27 Sep Capital 19 Catch-Up

Equity markets got spooked last Monday when Chinese property developer EverGrande announced they might not be able to meet debt obligations and is teetering on the brink of bankruptcy. Analysts warned the potential fallout could have far-reaching implications beyond China. After expanding rapidly for years and snapping up assets as China’s economy boomed, Evergrande is now snowed under a crushing debt of $300 billion.

That sent the Heng Sang index down 3% and Australia and the US followed.

But when we looked at the internals of the US market we saw no evidence of credit risk. For example, companies with the largest debt burden in the Russell 3000 index performed a lot better than those with small debt burdens. If Evergrande really was to cause an issue you would expect to see the opposite.

This tells us there is nothing to worry about here. The Chinese government simply will not allow a Lehman-esque collapse on their watch and whether they step in taking ownership or hide it under the carpet the result will be the same. No large credit collapse or contagion to worry about.

By the time Wednesday rolled around, miraculously Evergrande somehow made interest payments on its domestic bonds and traders bought back all those stocks they sold down on Monday.

And that’s when things got really interesting for the week.

The FOMC rolled out its September policy decision, signalling that purchases of bonds would be scaled back this year. Based on the language in the statement slower bond buys “may soon be warranted” and from Chair Powell during his press conference “meeting our substantial further progress test for prices and jobs could be the case by next meeting”. We feel confident that the FOMC will explicitly announce tapering in November for start in December. We also note Powell characterized this approach as having “very broad” support on the FOMC in terms of both timing and pace.

As for how long the taper will run, Powell said that “tapering ending around mid-2022 may be appropriate”; that suggests that both sides of the even split between FOMC members wanting 1+ 2022 hikes and those wanting none as reflected in the Summary of Economic Projections (SEP) could be right.

On the other hand, Chair Powell tried to stress that “taper timing doesn’t carry a direct signal on lift-off” and we don’t believe a mechanistic process of hikes following the taper completion at a lag of a few months necessarily makes sense.

The result – stocks rallied for two consecutive days and crude oil rose 2.1% to $71.97 and the dollar gained 15 bps. Gold fell 0.58% as other metals moved higher with industrials outperforming.

The hawkish Fed was surprisingly welcomed by equity markets as it was seen as a confirmation of continued strength and ‘substantial progress’ made by the economy in recovering from the Covid shock.

 So far this year the market has welcomed bad news as good news but a market reacting to signs of an economy able to stand on its own without the monetary policy crutches is a refreshing change.

We feel this change marks something of a turning point for markets in the United States and around the world.

For the last 18 months, it has been Big Tech that has led the way forward. We forecast some time ago that would change, and it would be the industrials that take over the leadership role as we look forward to a re-open economy. But the Delta strain set that trend back and markets have traded sideways for some time.

That time is now over. Delta has been and gone. US new cases, deaths and hospitalisations are all declining. But the easy money time is leaving us also meaning profits will now come from clever stock picking. Just hiding out in Big Tech won’t lead to big gains anymore.

Now is the time to begin rebalancing your portfolios and looking for those opportunities where the market will move to next. Airlines and other cyclicals are the obvious target.