Last week saw further falls on global stock markets. The S&P 500 and the NASDAQ both fell 2%, while the MSCI World ex US index fell 3.3%. The UK’s FTSE 100 index fell 2.5%.
The driving themes continue to be the rise in global bond yields, as the ‘higher for longer’ interest rate scenario becomes increasingly likely. Fear of oversupply has added to nervousness on the Treasury and UK gilt markets. The 10-year Treasury yield rose 10bp to 4.3%, back to levels last seen in 2007, while the 10-year gilt yield, at 4.7%, is back to 2008 levels.*
In addition, investors are reacting to what seems a persistent flow of poor economic data from China. The world’s second largest economy is doing opposite to that which was forecasted at the start of the year. Then, economists predicted a post-lockdown rebound in China GDP to 5.5% or more this year, providing a boost to global trade. This would help alleviate the impact in the U.S., and Europe, of weak domestic demand as interest rates rose.
Instead, China’s GDP growth has disappointed. Second quarter GDP grew by just 3.2% at an annualised rate. July saw double-digit falls in imports and exports over a year ago.** Factory goods prices in July were 4.4% lower than a year previously. The country is not exporting growth, but mild deflationary forces.
The fact that too-strong U.S. economic data and too-weak data from Chinese, is blamed for falling stock markets might well induce a sense of ‘heads I win, tails you lose’ in the investor. To understand the logic, we need to understand the difficult options facing the countries’ central banks.
Falling inflation is not enough for the Fed, if labour markets remain tight
The American economy appears to be too resilient for the Fed’s liking, meaning that even as inflation is falling, policymakers are nervous that it might take off again because of a very tight labour market (unemployment stands at just 3.5%). Hence the growing acceptance by investors that interest rates will be higher, for longer, than expected earlier in the year.
The Fed’s unease was made clear last week, in the release of the minutes of its July meeting. It saw a ‘significant upside risk to inflation’ coming from a resilient economy. For some, this nervousness would have been confirmed by data last week. Retail sales in July were well ahead of forecasts and a decline in new unemployment numbers was reported (for the week commencing August 12).
Growth stocks have been hit badly, as ‘higher for longer’ interest rates will mean higher long-term costs for capital in order to fund expensive, and speculative, research and development. The Financial Times estimate a combined drop in stock market value for the ‘Magnificent Seven’ Big Tech companies of around $1 trillion over the last three weeks. ***
Fear of oversupply of Treasuries is also being cited by investors as a reason to hold out for higher yields. During the Covid years, it seemed that bond investors were immune to supply issues. However, the sheer scale of the U.S. budget deficit, at around 5.7% of GDP -during a period of reasonably good economic growth- is causing alarm.
China- a property crisis unfurls
Chinese authorities face the bursting of a large property bubble, with broad economic fall-out. Consumer prices fell 0.3% in the year to July, and youth unemployment is up to 20%.
The policy response should be obvious. Monetary policy needs to ease with bolder interest rate cuts from the Bank of China than the 15bp reduction seen lately, and further reductions made to capital requirements from lending institutions. A large fiscal stimulus program, not so dissimilar from Biden’s (strangely named) Inflation Reduction Act, would also come in use. The budget deficit stands at around 2.8%, meaning it is affordable.
But Chinese policymakers are aware that any stimulus measures may well just prop up the property sector, which is undergoing a much- needed correction after a multi-decade cycle.
Last week Evergrande, once China’s most prestigious developer, filed for bankruptcy in the U.S. courts in order to protect its American assets. This came after announcing a combined loss for 2021 and 2022 of $81 billion. Also last week, Country Garden – long thought to be the best managed of the large property developers defaulted on debt payments. $200bn of liabilities, comparable to Evergrande when it ran into problems in 2021.
The implosion of the Chinese property sector represents a challenge for the Chinese Communist Party. As completion rates fall, protests are triggered from purchases who have already began paying mortgages on the properties. Discretionary spending on other goods and services is reduced.
We may see one more interest rate from the Fed, but markets are pricing in U.S. interest rates to remain at broadly similar levels (i.e., at the current target range of 5.25%-5.5%) until mid-2024. The Bank of England, meanwhile, is currently expected by the markets to peak at 6% early next year (from the current 5.25%). This discrepancy will continue to support sterling, which looks comfortable at $1.27.
Investors should remain broadly invested, across a range of assets and geographies, to maximise risk-adjusted returns. This is the philosophy of most multi-asset funds.
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