China dominated the capital market news cycle in September, sending markets sharply lower following two months of strong gains. Default risk – with global implications – surfaced at Evergrande, China’s second largest real estate company. The ruling Communist party also cracked down on cryptocurrency use, and, more broadly, businesses and capital market activity via sweeping regulatory measures. At the same time, U.S. Federal Reserve Chair Jerome Powell put on the table tapering of the Bank’s asset purchases for later in the year. This tightening of monetary policy hit highly valued growth stocks particularly hard. “Risk off” was most definitely the theme to end the quarter.
The MSCI All Country World Index, which includes emerging markets, returned -0.3% in local-currency terms. A popular measure of emerging market performance, the MSCI Emerging Market Index (in which China has a 34% weight) posted a 6.6% loss in local-currency terms. A strengthening U.S. dollar in September was symptomatic of building market stress, and as is often the case, this had a negative impact on emerging market investments.
Canadian equities took a pause in the third quarter, mirroring global benchmarks. The S&P/TSX Composite eked out a 0.2% gain, as selective gains in industrial companies and grocers offset losses in the equity of consumer discretionary and gold companies. Canadian equity valuation remains very low relative to the United States, a gap not seen since the dot-com bubble of the early 2000s.
Canadian government bond yields rose sharply in September, finishing slightly up on the quarter alongside a steepening of the yield curve. As bond returns are inversely related to changes in yields, the FTSE Canada Universe Bond index posted a small loss (-0.51%) over the quarter. The Bank of Canada continued to taper its quantitative easing program to a target pace of $2 billion per week, still a large number by any measure. Credit spreads were unchanged to slightly tighter, with muted volatility for a second consecutive quarter. With higher government bond yields and stable credit spreads, corporate bonds outperformed federals.
Despite the deflationary scare in September – at least in terms of asset prices – the Consumer Price Index and bond market inflation expectations continue to rise. Extending the theme from our previous commentary, it does appear that the inflation camp holds the upper hand at the moment. Companies, for the most part, have been able to pass increased input costs to consumers; stable profit margins and robust earnings helped fuel a sharp equity market rebound in October. The sustainability of this trend, especially in the face of soaring energy costs, is a major hurdle for markets going forward.