(Tech)tonic surprises

Source: Refinitiv DataStream, 31 July 2021. Total Returns in USD.
 

Developed markets posted positive returns as emerging markets lost ground in July. Small caps outperformed across most major regions including the UK and Europe but, in aggregate, outsized gains from US mega caps saw large caps pull ahead of their small cap counterparts globally. In terms of style, growth outperformed value in the month, but value and cyclical names remain ahead year-to-date.

UK mid-cap stocks and US equities led the market higher in July. European equities also logged positive returns while Asia ex Japan, Chinese A shares and Japanese equities all lost ground in the month.

While positive earnings data fuelled risk appetite in July, jitters around China’s regulatory crackdown on the IT and education sectors, and concerns of a resurgence in virus cases due to the more transmissible Delta variant created intermittent market volatility during the month. Yields plummeted and 10-year government bonds (UK gilts, US treasuries, German bunds and Italian BTPs) posted positive returns alongside equity gains. Corporate bonds also gained ground in July, but lagged government bond returns.

In commodities, Brent crude slipped to near $68/barrel in July amid OPEC supply discussions, before finishing the month above $76/barrel. It remains up more than 47% year to date. Gold regained some of its lustre, finishing up around 2.5% as risk aversion crept back in, and the US dollar marginally weakened against a basket of currencies.

A mix of defensive and cyclical sectors outperformed in July. Healthcare, information technology and materials led the gains. Energy stocks tracked the oil price lower in the first half of July and the sector finished the month down. Elsewhere, consumer discretionary stocks lagged the wider market, and financials remained under pressure. Energy and financials remain among the strongest relative performers year to date.

In July, we witnessed another strong earnings season aided by favourable base effects. Quarterly Earnings per Share (EPS) growth figures in Europe and the US tracked composite PMI readings higher as the global economy revived itself.

Source LHS: Refinitiv DataStream, J.P. Morgan as at 5 August 2021. Global Composite PMI = J.P.Morgan Purchasing Managers Index, World, Composite, Output, SA. 
 

With the reflation trade acting as a tailwind, cyclical sectors delivered some of the strongest year-on-year quarterly earnings growth. Second-quarter results for US and European cyclical sectors were materially stronger than for defensive sectors. Despite already elevated expectations, there were positive sales and earnings surprises across a broad range of sectors, while industrials, consumer discretionary, energy and materials companies saw some of the strongest earnings growth in the second quarter.

Source: Bloomberg, J.P. Morgan, as at 5 August 2021. EPS = Earnings per Share. European Industrials and US Energy blended 2Q21 EPS growth figures sourced from Refinitiv DataStream/ StarMine SmartEstimates, as at 8 August 2021. Includes data for fiscal quarter May 2021 – July 2021. Based on regional (US, Europe) large /mid cap universes. 
 

Company guidance remains relatively robust, but consensus estimates look softer over the medium term, potentially factoring in some petering out of the initial reflation trade, lingering COVID-19 risks, recent climate-related impacts, and localised supply-chain bottlenecks. With mixed economic data of late, and the gradual unwinding of monetary stimulus in sight, we will likely see further revisions to medium-term forecasts.

While investors will be keeping an eye on leading economic indicators and forthcoming central bank guidance in the second half of the year, geopolitical and regulatory risks could also be top of mind following China’s recent regulatory crackdown.

Chinese equity indices have tumbled in recent weeks, after Chinese regulators targeted large tech companies – conducting anti-trust probes, imposing data security reviews, announcing sweeping reforms of the country’s $100 billion high-growth ‘ed-tech’ private education and tutoring industry¹, and calling for a new listings regime for Chinese companies looking to list on overseas exchanges.

Businesses caught in the crosshairs of the recent measures (Alibaba’s e-commerce platform, Tencent’s online video games, and DiDi’s ride-hailing service to name a few) are primarily in the information technology and communication services sectors, along with consumer discretionary and consumer staples companies.

We saw relatively correlated moves across Chinese equity indices following Beijing’s actions in July. However, indices comprised of overseas-listed Chinese stocks, and those with greater exposure to targeted companies and sectors, saw some of the largest drawdowns in July.

Source LHS: Bloomberg, Refinitiv DataStream, 31 July 2021. Source RHS: Bloomberg, M&G Investments, 26 July 2021. Sector weights (GICS Industry, %). Consumer St/Disc = Consumer Staples/ Consumer Discretionary, and IT/Comm Services = Information Technology/ Communication Services. Other includes Energy, Utilities, Healthcare & Real Estate.
 

The NASDAQ Golden Dragon China Index of US-listed Chinese stocks was down 22% in July, while the MSCI China Index (25% of which is in two stocks, Alibaba and Tencent) and Hang Seng indices also logged double-digit losses over the month. Chinese onshore indices didn’t escape the rout but remained relatively steady and managed to curb the monthly losses.

Interestingly, two of the best performing Chinese indices in July were the innovative start-up and tech-focused indices – the STAR50 (SSE Science and Technology Innovation Board 50 Index) and the ChiNext Index (often referred to as China’s NASDAQ). Both have attracted tech IPOs and listings from smaller, innovative high-tech companies across a number of sectors including IT, healthcare and manufacturing in recent years. Company listings benefit from relatively less stringent listing standards versus the Main and SME boards. As the objective of these indices is to foster innovative start-ups, constituents are much lower down the market cap scale, and they have managed to find relative stability despite the increased regulatory scrutiny hitting the giants of the Chinese tech industry.

Under new regulations for the private education sector, which regulators state is aimed at addressing inequality of opportunity and affordability in education, companies teaching the national school curriculum will not be allowed to make profits and so will be unable to raise capital, list on public stock exchanges or accept foreign investment. On this latter point, regulators are prohibiting the use of variable interest entities (VIEs) to access the ‘ed-tech’ sector – structures which operate in something of a grey area, allowing foreign investors to circumvent rules against foreign shareholding in certain sectors.

Earlier in the month, the Cyberspace Administration of China (CAC) targeted Chinese ride-hailing app DiDi, halting new user registrations and calling for mobile app stores in China to remove the app days after the company’s $4.4 billion US IPO, to protect ‘national security and the public interest’.

Chinese tech company Tencent (who owns social media and messaging platform WeChat) also came under pressure to address alleged anti-competitive practices and security issues and, most recently, was compelled to address youth access to its online video gaming platform following state media criticism of online gaming as ‘spiritual opium’.

The moves in July follow earlier pressure on Chinese tech companies, including Alibaba which was subject to $2.8 billion antitrust fine, while the real estate and healthcare sectors have also been earmarked by Beijing.

Many market participants have been surprised by the scope and severity of China’s regulatory crackdown – officially aimed at limiting monopolistic practices, protecting consumers and spreading wealth – prompting the China Securities Regulatory Commission to make efforts to reassure foreign investors that the government would consider the market impact of its policy decisions.

However, the concern for some investors is the potential for China to implement more far-reaching regulations, across sectors and industries, which could also cast doubt on the future for overseas listings of Chinese companies and the mechanisms by which foreign investors can access Chinese markets in the future.

The swift action taken by Beijing is a timely reminder to investors of the potential impacts of evolving regulation, and the ability of China in particular to execute on those changes at a rapid pace. We’ve seen some stabilisation in share prices since the end of the month, and a number of investors looking to taking advantage of the share-price volatility in July. However, foreign investors will need to reassess the potential risks and implications of investing in Chinese companies if Beijing officials remain committed to broadening regulatory scrutiny in a bid to address national objectives.

In the near term, markets will likely remain preoccupied with inflation indicators, potential rate hikes and the timeline for tapering after some stronger-than-expected US non-farm payroll numbers. As we move through the second half of 2021, investors will be looking to central banks for guidance on the timing and nature of monetary policy tightening.

While the Fed noted it was ‘making progress’ towards its tapering goals, Fed Chair Powell offered little additional signposting, leaving the door open for more formal communications at the next central bank update in September. Consensus expectations are for US tapering to occur at the back end of 2021 or the beginning of 2022. In Europe, ECB President Lagarde flagged the potential for the COVID-19 Delta variant to weigh on the euro area services recovery, but she spoke of the risks being ‘broadly balanced’ on the whole. The Bank of England adopted a slightly more hawkish tone, providing further clarity on the triggers and pathway for ‘quantitative tightening’.

Mixed economic data more recently and the divergence in regional inflation indicators – with core inflation ticking up in the US and the UK but remaining more subdued or falling back in Europe – could point to a moderation in global economic growth through the remainder of 2021. The continued recovery, and any central bank action from here, will remain dependent on the prevalence and impact of COVID-19 variants, the pace of vaccinations, the strength of business and consumer confidence, and the shape of local labour markets.
 

¹ Financial Times, 26 July 2021 https://www.ft.com/content/dfae3282-e14e-4fea-aa5f-c2e914444fb8