Market Development: In September, the MSCI World Index (net returns in USD) retreated 4.15%, the EURO STOXX 50 (net returns in EUR) declined 3.08%, whilst the S&P 500 also came down by 4.65%.
The Dollar Index (DXY Index) strengthened by 1.73% over the period, whilst the generic 30Yr Treasury yield increased from 1.93% to 2.05% and the VIX naturally responded to a more volatile market to end the month higher, at 23.14.
Escalating news of energy shortages in China disturbed equity markets and contributed to concerns of rising inflation. After equity market valuations steadily increased during the summer and into September, typical market seasonality materialised, sparked by further developments in China.
While recent months have seen the emergence of an important reshaping of the technology eco-system, the Middle-Kingdom is now facing the unwinding of a highly leveraged Real-Estate sector. Given the extraordinary growth of China, and the critical role Real-Estate development has played in its economic ascent, the sector’s balance sheet size is intimidating, and evokes memories of disruptive episodes in financial market history.
The extent of Evergrande’s gross indebtedness is the first concern – around USD 300bn or close to 2% of China’s GDP – but maybe, more importantly, the market is grappling with the possible ripple effect of such a bankruptcy: the consequences for the banks holding loans; for the investors exposed via so-called “wealth-management products”; for other Real-Estate developers with tight balance sheets; for the millions of Chinese clients awaiting project deliveries; and for economic growth as a whole, given the range of jobs and suppliers exposed to a slowdown in construction.
As we grapple with the unknown, a few key lessons of past crises come to the fore. First, let us not forget the difference between gross and net indebtedness and the fact that we still ignore whether China faces a liquidity or solvency issue – a critical distinction.
Further, even significant deleveraging does not necessarily need to be disorderly. For example, the 2008 crisis demonstrated that while Lehman’s fall created a damaging cascade of events initially, an orderly deleveraging and stabilization of Real-Estate markets took place over the following years, once the government ensured liquidity and the recapitalisation of banks.
These interventions ultimately represented a financially profitable operation for the government, a key fact often overlooked. Governments, unanimously scarred by the 2008 experience, have proved to be highly attuned to the inner workings of financial markets, as evidenced as recently as during the COVID pandemic.
China’s vast reserves and preponderance of Yuan-denominated debt differentiates this case from the Real Estate busts of the Asian crisis, with full control over its money supply, unconstrained by currency mismatches. Lastly, we consider specific Chinese characteristics, such as the government deemed that it’s vital that a fluid economy and social order are maintained.
For now, in line with consensus, we remain cautiously optimistic that the situation can be managed without excessive spillovers by a powerful and highly incented government with significant resources at its disposal. Naturally, we will remain focused on these developments in the coming months and understand the potential for volatility as more information emerges from the government and exposed companies.
The second source of volatility in September was attributed to ongoing shortages in multiple categories of Goods and Services, including Shipping, and more worryingly, Energy. These shortages are particularly important due to their influence on the perceived stance of the Federal Reserve’s monetary policy intentions.
Following a rather dovish Jackson Hole speech in August, J. Powell communicated the first clear intentions to taper the extraordinary asset purchase programs initiated during the pandemic. With more Fed members openly discussing interest rate hikes beginning in 2022, and the nuanced “transitory” narrative surrounding inflation, interest rates moved higher towards the end of September.
In brief, the increasing likelihood of rising interest rates exacerbated the risk-off mood of equity markets. At this stage, slowing progress on the employment front continues to support our view that the price increases in certain parts of the economy are distinct from true policy-affecting inflationary dynamics, yet this subject will remain front of mind in the coming months.
We continue to view the market as supported by strong pillars of monetary policy, fiscal policy and earnings momentum, even though the post-COVID normalization of the economy will require monetary policy to adjust. While the second derivative of fundamentals is inflecting, companies will need to earn their valuations and prove their worth to retain investor interest.
We look for the upcoming quarterly earnings season to support investor sentiment in the companies with strong secular tailwinds and reasonable valuations.
The Sturdza Family Fund, returned -2.30% in September. With risk aversion affecting markets, and questions on interest rates and inflation, high-multiple stocks were the most heavily impacted, although few corners of the market were spared.
Autozone led the Fund contributions, returning +9.6%, followed by Dollar Tree, up +5.7%, Nitori Holdings, up +5.8% and Willis Towers Watson, up +5.7%. On the opposite side of the ledger, Worldline (-13.9%), Facebook (-10.5%), Iberdrola (-18.8%) and Air Liquide (-10.4%) were the top detractors.
In the case of Air Liquide and Worldline, this share price decrease provided the Fund with an attractive opportunity to put fresh capital to work, and we expect the same for the others, although we are awaiting the quarterly earnings for additional fundamental updates.
In line with our activity in the previous month, we reduced – albeit at the margin – exposure to stocks that we viewed to be most at risk in a rebound of interest rates (Medtronic, Teleperformance, IQVIA, Moody’s, Blackstone, etc), but consider these adjustments tactical rather than strategic in nature. The Fund exited its position in Nemetschek following a handsome run in the stock price, and continued to reduce its exposure to both Aon and Arthur J Gallagher on strength; so as not to overexpose the Fund to the attractive insurance brokerage business represented by our recent addition, Willis Towers Watson, a position we continued to increase during the month.
Whilst the market was more volatile in September, and certain macro developments will require close attention, we remain optimistic about the future of equity markets and especially so for our investee companies, looking for any drawdown to add or complement our existing portfolio with new, attractive investment opportunities.
The secular trends underlying the growth of our portfolio remain unchanged, and reasonably priced companies involved in those are likely to continue to gain in value on their own merits. We look to capitalise on such opportunities, particularly when volatility allows us to do so in the right conditions.
As always, we invite investors and prospective investors, to contact us should they wish to understand our views on the current situation and the positions held in the portfolio. Please do not hesitate to contact us for further information.
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The views and statements contained herein are those of Banque Eric Sturdza SA in their capacity as Investment Advisers to the Fund as of 19/10/2021 and are based on internal research and modelling. Please click on Disclaimer Page to view full disclaimers.