% 14.1%
Nasdaq 14672.7 1.2% 13.8%
S&P 500 4395.3 2.3% 17.0%
Topix 1901.08 -2.2% 5.3%
MSCI all countries (*) 724.2 0.6% 12.1%
MSCI Emerging (*) 1277.8 -7.0% -1.0%
(*) in USD

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions).

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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