Dr. Karsten Junius, CFA
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Emerging Markets Economist
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Fixed Income Strategist
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Dr. Claudio Wewel
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Wolf von Rotberg
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China macro & equities
Ebb and Flow – China’s economic recovery remains
China’s economic recovery remains on track. Robust consumption, government credit support and resilient exports have helped growth to rebound in Q1 from the COVID slowdown in 2022. Yet the rebound in the Chinese equity market has only been short lived. Earnings failed to benefit to the same extent as they did in previous recoveries, with the economic rebound concentrated in domestic consumption, while industrial sectors and the housing market lagged. More than that, rising tensions between China and the US weighed heavily on valuations ever since the balloon incident in early February. We would not give up on Chinese equities yet. Tensions between the US and China are set to ebb and flow, in our view, as both administrations have an interest to limit the economic damage. We also believe that the macro recovery should hold up in 2023 – in particular relative to the US – providing a solid base for earnings to rise in the months ahead.
|Both the Federal Reserve and the ECB will meet next week. The FOMC is likely to deliver a final 25bp rate hike, despite renewed stress among regional lenders. After that, rates should remain unchanged for a while, as widely expected. Where we differ is on the 2024 outlook. Credit conditions are likely to tighten further, eventually pushing the economy into recession. If we’re right, the Fed might have to cut rates more aggressively than what’s currently priced.
Contrary to the FOMC, the ECB governing council is probably not ready to pause just yet. Business and consumer sentiment have improved and high wage settlements are still a major risk for the inflation outlook. The inflation rate for April, published on the Tuesday before the meeting, will likely determine the magnitude of the hike. Headline and core rates above our forecasts of 7.0% yoy and 5.5 % yoy, respectively, should lead to a 50bp hike, while prints below that would speak for a 25bp hike only
|China’s rebound remains strong, driven chiefly by consumption, but also by government credit support and resilient exports.
China’s rebound continues to be strong. GDP growth in the first quarter came in better than expected at 4.5%, driven by robust consumption, government credit support and strong exports, especially to other emerging markets. We expect the robust consumption trend to continue, supported by a strong labour market and a solid household income out-look. Latest indicators suggest that foot traffic (and therefore retail sales) should remain robust, while bookings for the Labour Day holiday week were solid.
The Chinese equity market has however underperformed in the last three months.
However, the Chinese equity market has underperformed in the past three months despite the macro improvement. One reason is that the rebound in the manufacturing sector has been more moderate than in the services sector, partly weighed down by a more gradual recovery of the housing market. Total industrial profits dropped by 21 % compared to the same month last year (Exhibit 1). While sectors like computer and communication equipment manufacturing expectedly suffered from a large fall in profits, there were some bright spots, such as utilities. Heavy industries also suffered from a fall in profits, as producer prices are still retreating due to a surge in commodity prices last year and weak demand from the housing sector. Other indicators, such as the Cheung Kong Business conditions index (which includes both industrial and consumer sectors) shows a rebound in corporate profit as well as investment (Exhibit 2).
The weakness in Chinese equities has at least partly been a function of rising geo-political tensions
Another key reason why Chinese equities have underperformed global equities by 15 % in the past three months, in our view, has been the rise in geo-political tensions. Exhibit 3 shows that moves in the MSCI China have clearly been linked to geopolitical events. Most notably, the period between the beginning of November, when the Chinese government first announced an end to zero-COVID measures, and late January, when the MSCI China peaked, was marked by relative calm on the geo-political front. The Chinese president and the US president met at the November G20 summit in Bali for the first time since the pandemic started. Their dialogue was later deemed constructive by both sides and fol-lowed by conciliatory official statements, including the agreement that US Secretary of State Blinken would visit China in early 2023. Secretary Blinken’s trip to China never happened though, as the balloon incident in early February not only marked the end of the cautious reengagement between China and the US, but also the peak in Chinese equity outperformance. This was followed by a series of US measures directly targeting Chinese key industries, heated diplomatic exchanges after the balloon incident and China’s dis-content over the US house speaker’s meeting with Taiwan’s president Tsai Ing -Wen.
China-US tensions will likely ebb and flow with both sides having an interest to keep the economic fallout limited.
It is hard to imagine that tensions between China and the US will go away completely , but it is likely that they will ebb and flow, with both countries having an interest in keeping the economic damage limited. Given the degree of mutual economic dependency tough, any measures entail significant risks of backfiring.
Valuations of Chinese equities have fallen to 2023 lows and earnings have been down-graded sharply.
With the specific trajectory of potential future geo-political tensions hard to predict, we prefer to stick to fundamentals. Valuations of Chinese equities have clearly suffered from elevated levels of uncertainty over recent months, with relative PEs (vs global) dropping back towards the lows they had seen over the past three years (Exhibit 4). Earnings have retreated at the same time, with consensus downgrades over the past month being more pronounced than they were for global equities (Exhibit 5).
We expect China’s economic recovery to continue, supporting earnings in the months to come
While the market appears to have given up on Chinese equities, we believe the projected strength in economic data throughout 2023 continues to provide a solid backdrop for a recovery in the quarters ahead. The most important driver of earnings in China is the man-ufacturing cycle, which is best proxied by the Caixin manufacturing PMI (Exhibit 6). The manufacturing cycle itself is a function of the credit impulse (change in flow of credit), which tends to lead the manufacturing PMI by around 6 months (Exhibit 7). The recent recovery in the credit impulse, which turned positive in March, should carry the manufac-turing cycle in the months ahead and provide a relatively solid backdrop for GDP and earn-ings growth. The stabilisation of housing investment, which we also expect in Q3, should further support the manufacturing cycle.
China GDP growth is set to outpace the US by the largest margin since 2020, relative earnings growth and performance should follow
This is also reflected in Chinese GDP growth, which is set to accelerate in Q2 (due to the low base in 2022) and remain elevated in the second half of the year. In particular , the GDP gap between China and the US should open up further as we expect the US to move towards recession later this year, implying relative upside for China earnings (Exhibit 8). The prospects for long-term outperformance of Chinese equities, however, will likely be limited by structurally lower economic growth. In the past 20 years, Chinese earnings only managed to grow faster than US earnings when China’s GDP growth was more than 5 percentage points above US GDP growth. Even though we expect a cyclical bounce, we do not expect China to outgrow the US by that extent in the years ahead.
The tactical case for Chinese equities re-mains in place, but political risks linger and the long-term prospect remains muted
Bottom line, we believe the cyclical support for Chinese equities remains strong, as the economic recovery is on track (Exhibit 9). Yet geo-political risks continue to cast a shadow over the market and long-term prospects remain muted, as potential GDP growth in Chinais declining relative to the rest of the world.
Fed preview Reaching the peak
The FOMC is likely to deliver a final 25bp rate hike when it meets next week, despite renewed stress among regional lenders. After that, rates should remain unchanged for a while, as widely expected. Where we differ is on the 2024 outlook. Credit conditions are likely to tighten further, eventually pushing the economy into recession. If we’re right, the Fed might have to cut rates more aggressively than what’s currently priced.
Fed to hike by a final 25bp, despite renewed stress in the regional banking sector
As last time, FOMC members will meet against the backdrop of troubles among regional lenders. Investors have sold First Republic’s shares since it announced earlier this week that customer deposits were down 41 % in Q1. Yet this will probably not prevent the Fed from hiking rates by a final 25bp next Wednesday, before taking a break. The market broadly agrees, even if the latest banking woes have led investors to price in further cuts towards year end. Importantly, the Fed should have a bit more clarity on the extent to which the stress in the regional banking sector will affect credit conditions. Our sense is that investors have been a bit too eager to dismiss last month’s bank failures as idiosyn-cratic events. If instead these failures were symptomatic of higher interest rates and rap-idly falling bank deposits, as we think they might have been, both the Fed’s and financial markets’ outlook for the economy probably remains on the optimistic side.
Recent data releases have shown some signs of progress on inflation and the labour market
Since the FOMC last met, there have been only one extra CPI print and jobs reports (March data). They have shown some signs of improvement on inflation and labour market imbalances.
But progress has not been sufficient, in our view, to invalidate last month’s statementthat “some additional policy firming may be appropriate in order to attain a stanceof monetary policy that is sufficiently restrictive to return inflation to 2% over time”.
But it’s way too soon for the Fed to be comfortable with the inflation outlook
On the positive side, rent inflation stepped down in March, and the Cleveland Fed trimmed-mean dropped sharply. Less encouragingly, though, the Atlanta sticky CPI ex shelter index is still running at a pace that is twice as fast as what’s consistent with the Fed’s target (Exhibit 1). And core CPI is rising at an annualised rate of around 5%, whether you look on a 1-, 3-, 6- or 12-month basis. In short, inflation is still “unacceptably high”.
Demand for labour still exceeds supply by a wide margin
Imbalances in the labour market seem to be falling, coming from an apparent easing in labour demand (February’s JOLTS report showed a drop in job openings) and an increase in labour supply (prime-age participation rate has risen back to its pre-pandemic level).
Still, demand continues to exceed labour supply by a substantial amount, and a pay risefor higher-wage earners led to a pick-up in the Atlanta wage growth tracker in March, despitefurther announcements of job cuts in the Tech and Financial sectors (Exhibits 2-4).
Credit conditions have already worsened. A further deterioration is highly likely.
Recent data also suggest that while deposit outflows appear to have stabilised, it has al-ready led to a tightening in credit conditions for small businesses (Exhibits 5-6). The Sen-ior Loan Officer Opinion Survey on Bank Lending Practices – a survey the Fed conducts on a quarterly basis to assess lending standards of large banks and demand for loans – will be available to Fed officials ahead of their meeting, and is likely to show a deterioration too. Importantly, the survey is already at levels that in the past preceded recessions.
A US recession would likely push the Fed to cut rates much more aggressively than is currently projected
Given the data at hand, the Fed will decide to continue with its current strategy, in our view. That is using its liquidity, lender-of-last-resort as well as its prudential, regulatory and supervisory tools to mitigate future financial stability concerns, and the policy rate and QT to bring down inflation. We agree with the projections of Fed officials and investors, indicating that next week’s hike will probably be the last of this cycle. But our 2024 outlook is considerably different. The Fed sees only 80bp of cuts, the market around 175bp, while we expect 325bp. As we argued last week, credit conditions should tighten further and defaults rise, reinforcing our view that the US economy will fall into recession at some point in H2. While the Fed staff is now also forecasting one for 2023 – a rare thing – officials are only projecting a 1 percentage point rise in the unemployment rate, which would be unprecedented. History shows that if unemployment rises by 0.5pt, it ends up rising by 2pt or more, forcing the Fed to cut rates aggressively and below the neutral rate.
ECB Preview Still a data-dependent decision
The interest rate decision of the ECB next Thursday is still open and dependent on the incoming data that will be published early next week. Business and consumer senti-ment have improved lately as producer price inflation has abated. However, high wage settlements are the main risk for the inflation outlook. Currently, 30bp of rate hikes are priced in for the May meeting. The inflation rate for April, published on the Tuesday before the meeting, will likely determine the magnitude of the hike. Headline and core rates above our forecasts of 7.0% yoy and 5.5% yoy, respectively, should lead to a 50bp hike, while prints below that would speak for 25bp only.
The Euro Area economy has performed better than expected, largely reflecting two factors:
News out of the euro area have been overwhelmingly positive in the past few months.
Gone are fears of slipping into recession, losing jobs or freezing in the apartment. The unemployment rate remains at 6.6% – a multi-decade low – and job vacancies remain elevated even if they have declined somewhat lately.
(1) Better terms of trade
Two reasons drive the current development: (1) Lower energy prices have massively improved the terms of trade and therefore also the purchasing power of households (Exhibit 1). Fewer bottlenecks in production and trade have also helped bring down producer price inflation (Exhibit 2).
(2) Pent-up demand for services
(2) There still seems to be pent-up demand for services, while demand for manufactured goods is declining as in most other countries. So far, manufacturing production is still holding up, possibly as a result of past bottlenecks, however, orders are clearly comingdown and overall sentiment points to future contraction (Exhibit 3). In contrast, servicessector- and consumer sentiment have clearly improved over the past months, signalling a solid expansion over the coming months (Exhibit 4 and 5).
Restrictive monetary policy will eventually slow down the economy.
Eventually, restrictive monetary policy will slow the overall economy. Real money growth has been declining sharply for a while now and credit extended to both households and non-financial companies has slowed. The latest turmoil in the banking sector should have tightened financing conditions, such that anything else than a tightening of lending stand-ards would be a surprise when the bank lending survey for Q2 is released next Tuesday. As interest rates have been increasing sharply in the past quarters and housing afforda-bility has deteriorated, we also expect the survey to show falling expected loan demand
But so far, inflation has remained sticky, call-ing for additional tightening.
The latest news on inflation have been mixed at best. Price expectations for the coming months are falling but this should be no surprise given significant base effects, unravellingbottlenecks in production and falling energy prices (Exhibit 6). What is more important is the development for wages, which seem to be increasing strongly and thereby making more elevated core inflation rates more likely for a longer period of time. This might not come as a surprise at a time during which labour markets are tight, real incomes havefallen and corporate margins are elevated. In this environment, the ECB will need to see lower monthly price changes before it can slow or end its rate hike cycle. We believe that Tuesday’s inflation report for April will be decisive for the rate decision on Thursday. Headline and core rates above our forecast of 7.0 % yoy and 5.5 % yoy should lead to a 50bp hike, while rates below that would speak for a 25bp hike only. In both cases, we would expect another final 25bp hike in June to a terminal level of 3.5 % or 3.75 %. In the second half of the year, we expect the ECB to reduce its bond portfolio holdings at a faster pace, instead of hiking policy rates further.
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