04th Quarter 2021: Market Outlook

The following is my market assessment for the quarter.  I have tried to simplify it as much as possible.  However, market conditions are unprecedented in our era, and there is much to consider when balancing your portfolio.  This report has been pit together based on information provided by our own fund managers. 

The key points of note pertain to the effects of the pandemic on the global economy.  The Delta variant now makes up most of new cases globally.  Since the start of July, the global effective reproduction number has been north of the 1.0 threshold and climbing steadily upward, indicating the spread of COVID-19 is back to exponential growth.  Regardless, current economic recovery remains highly policy driven, especially with Delta infections likely to extend the progress of reopening and the uncertainty around the variant continues to weigh on market sentiment.  At the moment, relative valuation continues to favour equities over bonds and debt instruments, and the gap has widened given lower Treasury yields and improving earnings.  I expect this to ease as the Federal Reserve becomes hawkish on inflation, and raise interest rates.  At the moment, inflation in the US is 4.2%, which is well above their 2% threshold.  In the last quarter, all funds underperformed the benchmark due to the volatile market.  The market rotated from growth to value stocks in that period, and will take time to catch up.  However, since inception, all the funds have outperformed their respective benchmarks due to a higher asset allocation towards equities. 

The Delta variant now makes up most of the new cases globally.  While the spread of COVID-19 is back to exponential growth, both hospitalisation and fatality rates appear to be manageable compared to previous waves, for countries with high vaccination rate.  As such, there is no reason to expect the global economy to return to the tight lockdowns we saw back in March and April 2020.  Governments are incentivised to accept gradual lifting of restrictions even though cases continue to climb. 

Economic recovery remains on track in major economies despite market expectations are adjusting from elevated levels.  The service sector is recovering strongly at a global level thanks to the combined efforts of easing social distancing measures, active policy support, and vaccine rollout globally.  Additionally, with solid manufacturing activity, this should lead to strong economic growth in the remainder of the year, supporting the prospects of risk assets.  Inventories will be restocked when supply-chain disruptions are eased, providing additional tailwind to activity.  China is expected to be an exception among the major economies due to strict lockdown of provinces where there are cases.  The same applies to Hong Kong.  With China’s growth slowdown, its first mover advantage is fading when the cycle matures.  Recent policy actions should alleviate some of the concerns.  Overall, since vaccines are still highly effective in reducing severe COVID-19 illness and fatalities, countries with high vaccination rates should see a clear divergence in economic performance and inflation trajectory compared to those with low vaccination rates.  Vaccinations remain key to the broader reopening process. 

Inflationary concerns have receded over the past couple of months.  Inflation is elevated only in a few countries, and in the case of the US, it is mostly concentrated in goods and services sensitive to COVID-19 and the subsequent reopening of the economy.  In China, producer price inflation has likely peaked on the back of stabilising commodity prices, while consumer prices remain benign.  Therefore, anticipated rapid rise in inflation prints is likely transitory in nature. 

On company fundamentals, Q1 earnings season ended on a high note with over 85% of S&P 500 constituents reported earnings surprise.  The strong momentum looks to be carried on into Q2/  Out of the companies reported earnings so far, the magnitude of surprise is also stellar at near 20% on average.  Additionally, we can reasonably anticipate strong share repurchase activities for this year, with the announced share buyback so far beating the last 3-year average in the US markets.  These factors would provide additional tailwinds to developed market equities going forward under this ample liquidity environment. 

The outlook for Asian equities is less rosy for the moment.  Chinese equities continue to soften on the back of rising uncertainty from the regulatory scrutiny over key sectors.  Additionally, there is a fear of cascading corporate debt default lead by the impending collapse of Evergrande Group.  Although the ongoing structural reforms of capital markets could be positive to the markets in the long run, investors are pricing in a higher risk premium in the near term.  Outside of China, in major ASEAN markets barring Singapore, sentiments are largely weighed by the renewed COVID-19 infections from Delta combined with relatively low vaccination rates in these economies.  Meanwhile, momentum in Taiwanese and Korean equities is receding as the upcycle in electronics and chips manufacturing is gradually priced in. 

The current recovery remains highly policy driven, especially with Delta infections likely to extend the progress of reopening and the uncertainty around the variant continues to weigh on sentiment.  Policymakers will have to keep accommodative policies for some more time.  Managing the transition between ultra-loose economic policies and a sustainable setting continues to be the focus of the markets.  The Federal Reserve continues to maintain its accommodative stance.  Jerome Hayden Powell, 16^th chair of the Federal Reserve, reiterated the view that recent inflationary pressures are likely to prove transitory and acknowledged that the Fed will continue its discussions about tapering in coming meetings with “advance notice” on any tapering decision.  Similarly, the European Central Bank (ECB) remains its dovish stance with no sign of moderation in Pandemic Emergency Purchase Programme (PEPP) purchases and expects interest rates to remain at their present or lower levels until inflation reaching 2% well ahead in their forecast horizon of 2 to 3 years. 

In Asia Pacific, there have been some notable changes to central banks’ stance.  Notably, the Peoples Bank of China (PBoC) surprised the markets with an unexpected cut in reserve requirement ratio (RRR) in July, and future policy guidance is expected to be on the dovish side as the recovery continues.  Apart from the Delta infections and the idiosyncratic risks in Asia and China as briefly mentioned above, I am cognisant of the other risks in the system.  These risks should not derail the overall direction of relative performance between equities and fixed incomes, and within equities, developed markets versus East Asia and emerging markets. 

For this quarter, fixed income allocation has the following focus.  Treasury yields declined recently on the back of reduced inflation compensation.  The eventual path tapering of asset purchases should put a dampener on Treasury performance.  With US investment-grade default rates below historical averages, downside risk remains low.  However, limited upside for US investment-grade credit is expected, given the tight spread range and its higher sensitivity to interest rate movements.  Comparatively, Asian credit remains more attractive as spreads widened while default risks appear to remain stable.  Spillover risks from certain distressed Chinese corporates remain contained. 

Equities to continue to perform reasonably well against bonds.  More specifically global equities should continue their run relative to fixed income, likely driven by developed markets.  Major central banks remain accommodative for the time being, with any tapering discussion appearing to be well communicated with the markets.  In the US, reported earnings and sales continue to surprise on the upside with magnitude trending upward.  Strong buyback activities likely provide additional tailwinds.  Within equities, I am cautiously neutral on Asian equities given the region-specific headwinds including China’s regulatory scrutiny and low vaccination rates in ASEAN countries, except Singapore. 

Concerns surrounding the Delta variant remains our focus as governments are attempting to adapt to the new normal of living with the endemic COVID-19.  Relative valuation continues to favour equities over bonds and credits, and the gap has widened given lower Treasury yields and improving earnings.  Agility on adding or trimming equity in correction or for profit taking is necessary to balance the return potential against risks.  The factors driving recent weakness in Asian equities, could potentially provide a good entry point in the region. 

While our investments are all made with a long-term outlook, our portfolio performance has been delivering positive returns since inception.  There have been mixed results in the short term, but as the market turns, they will balance out, since the emphasis is on the long-term investment horizons.  During the quarter, our funds have continued to remain overweight to equities for the Adventurous, Balanced and Conservative Funds, adding to the outperformance since inception.  The global recovery is stemming from the flood in liquidity through fiscal and monetary policies.  The lifting of lockdown restrictions around the world is still very much on track even after the recent two months of rising Delta infections.  New waves of infections from further coronavirus mutations will only delay the recovery, but not completely derail the reopening narrative.  Global and regional economies cannot afford to remain closed. 

Baillie Gifford’s Iain McCombie, sub-manager of the AIA Global Quality Growth Fund, shared his views on stock picking fundamentals, the macroeconomic environment, and short-term volatility. 

Baillie Gifford has a long-term growth investment thesis for the AIA Global Quality Growth Fund.  What are the advantages of this strategy in the current cycle? 

The environment this year provides strong evidence for why a strategy based on market timing and economic forecasting is fraught with challenges.  At the beginning of this year, “re-opening” stocks came into vogue as the expectations of a strong and sharp economic recovery gathered pace.  As the number of COVID-19 cases has spiked again, the shine has been taken off these re-opening beneficiaries in favour of more defensive names.  It would be fantastic if we could accurately predict the see-sawing of the market between these two poles, but we think that it would be near impossible to do consistently.  Instead, we seek to own a small number of the world’s most exceptional growth companies.  These are structurally advantaged businesses with differentiated cultures and large markets to grow into. 

Ultimately, portfolio positioning is driven by our bottom-up stock picking and is reflective of where we are currently finding the most attractive growth opportunities on a 5-10 year view.  Key portfolio themes that emerge would include: climate and the energy transition, the opportunity in innovative healthcare, and the new wave of technology companies supporting entrepreneurship by offering “scale as a service” – this includes companies like Amazon Web Services, Shopify and Twilio which are helping to level the playing field between the largest and smallest, essentially lowering the barriers to entrepreneurship. 

What are the key risks that might derail your long term growth investment thesis? 

There is a lot of time and effort spent by market commentators on the likely risks created by rising interest rates and inflation.  Higher rates have traditionally been bad for equities, and growth equities in particular, because a larger proportion of their earnings lie further into the future, so a higher discount rate means a lower present value. 

However, within the Global Quality Growth Fund we would highlight a clear preference for companies with strong balance sheets - many holdings have net cash, pricing power and a market leadership position which should, on average, leave them better positioned than rivals in this type of environment.  For example, software businesses that operate subscription models rather than one-time only charges, and companies like Alibaba, Netflix and Amazon have illustrated that their customers stick with them even when they put prices up. 

So, we are pretty relaxed about the potential for a modest uptick in rates and inflation going forward.  The main reason we are unconcerned is that we are much more interested in how the world might look a decade in the future.  We are currently seeing a level of economic disruption that perhaps only presents itself once a century, so if our vision of the world in the 2030s is even close to correct – a world where there is abundant clean energy, where vast amounts of data is thrown off by innumerable connected devices, and where technology and healthcare collide to significantly improve the quality of people’s lives – then a bit of near-term inflation will seem insignificant in the context of the long term gains we can make for clients by looking past seemingly high near term valuations and investing around these structural megatrends. 

What are some of the recent portfolio developments and the rationale behind them? 

Perhaps one of the most exciting themes emerging in the portfolio at the moment is in healthcare.  Some have predicted that the 21^st century will be the century of biology, as our increasing ability to analyse and understand human diseases at the genetic level leads to a transformation in medicine.  This potential exploded into the public consciousness during 2020 with the rapid development of COVID-19 vaccines.  Famously, it took Moderna, which is not held in the Global Quality Growth Fund, just four days to create its version: two days for Illumina, a longstanding holding in the Fund, to sequence the coronavirus genome, then two days for Moderna to apply its technology to the problem. 

We firmly subscribe to the view that we are on the cusp of something quite extraordinary in healthcare and the Fund has been gradually increasing its exposure in this area.  Alongside current holdings Illumina, Staar Surgical and Denali Therapeutics, we have recently taken a new position in 10X Genomics, which develops instruments and consumables for the analysis of single cells, and added to the holding in Exact Sciences, which offers molecular cancer diagnostic tests.  We also own firms looking to improve the efficiency of new drug discovery and development, such as Dassault Systèmes, a software company that helps with the design and development of new products, and Codexis, a protein engineering company that creates custom enzymes. 

Since our clients are mostly Asia based, how does Billie Gifford identify companies with high quality growth potential in the long run given the idiosyncratic differences from this side of the world? 

At Baillie Gifford, we have been investing across the globe since our inception in 1908.  Indeed, our very first investments as a firm were in the rubber plantations of Malaysia, predicated on the growth of the car industry in the US.  The key point being, as investors, we have always retained a global outlook in our approach, married with a willingness to remain open-minded to different business models and consumer preferences emerging from different parts of the world. 

A case in point is China.  Many investors have and continue to view China largely through a Western prism.  How often have we heard the descriptions: “Alibaba is the Amazon of China” and “Meituan is China’s Grubhub”?  The danger with these lazy comparisons is that firstly they ignore the scale differences between the US and China, but they also infer that these are copycat businesses.  The reality, however, is that many of China’s internet businesses are leading rather than lagging on the innovation front.  The deep relationships we have been able to build with companies across Asia over the past few decades has helped immensely in educating us on these rapid developments and cultural differences. 

In addition, the emphasis we place on alternative sources of information in our research process has also been hugely helpful.  Rather than relying on traditional, financial sources of information which are typically short-term and US and Europe centric, we have spent the last couple of decades cultivating alternatives that we believe help us to see the world differently, expand our horizons, and help us generate value for clients.  Within China, as an example, these relationships span industrial and market experts but also experts within academia.  We sponsor the University of Oxford’s China Centre and have developed a relationship with Tsinghua University’s Computational Biology Department.  We are also continuing to grow and develop our own Shanghai investment research office.  Having an on-the-ground presence will help to deepen existing relationships with companies we own, get closer to exciting growth companies of the future, and provide a cultural lens to enhance and challenge existing perspectives.