Gains in equity markets this year reflect an outlook where economies continue to grow despite tight monetary policy, while the inverted yield curve points to a recession in the developed world. Such mixed signals contrast with clear signs of weakness in China, which are cooling investor sentiment and hindering a local stock market revival.
The Fed’s steer at Jackson Hole
First to the US, where core consumer price inflation continued to edge down, to 4.7% year-on-year in July after 4.8% in June. A further signal to guide US monetary policy in the near term should come from the annual Jackson Hole Economic Policy Symposium starting on 24 August. US Federal Reserve Chair Jerome Powell’s remarks there will likely be the market’s focus.
The Fed’s overriding objective is to return inflation to its 2% YoY target. However, with core personal consumption expenditures (PCE) inflation still running at 4.1% YoY, we believe the Fed is unlikely to loosen policy anytime soon. The fall in inflation is at least aiding the Fed buy pushing real yields into positive territory (see Exhibit 1).
On the data front, recent macroeconomic indicators, including those on the labour market and the senior bank officer lending survey, reveal cracks in the economy.
Anticipating an eventual slowdown, our multi-asset investment team has deepened its long duration position, including in long-dated US Treasuries, both nominals and inflation-protected securities (TIPS).
The team is tactically negative on developed market equities and positive on emerging Asia equities. While recent news of weak economic data in China could lead to sustained declines in Asian markets, this is not our base case.
China – Debt-deflation concerns
Like a bull in the proverbial ‘China shop’, the adverse reports from China have upset the local market.
Sentiment turned from already bearish after the release of negative CPI inflation and weaker-than-expected credit and GDP growth data for July, to even worse when Country Garden, one of China’s largest developers, suspended trading in its 11 onshore bonds on Monday (14 August).
Meanwhile, Zhongzhi Group, a wealth management firm with more than RMB 1 trillion of assets under management, has halted client redemptions.
Country Garden’s debt woes could be systemic. If the market fails to find a solution soon, Beijing will likely step in to manage a restructuring, as it did with Evergrande and Huarong Asset Management (both worth more than RMB 1 trillion when they failed between 2021 and 2022). To date, such careful policy management has kept systemic risk at bay.
The latest data for July showed wider economic weakness, with industrial output rising by only 3.7% YoY (down from June’s 4.4%), retail sales up by just 2.5% (down from 3.1% in June), and investment gaining a modest 3.4% (down from June’s 3.8%).
The data prompted the People’s Bank of Chinas to cut its policy rates unexpectedly, including the Mid-term Lending Facility rate and 7-day reverse repo rate, by 15bp and 10bp to 2.5% and 1.8%, respectively.
The economy’s poor performance has hit public confidence. That in itself could drag on GDP growth momentum and compound investor concerns about China falling into a debt-deflation spiral. Indeed, CPI inflation was -0.3% YoY in July, another month of a negative credit impulse (see Exhibit 2).
Further pressure on Beijing
Despite these problems, the odds of China falling into prolonged deflation we believe are low. Weak pork and energy prices were the main causes of lower inflation.
Prolonged deflation would depend on several factors:
- Monetary contraction. This is clearly not the case, with the M2 broad money supply still growing at double-digit rates.
- Demand destruction. We are not seeing rising unemployment, falling incomes, and contracting consumption and investment. Only exports have been flagging. Demand and income growth have been slow, but are not shrinking; youth unemployment is high, but overall labour market conditions are not dire. And demand is recovering, mostly for domestic services and tourism (tour prices jumped by over 10% YoY in July, for example).
- Persistent loss of public confidence. While confidence is weak because of the earlier zero-Covid policies and the drooping property market, it is too early to say this will persist. More assertive policy easing by Beijing in the coming months should help stabilise the property market and improve confidence, reviving private sector spending and investment.
- Increase in the real value of debt. This is a long-term factor and is partially true in China, as the debt ratio rises when inflation falls. But Beijing has been addressing the debt problem since 2017 by stimulating deleveraging through good and bad economic times.
Nevertheless, the intensifying economic and financial woes add pressure on Beijing to pursue a more aggressive policy, including for the property market.
The government needs to act quickly and decisively to shore up activity and confidence before the current pessimism becomes entrenched and hits growth harder.