2 Week Hiatus, What Have We Missed?

Week Ending 9th December, 2022

In this week’s update and after a two-week hiatus, let’s take a look at what’s happened in the markets.

• 10y Government bond yields have taken quite a dive suggesting perhaps a halt to rate hikes and possibly good news on inflation (consumer and factory gate level).
• The further substantial decline in energy (Oil) prices would seem to reinforce this perception.
• A further rise in iron ore prices suggests industrial growth ahead?
• The general trend of non-US$ currencies continuing their rise vs the US$ suggests a risk-on appetite.
• …..yet developed market equities have taken a bash this week while EM Asia is up strongly.
• Volatility is hardly changed over the past two weeks; in fact, it is less than 4% higher vs one year ago. How can that be despite everything we have seen this year?l

Continue reading to find out what has driven the above these past two weeks.

Massive uncertainty, at the time, around China’s reopening when covid cases were surging (over 30,000 per day on a 7-day average). New cases had exceeded their Shanghai lockdown peak; cities representing some two-thirds of China’s GDP were at high to medium risk. This was a primary driver for bond yields globally. Now, China has announced that its two pillars of “zero Covid” (frequent tests and digital health codes) are no longer required for daily life or travel within the country. This is big – it led to significant unrest in over a dozen cities. The State Council also released a 10-point plan. In it, those with less severe infections could quarantine at home. Digital health passes (an app that tracks movement and testing history) will not be required for the most part. These measures were an extension of a 20-step “optimisation” plan released in early November which were aimed at reducing the economic and social costs of arbitrary and excessive restrictions. The country now has to deal with a new culture – how to handle covid. There will be many deaths as China comes out in the open and covid undoubtedly spreads. There is a recognition and acceptance for the need to accelerate vaccinations for the over 60s as well as improve monitoring now that it is reopening. Some things remain the same – international travel restrictions stay in place meaning eight days of quarantine for overseas arrivals and still closed to tourism. Of note – and concern – are the protests which started as an end to zero covid but developed into something wider: freedom of speech, human rights and even for President Xi to step down. This is the most challenging moment for the old guard officials. The lessons go back to Tiananmen.

The Fed continues to express its nervousness around inflation despite stating it will slow rate hikes from here. It meets next week for its December meeting. +0.50% is very likely. Three more rate hikes of 0.25% each are forecast taking the Fed Funds Rate to 5% to 5.25%. Q3 GDP growth was revised up to a solid +2.9% y/y. The November job number was another good print of +263,000 – better than the 200,000 expected. October’s gain was revised up by +23,000. Critically, wages rose faster than predicted (+0.60% m/m) to +5.1% y/y - the gap with inflation is closing, especially as the headline rate comes down. I can see parity during the course of 2023. October’s wages rise was also revised up to +0.5% m/m (from +0.44% m/m). Thursday’s weekly jobless release also reinforces how tight the market is.

In Europe, inflation moved down while activity indicators leaned to the upside. German industrial production surprised to the upside (it fell only -0.1% m/m when the consensus was for -0.6% m/m). This further alleviated bond yields.

Overall, inflation seems to be easing even across Asia EM – so too are the pace of rate hikes; China’s manufacturing activity is slowing but this largely reflects the zero-covid policy of the past. I believe this will change as the focus now becomes growth – but it will be a volatile process in the short-term. Ex-China, growth is holding up reasonably well – and this gives me optimism in a scenario where China is reopening. Australia saw good Q3 growth and that’s despite a drop in trade driven by China’s slowdown. There will be a big impact “in the region” as South Korea and Taiwan see trade pick up. Indonesia, Thailand and Taiwan reported lower inflation (5.4% y/y, 5.5% y/y and 2.5% y/y respectively). Several central banks announced a “wait-and-see” approach on rate hikes (Brazil and Poland)

So, with year-end approaching and given the way 2022 has gone and where we are now, what factors should one focus on for 2023?

Growth: will return! It will be modest as all forecasts have been revised downwards with suggestions of recession. China is big in all of this – its own opening up will help revitalise trade in the region and spur growth. This will suck Europe into the equation – we saw this week how German industrial activity has held up much better than expected because of Asia.

Inflation: for the “Nth” time, it’s all about core inflation. Wage pressures are rising and, at some point next year, the combined effects of a very tight labour market plus falling headline inflation will mean an end to negative real wage growth. That’s a turning point – it’s good as neutral to positive wage increases mean extra spending power which helps fuel growth and keep it going.

Is the US$ rally over? Since the end of September, the US$ Index has fallen over -9% as the conditions that drove it up seem to be unwinding – Covid easing in China, Europe’s energy crisis and large rate hikes by the Fed. The significance of a falling US$, affects the value of foreign earnings; capital will flow out dragging down growth; inflationary pressures will rise; higher costs for those US companies with foreign operations (converse is also true). From here, the only further compelling reason for the US$ to keep going up is geopolitical risk. Otherwise, there is a currency play from the other direction entering the equation.

There are three, massive risks to the above:

China: what if it can’t control covid-easing, deaths get out of hand and, suddenly, the above calls for President Xi to leave become even greater? Youth unemployment (16y to 24y) stands at 18%

Ukraine / Russia: Ukraine is now going deeper into Russia – to the point that it is making the West nervous! This week we witnessed drone strikes on Russian airfields INSIDE Russia is a major concern for Putin – what message must it be sending to ordinary Russians and will it tip Putin into going nuclear? Europe is split on next steps – after all, Russia is its major energy supplier

Energy: In its latest report, the International Energy Agency says “renewables will become the largest source of global electricity generation by 2025”. Not everyone agrees with this and many challenge how soon this is likely to be the case. If supply lines continue to free up especially from the situation in China then energy demand will rise as growth picks up globally. Very likely, it will return to pre-Covid levels. We will need more energy supply and, for at least the next 3 years, hydrocarbons will remain in big demand. OPEC and OPEC+ will need to think very carefully how it balances supply/demand – supply is falling and, in the absence of a recession, demand will start rising.

Key takeaways:

• Spread FX risk: until now, it has all been US$. That’s already changing as non-US$ currencies continue their rise.
• Growth is relative – valuations are looking more attractive for ex North America given the new China dimension.
• Interest rate hikes will slow until they are compatible with a manageable level of core inflation. Eventually, the latter will start to diminish when renewables really kick in – that’s some way off.

MARKET SUMMARY

For w/e 9th December, global equity outflows reached over -$22bn. US equity funds fared the worst (-$26.65bn) while European (+$3.41bn) and Asian (+$0.99bn) saw inflows. Corporate bond funds saw inflows of $2.17bn. Government bond funds faced outflows of -$1.06bn.