The gales of November

The gales of November

Turbulence in the forecast


September has once again lived up to its reputation for volatility. In many ways this had to be expected as equity markets have experienced one of the longest runs of stable returns and minimal drawdowns in history. However, the timing of this recent volatility should not surprise many, as most of the positive tailwinds that have carried the market to these levels are starting to fade away, setting up what could be a difficult period for capital markets.

Global central banks are the most important factor that have helped elevate recent returns. To their credit, they learned from the mistakes of the global financial crisis where indecision and delay exacerbated things – this time, right from the beginning, the banks did everything they could to help the markets and the economy. But all good things must come to an end, and 18 months after the start of the pandemic, it is time for central banks to begin to remove some emergency measures.

This isn’t a bad thing at all. Central banks need to begin to normalize policy to prepare for the next crisis. But it is a change from the recent normal and means that central banks may be less accommodating for the next while. This action resulted in bond yields moving higher across the curve and has led to a change in sector leadership.

The growth/value trade has been a subject of much debate over the last few years. As growth has dominated in a period of ever lower bond yields, with the threat of inflation, has this turned? Will the rally in energy be the trigger to get this going once again? The energy sector was a victim of the climate movement, but the resulting cuts to production may be setting us up for a bull market in the commodities as we are already seeing shortages in both natural gas and heating oil. The resulting price increases is also adding further ammunition to the inflation argument as higher costs will undoubtedly flow through to the price of goods.

China risk

What no one really expected in September was the China risk. Consistently over the last year, China has been working to extend their influence over the capital markets, which has caused many to question if China is at all investible. Their constant clampdown on social media and other growth sectors became a secondary concern as their largest construction company ran into liquidity issues. Evergrande was never going to be a Lehman moment, but it had the potential to leave some scars. For the moment, this risk has faded to the background, but it can’t be ignored and has the potential to flare up once again.

What could prove to be the biggest risk to the markets in the near term is earnings season. With the advent of quant funds gaining a greater market share, we have seen companies that beat earning expectations gain versus those that don’t. But as easy comparable estimates fade, huge beats will be harder to achieve. We have already seen some notable companies miss these expectations, and the risk is that the next month will be filled with negative earnings revisions.

One of the biggest reasons for earning misses has been the broken supply chains. Covid lockdowns and pulled-forward demand for goods did immeasurable damage to the concept of “just-in-time” inventory models. Companies continue to scramble for components, such as semiconductors, in order to produce goods. As indicated by the surge in used car prices, the automotive sector has been one of the hardest hit. Until this is fixed, we must expect inflated prices of goods and services and squeezed margins. Whether this is temporary or permanent is still up for debate, but it’s another headwind to markets.

Investment implications

The year has already been a huge success for many investors as markets are near all-time highs, but with supportive measures being pulled back and the risk of earnings disappointments, the risk/reward going forward is looking less attractive than it has in past months. Markets have been due for a correction or volatility for a while.

However, this is by no means the end. There remains a record amount of “un-risked capital” that is looking to be allocated and buy the dip. Investors should be prepared for a pullback, but also be aware that these are opportunities. As a famous investor once said, “The stock market is the only store in the world that when things go on sale, buyers run away screaming.”

Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.

Notes and disclaimer

© 2021 by Purpose Investments Inc. All rights reserved. Reproduction in whole or in part by any means without prior written permission is prohibited. This article first appeared on the “Thoughtful” page of the Purpose Investments’ website. Used with permission.

All data sourced from Bloomberg unless otherwise noted.

The content of this document is for informational purposes only, and is not being provided in the context of an offering of any securities described herein, nor is it a recommendation or solicitation to buy, hold or sell any security. The information is not investment advice, nor is it tailored to the needs or circumstances of any investor. Information contained in this document is not, and under no circumstances is it to be construed as, an offering memorandum, prospectus, advertisement or public offering of securities. No securities commission or similar regulatory authority has reviewed this document and any representation to the contrary is an offence. Information contained in this document is believed to be accurate and reliable, however, we cannot guarantee that it is complete or current at all times. The information provided is subject to change without notice.

Commissions, trailing commissions, management fees and expenses all may be associated with investment funds. Please read the prospectus before investing. If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated. Certain statements in this document are forward-looking. Forward-looking statements (“FLS”) are statements that are predictive in nature, depend on or refer to future events or conditions, or that include words such as “may,” “will,” “should,” “could,” “expect,” “anticipate,” intend,” “plan,” “believe,” “estimate” or other similar expressions. Statements that look forward in time or include anything other than historical information are subject to risks and uncertainties, and actual results, actions or events could differ materially from those set forth in the FLS. FLS are not guarantees of future performance and are by their nature based on numerous assumptions. Although the FLS contained in this document are based upon what Purpose Investments and the portfolio manager believe to be reasonable assumptions, Purpose Investments and the portfolio manager cannot assure that actual results will be consistent with these FLS. The reader is cautioned to consider the FLS carefully and not to place undue reliance on the FLS. Unless required by applicable law, it is not undertaken, and specifically disclaimed, that there is any intention or obligation to update or revise FLS, whether as a result of new information, future events or otherwise.