January begins full of surprises ; Monday digest

Posted 9 January 2023

Overview: January begins full of surprises
Last week, a barrage of hit the UK. We can’t have been the only ones left feeling that the UK was off to one of the most subdued starts to a new year we can remember, but the FTSE 100 achieved its best price level since April last year – surpassing the 17 January 2020 pre-Covid level of 7674.6. This leaves it less than 3% below the all-time high of 7877.5 reached on 22 May 2018.

European stock markets have also had a great start to the year, as energy prices have come down quite sharply, partly because of a bout of warmer weather. Gas prices have continued to decline, particularly in the longer-dated contracts. While year-on-year inflation data is expected to remain uncomfortably elevated, the now more persistent decline in European energy costs is also happening here in the UK. That should take some pressure off the Bank of England. Indeed, the UK’s central bank may now be amongst the most dovish of developed world central banks, given that the Bank of Japan tightened policy just before the holidays.

And what about the US? Last Friday’s employment data showed a continuation of steady job gains and no compensating increase in the labour supply. Thus, the unemployment rate fell back from 3.6% to 3.5%. We have written before that the US Federal Reserve (Fed) is by now more focused on labour market tightness than outright price rises – for fear of second–round effects embedding inflation structurally in the economy. Not surprising then, that many Fed members have been talking this week, with almost all saying they see rates heading above 5% and staying there. The market is having a hard time agreeing with this view, seeing the likelihood that rates will not go above 5% and will start falling before the year is out.

The losers in this situation are those most sensitive to interest rates. Last week, Bed Bath & Beyond, famous in the US for providing beds, baths and other big-ticket items, announced it was pulling the plug (so to speak). It got caught with high leverage levels and failed to secure financing. Interestingly, it did not fail because of a lack of potential demand. Rather, it was unable to get the financing to buy inventory, which then meant its customers went elsewhere. The Fed knows that this situation will be repeated for similar companies, but there is little it can do about it – the purgatory effect of the ‘late cycle’ environment at work. For us, this typical late-cycle phase puts a premium on stock and credit selection, which was already the key determinant of outperformance during 2022.

Interestingly, credit market dynamics appear to be in better shape at the start of this year. Credit spreads declined somewhat last week, helped by the rapidly improving situation in China. That provides a window of opportunity for many companies to issue bonds over the next few weeks, and may help bring about a more tranquil start to the year than we saw this time last year.

China’s reopening bounce is welcome news
A few months ago, the prospect of China ending its strict zero-Covid policy seemed frustratingly distant. away. But over the holiday period, the government diktat that had placed 1.4 billion citizens under repeated lockdowns for three years, was swept away. The National Health Commission (NHC) also downgraded the threat posed by Covid, announcing that those with positive tests were no longer required to quarantine at a central facility, and that daily virus tallies would no longer be reported. And inbound travellers to China no longer have to quarantine after entering the country.

It is hard to overstate how big a shift this is. Low vaccination rates among the elderly and vulnerable, together with hard-line messaging on virus control, meant the Communist Party leadership could not change tack without damaging its reputation. That things have changed so quickly speaks volumes. For starters, it shows how seriously Beijing takes the current economic struggles. In the very short term, China is still suffering from a severe Covid outbreak, with estimated cases in the hundreds of millions. Vaccination rates (which have improved among the vulnerable) should mean the overwhelming majority of cases are mild, but even so deaths might well top one million over the winter. The spread will naturally lower mobility heading into the lunar new year in February, which could mean slower domestic demand at what is usually a bustling time. JPMorgan has revised down its China growth estimates for the first quarter of 2023 in light of these factors. Growth after that point, though, is expected to be much stronger.

On the international front, China’s foreign relations – particularly with the US – look much calmer, especially after Xi indicated a coolness towards Russia during his meeting with Vladimir Putin before Christmas. In growth and trade terms, this is already bearing fruit. Other areas of policy are easing too. The People’s Bank of China has announced targeted monetary stimulus to get the domestic economy roaring again. The government even approved billions in financing for Ant Financial – the fintech company whose initial public offering it crushed in 2020. The latter is particularly symbolic, given that move against the company started the current wave of private sector crackdowns. However, the sting in the tail for Ant Group is that owner Jack Ma is to step down as part of the group’s more regulatory-friendly restructuring.

As a result, Chinese equities have rallied strongly so far this year, as investors look to take advantage of the improved economic outlook. A strong Chinese rebound is now extremely likely and that will be positive for global growth, offsetting the Western monetary tightening that is likely to reach peak effect during 2023.

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