Monetary Policy and Inflation
September wobbles reflect, in part, unease about the changing monetary policy landscape. Central banks in South Korea, Hungary and Norway moved official rates up from historic lows, the first tangible signs of the changing monetary policy environment. The European Central Bank is preparing to retire its Pandemic Emergency Purchase Programme, while the Fed said it is likely to begin tapering asset purchases in November and signaled that rates may rise next year.
Yet, there has been no full-blown taper tantrum so far. While there have been some tough trading days, investors appear to be adjusting in fits and starts to the reality of the imminent end to extraordinary monetary policies that have prevailed through the pandemic.
Inflation, however, is a real threat, especially as the supply-chain squeeze pushes prices up in many industries. In Europe, inflation reached 3% in August, well above the European Central Bank’s 2% target. The Bank of England predicted UK inflation could breach 4% into the second quarter of 2022, while in the US, the Fed updated its 2021 inflation outlook to 4%. Companies around the world are taking note and talking about inflation more than they have in years on earnings calls.
Macroeconomic and policy trends matter, and they do drive stock prices and return patterns. For example, higher-growth stocks are generally more vulnerable to rising interest rates than lower-growth or value stocks. But we believe that predicting near-term macro trends, which have little bearing on longer-term company earnings, isn’t a prudent investing approach. Instead, we think investors should insulate portfolios against macro risks rather than taking a directional point of view. Active management can help by finding companies that are poised to thrive no matter what happens with policy, rates or inflation.
To be sure, if inflation stays over 4% for a long time, our research suggests that equity returns will suffer. However, in our view, investors shouldn’t avoid equities because of inflation, whether it turns out to be transitory or longer lasting. Either way, the inflation lens should now be applied systematically to company research. Companies that command real pricing power are likely to do much better in an inflationary environment than competitors who do not. Other companies might be hurt by rising prices of raw materials. Still others, such as commodity producers, real estate firms and banks, tend to benefit from inflation. Active managers can help ensure that equity holdings are prepared for the complexities created in an inflationary world.
China’s Twin Challenges: Is It Safe to Invest?
Risks emanating from China must also be proactively managed. Recent developments in China have rattled investor confidence in the world’s second-largest economy. In July, Chinese stocks tumbled amid a regulatory crackdown on education and technology companies. Then, in September, debt troubles at giant property developer Evergrande sparked concerns about the stability of the sector and China’s financial system.
Concerns about contagion from Evergrande are understandable. However, while a default would be painful for bondholders and will likely stoke volatility, we believe China’s banking system can probably withstand the pressure. Although the government is unlikely to rescue Evergrande, we expect it will take steps to prevent a collapse of the property sector. And over the medium to long term, cleaning up unsustainable businesses such as Evergrande is good for the financial health of the system, especially if a measure of risk-pricing discipline can be introduced in the process. This should lead to more transparency for stock pickers.
China’s regulatory moves during the summer also require context. Regulatory surprises in China are not new. Since China has grown so fast in recent decades, regulators often introduce changes to catch up with new industries that developed at lightning speed.
While regulatory action is unpredictable—even in developed countries—selective investors can identify companies that are less likely to be in the crosshairs of watchdogs, particularly in more mature Chinese industries such as consumer staples, industrials or materials. For attractive companies that are more vulnerable to regulation, investors can apply higher risk premiums to fundamental analysis and buy them at an appropriate price. And as the Chinese government pursues its common prosperity policy as well as policies to reduce carbon emissions, new regulation will also have a positive impact on some industries and companies, creating opportunities for investors.
Perspectives on Valuations and Concentration Risk
China might seem like a world away from developed markets, but there are parallels. Many concerns about the power of technology and consumer giants in China are shared by US regulators. During the recent sell-off in China, some of the largest names were hardest hit, perhaps providing a cautionary tale for some of the popular US mega-cap companies.
In the US, the retreat of high-growth mega-cap companies during September warrants a closer look at the risks of market concentration. By quarter end, the five largest companies—Apple, Microsoft, Amazon.com, Alphabet Inc. (Google) and Facebook—made up 22% of the S&P 500 Index and 37% of the Russell 1000 Growth Index. In the US, the 10 largest companies are now 57% more expensive than the rest of the S&P 500 companies, and the valuation premium has doubled since early 2019. For the MSCI World, the top-10 premium is 65% (Display, left).
