While equities continued higher in July, the were periods of selling during the month. A growing section of the market is becoming concerned over the outlook for global growth. This marks a significant change in sentiment on previous months, where the greatest concerns have been about inflation, and growth running too hot. Nevertheless, the spread of the Delta variant and signs of a slowdown in China has stoked concerns that the current bounce will not be long lasting.
The theme of potentially weaker growth has impacted across asset classes, with fixed income clearly reflecting this outlook. Government bonds, which had seen yields rise, have been in high demand, even with the prospect of high inflation. With further increases in headline readings, the US CPI has now risen 5.4% year on year, the real yield generated by government bonds has now fallen to historic lows. This has implications for other asset classes as investors that are naturally incumbent in government bonds move up the risk curve. With fixed income expensive by this measure, valuations in other asset classes are rightfully high as well.
Within equity markets, the signs of this change in sentiment are also being seen at a sector level, with a rotation out of cyclical recovery stocks and back into tech and growth names. However, with this battle between styles, it also appears that quality defensive companies are now being overlooked and for the first time in many years, these stocks are beginning to look better value.
Finally, Chinese equities suffered a material correction towards the end of the month as investor concerns over regulatory action by the Chinese authorities led to some significant selling. Particular attention was focused on the frequently used VIE (Variable Interest Entity) that enables foreign investors to access Chinese stocks by skirting around foreign ownership rules. Legally, holders of VIEs are not technical owners of stocks, although they are entitled to the economic benefits. The Chinese government has voiced discomfort over the use of these, particularly in key industries, and has ordered more limited use. There is now concern that a more severe government intervention would leave foreign investors exposed to write offs where they have little legal standing for compensation. However, the most likely direction of travel is a movement of US listed Chinese companies to Hong Kong. Although this may cause some foreign selling, which may suppress valuations in the short term, the longer-term implications are less clear. Nevertheless, this episode does illustrate the growing geopolitical risks and ongoing decoupling between the US and China, and it is unlikely to be the last bout of concerned selling.