Monday digest

Posted 6 March 2023

Overview: Mood swings
Bond and equity markets have been experiencing teenager-like mood swings for some time now. Investors have oscillated between optimism over the surprising resilience of consumer demand and relative company earnings stability, and pessimism that the same economic resilience will force central banks to keep raising rates for longer. Last week, focus shifted back to more positive growth indicators, resulting in an improvement at least for equity markets. Meanwhile, the bad mood in the pan-European bond market worsened. While Europe’s economy has avoided an outright energy crisis, and delivered some positive economic updates, the unfortunate upshot of this has been inflation creeping back up.

The latest purchasing manager index (PMI) reports of business expectations showed that global growth had returned in February but that it (quite literally) came at a cost. Despite falling energy prices, input cost pressures rose, a sign that even the smallest amount of growth takes us back to a position where there is little or no spare capacity. That view was backed up by German, French and Spanish inflation data which showed a surprising rebound, especially given that companies’ energy bills should have fallen somewhat.

For the central banks, therefore, this information has been enough to warrant another round of warnings that rates will probably have to go higher and stay there for longer. In the US, there is growing talk of a return of a jumbo 0.5% rate rise step on 22 March. The European Central Bank (ECB) had already said rates would rise by 0.5% on 16 March, but could be tempted to go to a deposit rate of 3.25%, a rise of 0.75%. On the back of this, bond yields rose again, with ten-year US Treasuries decisively breaching 4% for the first time since last November and German ten-year Bunds for the first time up to 2.7%. It is worth remembering it was only a year ago that Bund yields stopped being negative.

Higher government bond yields are problematic for other asset classes since they form an important part of market valuations. However, even with the impact of higher yields, confidence in the resilience of economies and household spending has improved – in terms of that looming recession, we are not even close to a downwards spiral. Equity markets are still in a risky position, particularly if consumer demand was to eventually buckle and corporates were no longer able to maintain revenues and thus profits. But if profit growth confidence is starting to improve – as we had some reason to believe last week – then we could see reasonable upside from current levels.

Will financial crackdowns mean China’s recovery bounce falls short?
Global investors were delighted when President Xi Jinping finally reversed China’s zero-Covid policy at the end of last year, opening up the world’s second-largest economy. Many predicted a post-pandemic bounce even bigger than that experienced in the west two years ago. But those expectations have faltered as the year has gone on. China’s stock rally tailed off at the end of January, and the CSI 300 – mainland China’s benchmark equity index – traded sideways through all of February, while Hong Kong’s Hang Seng index fell by more than 6%. So, should we be worried about China’s recent lack of spark? The answer is not just yet.

Following  the Lunar New Year and subsequent spring festival, early March has seen some overwhelmingly positive signs. February PMI data shows the best reading for the manufacturing sector in more than a decade, well above economist expectations and suggesting manufacturers are increasingly positive about the near term. Likewise, high-frequency data like mobility figures are extremely positive, suggesting citizens are taking the opportunity to travel. While it remains to be seen how this will impact the hard data later on, the signs are exactly what we would expect from a strong demand-led rebound.

Some commentators have sought deeper explanations for China’s disappointment, such as the (supposedly) lower savings base that consumers have to work with, compared with western counterparts in 2021. But we suspect that funding troubles on the institutional side – for property companies and local governments – are one of the reasons why China’s bounce has been underwhelming. As well as a break from zero-Covid, Chinese positivity was prompted by a change of fortunes for the property sector. Developers were suffering after the crisis at Evergrande, and found funding hard to come by, thanks to Beijing’s crackdown on private sector lending. There are signs Beijing may be embarking on another crackdown, this time across the financial sector. Deleveraging and financial crackdowns are part of Xi’s drive for stability in China, but pushing too hard too soon could massively destabilise things. Central authorities will no doubt be aware of some of these issues, but we have seen how Chinese ideology can often trump pragmatism and short-term growth.

That Chinese growth is a vital part of the world economy is arguably truer now than ever before, partly due to its size but also because of the current relative weakness of the western world. For global investors, positivity around China has been one of the few bright spots in an otherwise challenging environment. Fear of disappointment is therefore understandable. If there is a broad and deep crackdown ahead, it would be a mismatch with Beijing’s stated growth drive. While the consumer demand bounce is most definitely coming, we will be keeping a close watch on measures which could undermine confidence at least in the short-term, even if authorities believe they act for the greater good.