The known unknowns
Equity markets do not like uncertainty which is why the statement from the US Federal Reserve in September provided some comfort around the start of the taper in bond purchases. That relief was short-lived, however. China Evergrande, the world’s most indebted real estate developer failed to pay a coupon on its US dollar bonds raising the risk it would default. Then came the UK/European energy crisis and the power outatages in China. Then came the debacle known as the US debt ceiling which the Biden Administration hit and now has to ask permission from Congress to lift it.
The third quarter of the year is historically the most volatile of the year and this one didn’t disappoint.
1. Transitionary inflation
Transitions are difficult to adjust to at the best of times. Pacing the transition to minimise the disruption is key. When two transitions happen at the same time the task becomes even harder. While the world economy transitions from being closed to open the fuel that powers it is itself transitioning from dirty to clean. Both transitions require a reallocation of resources that together are leading to supply-demand imbalances, raising the risk of substantially higher inflation. We believe these risks are overblown. Supply-chain bottlenecks in the manufacturing process should ease as economies open up and consumers rotate their spending away from goods toward services. Continued progress toward the new normal of living with COVID will also ease labour supply issues in the hospitality and leisure industries. This rotation toward services will also help ease the short-term pressure on clean energy supplies that have been shocked by surging global demand this past year
Chart 1: Bloomberg Commodity Index
2. Taper timing
The US Federal Reserve Meeting in September strongly suggested that an asset purchase tapering announcement could come at their November. Fed Chairman Jerome Powell indicated that the taper process could be complete by the middle of 2022. The market response was very similar to the market response from the June meeting of the Fed when the famous dot plot of interest rate expectations among the 18 members of the Committee revealed an earlier than expected lift-off in interest rates. Bond yields and the US dollar both rose. The difference this time was the response from the equity market. In June equities fell while this time equities rose in response to the Fed’s policy announcement. This suggests that equities have become comfortable with the pace and timing of taper and eventual lift-off of interest rates. This comfort level is being tested more recently as the energy crisis in Europe hits inflation expectations.
Chart 2: Market based inflation expectations has lifted (US 2-year breakeven inflation, %)
3. China risk still elevated
The People’s Bank of China may cut its reserve ratio yet again after the cut in July, while the finance ministry vowed to accelerate fiscal spending. Both efforts are designed to accommodate an economy whose momentum was slowing even before the Evergrande issue. Evergrande Group, a real-estate giant, delayed repayment on a loan equivalent to about $46 million that matured earlier. With its offshore bonds now trading at a deep discount to face value, the central government has reportedly told local provincial officials to take a “market-oriented approach” to resolving the company’s debt issues. Credit investors in Asia are facing a wider fallout from Evergrande bond woes as the US dollar bond sector starts pricing in wider risk margins for other Chinese property names.
The yield on the Bloomberg Asia Ex-Japan USD Credit China HY index will likely stay elevated in the near term at around 15-18% which is above the levels reached during the early pandemic panic in March 2020.
Chart 3: Average price of dollar bonds for Chinese Real Estate companies
– Despite several ongoing and emerging headwinds for the Australian equity market, the ASX 200 managed to deliver a fourth consecutive quarter of positive returns over the September quarter.
– The Australian market rose through the extended COVID lockdowns in Melbourne and Sydney. The lockdowns are expected to result in negative economic growth for Australia in the September quarter and were the catalyst for more cautious outlook statements from companies reporting full year results in August.
– Consequently, this triggered the first sign of negative earnings revisions for the market in nearly a year. However, investors were generally prepared to look through this temporary impact, particularly as vaccination rates increased and ‘reopening roadmaps’ were released.
– A sharp correction in the iron ore price led to a significant selloff in Australia’s three large iron ore miners – BHP, Rio Tinto and Fortescue. While the consensus view was that the iron ore had risen to unsustainably high levels through the first half of 2021, the decline was much sharper than anticipated and exacerbated by negative sentiment relating to Evergrande and China’s property market.
– However, a sharp rise in bond yields in September on the back of a return of inflationary concerns proved to be a more significant headwind for the Australian equity market’s returns and led to another rotation out of growth stocks into cyclicals late in the quarter.
– While this was a factor towards the end of the quarter, overall, the exposure of large cap funds to iron ore was the key driver of relative performance. Funds that are more growth-orientated in nature, such as Selector and Bennelong Concentrated, are typically underweight the resources sector and this assisted performance in the quarter, adding to the strong performance of their respective portfolios.
– Of other large cap funds, WaveStone recorded a solid quarter, while the performance of the more balanced Pendal SMA was broadly in line with the benchmark
– Small caps outperformed large caps over the September quarter and these two sectors of the market have now produced similar returns on a rolling 12 month basis.
– Our small cap managers produced strong numbers, with the standout performers being QVG and Ophir Opportunities.
– Global equities fell slightly in the September quarter after rising by 7.3% in the June quarter.
– For the third consecutive quarter emerging markets underperformed developed markets falling by 8.8% over the three months. The quarter saw some heavy selling of Chinese equities, down 18.2% as regulatory risk rose. The weakness spread into other Asian markets with Hong Kong down 14.8%, South Korea down 6.9% and Taiwan down 4.6%. Europe was little changed while the US S&P500 finished up just 0.2%.
– Pleasingly our preferred developed market equity fund managers generated positive returns over the three months to September with our sustainable funds (Stewart, Pengana, and Impax) leading the way.
– The Australian dollar fell 3.6% in the quarter leaving our unhedged funds outperforming their hedged equivalent funds.
– Our small company funds outperformed the large cap funds. This was particularly the case for WCM International (+7.8%) and Artisan Global Discovery Fund (+7.0%) after fees.
– Loftus Peak lost some ground over the quarter but is up 22.2% over the year. Underperformance in Alibaba, Tencent and Roku, was partly offset by outperformance in Netflix, Alphabet and Microsoft.
– Government bond yields were little changed over the quarter leaving the high duration funds such as Western Asset Management Australian Bond Fund and the PIMCO Global Bond Fund little changed.
– The two pure credit funds (where the majority of the risk comes from credit and not duration) did relatively well in the quarter. The Perpetual Credit Income Fund returned 0.28% while the Bentham Global Income Fund returned 0.52% after fees.
– The Ardea Real Outcome Fund declined by 0.77% over the quarter. This fund is designed to take advantage of short-term dislocations in the bond market. At its core, the Fund has an allocation to inflation-linked bonds the value of which declined due to a rise in real yields over the quarter.
– Our best performing funds over the quarter where the Realm Short-Term Income and High Income Funds. These Funds are designed to provide investors with high level of liquidity while also being low in volatility. The rolling one year volatility for the Western Asset Management Australian Bond Fund for example is currently 4.7% while the volatility for the Realm Short-Term Income Fund is 0.2% and for the High Income Fund is 1.2%.
– The third quarter proved to be volatile for hedge funds as world equity markets took a breather during September following a long upward march. Across the quarter there was a high level of dispersion in equity long short hedge fund managers returns.
– Market neutral hedge fund Bennelong Long Short was the worst affected by the sell-off during September finishing the quarter -5.35% bringing the 12-month performance -13.58%. Across the quarter the Fund’s long book underperformed the market. Coupled with this the short book made an absolute negative return. Pair trades in Qantas/Flight Centre, Xero/TechnologyOne and Bluescope Steel/Sims drove downside returns.
– Private equity (PE) markets have continued their record breaking year with total dealmaking value to the end of Q3 already estimated to have surpassed the full year figures for 2019 and 2002 with a total value of over $780 billion and over 6,000 transactions taking place year to date. Exit activity also continues to break records with sustained high valuations in public markets and PE firms looking to take advantage of ample liquidity within private markets, PE exits have also set a record according to Pitchbook data.
– Within our PE funds, both Hamilton Lane and Partners Group have strong returns for the 3 month period ending August 2021, finishing up 6.6% and 7.6% respectively. Both have benefited from the above highlighted market dynamics with Partners Group seeing upward revaluations to SPi Global, a content and data solutions provider, and Blue River Petcare, a leading US-based provider of veterinary hospitals, both on strong financial performance over the previous twelve month period. Hamilton Lane saw gains for recently listed growth equity positions in Monday.com and Bright Health in the software and healthcare tech industries contribute strongly for the quarter.
– In the private debt space, Merricks Partners Fund added circa 2% in the September quarter as loans in the agricultural industry and commercial real estate were fully repaid during the quarter. Additional funds were deployed across both sectors during the quarter. In agriculture, there is currently a mix of high commodity prices, low supply levels and increased demand for land which has led to a steady increase in agricultural land prices. Rising land values have also contributed to a number of successful loan exits. The forecast continued growth in land value is central to the manager’s continued confidence in investing in agriculture.
– In direct property markets, the Charter Hall Direct Office Fund had an above benchmark twelve month return of 15.5% on the back of positive revaluations for all office properties within the portfolio as of June 2021. The fund’s focus on A-grade buildings in prime CBD locations on the eastern seaboard have seen returns remain resilient through the last eighteen months. Barwon Healthcare Property Fund also benefitted from recent revaluations to many healthcare facilities in their portfolio as strong investor demand for healthcare properties drives valuations higher.