Financial analysis of the third quarter, 2021
Here is a look at sustainability news and the global situation at the close of the third quarter, by the Investment Team.
A quick summary:
- As COP26 closes, it’s a chance to reflect on sustainability news from the last quarter, with a “code red for humanity” and the sale of the UK’s first sovereign ‘green gilt’.
- In the UK, soaring energy prices lead to inflationary pressures.
- The US debt-ceiling has made the headlines, and interest rates look likely to be raised.
- An overall positive quarter for Europe, with growth predictions up from previous expectation.
- Japanese equities rally and a change of leadership brings increased optimism.
- A difficult time for China spills over into other markets.
- For commodities, the situation is dominated by challenges in the energy market.
- We update on how our portfolios have fared, with sustainable models once again outperforming peers.
The in-depth read:
A spotlight on sustainability
COP26 in Glasgow has ended, and there is much debate about the success. There is evidence of progress for sure, but does it go far enough? George Monbiot describes it as a “suicide pact” in the Guardian.
Christiana Figueres, who was involved in achieving the Paris agreement in 2015, is more positive, and said it has “hastened the speed of the wheels of change.”
Let’s look back on the last financial quarter, and the run up to COP26.
In August, the UN’s Intergovernmental Panel on Climate Change (IPCC) released a significant study concluding that human influence is the main driver of changes seen to the climate over the last 40 years.1 The report concluded that by 2040, it is likely that we will surpass the 1.5 C degree temperature limit rise (as defined in the 2015 Paris Agreement). There will more frequent and severe weather events compared to the historical record and sea level rises of more than 2m are possible by 2100. 2
This disturbing report was described as a “code red for humanity.” Prime Minister Boris Johnson hoped it would be a “wake up call for the world to take action” in advance of COP26. Scientists urge that there should be no delay in cutting global emissions in half by 2030 and reaching net zero by the middle of the century to stifle the detrimental effects of climate change. 3
Net zero pledges continued to increase over the quarter, with Mark Carney, former Governor of the Bank of England, launching the Net Zero Financial Services Provider Alliance earlier this month. Members of this pledge include global credit rating agencies, stock exchanges, index providers and auditors who have promised to align their products and services with net zero by 2050. 4 Additionally, the Net Zero Festival was hosted virtually from Wednesday 30 September to Friday 2 October, bringing together global business leaders, influential academics, and policymakers to explore the opportunities and challenges of the “green revolution”. 5 Topics included practical guidance surrounding leadership, innovation and culture for top businesses to accelerate a decarbonised world.
In September, the UK’s Debt Management Office, the branch of the Treasury that manages bond issuance, raised £10 billion from the sale of the UK’s first sovereign green gilt.6 The funding will be ringfenced for government projects across the country such as clean transport, renewable energy and preserving the natural environment. There was huge demand for the sale as investors looking to buy the 12-year bond placed more than £100 billion of bids, the highest ever for a UK government bond sale.7 While the UK Government has arrived slightly late to the market for green sovereign debt compared to European countries, the Green Gilt will be followed later this year by the world’s first retail Green Savings Bonds, issued by NS&I, which will allow individual savers to contribute to the green agenda.8
That was last quarter – we now enter a new era, post-COP26, with hopefully a new sense of urgency.
Financial analysis from round the globe
UK
UK equities fared reasonably over the third quarter, with the FTSE All-Share up 2.2% over the period. While supply chain issues and labour shortages continue to be key themes, it was the energy sector that took many of the headlines over the quarter. Gas and energy prices have soared this year due to low fossil fuel inventories and lacklustre wind generation in comparison to previous years. From this, we have seen a number of energy companies collapse, partly from the inability to pass on rising costs to consumers due to the price caps set by Ofgem but also due to the company not protecting themselves against rising prices, something large companies often do.
From these issues, we have seen that inflationary pressures continue to exist, forcing the Bank of England to adopt a more hawkish (in favour of raising interest rates) tone. The Bank’s inflation forecast has been revised with the figure expected to hit 4% by the end of the year, and markets are expecting the first rate rise earlier than expected. Although the Bank’s remaining asset purchases are due to be carried out before the end of the year, an earlier rate rise – even in November or December – is looking much more likely as the issues persist. The Monetary Policy Committee meetings in November and December will be key events to watch, but we have already seen the 10-Year Gilt yield rise above 1% for the first time in over a year as concerns continue.
Despite the saga of petrol panic buying, retail sales remain weak, showing signs that the recovery we saw over the summer is starting to slow. On a similar note, consumer confidence also continues to fall, which is unsurprising considering all the above. Household budgets will surely be squeezed in the coming months with the threat of inflation and incoming tax increases.
US
The media whipped up worst case scenario headlines as the US approached its borrowing cap (debt ceiling), an issue that has arisen several times in the past decade but theoretically could lead to a very unlikely but potentially cataclysmic US debt default. The issue, together with the annual ruckus regarding government funding that accompanies each new fiscal year, has effectively been suspended by kicking the can down the road until December.
Over at the Federal Reserve, a Federal Open Market Committee (FOMC) statement wiped most of the equity market gains made earlier in the quarter on the back of strong corporate earnings. The release pointed towards a November announcement regarding the moderation of asset purchases and a speedier projection for interest rate rises over the next three years amid higher inflation expectations.
Investors who know their history may recall the panic in financial markets last time the Fed attempted to scale back their purchases, the famous ‘taper tantrum’ of 2013. This time round, the news roiled markets to a lesser extent due to the expected nature of the announcement, with recurrent talks of tapering and rate rises in the near future for the US over the past year. A minor hike and tapering can be considered far from hawkish given inflation has tipped over 5%, but given the transitory comments made by the Federal Reserve earlier in the year, investors could perceive the news as a forced act from a position of weakness – driven predominantly by inflation concerns, rather than economic growth.
The combined faster pace of projected hikes, high inflation and withdrawal of the asset purchasing programme drove US Treasury yields to reverse declines seen earlier in the quarter, rising back to similar levels seen at the beginning of the quarter. Rising yields pose a potential problem for seemingly expensive US equities, should economic growth and subsequent corporate earnings falter. High yields make future earnings less attractive, providing an environment for value outperformance as high growth stock valuations are more reliant on projected earnings far in the future.
Europe
European sentiment was positive this quarter following a rapid recovery and positive macroeconomic data. The success of the rollout of the vaccination program has kept the Delta variant at bay, with most large European countries now with 75% of the population fully vaccinated, allowing for the full opening of most economies.9
While economic growth did slow a little this quarter, the European Central Bank (ECB) expects the Eurozone economy to grow by 5% this year, up from previous expectations of 4.6% growth.10 The ECB announced that it will start to remove the economic stimulus provided because of the pandemic, but this would be gradual. Additionally, as fears of inflation continued, the ECB seemed in no rush to put interest rates up in comparison to the US and UK.11
Germany’s general election will likely see a centrist coalition government, with the Social Democrat Party (SPD) taking the largest share of votes. This should have a positive effect in Europe as the new government is likely to support the ECB’s decisions to continue with an expansionary fiscal policy and dovish stance (unlikely to take strong action) with regards to adjusting interest rates.12
The MSCI Europe ex-UK Index performance was relatively flat with the energy sector as one of the strongest performers and consumer discretionary stocks (companies which sell non-essential goods and services) faltering. Given Europe’s reliance on natural gas and wind energy, there was a surge in power prices due to low gas supply and lack of windy weather over the summer, towards the end of the quarter.13
Japan
After a grey second quarter, Japanese equities were among the strongest performers in quarter three, with the TOPIX returning 5.3%. Demand for Japanese exports was lifted through the global economic recovery, and a shakeup of leadership sparked hopes for fiscal stability and change.
The belated Olympic Games went ahead despite large public opposition and empty stands. Whether the games were a success or not remains to be seen. Quantifying the costs and benefits of such events has always been a difficult task, but with an estimated bill of around $20 billion it is hard to see organisers recuperate this cost, and equally hard to see cities queuing up to host future games in a post-covid world.
Allowing the games to go ahead proved to be one of the final blows for Yoshihide Suga’s one year tenure as Prime Minister, whose approval ratings plummeted to below 30% . Suga announced that he would not seek re-election, and his successor Fumio Kishida now has the task of regaining the Liberal Democratic Party’s (LDP) popularity following their poor handling of the pandemic. His first speech touched on several economic policies, including a 10 trillion-yen fund to boost research at universities, along with large investments in the latest technologies in areas such as artificial intelligence and space exploration. He also pushed for tax benefits for companies that raise wages and pushed for efforts to increase remuneration for nurses.
Further details of this should emerge over time, but when paired with a stronger position in the vaccination programme and decline in covid cases, the outlook seems much more positive than 3 months ago. Supply chain issues remain a problem, with Toyota cutting production over the period due to component shortages, particularly with microchips. Although a big issue, supply bottlenecks and material price increase could bring some much-needed inflationary pressure to the country.
Asia Pacific and Emerging Markets
Both the MSCI Asia Ex-Japan index and the MSCI EM index were down this quarter by 9.2% and 8%, respectively.
China has played a big part in these movements:
- Evergrande, China’s second largest property developer, struggled to meet debt payments to customers, investors and suppliers during the quarter.14 This spooked global investor over worries of further possible systematic financial risks.
- The Chinese Communist Party (CCP) introduced tighter regulation on the technology and education sectors including banning social media sites and making private cram schools public.15
- China’s power consumption surged on the back of a strong economic recovery from COVID which has now led to dwindling shortages and even rationing in certain areas.16
- There were concern over supply chain disruptions in August as the covid restrictions were introduced.17
In the MSCI EM Index, the consumer discretionary, communication services, real estate, and health care sectors underperformed the index. Energy, utilities and financials were the only sectors to finish positively over the period. 18
China’s adverse outlook over the quarter has had negative spill over effects into Hong Kong and South Korea, particularly energy disruptions on production and supply chains. India, on the other hand, saw strong gains boosted by the recent stream of initial public offerings (IPO) alongside policy rates remaining low and the easing of covid restrictions. Latin American equities had a rough quarter, with the S&P Latin America BMI falling 14.7% in USD terms due to political uncertainty and civil unrest, a steep drop in Brazilian equities and the US dollar strengthening against local currencies.19
Commodities
Many of us will remember this quarter by the lengthy queues at the petrol pumps or scrapping plans due to an empty tank. Whilst the HGV driver shortage has plagued the UK, the rising costs at the pump reflect a more profound problem, that of a global energy crunch. The oil supply-demand deficit is a result of major OPEC output cuts last year when demand waned for petroleum, and the lag to reopen the taps has caused global oil inventories to trickle down. To add to the demand pressure, a shortage of natural gas and coal have boosted oil prices, as nations seek alternative fuels to keep the lights on and power plants open.
Coal shortages have had a series of knock-on effects, as the fuel is a vital energy source in the production for other key commodities; aluminium prices soared as production of the energy intensive metal has stalled. These supply ‘bottlenecks’ have contributed to the forecasted deceleration of global economic activity, pushing up the prices of key commodities, and boosting inflation.
The rising energy costs wreaked havoc amongst smaller utility firms across Europe, as fixed contracts and price caps stopped energy distributors from passing rising prices onto customers. Silver and gold prices fell as industrial demand waned and bond yields rose, a historic relationship that increases the opportunity cost of holding precious metals.
How our portfolios fared
Our models performed well against their IA benchmarks over the quarter, and once again the sustainable models outperformed their conventional peers. Notable contributors to performance include our core active fund, Emerging Market fund Stewart Asia Pacific Leaders Sustainability, who benefited from their relative underweight in Chinese equities and strong performing Indian assets. Our overweight to smaller UK companies paid dividends as both active funds within the sector significantly outperformed large cap indices.
Our longer duration fixed income exposure weighed on performance unsurprisingly given the broad expectation that rates will rise faster than anticipated. The decision to underweight duration within our portfolio dampened losses with shorter duration assets posting flat and positive returns. Despite sharing in the equity market turbulence in September, our core property real estate investment trust (REIT) TR Property posted impressive returns for the quarter following from strong sentiment and returns in July and August.
Do get in touch with your advisor if you’d like to discuss this update or your investments.
The value of investments can fall as well as rise. You may not get back what you invest.
Past performance is not a reliable indicator of future results.
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1 https://www.bbc.co.uk/news/science-environment-58130705
2 The Week, 2021. “Code red for humanity”, 14 August 2021 [Issue 1344].
3 https://www.bbc.co.uk/news/science-environment-58130705
5 https://netzerofestival.com/netzerofestival2021/en/page/home
6 https://www.gov.uk/government/news/uks-first-green-gilt-raises-10-billion-for-green-projects
7 https://www.ft.com/content/94d604a9-50b9-49f1-b377-a7b6e4083d01
8 https://www.gov.uk/government/news/uks-first-green-gilt-raises-10-billion-for-green-projects
9 https://www.schroders.com/en/insights/economics/quarterly-markets-review—q3-2021/
10 https://www.lazardassetmanagement.com/research-insights/outlooks/european-outlook.html
13 https://www.schroders.com/en/insights/economics/quarterly-markets-review—q3-2021/
14 https://www.lazardassetmanagement.com/research-insights/outlooks/emerging-markets
18 https://www.lazardassetmanagement.com/research-insights/outlooks/emerging-markets