IN THIS PUBLICATION:
- A continuation of the current US stock market rebound might give the Fed more room to accelerate tightening.
- Given a supportive Central Bank and so much negativity already priced in, China might perform well into year-end.
- Investors should focus on direct exposure to commodities rather than exposure to the companies that mine them.
Stock Market Rally: When Good is Bad
In the aftermath of the July 26-27 FOMC meeting, bond yields briefly fell, whilst the equity market surged – a classic expression of bullish market sentiment. The inflation print was still high, so why has the market reacted positively? Because it believed that a bout of weak macro data paired with a lower year-on-year inflation print (8.5% vs 9.1% in the previous month) might lead the Fed to hit the brakes on its trajectory for rate hikes (i.e. pivot).
The weak macro data backdrop was:
- Consumer sentiment and the NFIB small business expectations survey reaching recessionary levels.
- The ISM prices paid index falling sharply from 78.5 to 60, which implied that the threat of higher prices could be receding, therefore increasing the chance that June’s year-on-year change in the Consumer Price Index (CPI) of 9.1% might be the peak.
- With many investors already predicting a recession in 2022, a second consecutive negative quarterly print for US GDP appeared to confirm those fears. Over the last 50 years, recessions have always seen CPI drop significantly, which would once again put less pressure on the Fed to continue its hiking of interest rates.
Has the market correctly anticipated the Fed’s pivot? Well, the optimism may have been premature. In fact, the rally in risk assets (the NASDAQ has now reverted back to a bull market) may increase the potential for the Fed to be more hawkish.
The Fed is raising rates so that they can tighten financial conditions, which should help to bring inflation under control. If, however, stocks rally and yields fall, then financial conditions will loosen, the exact opposite of what the Fed wants to achieve.
Since the market’s positive reaction to the FOMC, Fed speakers have consistently re-iterated their desire to combat inflation via tighter policy. For economic growth to be sustainable, inflation still needs to pull back significantly, and that is mostly achieved by tightening financial conditions further.
It’s important to remember, when trying to time the Fed’s pivot, that a peak in CPI alone is insufficient.
- If the Fed wants year-on-year CPI closer to 3%, then month-on-month CPI (on an annualized basis) needs to be closer to 0.3%.
- July’s CPI has provided some respite, with a better (lower) than expected year-on-year headline at 8.5% and the month-on-month figure dropping all the way back to zero.
- This has led the market to react as if the peak prices are in, and the Fed can now start to back off from its higher rates strategy.
The market and the Fed are currently looking at different datasets.
- The market is now focusing on a deterioration in forward-looking data, such as the subcomponents of the ISM survey.
- The Fed is watching the backwards-looking data like employment (most recent payrolls release was much stronger than expected, at 528k vs a consensus forecast of 250k), which is giving them further reason to tighten.
A wage-price spiral (i.e. higher prices as a result of higher wages that stem from a tight labor market) could further support inflation, which is why the Fed emphasizes employment data so much.
- But it’s important to remember that employment data is notoriously fickle, and it is often at its tightest just before the onset of a recession. Furthermore, payroll data is also subject to significant revisions and seasonal adjustments, which have become more volatile since COVID.
That said, taken at face value, the backwards-looking data that the Fed looks at to set its monetary policy still looks strong:
- Overall CPI is still high.
- The labor market appears tight.
- Shelter inflation (i.e. costs associated with housing) continues to be high. As John Authers at Bloomberg wrote last Monday: “Shelter inflation is now four standard deviations above its norm for the last decade. As it accounts for a third of the index and tends to come through with a lag, this bodes ill for headline inflation descending quickly to 2%.”
Therefore, the Fed will remain in a hawkish mode. Despite the bounce in the equity market (which instead is focused on forward-looking economic data), Fed Funds for the end of 2022 have hardly moved and still imply that interest rates will get to 3.4% by year-end, in line with the Fed’s own forecast for terminal rates (at 3.4%).
Prior to the July rally, equities were oversold, and sentiment was very bearish. A rally had been overdue. But, if US stocks rally too far, the Fed may need to shock the market by ramping up the hawkish rhetoric in order to continue tightening financial conditions.
Therefore, a further equity rally could now be self-defeating, emboldening the Fed to tighten at a faster pace until something finally breaks.
China Turnaround in H2 2022?
China’s economy and financial markets, which often offer uncorrelated returns to other major markets, have frustrated investors this year.
- At the beginning of the year, China’s credit impulse appeared to be turning higher from its trough (bullish indicator), and investors took note. (The credit impulse compares the rate of change of the flow of credit versus the growth of the economy).
- Whilst it took a couple of months to work, during the second quarter of the year, the Shanghai Composite experienced a powerful bounce at a time when the S&P500 was entering a bear market (a decline in excess of 20%).
Since early July, however, China’s market has once again rolled over. The primary culprits are:
- The ongoing zero-tolerance covid policy, which has led consumer confidence to decline to an all-time low.
- Default cycle that has its roots in the real estate market. This matters particularly because it’s the largest contributor to China’s GDP, yet it has provided a negative contribution to fixed asset investment in 8 out of the last 10 months, according to an analysis by UBS. In fact, China’s high yield default rate is still rising and is significantly above both the 2008-2009 and 2015 downturn periods.
- Dollar strength in general, and the Japanese Yen’s weakness (in particular) have also eroded China’s competitiveness, leading to a decline in China’s currency. (Side note: additional weakness in the Yuan is not simply a local problem, but also a major risk for global markets because a stronger US dollar tightens financial conditions, and the more investors move out of the Yuan and into the USD, the more they tighten financial conditions.)
All of this has led to capital outflows, which have forced the People’s Bank of China (PBoC) to tighten the reigns through macroprudential regulation. Some have argued that the recent travel restrictions, under the guise of a zero-tolerance Covid policy, have also been an attempt to reduce capital flight.
China is not an exception - many emerging markets were already reeling from the surge in global bond yields. The underperformance of emerging markets due to higher rates was compounded by US dollar strength, creating problems for corporates and countries with US dollar-denominated debt (the higher the USD goes, the more EM countries and corporates will need to pay to service their debt).
Investors are, however, reluctant to throw in the towel on the China turnaround.
- Covid restrictions will come to an end and consumer confidence will rebound.
- The correction in tech stocks may already be complete. Domestic regulators are starting to ease back on measures that initiated an 80% decline in China’s tech stocks.
Whilst the threat of US regulation could still bring top-down pressure to bear on the US listings of these Chinese tech companies (ADRs), the local outlook is improving.
China’s policymakers have also been attempting to ease policy, with 7-day repo rates having dropped by over 50 basis points during the last three months and helping the financial sector, even as they have tried to stem the capital outflows by tightening elsewhere within the real economy. Additionally, this past Monday, the PBoC cut two key interest rates as a result of slower economic growth.
The consensus is for China’s growth to rebound in H2 2022, though full-year growth is likely to fall short of the government targets.
The nature of that growth will be different from the scattergun approach that existed prior to 2018, in which credit and leverage led to unsustainable growth in real estate. Policymakers will probably focus on rebalancing the economy toward domestic consumption and away from the excesses of the real estate sector.
The optimists are already looking toward the 20th National Congress of the Chinese Communist Party, which will be held in Beijing in the second half of 2022. This may be the leadership’s opportunity to adjust the economy to a post-COVID world and ease back on the regulatory handbrakes that have held the market in check this year.
Given a supportive Central Bank and so much negativity already priced in, China might perform well into year-end.
Commodities: Price, not Volume
The US dollar usually has an inverse relationship with commodities.
- When the dollar is strong, commodities tend to struggle and vice versa as most commodities are priced in USD (so a higher dollar makes commodities more expensive, reducing demand when possible).
- But over the last 15 months, the two have often (and unusually) been positively correlated. The dollar and commodities have risen at the same time.
The primary reason for the changed relationship is that commodities have been beset by supply issues – this means that, even as the USD strengthened, commodities prices rose on the back of lower availability of goods due to said supply chain issues.
Demand (and demand growth) however, have not returned to pre-Covid levels in many commodities because the global economy has not yet fully recovered. The global economy has rebounded, but in real terms, it has fallen short of the pre-Covid trajectory.
The narrative behind commodity markets has recently been about higher prices but not higher volumes. Prices that are elevated because of supply constraints are not necessarily a positive for commodity exporters (be it countries or companies). This is because revenues are driven by both price and quantity, and whilst prices have risen, quantities have remained subdued because of uncertain demand in the pandemic era and supply constraints brought about because of years of underinvestment in the commodity sector.
This has been apparent in the performance of many commodity currencies, such as the Australian Dollar. Apart from a brief bounce on the back of the invasion of Ukraine, the Aussie has been in a downtrend for most of the last 18 months.
Contrast this with the period from 2001-2008. China demand was driving both price and volume higher. Why would a commodity currency fall during a commodity bull run? The answer is that today’s prices are not matched by surging volumes, leading commodity currencies to struggle.
China is unlikely to drive volumes higher in the short term:
- As noted in the previous section, China is rebalancing its economy, moving away from ‘growth-at-any-cost’ toward domestic consumption – this implies a reduction in commodities imports when compared to prior years.
- China rebuilt its stockpiles of copper when prices were between 5000 and 7000 USD/MT in 2020. This wasn’t preempting another real estate binge but was part of the plan to become a world leader in green technologies which require significant inputs of industrial metals (namely copper). So, a big chunk of imports that China needs has already been frontloaded at cheaper prices.
Furthermore, the US appears to be in recession (even if it is mild), supply constraints will remain, and the war in Ukraine is unlikely to get resolved in the short-term (i.e. Europe’s energy crisis will roll into 2023). Commodity prices should remain elevated, even with a recessionary bust.
Although many energy companies have provided excellent earnings in the last few weeks, they are now clear targets for governments that are trying to find scapegoats for the cost-of-living crisis that their fiscal policies enabled. Investors should focus on direct exposure to commodities rather than exposure to the companies that mine them.
Thanks for reading through! Obviously, none of this is investment advice.
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