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- After a very good summer from an investor's point of view, financial markets, especially stocks, began to suffer a correction in September.
- Nervousness is being fueled by high energy prices, supply shortages, the prospect of tighter monetary policy and China's regulatory initiatives, as well as Covid.
- While not all of these problems are likely to prove temporary, we believe the overall environment remains quite positive.
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1 / Market overview
The markets stood up remarkably well to the summer’s negative headlines, but September’s news proved to be too much for them. And so finally the stock indices’ climb to new record highs came to a halt. What went wrong in September from an investor's point of view can be condensed into two international pictures: protesters outside Evergrande's headquarters in China and long lines outside British gas stations.
The financial difficulties of China's second-largest real estate developer are leaving both customers and anxious investors wondering about the extent to which the government will provide a cushion – and therefore prevent a chain reaction. It is important to remember, however, that Evergrande's recent problems are the result of stricter regulations with which Beijing is aiming to curb speculation and spiraling home prices. That goal is as understandable as the regulatory steps[1] taken against the tech sector back in August, but they are leaving a clear mark on the stock markets. The Hang Seng, for example, has already fallen 23 percent from its mid-February high. In the case of Evergrande, it is not so much the fate of the company itself that could have a lasting impact on the market but whether consumer confidence will be hurt if doubts about real estate as a means of retirement provision are increasing. In the shorter-term, economic growth is likely to suffer from the already visible slump in construction activity. An increasing number of strategists are now cutting their China GDP growth forecasts for 2021 and 2022. Adding to the nervousness is the energy shortage (partly instigated by state interventions), which has even led to the closure of some factories.
The UK is suffering from a shortage of truck drivers – and of wind for turbines, which is why gas prices rose more in the UK than elsewhere.
Energy shortages, or at least sharp spikes in energy prices, also dominated the news in other parts of the world. The most obvious was in the UK, where long lines of cars formed (and continue to form) at gas stations all over the country. The UK is suffering from a shortage of truck drivers – and of wind for turbines, which is why gas prices rose more in the UK than elsewhere: they almost doubled in September alone. These factors and labor shortages exacerbated by Brexit and lockdowns were partly responsible for a relatively hawkish monetary policy statement in September from the Bank of England, with two members seeking a tightening of policy.
Quite apart from truck driver shortages, however, supply bottlenecks are occurring elsewhere. Production output in the European auto industry is expected to be down by a double-digit percentage in the second half of the year because of the global shortage of semiconductors. But the major central banks remain largely unfazed. While the ECB only took a small step towards exiting its ultra-loose monetary policy, the Fed surprised the market by announcing with that net bond purchases would be reduced to zero by mid-2022.
Other issues affecting the market in September were the continuing threat of a U.S government shutdown in the absence of a political solution (debt ceiling), as well as further wrangling over the Biden administration's stimulus and infrastructure packages, which could turn out to be smaller than expected by the market. In Germany, the federal election brought little certainty about who would govern the country but some certainty about who would not do it: the red-red-green alliance did not receive enough votes to form a majority government, a risk scenario in view of the markets.
At the global level the markets reacted uneasily to all the mixed news after their previous strong rise. The S&P 500, for example, posted its first negative monthly result since January, with a total return of minus 4.7 percent – but it remained up by 16% in the year to date, and slightly up during the third quarter, unlike the technology-heavy Nasdaq.[2]
Almost all regions ended the month in the red except for Japan[3] where the stock market gained 4.5 percent, after it saw the biggest increase of earnings estimates of all regions. At the sector level, the rise in interest rates helped the financial sector[4] somewhat, in that it fell by only 1.4 percent. The sharp rise in energy prices propelled the energy sector[5] to a gain of 9.1 percent while utilities[6] suffered, which dropped by 6.2 percent. A striking feature of September was the flat performance of high-yield corporate bonds (USD and euro) despite weak equity markets.
The rise in government bond yields (in both Treasuries and Bunds) was the dominant topic in fixed income. Surprisingly this rise was mainly driven by rising real interest rates in September; for almost one and a half years the inflation component has been the main driver of higher nominal interest rates. Further, in September the oil price again rose by almost double digits and coal by over 40 percent while the price of gas in Europe almost doubled. Although some industrial metals lost ground, overall the Bloomberg Commodity Index still managed a gain of 4.9 percent. Gold and silver, however, fell as tighter monetary policy began to loom.
Inflation is likely to remain the central issue for investors and chief concern of central banks in the remaining months of the year. It could dash shareholders’ dreams of a year-end rally. And it poses a difficult problem for the central banks. They are under increasing political pressure to act but there’s not much they can do about inflation generated by energy price rises and supply-side bottlenecks.
The rise in government bond yields (in both Treasuries and Bunds) was the dominant topic in fixed income.
2 / Outlook and changes
The third quarter ended weakly and the fourth quarter began in the same vein. There is no need to use the ugly word "stagflation"[7] but the combination of rising energy prices, supply-side disruptions, the prospect of slowly tightening monetary policy, slowing growth in Asia and the ongoing U.S. budget dispute are not the mix of which investor dreams are made of. Some investors may also be getting extra nervous as winter approaches given that the number of new Covid infections may be on the rise again after declining globally for more than a month. However, the significant year-on-year decline in deaths should generate a more positive assessment, even if the combination of the Delta variant and slowing vaccination momentum has dampened initial expectations somewhat. At the same time, however, the clinical trial results for Merck Co's antiviral pill are a positive surprise. The pill promises to be able to curb the progression of severe disease and has so far shown no serious side effects. Rapid market approval is being sought. Overall, however, we expect Covid to dominate the headlines less this winter than compared to a year ago.
2.1 Fixed income
After moving sideways for some time government bond yields have shifted notably higher in recent weeks. We expect this to continue, but in smaller steps. Central banks have put their cards on the table and so their slightly tighter stance should now be known to the market. We have closed our short position on German 2-year and 10-year government bonds and moved back to neutral. We do not think that government bonds will be sought after as safe havens even if equity markets continue to be volatile, especially in an environment in which there is continuing concern about economic growth and inflation.
Where we think the higher uncertainty and volatility compared to the summer could make itself felt is in the high-yield corporate bond segment. These bonds have almost entirely escaped the market correction so far, and so their risk premiums are still very low. However, in addition to idiosyncratic risks that could arise from energy price spikes or supply chain problems, we also expect brisk issuance, which could strain demand in some cases. We therefore downgrade US and Euro high-yield from positive to neutral. The same applies to corporate bonds from Asia, where the volatility around Evergrande has already left clear traces, but we cannot rule out further measures by Beijing that may put this asset class under pressure again.
2.2 Equities
The long overdue correction in equities has started, but how long it will last remains to be seen. The overall environment remains positive, with low interest rates and good economic and earnings growth. Despite a very strong second quarter reporting season, analysts have again raised their earnings estimates for the third quarter. But things could get more difficult in the fourth quarter as numerous companies have issued a cautious outlook for the end of the year. The increase in the cost of materials, as well as labor shortages, are no longer leaving companies unscathed, and they must now decide whether to try to preserve their margins through higher selling prices or to maintain sales volumes by keeping prices the same. Consumers' propensity to spend could also dim as energy price increases, the end of wage subsidies and even the temporary end to capital market gains make themselves felt in their wallets. We are maintaining our relatively balanced positioning of high-margin, high-growth technology stocks on the one hand and cyclical quality stocks on the other.
2.3 Alternatives
Nervousness about energy prices is high and is likely to remain so. Many market participants are praying for a mild winter: that is how serious the situation is. Gas inventories are depleted, the renewable sector is suffering from a lack of wind, and coal and oil are experiencing a surge in demand bringing tears to the eyes of ESG advocates. From today's perspective, there is little to suggest that rising energy prices will ease for the time being.
In metals we continue to expect very heterogeneous markets. The events surrounding Evergrande and the Chinese construction industry will weigh on construction-related commodities. But the energy shortage in China is likely to lead to production bottlenecks and thus provide support for the aluminum price. Precious metals, especially gold, will not be able to benefit from higher market volatility as rising real yields and a firmer dollar will count against them.
3 / Past performance of major financial assets
Total return of major financial assets year-to-date and past month
Past performance is not indicative of future returns.
Sources: Bloomberg Finance L.P. and DWS Investment GmbH as of 9/30/21
4 / Tactical and strategic signals
The following exhibit depicts our short-term and long-term positioning.
4.1 Fixed Income
Rates |
1 to 3 months |
until Sept 2022 |
|---|---|---|
| U.S. Treasuries (2-year) | ||
| U.S. Treasuries (10-year) | ||
| U.S. Treasuries (30-year) | ||
| German Bunds (2-year) | ||
| German Bunds (10-year) | ||
| German Bunds (30-year) | ||
| UK Gilts (10-year) | ||
| Japan (2-year) | ||
| Japan (10-year) |
Spreads |
1 to 3 months |
until Sept 2022 |
|---|---|---|
| Spain (10-year)[8] | ||
| Italy (10-year)[8] | ||
| U.S. investment grade | ||
| U.S. high yield | ||
| Euro investment grade[8] | ||
| Euro high yield[8] | ||
| Asia credit | ||
| Emerging-market credit | ||
| Emerging-market sovereigns |
Securitized / specialties |
1 to 3 months |
until Sept 2022 |
|---|---|---|
| Covered bonds[8] | ||
| U.S. municipal bonds | ||
| U.S. mortgage-backed securities |
Currencies |
||
|---|---|---|
| EUR vs. USD | ||
| USD vs. JPY | ||
| EUR vs. JPY | ||
| EUR vs. GBP | ||
| GBP vs. USD | ||
| USD vs. CNY |
4.2 Equity
Regions |
1 to 3 months[9] |
until Sept 2022 |
|---|---|---|
| United States[10] | ||
| Europe[11] | ||
| Eurozone[12] | ||
| Germany[13] | ||
| Switzerland[14] | ||
| United Kingdom (UK)[15] | ||
| Emerging markets[16] | ||
| Asia ex Japan[17] | ||
| Japan[18] |
Style |
||
|---|---|---|
| U.S. small caps[30] | ||
| European small caps[31] |
4.4 Legend
Tactical view (1 to 3 months)
- The focus of our tactical view for fixed income is on trends in bond prices.
- Positive view
- Neutral view
- Negative view
Strategic view until September 2022
- The focus of our strategic view for sovereign bonds is on bond prices.
- For corporates, securitized/specialties and emerging-market bonds in U.S. dollars, the signals depict the option-adjusted spread over U.S. Treasuries. For bonds denominated in euros, the illustration depicts the spread in comparison with German Bunds. Both spread and sovereign-bond-yield trends influence the bond value. For investors seeking to profit only from spread trends, a hedge against changing interest rates may be a consideration.
- The colors illustrate the return opportunities for long-only investors.
- Positive return potential for long-only investors
- Limited return opportunity as well as downside risk
- Negative return potential for long-only investors
