Third Quarter 2021 Market Outlook: Navigating the Delta Wave without Losing the Plot

This report draws on analysis from our fund managers, simplified as far as the subject matter allows.  Market conditions this cycle remain unprecedented within living memory for most investors, and there is a considerable amount to weigh when balancing a portfolio through it.  I will not insult anyone’s intelligence by pretending otherwise.

The Delta Variant and What It Changes

The Delta variant now accounts for the overwhelming majority of new global cases.  Since the start of July 2021, the global effective reproduction number has sat above the 1.0 threshold and continued climbing, confirming that COVID-19 transmission has returned to exponential growth.  Economic recovery, however, remains highly policy-driven, and Delta is more likely to extend the timeline of reopening than to reverse it outright.  Critically, in countries with high vaccination rates, hospitalisation and fatality rates remain manageable compared to previous waves.  There is no credible reason to expect a return to the tight lockdowns of March and April 2020.  Governments are structurally incentivised toward gradual reopening even as case counts climb, because the fiscal and political cost of another full lockdown has become considerably higher than the cost of managing Delta in the open.

The Valuation Picture

Relative valuation continues to favour equities over bonds and credit, and that gap has widened on the back of lower Treasury yields and improving corporate earnings.  I expect this gap to narrow as the Federal Reserve turns hawkish on inflation and begins raising rates.  US inflation currently sits at 4.2%, more than double the Federal Reserve’s 2% target.  Every fund in our range underperformed its benchmark last quarter, driven by a rotation from growth into value stocks that will take time to unwind.  Since inception, however, every fund has still outperformed its respective benchmark, a direct result of maintaining a higher equity allocation through the cycle rather than flinching at quarterly noise.

Economic Recovery, Region by Region

Recovery remains on track across major economies, even as market expectations recalibrate from earlier, more elevated levels.  The services sector is recovering strongly at the global level, supported by eased social distancing, active policy support, and continued vaccine rollout.  Solid manufacturing activity should support strong growth for the remainder of the year, and inventory restocking, once supply-chain disruptions ease, will provide an additional tailwind.

China stands as the exception among major economies, given its strict provincial lockdowns wherever cases appear.  Hong Kong follows the same pattern.  China’s growth slowdown is eroding the first-mover advantage it built earlier in the pandemic cycle, though recent policy actions should ease some of that pressure.  The broader pattern holds regardless: countries with high vaccination rates will diverge clearly, in both economic performance and inflation trajectory, from countries with low vaccination rates.  Vaccination remains the single variable that matters most to the reopening timeline.

Inflation: Transitory, Not Structural

Inflationary pressure has receded over recent months and remains elevated in only a handful of countries.  In the United States, that pressure concentrates specifically in goods and services sensitive to COVID-19 and the reopening process itself, rather than broad-based structural inflation.  In China, producer price inflation has likely peaked as commodity prices stabilise, while consumer prices remain benign.  The anticipated rapid rise in inflation prints across major economies is most plausibly transitory rather than structural.

Corporate Earnings, and Why They Matter More Than the Headlines

The first-quarter 2021 earnings season closed strongly, with over 85% of S&P 500 constituents reporting an earnings surprise, and that momentum appears set to continue into the second quarter.  Among companies reporting so far, the average magnitude of surprise sits near 20%.  Announced share buybacks are already beating the trailing three-year average across US markets.  Together, these factors provide meaningful tailwinds for developed market equities in an environment still flush with liquidity.

Asian Equities: A More Complicated Picture

The outlook for Asian equities is considerably less rosy at present.  Chinese equities continue to soften under mounting regulatory scrutiny across key sectors, compounded by fears of cascading corporate debt defaults tied to the impending collapse of the Evergrande Group.  The ongoing structural reform of Chinese capital markets could prove positive over the long run, but investors are pricing in a materially higher near-term risk premium in the meantime.  Outside China, sentiment across major ASEAN markets, Singapore excepted, remains weighed down by renewed Delta infections layered onto relatively low vaccination rates.  Momentum in Taiwanese and Korean equities is also receding as the current upcycle in electronics and chip manufacturing becomes increasingly priced in.

Central Bank Policy: Still Accommodative, For Now

The current recovery remains highly policy-driven, and Delta continues to extend the reopening timeline while its uncertainty weighs on sentiment.  Policymakers will need to sustain accommodative policy for some time yet, with managing the eventual transition away from ultra-loose settings the market’s central preoccupation.  Jerome Hayden Powell, the sixteenth chair of the Federal Reserve, has reiterated that recent inflationary pressure is likely transitory, and confirmed the Fed will continue discussing tapering in upcoming meetings, with advance notice attached to any eventual decision.  The European Central Bank remains similarly dovish, with no sign of moderating its Pandemic Emergency Purchase Programme, and expects rates to hold at present or lower levels until inflation reaches 2% well within its two-to-three-year forecast horizon.

In Asia Pacific, the People’s Bank of China surprised markets with an unexpected cut to its reserve requirement ratio in July 2021, and future guidance is expected to skew dovish as recovery continues.  Beyond Delta and the idiosyncratic risks already noted across Asia and China, other systemic risks remain on our radar.  None of them, at present, appear sufficient to derail the broader direction of relative performance between equities and fixed income, or between developed markets and East Asia and emerging markets within equities themselves.

Fixed Income Positioning

Treasury yields have declined recently on reduced inflation compensation.  The eventual tapering path for asset purchases should dampen Treasury performance further.  With US investment-grade default rates sitting below historical averages, downside risk remains contained, though upside is similarly limited given tight spreads and high sensitivity to interest rate movement.  Asian credit looks comparatively more attractive, with spreads having widened while default risk remains stable, and spillover risk from certain distressed Chinese corporates appears contained rather than systemic.

Equity Positioning

Global equities should continue outperforming fixed income, led by developed markets.  Major central banks remain accommodative for now, and any tapering discussion appears well communicated in advance rather than sprung on markets.  In the United States, reported earnings and sales continue surprising to the upside with rising magnitude, and strong buyback activity provides an additional tailwind.  Within equities, I remain cautiously neutral on Asia, given China’s regulatory overhang and the low vaccination rates weighing on most ASEAN markets outside Singapore.

The Long View

Delta remains the central concern as governments adapt to living alongside an endemic virus rather than eliminating it.  Relative valuation continues to favour equities over bonds and credit, and that gap has widened as Treasury yields fall and earnings improve.  Agility in adding or trimming equity exposure during corrections, or for profit-taking, remains necessary to balance return potential against risk.  The very factors currently weighing on Asian equities may well provide the entry point the region needs.

Every investment in our range is made with a long-term outlook, and portfolio performance has delivered positive returns since inception despite short-term volatility.  Our Adventurous, Balanced, and Conservative Funds have remained overweight equities throughout the quarter, adding to that outperformance.  Global recovery continues to draw on the flood of liquidity from fiscal and monetary policy, and the lifting of lockdown restrictions worldwide remains broadly on track even after two months of rising Delta infections.  Further mutations may delay recovery.  They will not derail the reopening narrative outright.  Global and regional economies cannot afford to remain closed indefinitely, and every government involved knows it.

In Conversation with Iain McCombie, Baillie Gifford

Iain McCombie, sub-manager of the AIA Global Quality Growth Fund at Baillie Gifford, shared his perspective on stock selection, the macroeconomic backdrop, and short-term volatility.  On the advantage of a long-term growth thesis in the current cycle, McCombie’s central argument is that this year has made the case against market timing and economic forecasting better than any theoretical argument could.  Early 2021 saw “re-opening” stocks come into favour as investors bet on a sharp economic recovery, only for that enthusiasm to fade back toward defensive names once case counts spiked again.  Rather than attempt to call that pendulum swing, which he regards as close to impossible to do consistently, the Fund concentrates on owning a small number of exceptional growth businesses with structural advantages, differentiated cultures, and large addressable markets.  Positioning follows bottom-up stock selection reflecting where the most attractive growth opportunities sit on a five-to-ten-year view, with key themes spanning the climate and energy transition, innovative healthcare, and a new wave of technology companies offering what McCombie calls “scale as a service”, firms such as Amazon Web Services, Shopify, and Twilio, which lower the barriers to entrepreneurship by levelling the playing field between the largest and smallest players.

On the risks to that thesis, McCombie acknowledged that rising rates and inflation dominate market commentary, and for good reason: higher discount rates typically hurt growth equities disproportionately, given how much of their earnings sit further out on the horizon.  His counterargument rests on portfolio construction rather than macro prediction.  The Fund favours companies with strong balance sheets, net cash positions, genuine pricing power, and market leadership, citing subscription-based software businesses and firms such as Alibaba, Netflix, and Amazon, all of which have demonstrated that customers tolerate price increases when the product commands genuine loyalty.  McCombie describes the team as broadly unconcerned about a modest uptick in rates and inflation, on the basis that their focus sits a decade out rather than on the next earnings cycle.

On recent portfolio developments, healthcare emerges as the theme generating the most excitement internally, tied to the broader thesis that the 21st century may prove to be biology’s century as genetic-level disease analysis transforms medicine.  McCombie pointed to the 2020 COVID-19 vaccine race as the moment this potential entered public consciousness, noting that Moderna, which the Fund does not hold, needed only four days to develop its vaccine candidate, built on two days of genome sequencing work by Illumina, a long-standing Fund holding, followed by two further days for Moderna to apply its own technology. Alongside existing positions in Illumina, STAAR Surgical, and Denali Therapeutics, the Fund has taken a new stake in 10x Genomics, which builds instruments and consumables for single-cell analysis, and added to its holding in Exact Sciences, a molecular cancer diagnostics firm.  It also holds companies improving drug discovery efficiency, including Dassault Systèmes and Codexis.

On identifying quality growth across Asia’s idiosyncrasies, McCombie traced the Fund’s global outlook back to Baillie Gifford’s founding in 1908, noting that the firm’s very first investments were in Malaysian rubber plantations, made on a bet about the growth of the American car industry.  That global, open-minded posture, he argues, still shapes how the Fund approaches China today.  He is dismissive of the lazy comparisons that dominate Western coverage of Chinese technology, casting Alibaba as “the Amazon of China” or Meituan as “China’s Grubhub”, arguing these labels ignore both the scale differences between the two markets and the extent to which Chinese internet businesses are frequently leading on innovation rather than copying it. Baillie Gifford’s research process leans on decades of cultivated relationships spanning industry experts, market specialists, and academia, including a sponsorship of the University of Oxford’s China Centre and a relationship with Tsinghua University’s Computational Biology Department, alongside a growing Shanghai investment research office intended to deepen existing company relationships and sharpen the firm’s cultural lens on the region’s genuine pace of innovation.

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Terence Nunis | Executive Chairman, Equinox Zenith | Author, The 1% Playbook: The Billionaire Cheat Code