Second-quarter purchasing managers’ indices (PMIs) suggest that the steep cycle of interest rate rises by leading central banks might be putting the brakes on economic activity.
The slowdown is more pronounced in the manufacturing sector, which saw PMIs signalling contracting growth in most economies (see Exhibit 1). This was more the case in Europe and the US than in Asia. Services sector PMIs still mostly indicate expansion, although activity is slowing there, too.
In the coming months, the PMIs will tell us whether the decline is temporary or if monetary policy tightening is finally squeezing demand.
Geographically, Asia appears seems to be doing better than major developed markets. Europe’s PMIs have been weak since June, with manufacturing activity contracting (notably in Germany). Services sector growth in France, Germany and the UK has eased. US data has also softened.
As a result, price pressures have mellowed in the manufacturing sector and have reversed in the services sector, helped by a drop in energy prices and improving supply chains.
Other signs of slowing inflation include the drop in the US Employment Cost Index to 4.5% year-on-year in July from 4.9% YoY in June, and decline in the core personal consumption expenditures index – the inflation rate the Fed monitors closest – by 0.5 to 4.1% in June from May. In Europe, headline inflation fell to 5.3% YoY in July, but core inflation was stuck at 5.5%, more than twice the ECB’s target rate.
The latest US Senior Loan Officer Survey showed banks have tightened lending standards further (see Exhibit 2), which should further slow economic activity. In Europe, housing and business investment, two of the most interest rate-sensitive sectors, are showing signs of weakness amid tightening financial conditions.
The slowdown in growth and softening inflationary pressures should come as welcome news for central bank policymakers, but we believe it is not enough to prompt central bankers to drop their inflation-busting policies. The US Federal Reserve and the ECB have so far kept the doors open to further rate increases.
After delivering the expected 25bp rate rises at the latest policy meetings, neither the Fed nor the ECB gave any clear guidance on future rate moves. They reiterated that their course of action would depend on the shape of the economy and that they would keep policy tight for as long as needed to bring core inflation down to the 2% target level.
China’s ‘Politburo put’
The outlook for developed markets depends partially on China’s growth prospects. Three years of restrictive zero-Covid policy and a still badly troubled property market have quashed private sector investment in China, dampening animal spirits. Private sector investment growth has dropped steadily since 2021 (see Exhibit 3). This has sapped the post-pandemic rebound of momentum, with Q2 2023 GDP growth weakening to 3.2% quarter-on-quarter from 9.1% in Q1.
China’s growth and market outlook are contingent upon Beijing acting quickly and decisively to shore up activity and confidence before the current pessimism becomes entrenched. In this light, the supportive messages from the Politburo meeting on 24 July are encouraging. They have created market expectations of a ‘Politburo put’ option to prevent GDP growth from weakening further.
The Politburo’s tone, especially the removal of the statement that ‘housing is for living, not for speculation’, is important. If it lifts consumer confidence and boosts the property market in the short term, we could see a re-rating of Chinese stocks. The market reaction since the Politburo meeting has so far been positive.
However, the biggest uncertainly is the timing and magnitude of the ‘Politburo put’. If it is not implemented forcefully enough to turn around confidence and ease the property market’s woes, investor sentiment could quickly sour again, regardless of the amount of (additional) liquidity in the system.
An alternative scenario
Our base case is for China’s GDP to grow by 5.3% this year and by 5.0% in 2024, with inflation remaining to well below 3% annually. However, weak confidence and a struggling property market mean there is a non-negligible risk of China missing its 5.0% target. If that becomes a ‘pain point’ that touches Beijing’s nerves, it could prompt even more forceful policy action than the consensus currently expects.
Recent actions and statements appear to show that Beijing might be approaching that pain point. It looks likely that we will see firmer action to boost growth, which would support a sustained rebound in Chinese stocks in the coming months.
Given the challenges developed equity markets are facing, our multi-asset investment committee sees greater potential in emerging markets, particularly emerging Asia and China. It notes that the latest measures from Beijing illustrate the scope for further gains if additional steps to support the property market and domestic consumption follow.
Valuations of Chinese equities look attractive to us despite the negative investor sentiment. Partly because earnings were depressed during the lockdowns, the forecast earnings growth rate in 2024 for MSCI China stands at 15%. Even if in our view this is too high, we still expect realised earnings to grow faster in EM Asia than in Europe and the US.