September was another painful month for risk assets as investors saw the largest decline in the MSCI ACWI since March of 2020. Domestic equity indices fared similarly as the Dow returned -8.75%, the S&P -9.20%, and the Russell 2000 -9.56%. The Nasdaq return of -10.43% was the second worst month since late 2008. Emerging markets generally underperformed, as the MSCI EM returned -11.72%. This left Q3 as the fifth consecutive quarter of losses across the major EM asset classes. Unfortunately, this September was no exception to the calendar anomaly that generally leaves the month as relatively weak for stock returns.
The narrative remains centered around the relative hawkishness of central banks, with the Fed continuing to set the tone. Notwithstanding some relief from easing supply chain congestion and commodity prices, inflation has not yet shown any significant signs of turning and the domestic labor market remains worryingly tight. Indeed, that was the message we got from hard data as the August payrolls report showed a stronger than expected 315k increase and core inflation printed a higher than expected 6.3%.
In that context, we saw the Fed deliver their third consecutive 75 basis point hike in their September meeting. That hike was in line with market consensus (which had migrated more hawkish since the pivot-consideration days preceding Jackson Hole) and came alongside updates to economic forecasts that were skewed to the hawkish side. The committee is split on whether 100 or 125 basis points of hikes is appropriate from the remaining 2022 meetings, but the reality remains that we should not expect a change in tone until there is a material improvement in inflation and labor market dynamics. This left the market pricing a more aggressive trajectory of hikes as the reality sets in that the Fed is forced to accept a relatively higher risk of recession or hard landing as they venture to put inflation on a trajectory back to 2%. As we end the month, the central case for the market has migrated toward another 75 basis point hike in November followed by a 50 basis point hike in December with a terminal rate in the 4.50% context.
This Fed hawkishness coupled with persistent inflation pressures has kept most global central banks on a hiking trajectory. Given that, we saw another procession of hikes this month. That said, it is important to note that some of the early hikers are nearing what they hope to be the later innings of their cycles. The BCB in Brazil signaled the potential end of their hiking cycle when they held their benchmark rate at 13.75% in this month’s meeting. Brazil was one of the first central banks to hike and they have delivered a substantial increase in rates from the pandemic-era lows of 2%, one of the first in and one of the first out as has been said colloquially. Elsewhere, the central bank in Turkey continued their unorthodox monetary policy and once again cut rates. This cut came while measured inflation was north of 80%; Erdogan has made it clear that he wants to see further cuts.
The natural consequence of a more aggressive Fed and persistent inflation concerns is higher yields, and that is exactly what we saw in September. The 10-year Treasury ended the month yielding 3.83%, some 64 basis points higher than in August and marking the largest monthly increase of the year. While that move is extraordinarily large in magnitude, the trading range was even more exceptional as the intraday peak was north of 4%. In contrast, Brazilian 10-year local bond yields declined by approximately 25 basis points on the month as the market considers the implications of the potential end of their hiking cycle.
Higher Treasury yields and a generally soft risk sentiment allowed the USD to continue its path of appreciation. The Dollar index appreciated by 3.14% on the month which takes the USD to a fresh 20-year high with a year-to-date appreciation that is approaching 20%. The Euro ended the month at 0.98, south of parity versus the Dollar for the first time since 2002, the British Pound experienced a massive bout of volatility and fundamental deterioration that engendered conversations about potential parity with the Dollar, and the Yen lost another 4%. Unsurprisingly, the broader MSCI EM currency index declined by 3.06% in its worst monthly performance of the year.
The strength of the Dollar has necessarily become a common topic of conversation amongst market participants as this magnitude of currency moves has significant economic consequence. This has left many central banks defending their currency with some form of intervention in markets. We have several recent examples of this: the Chilean central bank recently completed an intervention program that saw some $5.6 billion sold in the spot market, in China we have seen a series of daily fixings biased towards a stronger CNY, in Japan the Ministry of Finance intervened to support JPY after the steadfast dovishness of the BOJ proved more salient to the market than previous verbal intervention, and Turkey has a series of measures designed to limit dollarization and pressure on TRY as they retain exceptionally negative real yields.
The UK markets also endured their own intervention after elevated volatility in rates markets threatened to upset liquidity and the normal functioning of domestic markets. This turmoil started when the new government of Liz Truss introduced a more expansionary fiscal plan than the market had expected. The plan put forward to the market entailed the largest program of tax cuts the UK had seen in nearly half a century, and these cuts were unfunded which implied an increase in bond issuance alongside a wider deficit. The market reacted quickly and violently with rates exploding higher and an aggressive depreciation of GBP; the trough in the currency was near 1.04 versus the Dollar relative to a peak earlier in the month in the 1.17 context. This eventually prompted a policy about face from the Truss government as well as a temporary bond buying program from the BOE.
That BOE intervention was a reaction to a legitimate concern that margin calls facing UK pension funds could have exacerbated the selling in GBP government bonds and pushed yields even higher. The practical implications were seen almost immediately as several mortgage lenders pulled mortgage deals as they reassessed the interest rate environment. This was only one of several market stressors on the continent this month, as the market was also confronted with a massive move wider in the CDS of one large investment bank and a still uncertain energy picture as we move closer to the winter months. Given the extreme moves that investors have seen across asset classes, the market is acutely reactive to any potential liquidity stressors and generally spending more time thinking about the tails of potential return distributions.
The continued pressure on energy markets in Europe remains a significant risk to economic activity levels as well as government budgets, as there are large fiscal programs being implemented to soften the impact on the household. We did have some relief in price pressure from the commodity side this month, as oil was lower by nearly 10% and closed at the lowest level of the year, while natural gas was lower by 28%. While European gas storage levels have made progress and are now approaching their historical average, there is still a great deal of uncertainty as to how much gas will be flowing during the winter months. This uncertainty was highlighted this month by a series of explosions that ruptured the Nord Stream pipelines; those explosions were ostensibly an act of sabotage which further heightens geopolitical tensions as speculation about the saboteur and related motivations swirls.
Geopolitical stress continues to be an important macro variable. The potential for an escalation of the war in Ukraine was highlighted as Putin ordered a partial mobilization of reserve forces and later said that he would be willing to use nuclear weapons to defend Russian territory. That notion of territory itself became dangerously convoluted after referendums were staged in several Ukrainian territories and an announcement followed that those territories had voted to join Russia and would thus be considered Russian territory. In addition, the rhetoric between the US and China with regard to Taiwan continues to be closely watched.
While the Truss government had a relatively eventful month, there were significant political developments in several other economies as well. Italy elected a new government to be led by Giorgia Meloni following the departure of Draghi. The Chilean population rejected the draft constitution in a plebiscite early in the month; while this result leaves some open questions about how a new governing document will be drafted, the strong rejection of the existing draft was taken positively by the market as it signals a preference for more moderate changes. The first round of the Brazilian election will be held in early October; recent polls have shown a double-digit advantage for Lula over Bolsonaro, but perhaps nearly as important as the actual winner of the election will be that the election proceeds without disruption.
Investors in emerging markets have been presented a procession of market moving political and geopolitical events in recent history. In addition to the events mentioned above, we recall that Colombia elected their first leftist president earlier this year, Peru’s president has faced impeachment motions and overhauled the cabinet several times since election last year, and South Korea had its most closely fought election in recent history. In this context packed with macro-significant events, the 20th Party Congress to be held in Beijing beginning October 16th has been one of the most anticipated political events of recent history and will certainly be one of the most watched events of October.
A Party Congress occurs every five years and is always a seminal event as the meeting sets policy priorities and draws the blueprint for the coming five-year term. This year, President Xi is widely expected to further consolidate power while securing a third term. That potential third term is by itself precedent breaking and would leave Xi as the most ascendant CCP chief since Mao. Aside from a few unsubstantiated murmurings, we have heard very little debate on Xi’s reappointment, evidencing a market consensus that is quite clearly defined. Beyond Xi’s position, there will be an important reshuffling of leadership positions within the party.
Market participants will be closely watching the composition of the Politburo, its Standing Committee, and the broader Central Committee. This composition, coupled with the report from Xi that will highlight the Party’s achievements over the preceding five years and outline strategies and priorities for the coming years, will shed some light on how centralized decision making is likely to be going forward. Roughly speaking, a Standing Committee full of close allies of Xi would imply concentrated decision-making power and the potential for larger policy moves and greater depth of influence from Xi himself.
The most pressing Chinese policy issues for investors at this point are Covid-zero, geopolitics, and economic growth. There has been some speculation that we could see announcements on Covid policy following the meeting, but it seems that any such policy changes would more likely come next year from the National People’s Congress. The Party Congress itself will be focused on the political transition and longer-term objectives and policy directives. The focus on Covid-zero and economic policy is clearly warranted as the former is, and has been, one of the most important variables for the investor community, as the implications of a change in policy are significant for both the domestic and global economy. Market consensus has migrated toward spring of 2023 as a central case for a potential loosening on the covid front. We maintain that this will be one of the most meaningful variables for the macroeconomy in coming months.
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