KCS Quarterly Market Review for Q3 2021
October 28, 2021
Equities lost some steam during the 3rd quarter of 2021, with the benchmark MSCI All Country World Index (“ACWI”) ending the quarter down –1.1%. The entire decline happened in September, which saw a –4% pullback in the markets over worries around the US budget impasse and a Chinese economic slowdown. So ended the recent “hot streak” in global equities, which had been enjoying five straight quarters of gains. Still, markets remain firmly in bull territory—the ACWI is up an impressive +89% since the March 2020 lows and is +27% higher than its pre-pandemic levels.
Don’t blame developed markets for this quarter’s decline, as they finished the quarter unchanged. The clear culprit was emerging markets, which account for about 10% of the ACWI. These stocks tumbled by –8%, driven largely by a –18% swoon in Chinese stocks. China-based companies were weighed down by concerns over heightened government scrutiny of Chinese businesses and an imminent slowdown in the local economy, both likely to weigh on corporate profits. We discuss these issues in more detail below.
Countries with close economic ties to China, including Brazil, Korea and Hong Kong, were also down significantly during the quarter. There were some regional bright spots, however, including India, which soared over +10% on post-COVID optimism, and Japan, which jumped +4% on a change in leadership.
Meanwhile, bonds generally failed to live up to their safe haven status, falling –1.1% as measured by the Bloomberg Barclays Global Aggregate Index. Higher rates and a stronger US dollar weighed on most of fixed income, while tightening of credit spreads benefitted riskier bonds, which outperformed for the period.
Third quarter results bring the return of the MSCI ACWI to +11.1% for the year, while Global Aggregate bonds are down an impressive –4.1%. Regionally, US stocks have outperformed, while emerging markets are notably in the red. The worst performing sectors have been Utilities, Consumer Staples and Materials. Meanwhile, the best performers this year were the worst performers of 2020, with Energy, Financials and Real Estate significantly outperforming the broader indices.
So far this year, KCS portfolios continue to benefit from our individual equity selections, our underweight to emerging markets (and particularly, Chinese equities), and our tilt toward cyclical companies. This was partly offset by declines in some of our emerging market names. Meanwhile, our bond investments have been bolstered by success in our individual bond selections and a tilt toward economically sensitive sectors. This strength was tempered somewhat by weakness in our longer-dated, safe-haven bonds.
Why Invest in Emerging Markets (Including China)?
As mentioned above, some of the biggest detractors from our portfolios during the 3rd quarter were in emerging markets, especially some of our Chinese equities. And in response to recent headlines about China, we have been fielding some client questions around investing in the region.
To start, note that this is not just a KCS story. The MSCI China Index fell –18% during the 3rd quarter and is down almost –30% from its highs for the year. And China plays a big role in global indices: at the start of 2021, Chinese equities accounted for about 6% of the ACWI and half of its emerging markets weight.
Fortunately, our portfolios started the year well underweight Chinese equities, and to the extent we had exposure, it was focused on businesses with ties to the consumer rather than to building and investment. We also started the year with virtually no exposure to Materials, in large part owing to our concerns around how a Chinese property slowdown could one day weigh on this sector’s businesses.
So what’s really going on with China?
Three main factors are weighing on Chinese equities. The first is that the Chinese government has started to be more aggressively involved in the affairs of its businesses. This began late last year when Chinese officials halted the impending IPO of then-market darling Alipay. It has continued since then with a series of additional policy actions, including: the forced representation of the state on the boards of major tech companies; the mandated opening of “platform” businesses such as Alibaba within the country; stricter control of consumer data and the prohibition of storing it on non-Chinese servers; and the banning of for-profit educational services.
Second, amid this heightened regulatory drive, the country has also been dealing with significant credit stresses in one of its largest property developers, Evergrande, which carries about $300 billion of liabilities. Its difficulties and massive size have sparked fears that its troubles could spill over to other developers and the broader economy— after all, the real estate sector is one of the major drivers of Chinese economic growth.
Finally, China is also entangled in several major geopolitical issues that 1) are not going away and 2) have the potential to result in a military conflict. Areas of tension with the West include China’s positions with respect to Taiwan and Hong Kong. Given the seemingly insurmountable differences, investors are rightfully skittish about the potential for these issues to flare up.
While investors need to be aware of the above risks (and we at KCS watch them closely), we don’t believe they should preclude investing in China at any price. Ultimately, we find the primary principles behind China’s business actions to be to limit excesses, minimize monopoly, and improve the welfare of its people. These are enviable goals that Western countries are also pursing, albeit more gradually. (The main differences from the West—and also the main source of risk—revolve around state intervention in corporate affairs and controls over consumer data.)
With Evergrande, we don’t believe there will be contagion, as China has both the incentive and the wherewithal to contain any fallout. Finally, saber-rattling aside, we are optimistic that these geopolitical issues will remain at a simmer rather than grow to a boil. China benefits immensely as part of the global economy and its capital markets, and excessive aggressiveness risks severing those ties.
Not coincidentally, investor sentiment toward China and other emerging markets is currently at a low point. Momentum in markets tends to flow in cycles, and it is not remotely true that emerging markets always underperform. In fact, there have been decade-long periods when emerging markets have significantly outperformed the S&P 500, as the chart below illustrates. We believe that another inflection point is near.
More fundamentally, there are reasons to be excited about investing in emerging economies over the next few decades. Among them, GDP per person is projected to nearly triple in these countries by 2050, and 88% of the next 1 billion entrants to the middle class will be in Asia, most of these in developing countries. Some of our best performing individual securities have been from emerging markets, and we will continue to dedicate a part of our portfolios to emerging market companies that we believe have great long-term prospects. Therefore, given the recent pullback in the area, we have increased our exposure to these regions.
When The Juice Isn’t Worth It
Elsewhere, we continue to navigate the fairly treacherous waters of fixed income, and readers of our newsletters know we are no stranger to calling out this bond market. In our last newsletter, we wrote:
…said another way, who other than a global central banker is truly interested in the 1.1% average annual yield provided by the global bond market? It ensures a loss in purchasing power each year after inflation, and recently, even the interest rate on “junk” bonds (the debt of the riskiest companies that issue bonds) failed to cover inflation, something that hasn’t happened before in the past two decades. We view the signal here as loud and clear: stocks may be pricier than normal, but bonds are downright exorbitant.
The –4% decline in bonds so far this year thus did not surprise us. Risk-free rates remain stubbornly low, in some cases still negative. Meanwhile, rewards for taking investment risk are also near all-time lows, resulting in some shocking outcomes, such as the current 3.5% average yield on lower quality junk bonds. We find that to be an astonishing figure—especially given that in a typical year (a “median” year) junk bonds lose about 2% of that return to credit defaults. In a recession, they end up losing much more.
We currently have little appetite for low credit quality as a result. If interest rates move higher, borrowers will be pressured by higher interest costs. If rates drift lower, it will likely be in conjunction with a weakening economic outlook. Both possibilities would lead to a difficult environment for lower quality franchises. Either way, high-yield bonds priced at current yields seem like a raw deal.
As a result, we have shifted away from most of our high yield exposure. But all is not hopeless. Instead of diving into crowded trades, we have instead opted to emphasize relative safety, then bolstering our yields with what we view as attractive individual opportunities. The most notable such areas include preferred stocks and convertible securities. This positioning has helped our fixed income results during an otherwise dreadful year for most bond investors.
The Reopening Trade
After surging again in August, COVID case trends are back on the mend in the US. Rates of hospitalization and death are down materially as well, due largely to high vaccination rates among those most at risk. We are optimistic that this can continue, though the holidays could be challenging. Through a combination of additional vaccinations, booster shots, and at-home testing, we are hopeful that the US will enter the new year in much better shape with respect to COVID.
Here’s an interesting phenomenon: As COVID cases decline, interest rates rise, presumably on the market perceptions of higher corporate profits, increasing consumer demand, and greater strength in the economy. Thus, from their lows of about 1.2% in August, interest rates on 10-year Treasuries are back above 1.6% as of this writing. We believe sustained progress in containing the pandemic will continue this trend, leading to continued strength in equity markets and rising fixed income yields.
Conclusion & KCS Positioning
Though equity indexes remain near their highs, several underlying rotations among industry groups have occurred throughout the year. Case in point: 91% of the S&P 500 has had a –10% decline at some point this year, with the average S&P constituent experiencing an –18% drop from peak to trough. On the Nasdaq, the moves have been much greater, with an average decline of –38%. This phenomenon illustrates that adage that the stock market is a market of individual stocks that rarely move in lockstep. Even in a market near all-time highs, there are almost always bargains to be had.
During Q3, growth stocks made a bit of headway versus value as COVID cases flared. However, we believe the ramp up in economic activity that will accompany a continued waning of COVID cases (accompanied by easing of supply chain challenges) will lead to a surge in both consumer and business demand, boosting interest rates and equity markets alike.
In view of the above, we continue to maintain our general positioning in equities, with changes so far this year focusing on individual names. Meanwhile, in fixed income, we have nearly eliminated our exposure to high yield, and instead are opting for safety while taking on risk in areas where it appears to be properly compensated. These include individual preferred stocks, convertible bonds, and more recently, small positions in commodities and pipelines. We continue to find compelling opportunities even in richly-priced markets, and believe that maintaining exposure to more cyclical value equities alongside growth stocks will continue to reward our clients as supply chains loosen and the global economy strengthens.
The KCS Investment Team
KCS Wealth Advisory is a registered investment adviser. Our services include discretionary management of individual and institutional investment accounts, along with personalized financial, estate and tax planning services.
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 The All-Country World Index (ACWI) is a global index that includes about 3,000 companies publicly traded around the world. It accounts for about 85% of all publicly traded equities and is the benchmark against which KCS measures it’s equity returns.
 Credit spreads measure the difference in yield between a “riskless” US Treasury bond and other bonds of similar maturity but different credit quality.