Markets Weekly podcast - 4 October 2021

Henk Potts (HP): Hello. It’s Monday, 4^th October and welcome to the Barclays Private Bank Markets Weekly podcast, the recording that will guide you through the turmoil of the global economy and financial markets.

My name is Henk Potts, Market Strategist for Barclays Private Bank. Each week I’ll be joined by guests to discuss both risks and opportunities for investors.

Firstly, I’ll analyse the events that moved the markets and grabbed the headlines over the course of the past week. We’ll then consider the outlook for credit markets. Finally, I will conclude by previewing the major events and data releases that are likely to shape the week ahead.

It was yet another nervous week for investors last week, as they assessed the impact of the global energy crunch, significant slowdown in China and fears that a prolonged period of supply bottlenecks will infringe upon activity, further stoke inflation and weigh on profitability.

Over the course of the past month, markets have also been adjusting their expectations as central bankers begin laying the groundwork for policy normalisation, as they start to take steps to withdraw the extraordinary measures implemented during the course of the pandemic which had been pushing up bond yields, creating greater competition for equity markets.

If we look at equity market performance, US stocks registered their biggest monthly sell-off since March 2020 in September. The S&P 500 lost 3.3% last week and was down 4.8% over the course of the month, which wiped out most of the gains for the quarter.

A very similar picture is playing out in Europe. The STOXX 600 posted its worst monthly decline since October last year. It was down 3.4% last month and is only up four-tenths of 1% for the quarter.

In terms of sectors, understandably it’s been a strong month for energy but also for banks that would benefit from rate hikes. Underperformers, well, it’s those rate-sensitive sectors, including real estate and utilities that have been coming under pressure.

In terms of investment strategy, remember we haven’t seen a meaningful pullback in equities for some time, so it could create a good entry point for long-term investors. We still expect markets to remain volatile, but global growth projections remain robust. Earnings forecasts are supportive and policy remains very accommodative by historic standards.

Oil prices have jumped 10% over the course of the past month, crude trading close to its highest level in three years at the start of last week, Brent above $80 a barrel for the first time since October 2018, driven by a recovering demand and ongoing supply constraints. BP are forecasting consumption will return to pre-pandemic levels in the third quarter of next year, with a year-on-year increase of 3.8 million barrels per day in 2022.

This is as key inventory data continues to show drawdowns have been the largest on record and analysts anticipate the shortage of natural gas will force suppliers to use alternative energy sources. Pressure is certainly mounting on the OPEC+ group, which is meeting this week to ramp up production levels to ensure that prices don’t overheat and infringe upon the economic recovery.

Higher energy prices also, remember, pose a problem for central bankers given the propensity to stoke inflation and potentially force tighter policy. The energy crunch is now starting to have a tangible impact on economic activity in China, a combination of higher global energy prices, remember China is the world’s largest importer of energy, and its commitment to meet its aggressive emissions target, which includes peak emissions by 2030, zero carbon emissions by 2060, has created a supply and demand imbalance.

The decarbonisation objective has reduced coal production growth while its renewables have failed to meet the shortfall. It’s reported that two-thirds of provinces in China are now experiencing power outages. Factories have been told to reduce production, particularly those who are in the highly energy-intensive sectors such as chemicals, coal and steel. Last week’s PMI report showed that China’s manufacturing sector contracted in September for the first time since the pandemic started.

The power crunch is coinciding with the marked slowdown in the property sector, where the government has been concerned about a bubble developing so have been reining in mortgage lending growth and restraining financing to property developers. There’s also, of course, the ongoing fallout from the Evergrande debt crisis.

In terms of the economic impact, the concern is that China’s main growth drivers, manufacturing and property, are now coming under pressure, while household consumption continues to be held back by its zero-COVID strategy.

On the positive side, authorities have the policy tools required to orchestrate a soft landing, but they will take some time to filter through to the economy and need to be balanced off with the broader long-term objectives to focus on the quality and sustainability of growth rather than the headline speed, but no surprise that growth forecasts have been coming under pressure. We now expect year-on-year growth to slow to 4.6% in the third quarter. That’s down from 7.9% in Q2.

Moving on to Europe, where data showed that the labour market recovery has been gaining momentum. The euro area unemployment rate fell to 7.5% in August. That means, compared to August 2020, unemployment’s decreased by 1.86 million and is now within sight of that all-time low of 7.1%.

Turning to the outlook, pressure on the labour market may increase in the coming months as furlough schemes are gradually unwound but hiring expectations remain positive. Vacancy rates are high, which suggests that the improvement in household consumption should continue to support growth prospects.

So that was the global economy and financial markets last week. Let’s move on to consider the outlook for credit markets.

I’m pleased to be joined by Mark Jenkins, who’s Managing Director and Head of Global Credit at the Carlyle Group. Mark, great to have you with us today. Let’s start by setting the scene.

We know it’s been a very volatile period for credit markets over the course of the past 12 to 18 months with spreads widening and compressing at various points. Can you talk us through the drivers of the volatility that we have been seeing and discuss your expectations for credit markets over the course of the next year or so?

Mark Jenkins (MJ): Yeah, sure. Thanks, Henk, for having me today. You know, we really have gone through a full credit cycle in the past 16 months where you’ve gone from, you know, a dislocation in the marketplace to a settling in the marketplace, or transition if you will, to stabilised markets.

So, as you said, we’ve seen credit widening. Credit has like paced out and stabilised and now we see credit tightening. And really what’s happened is, and distinguished between the private and the credit markets, there’s a lot of volatility that we’ve seen in the public markets we haven’t experienced as much in the credit markets.

And, for example, I would say two things. One is that the actual illiquidity premium for private credit has actually increased over this period of time. It’s been relatively stable in the beginning, but as public markets have tightened the credit spreads for private credit haven’t actually tightened in as quickly so we’ve actually benefited from it if you will.

HP: We know that investors appear to be finding it very difficult to generate returns from credit markets more recently. Do you still feel that there are pockets of opportunity that remain?

MJ: Yeah, you know, the public markets have been challenged because with the, you know, stimulus that we’ve seen and the monetary policy globally it has driven, you know, interest rates to all-time lows and we’ve seen credit spreads come in.

But across markets on the private side, you know, there continues to be, you know, a need for capital, and specifically what I call transitional capital, for companies that are looking to grow into this market that don’t have access to the regular way capital markets, and they tend to have much more complex credit stories.

They’re good companies but still have more complex credit stories that aren’t easily explainable to the public market and there’s an illiquidity, and I’d say complexity, premium for those credits and that’s really where we’re focusing our time on a global basis predominantly in the US and Europe at this point in time.

HP: So, Mark, let’s get a little bit more focused. How are you identifying investment opportunities in the current environment? What are the key risks to those assumptions you are making and what are the parts of the market you’re specifically focused on?

MJ: Yeah, I’d say we’re, you know, market-wise or industry-wise we’re relatively agnostic. I think that, you know, we distinguish between what I would call COVID-affected and non-COVID-affected companies at this point in time. And, you know, these challenges that the COVID-affected companies are facing or industries, you know, is really a timeline that is focused on with respect to the actual pandemic itself and the virus and the impact that it has.

So, you know, we put them in a separate bucket. They have more complexity, a longer timeline, but can be really good companies, like any entertainment business, gyms, restaurants etc, they all have that COVID-affected element to it. And then there’s the non-COVID-affected element as well.

And we look for, really, companies at the end of the day that we believe are good underlying businesses that will require our capital which is a little bit more bespoke, if you will, and tailored towards, you know, frankly, mostly entrepreneurial-owned, family-owned businesses rather than sponsor-led businesses where they have unique challenges and aren’t as, you know, don’t access the capital markets as just said as regularly as some as the sponsor-led deals.

So that sort of buckets out what we look at. Industry-wise, I would say, you know, we’re really not, you know, there’s nothing that’s off the table. I think it’s a matter of what is the underlying credit protection or underlying margin of safety that we have when we’re looking at a company and that’s very important to us at this point in time.

But ironically, that margin of safety has actually increased over time as valuations have gone up. So that equity cushion that we typically have in credit investments has actually increased over time, over this period of time, as valuations have gone up and the leverage hasn’t paced those valuations as much as you would have expected.

HP: So you continue to remain optimistic about the prospect for returns across credit markets over the course of the next couple of years?

MJ: I think in credit because of the margin of safety that we see today, because people are contributing if you will more equity to the acquisitions or asset acquisitions that they’re making that right now we feel pretty good about the longer-term prospect.

I think as well that, so put another way, is we have more cushion, if you will, in our credits today to absorb any volatility than we did pre-pandemic, which again is a little bit ironic but given where equity values have gone, it’s not surprising. And I’d say that we’ve learned over time, and we’ve watched this with all of our companies, to adapt to this post-pandemic environment.

It’s obviously challenging. There’s going to be pockets of volatility, we’ll take advantage of that for our investors, but we’ve seen that companies for instance have learned to adopt to this environment and probably have accelerated a number of the trends that we saw pre-pandemic, so digitising their business for instance. So I think, you know, 12, 24 months out we see continued growth, slowing growth perhaps, as we kind of look forward, but definitely growth that are going to help the underlying credits that we invest in in our portfolios.

HP: Well, thank you, Mark, for your insights there. I think you’ve done a great job of highlighting both the risks and opportunities for investors in the credit space. We will of course follow your guidance very carefully over the course of the coming quarter.

So let’s leave credit markets there and move on to consider the week ahead where the focus will be on the US labour market. For Friday’s September employment report, we look for solid if unspectacular employment gains, as hiring continues to be constrained by elevated numbers of COVID-19 cases from the highly transmissible Delta variant and fading reopening effects. Hence, we expect leisure-orientated payroll gains to be subdued.

Turning to the numbers, we forecast that the US economy created 475,000 jobs last month, driven by a rise in private payrolls of 350,000. Elsewhere, we look to the unemployment rate to fall one-tenth of 1% to 5.1%, average hourly earnings to rise by four-tenths of 1% month on month, or 4.6% year on year.

In terms of the impact, well, barring a major disappointment, it would have to be a major disappointment, the figures should be enough to encourage the Federal Reserve to proceed with its formal taper announcement at the November meeting.

With that I’d like to thank you once again for joining us. We will of course be back next week with our latest instalment, but for now may I wish you every success in the trading week ahead.