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Investment Commentary – Q3 2021

The third quarter of 2021 generally delivered small positive returns to diversified investors.   

While it is human nature to enjoy seeing the value of your investment portfolio increasing quickly, it is also not reasonable for us to expect large gains each quarter. If markets ever get too far ahead of themselves, it can increase the chances of a future correction. In that context, a small positive return can sometimes be more reassuring than a large one.  

Following the extended strong bounce-back from the Covid market crash in March 2020, the recent quarter represented both a consolidation of those prior gains and an opportunity for the market to digest new information.  

And what a considerable amount of new information there was to digest. 

One relatively recent development has been the emergence of an evolving energy crisis across both Europe and China, resulting in record price increases in commodities used to generate electricity and heat, namely oil, natural gas and coal.   

About 40% of the UK’s energy comes from renewable sources, but the reliability of a renewable supply can be problematic. With low winds across Europe and the UK in their northern summer, wind power generation waned, forcing these regions to turn to gas and coal. UK petrol prices have also hit an eight-year high with widespread reports of petrol stations running dry. 

In a similar vein, demand for natural gas has been surging in China, as low water levels restricted hydropower generation and severe coal shortages affected electricity supply. A combination of coal shortages, toughening emissions standards and strong demand from manufacturers and industry pushed coal prices to record highs and triggered widespread curbs on usage. 

The chequered pathway back to normal 

With much of the developed world abandoning strategies designed to eliminate Covid-19 and instead opting to “live with it”, a continued reorientation has been underway globally. Individuals, businesses and governments are exploring pathways back towards normal, or ‘post-Covid normal’.  

Increasingly, this is reflected in many countries through relaxation in previous social and business restrictions, and travel restrictions.   

Unfortunately, the pathway back to normal on the trade front faces some significant hurdles, at least in the near term. Anyone who has recently tried to buy significant consumer goods from overseas, will already have a sense of this – shortages and delays are now commonplace – but why is this? 

It’s what can happen when an extremely complex system gets disrupted.  

Supply chain breakdown 

During the first half of 2020, when much of the global economy went into lockdown, demand for most consumer goods came to a near standstill. Manufacturing capacity was cut, sailings by container ships were cancelled, and workers everywhere were furloughed or displaced. 

By the second half of 2020, following massive fiscal and monetary stimulus by most central banks, consumers started flooding online retailers with new orders. Manufacturing restarted, and international trade resumed. The global economic switch was suddenly turned back on. 

Unfortunately, restarting the global manufacturing machine after the lockdown turned out to be anything but seamless. The vast and interconnected system that continuously moves raw materials and finished products all around the globe requires predictability and precision. But with the advent of Covid, both had been lost. And, when the switch did turn back on, it occurred when thousands of shipping containers were stuck in the wrong place. 

Many containers that carried millions of protective face masks to Africa and South America early in the pandemic today remain empty and uncollected because shipping companies, aiming to make up for lost time and lost profitability, decided to direct their vessels towards their most profitable routes between Asia and North America or Europe.   

With significantly fewer containers suddenly in circulation, an immediate imbalance between the supply and demand for usable shipping space resulted. Unfortunately, this global supply chain breakdown directly contributes to the spike in transportation costs we are now witnessing, as well as shortages in key manufacturing components, order backlogs and frustrating delivery delays. Perhaps most obvious of all, we are seeing these effects coalesce all around us in the form of rising consumer prices.   

Inflation – temporary or permanent? 

And that leads to the question that policymakers and market participants are now grappling with – are these price rises likely to be temporary or something more permanent? 

Inflation measures have certainly gone up but that only reflects what we already know – that many prices have already increased. It doesn’t tell us how persistent those price rises may prove to be. If recent price rises can largely be attributed to supply chain issues, which are likely to be remedied in time, in that case the idea that the current inflation spike will only be temporary may have more credence.  

Early in the year, long term interest rates rose sharply as forward-looking markets anticipated a global economic acceleration would propel growth and inflation rates higher.  However, as the year has progressed, several of the world’s largest economies have recently revised their future economic growth projections downwards in light of these existing manufacturing and supply side constraints. At least temporarily, this paints a picture of rising inflation and reducing growth – a relatively rare condition (known as stagflation) that most central bankers are extremely wary of. 

Interest rate arm wrestle 

After losing momentum from April through to early September, long term bond yields – led by the 10 year US Treasury bond – rose again during the second half of September following policy meetings from the Bank of England and the US Federal Reserve. Both indicate a need to consider raising interest rates in the wake of rising inflation. 

Although many of the current inflationary forces are still seen as transitory, persistent disruptions in supply chains and surging energy costs have increased fears that inflation might last longer than anticipated. This added impetus to the increase in global yields from mid-September. 

Weighing into this debate, Federal Reserve Chairman Jerome Powell said they anticipate the current surge in prices, due primarily to supply-chain bottlenecks, continuing into next year before fading. He said the Federal Reserve doesn’t expect the current inflation spike to “lead to a new inflation regime, in which inflation remains high year after year.”  

Still, Mr Powell also conceded that the Federal Reserve faced a situation it hasn’t encountered for a very long time: an emerging tension between the bank’s two primary objectives of low, stable inflation and high employment. The dilemma for Federal Reserve rate setters is that any movement towards increasing interest rates to dampen down inflation is likely to be negative for economic growth, leading to increased unemployment. 

The world continues to watch developments in this space with keen interest. 

China struggles 

Outside of the major markets, China also hit the headlines for a range of reasons recently, not least of which being the relatively poor performance of the Chinese sharemarket last quarter.   

Chinese shares have always been subject to something of a “China discount” regarding the perceived additional political risk, but investors appeared to be surprised by the speed and swiftness with which large parts of the economy have been targeted for new regulations.   

A regulatory crackdown on social media and education firms contributed to weaker share prices in those areas. Companies with exposure to property also suffered due to the government’s clampdown on leverage coupled with a liquidity crisis at Evergrande, a very large Chinese property developer. There was even a Chinese ban on cryptocurrency transactions announced on September 24th which knocked the price of bitcoin.  

As if that wasn’t already enough, a rush by provincial authorities to meet strict national carbon emissions targets, together with tight supplies of coal, has led to power shortages, which could, in turn, weigh on both the wider economy and asset prices. 

But . . . not all doom and gloom 

So, on the surface – where the media tend to search for their headlines – the new information presented during the quarter seemed rather negative. It might be one explanation as to why returns during the quarter were fairly flat. However, when you scratched a little deeper, there was often better news to be found.        

Globally, most countries have successfully reduced the spread of the highly infectious delta strain via a combination of vaccines and increased mobility restrictions. And, with global vaccination rates still climbing, there is a sense of the tide slowly turning in this global fight. It is far from an immediate salve but is a brighter light at the end of the tunnel.   

On this pathway towards greater personal and economic freedoms, we can begin to consider the impact on trade, business profitability and economic prosperity. Taken together, the International Monetary Fund and World Bank see an average global growth rate next year of 4.6%.  This may be a touch below the current growth rate, but this is still a very healthy annual growth rate for the world economy relative to its pre-Covid pace of around 3%. 

A global reopening with increasing vaccination rates may also help reduce inflation pressures as the business community consistently gets back to work. Earnings volatility should reduce as supply chain pressures ease and businesses incur less of the stop/start disruptions they have experienced to operations and earnings. And while global interest rates may have commenced an upward path, they are likely to remain highly attractive (by historical standards) for some time, providing significant ongoing support to share markets. 

Covid-19 will go down in history as a global health disaster and an extraordinary economic disrupter. The word is rarely so utterly unprepared for something so seismic, but while its health impact and implications may linger long into the future, its long-term economic impact – in aggregate – may be considerably less devastating. 

This information has been furnished to you by Cambridge Partners Ltd, a fee-only Independent Financial Adviser registered in New Zealand. Copies of our advisers’ disclosure statements are available on request and free of charge. Disclaimer: there are no warranties, expressed or implied, as to accuracy or completeness of any information included in this document. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficiency, and timeliness.

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