Q3 2021 - Market Review
ECONOMIC COMMENTARY
During the 3rd quarter, global equity markets performance was mixed for the first time in a year. This happened while the Delta-Variant ravaged communities with low vaccination rates as fast as the Dixie fire burned through Northern California. Specifically, the S&P 500 Index and the S&P TSX 60 Index gained 0.58% and 0.21%, respectively, while the MSCI All Countries World Index[1] declined -0.36%.
The Federal Reserve (“Fed”) Chairman, Jerome Powell, managed quite a feat in his Jackson Hole address by mentioning that the Fed would start tapering its bond-purchase program without causing a crash in risky assets. His predecessors were not as successful. Government bond yields, however, moved up modestly in the latter part of the quarter in response to Powell’s speech. As a result, like for equities, the performance of different bond market segments diverged. For instance, the ICE Bank of America Merrill Lynch Global Government Bond Index retreated by -0.12% while the ICE Bank of America Merrill Lynch Global High Yield Index gained 0.17%. In Canada, the ICE Bank of America Canada Broad Market Index declined by -0.70%.
While the performance of equities and fixed income markets was without consequence, the same could not be said for commodities. In fact, the S&P GSCI Total Return Index, led by the energy sector, gained 5.22% during the quarter. The price for a barrel of Brent Crude oil reached 80$ in early July, following yet another round of failed talks between the members of the OPEC+ cartel, before subsiding when the group reached an agreement on how to split production increases amongst members a few weeks later. Still, crude and petroleum prices have remained elevated. Nonetheless, notwithstanding the structural underinvestment in the space over the past decade, which should lead to a supply deficit, we note that the price barrel of Brent Crude for delivery in December 2022 was at 75$ around the end of the quarter and 70$ in December 2023. So, the consensus seems to be that oil is going a bit lower and that there is no incentive for refiners to seek to build inventories. The price for oil delivery on future dates has not been a perfect indicator in the past but it is something to take into consideration.
XI’S GRAND PLAN FOR EVERGRANDE
Many might remember watching professional wrestling Sunday mornings on television in the 1980s. It was well known that the matches were staged but nevertheless the spectacle was pretty enjoyable. One can recall a wrestler in particular, Rowdy Roddy Piper whose signature kilt and bagpipe music entrance were crowd-pleasers. He was not the most physically impressive wrestler but he had mastered the “sleeper hold” move, which, as the name implies, could put any opponent, big or small, to sleep. In fact, as soon as Piper locked his arms around his opponent’s neck, the audience knew that the outcome of the match was sealed.
In the financial sector, this effective technique was somehow applied to the Evergrande Group, one of China’s largest property developers which was on the brink of bankruptcy at the time of writing this letter. Our view is that Evergrande’s fate had been sealed some time ago when China imposed strict leverage guidelines on selected property developers in August 2020 against a backdrop of growing debt levels and rising land prices[2]. These guidelines were merely reflecting President Xi Jinping’s desire to curb excessive speculation in the real estate sector, which he had been vocal about since at least 2017.
But Evergrande is just one of China’s national champions that have recently been put to sleep, figuratively. From the moment that the regulators thwarted Jack Ma’s plans for the initial public offering (“IPO”) of Alibaba’s Ant-Digital unit, it should have been clear that no company was beyond their reach if they perceived that it contravened to their grand plan, which is that the search for profits must be in society’s best long-term interest. To this point, since then, the Chinese regulators have gone after the tech sector behemoths, the online education sector and the real estate construction sector while effectively banning virtually all activities related to the nascent cryptocurrency sector.
The good news is that after a few volatile days for global equities following the disclosure of Evergrande’s woes, market participants quickly concluded that the Evergrande’s debacle was not China’s Lehman moment and that the country had the means and resolved to manage this crisis. However, we should not dismiss the impact that an important reduction in housing construction in China might have on the global economy. In fact, while recent discussions with clients have revolved around inflationary forces, we cannot dismiss the deflationary effect that Evergrande’s bankruptcy could have.
THE CULT OF THE START-UP
A high-profile trial for wire fraud and conspiracy opened in California in late August. The defendant, Elizabeth Holmes, was the founder and CEO of Theranos, a company that claimed to have devised a machine that could run rapid and complex blood tests from very small amounts of blood. Theranos promised to revolutionize healthcare and, without surprise, Mrs. Holmes became a celebrity and was seen as the rightful heir to Steve Jobs[3]. Armed with signed partnerships with Wal-Mart and Walgreens, Theranos was able to raise over 700 million from high-profile venture capitalists and attract individuals such as James Mattis[4], George Shultz[5], William Foege[6] and even Henry Kissinger on its board of directors. For a while, Theranos acquired the status of a cult in Silicon Valley and Elizabeth Holmes was its guru. However, thanks to the work of New York Times investigative reporter John Carreyrou in collaboration with Theranos whistleblowers, it was revealed that Theranos’ claims were totally fabricated and that its blood testing machines did not work.
The reason we mention Theranos[7] is that as access to private equity, venture capital or even start-up deals is becoming increasingly easier, it may be tempting for a new generation of affluent investors who may have missed out the last decade of spectacular returns to sign their name at the bottom of a subscription agreement without doing much analytical work. That being said, we recommend investors inclined to go down that route to be prudent as Theranos’ fall from grace is a reminder that for every Lightspeed, there are many Theranos. We strongly prefer to invest in funds specializing in this segment because these funds typically seek participation in roughly a dozen companies with high growth potential, thereby minimizing the risk should one or more of them end up being write-offs.
[1] Index returns refer to the net total return series in local currency terms, unless specified otherwise.
[2] Summarily, compliance with three financial ratios must be met: 1) Liability-to-asset ratio (excluding advance receipts) of less than 70%; 2) Net gearing ratio of less than 100%; 3) Cash-to-short-term debt ratio of more than 1x. If the developers fail to meet one, two, or all of the ‘three red lines’, regulators would then place limits on the extent to which they can grow debt.
[3] Founder and CEO of Apple.
[4] Former US Defense Secretary
[5] Former Secretary of State
[6] Former CDC Director
[7] A movie is reportedly in the works starring Jennifer Lawrence as Elizabeth Holmes.