"Why, sometimes I've believed as many as six impossible things before breakfast.”
- Lewis Carroll, Alice’s Adventures in Wonderland
Alice’s Adventures in Wonderland begins when young Alice falls asleep in a meadow and dreams she follows the White Rabbit down a rabbit hole. She finds herself in Wonderland, where she has bizarre adventures among strange creatures who live under circumstances that constantly shift and defy logic. In this nonsense realm, she struggles to understand what’s going on.
Looking back over 2021, we might be forgiven for feeling like Alice. As the Red Queen said, “It takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that.”
Here are a few examples.
There was a snap federal election in Canada. When Parliament resumes, the new government will look very much like the old government.
Beijing said the two Michaels – Canadians Michael Spavor and Michael Kovrig – were not detained in retaliation for the arrest of Huawei CFO Meng Wanzhou in Vancouver. Their release just happened to coincide almost to the minute with her release.
Afghanistan is back under Taliban rule, where it was 20 years ago before the U.S. invaded.
A continuous stream of misinformation about COVID-19, masks and vaccines has led to alternate left and right realities. Canadian healthcare workers, who were heroes in 2020, are now under attack from anti-vax protesters blocking access to hospitals.
After almost a year, conspiracy theorists are still contesting U.S. presidential election results. Looking into baseless claims of massive voter fraud, a company called Cyber Ninjas concluded what they called a full forensic audit that confirmed Arizona’s Maricopa county had indeed elected Joe Biden. Other states have indicated they will also conduct audits despite having already certified their election results.
Ten months into 2021, we still don’t know if we are in a temporary or more entrenched period of inflation. Shifting their positions, central banks now seem to be thinking they will need rate hikes to tamp it down.
Equity markets finally stumbled in September (historically the year’s weakest month). Contrast that to the first eight months of 2021, when they put on blinders and sailed forward.
Although they have been growing and shrinking less dramatically than Alice, bond yields and prices have been seesawing up and down. After a startling decline in Q1, bond prices spent most of Q2 and Q3 recovering. That pushed yields down (prices and yields move in opposite directions). This trend reversed again at the end of September, when yields rose after the U.S. Federal Reserve said it could begin tapering its bond purchases sooner than expected.
Canada – Highs and lows
At the start of September, the Bank of Canada (BoC) held its policy interest rate steady at 0.25%. It will continue to purchase bonds, but at a reduced rate while the economy recovers. BoC Governor Tiff Macklem said that our central bank would raise interest rates before fully ending its bond-purchasing program.
Canadians are now sitting on excess savings of more than 10% of current GDP. Spending should rebound when pandemic restrictions ease. Natural gas prices are at seven-year highs thanks to increased demand and reduced international production. Consumers are already reeling from surging gasoline, food and housing costs. While home sales have fallen from their 2021 highs, they are still up about 20% from 2019. Prices continue to climb, fuelled by elevated demand and fewer new listings.
The BoC believes headline inflation will remain above its ideal range of 1% to 3% before it drops back to 2% in 2022. Increasing prices have driven nominal GDP (which does not adjust for inflation) back to its pre-pandemic upward trend. Real growth (which does adjust for inflation) has been muted, so real GDP remains around 2% below pre-pandemic levels.
In September, the Liberals under Prime Minister Justin Trudeau captured enough ridings to form a second minority government. After a 36-day campaign, the final seat tally remains almost the same for each party.
Canada’s stock market declined by 2.21% in September, but finished up for Q3, climbing by a meager 0.18%. Bond yields also spiked sharply by 35 basis points in September. Equity and bond markets were unhappy that the U.S. Fed suggested it might taper bond purchases and raise interest rates early. Oil prices are approaching a three-year high at nearly US$75 a barrel for WTI. Natural gas producers are enjoying a windfall. North American prices have increased about 115% over the year; in Europe, prices have gone up about 500%.
U.S. – Weighing its options
The world’s largest economy continued to rebound in Q3, but the more infectious Delta variant is squelching progress. The labour market added fewer jobs than expected in August and spending in the travel and hospitality sectors slowed.
Fed Chair Jerome Powell said the decision to taper the bond-buying program could come in November. The program will likely end “sometime around the middle of next year” if recovery remains on track. Mr. Powell has long said that rate increases will only come when inflation is above its 2% target and the economy is at maximum employment. Inflation is at 5.3%, the highest it’s been in almost 13 years, and unemployment stands at 5.2%, which is higher than it was before the pandemic. Even so, rate hikes in 2022 are clearly on the table.
Vaccination rates remain stalled, primarily in the South. In 18 states, less than half the population is fully inoculated. Currently, the unvaccinated account for 80% of COVID-19 hospitalizations. The CDC is now recommending booster shots for certain population segments; a vaccine for children will likely be cleared for emergency use very soon.
In September, Sino-U.S. relations chilled after President Biden announced the U.S., UK and Australia had formed a trilateral security pact. The three nations will forge an agreement to build a new class of nuclear-powered submarines, a response to China’s escalating presence in the South China Sea. To Beijing, this was an act of aggression, but relations warmed when the Biden administration removed the extradition request for Huawei CFO Meng Wanzhou. Beijing then released the two Canadian Michaels in what looked like an old-fashioned hostage swap. It was a pragmatic move since President Biden wants President Xi Jinping’s support on a global climate deal at the upcoming UN Climate Change Conference in Glasgow.
U.S. equities have remained remarkably resilient. While the S&P 500 fell by 4.65% in September, strong corporate earnings pushed returns up by 0.58% for Q3. We expect rising volatility in Q4, when monetary policy will likely tighten and escalating global COVID-19 cases will once again disrupt global supply chains.
Europe – Seeking a new path
“Who are you?” the Caterpillar asks Alice, who has trouble explaining her identity.
Germany, which has long been the EU’s anchor nation and economic engine, is preparing to carry on without Chancellor Angela Merkel, Europe’s de facto leader. She didn’t seek a fifth term in September’s national elections. Her centre-right Christian Democratic Union (CDU) came second to the centre-left Social Democrats (SPD) under Olaf Scholz in the worst showing for right-leaning candidates since World War II. Still, it’s not clear who will govern as six parties must vie for power; it will take time to see which ones can form a winning coalition.
Voters chose a shift leftward and away from a conservative agenda. We could see moderately increased government spending, more taxation and commitments to sustainability.
EU economic development quietly outpaced growth in the U.S. and China in Q3. With 70% of EU adults fully vaccinated, employment and investments are expected to continue to recover. However, uncertainty around the Delta variant and global supply bottlenecks, including skyrocketing energy prices, are dampening optimism going into winter. Purchasing Managers’ Index (PMI) readings missed expectations but stayed in expansionary territory.
Earnings estimates have been revised upward, but this has not translated into strong stock market returns. In September, the Euro Stoxx 50, FTSE 100 and DAX declined by 3.37%, 0.19% and 3.63%, respectively. For the quarter, Euro Stoxx 50, FTSE 100 and DAX returned -0.08%, 1.94% and -1.74%, respectively.
Japan – A change at the top
Japan’s governing party elected Fumio Kishida to replace an unpopular Yoshihide Suga and assume leadership of the ruling Liberal Democratic Party. Mr. Kishida faces economic and demographic challenges while trying to manage the COVID-19 contagion.
GDP grew at an annualized clip of 1.9% in Q2, beating earlier estimates. Solid capital expenditure helped offset pandemic-related weakness in the service sector. Despite this recovery, GDP growth is still negative for 2021 thanks to a sharp 4% slump in Q1. July GDP growth was 0.6%, which was spurred by enough corporate capital spending to offset a 0.7% contraction in household consumption.
The Nikkei rallied by 5.41% in September, contributing to a 2.90% return for Q3.
China – Signs of slowing
In September, investors worried that Evergrande, one of China’s biggest property developers, could default on US$300 billion in debt. Markets sold off based on calculations that China’s property sector poses a meaningful risk to the global recovery. Last year, Beijing took steps to curb booming housing prices and de-lever corporate balance sheets, which weakened the real estate market. The Evergrande situation exacerbated concerns about the Middle Kingdom because Chinese economic growth was already showing signs of slowing.
In August, service PMI readings dropped below 50 for the first time since April 2020 (50 is the expansion/contraction benchmark), then bounced back in September. The manufacturing PMI contracted in September, dropping to its lowest point since February 2020. China is now grappling with a power crunch caused by coal shortages, strong industry demand and tightened emission standards. Power rationing has led to factory shutdowns and production cuts. Although the country has been relatively successful at containing COVID-19, businesses have suffered from pandemic restrictions and people’s fear of mingling. Economists want Beijing to take a more stimulative stance after the government pulled back support as the country recovered rapidly from the pandemic.
The Hang Seng declined by 4.71% in September, while the Shanghai Composite rose by 0.77% in the month, ending Q3 with a 13.88% loss and 0.44% gain, respectively.
Our strategy
Global risks and rising rates caused a slight stock correction to close September, especially among high-value tech names. Bond prices also declined after the Fed cleared the way to taper bond purchases and raise interest rates.
Strong outperformance in equity markets this year pushed some of our portfolios toward the upper end of our allocation range. To counter this, we reduced exposure to various equity asset classes and made a corresponding increase to fixed income.
Overall, our positioning remains overweight to U.S. equities, with an offsetting underweight to bonds.
The last word
This quarter has certainly seen new stories and trends that would have been hard to imagine a short while back. Looking ahead, negotiations over the U.S. debt ceiling and President Biden’s Build Back Better agenda will deliver reliable drama.
Alice’s Adventures in Wonderland remains one of the world’s most popular children’s books 150 years after it was published in part because it shows the many ways that life frustrates expectations and defies interpretation. We look forward to meeting the challenges that the fourth quarter will bring.
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