Monday Digest

Posted 25 April 2022

Overview: Spring sentiment still finely balanced

The post-Easter week was again mixed for investors. Surprisingly positive corporate sentiment data across Europe last week indicated consumer demand may not be as significantly impacted by the war in Ukraine as markets had been pricing in. On the other hand, there were signs in the US and the UK that consumers are feeling rather more  pressure on their household budgets from rising energy and housing prices than anticipated.

The most remarkable moves of the past fortnight have been in the bond markets, where government bonds have sold off to such an extent that real yields (yields after inflation) of longer maturity bonds are finally at the brink of turning positive. That markets are nevertheless down for the month of April tells us that competing views remain finely balanced. In recent weeks, one would have expected rising bond yields and rising corporate credit spreads to have hurt equity prices. However, relative to bonds (real yields) the markets’ valuations were a bit cheap beforehand, so relatively stable earnings projections meant equity markets kept valuations steady as well. Unfortunately, as noted, sales projections are starting to slide, which takes away the equity markets solidity.

The S&P 500 has flittered between sell-off and recovery, and returns are still down year-to-date. Historically, the midpoint of the economic cycle (as we are in now) can bring plenty of upside for equities, as earnings keep expanding. But this is no normal cycle. Central banks are already aggressively tightening from extraordinarily loose positions – which means equity valuations (in terms of price-to-earnings ratios) are still elevated and vulnerable. With market volatility and a deeply uncertain economic outlook, risks and rewards are finely balanced.

Equity risk: a tale of two outlooks

What would tip this balance one way or the other? Or, in practical terms, what would we have to see to move to either an underweight or overweight position on equities? On the positive side, we note that a reset on inflation policy already seems to have happened. Bond markets expect the Fed will ultimately get inflation under control, after which we should enter a stable growth environment, and with inflation settling at just over 2%. If, as some data suggests, we are past the peak of input price inflation, central banks will no longer have to deal with extraordinary pressures, and can then focus on containing wage pressures instead. Of course, slipping into recession is a looming risk. The recent inversion of the US yield curve suggests this could happen – as yield inversion has reliably predicted almost every major recession in the post-war period (but also a few more that never happened). If the economy contracts, even briefly, it would likely mean a corporate earnings recession too. With valuations still elevated, equities would be under serious threat.

There are several routes that could lead us to a recession, which we will have to look for closely. First, input cost pressures could remain elevated for longer than expected, and lead to a significant drop in demand. This seems unlikely given the clearing of some major supply bottlenecks, but many said the same a year ago and were surprised by how long these issues lasted. Second, and relatedly, inflation indicators themselves could prove sticky, causing inflation expectations to become ingrained and beginning a vicious cycle that central banks would be obliged to fight with yet higher rates. Third, tightness in the labour market could also prove slower to adjust than expected – with labour supply not responding to demand and businesses being unable to cope. One consequence of such a situation could be labour hoarding. Despite deteriorating business conditions, companies keep labour or even hire more, and hence wage pressures remain elevated. In such a situation, it would be difficult for the Fed to ease policy, even as growth expectations falter. A recession would then ultimately ensue, as companies go under or start saving and consumer demand weakens. Ultimately of course, policy support would come through.

We do not see signs of this yet. However, to see us clear, the Fed would need to be confident that financial conditions have tightened enough to prevent overheating. This is what the rise in real rates is aimed at, but there is some way to go by historical standards. During the last cycle, US real rates rose to 1%, while currently they are at just below 0%. To put it another way, we would have to be confident that equity valuations offer enough of a buffer, such that markets can stomach another rise in real rates.

The value of the US dollar is also a key indicator of risk attitudes. As a ‘safe haven’ asset, it tends to be strong when investors are nervous and weak when they feel lucky. So far this year, the dollar has appreciated somewhat, but not enough to indicate widespread fear. The signs are, perhaps uncomfortably, still too finely balanced to make a clear call either way.

China concedes some policy ground, but will it be enough?
Chinese President Xi Jinping appeared typically resolute in last week’s keynote speech to the annual Boao Forum for Asia. Not only did he defend China’s zero-COVID approach, he also delivered a thinly-veiled criticism of the US for its sanctions against Russia, lamenting the “long-arm jurisdiction” of the unilateral actions. However, behind the rhetoric, while the Chinese government decries the West’s actions against Russia, many businesses and institutions have de facto joined the sanctions regime for fear of getting caught in second-round restrictions. China’s economic ties with the US and Europe are simply too important to risk. This is especially so given the immense problems China is facing.

Beijing’s zero-COVID policy looks increasingly like an expensive but ineffective exercise, with China now experiencing its biggest wave of infections since the initial pandemic shock. China’s most wealthy and numerous metropolitans (some 28 million) are experiencing food and medical shortages from restrictions – leading to explicit anger and even clashes with the police. The virus is also finding its way across the country, and Guangdong is also reported to have new cases. The harsh economic impact of lockdowns is already showing up in the data. Overall, the world’s second-largest economy grew faster than expected in the first quarter of 2022 – but the underlying figures showed a dramatic slowdown in March. Analysts have cut their forecasts for growth in 2022. Bank of America and UBS both now expect a 4.2% expansion this year, down from 4.8% and 5% respectively. Nomura is more pessimistic at 3.9%.

The sharp slowdown has yet to prompt a rethink of COVID policy, but other policy areas have had to change. The People’s Bank of China (PBoC) has effectively loosened policy – not by using interest rates, which remained unchanged, but by lowered its daily fixing rate for the renminbi, allowing it to break through the 6.4 level against the dollar for the first time since November. The PBoC also announced a raft of other measures designed to increase lending and bolster the government’s finances, but this long list seems rather emblematic of Beijing’s ramshackle economic management in recent times. Rising global commodity prices convinced the government against monetary easing (due to the fear that it would ignite inflation pressures), though now that appears to be changing. Input cost inflation seems to have peaked, leading Beijing to think it can withstand some currency weakness.

The credit story is particularly interesting. China’s government has been cracking down on excess leverage for years, causing several economic slowdowns along the way. These efforts came to a head when Evergrande – the world’s most indebted property developer – began its collapse. The problems arising from this have caused sporadic episodes of credit impulse from the government, but officials are clearly hesitant to inflate the debt bubble any more. The problem is, not doing so makes it extremely hard to meet Beijing’s other great objective: stoking domestic demand. It seems to have miscalculated how much compression of the housing market would weigh on consumption. Together with periodic lockdowns, the weak housing market has taken a huge toll on consumption, making it very difficult to get out of the current slowdown. This means we should not expect Chinese domestic demand to be a driver of growth in the short term; once again, this will instead have to come from external demand. China’s authorities are desperately trying to keep supply chain issues from halting the current flow of exports. But for now, the world’s second-largest economy is in the passenger seat, as far as the global economy goes. This could mean the renminbi gets even weaker from here. Maybe President Xi will have to reconsider his resolute stance after all.

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