At GAM Investments’ latest Active Thinking forum, David Dowsett and Rahul Mathur discuss recent choppy market behaviour, the future path for rates, as well as the markets that could provide tactical opportunities. Wendy Chen explores the key factors shaping investor sentiment towards China and outlines four sectors she is watching closely.
01 March 2023
David Dowsett, Global Head of Investments
Markets proved more challenging last week, providing investors with something of a reality check. Friday saw the latest core PCE release, which came in at a monthly rate of 0.6% versus expectations of 0.4%. The 3-month, 6-month or one-year annualised core PCE is in the range of 4.7% to 5.1% which we regard as evidence that the initial easy reduction in inflation, which occurred between September and the end of 2022, was what drove markets and allowed terminal rates to remain constant in terms of market pricing. Now the more difficult work of reducing inflation to meet the central banks’ targets is beginning to confront markets. I think there are many trends that mean inflation is likely to be sticky and to some degree markets are recognising this. Terminal rates for Federal funds during the market rally were fairly constant, oscillating between 4.75% and 5.1%, but over the course of the last month, we have seen a breakout to 5.4%. We have also seen new highs reached on 2-year yields in the US and indeed in Europe. I do not think this is likely to result in a very dramatic capitulation of risk, a big sell-off or a return to the market conditions experienced last year. This is because the quantum of change that we are thinking about here in terms of Fed funds is 50 basis points (bps) rather than the 450 bps correction that we saw last year. In short, this may lead to choppy markets and a degree of correction after the very dramatic risk rally that we have seen, but it is unlikely to be so severe that we are required to go into full defensive mode. There is some speculation that the Federal Reserve (Fed) will reaccelerate and implement a 50 bps hike at its next meeting but I think this is unlikely on the basis of what we are seeing in markets at present. Rather, I think we are witnessing an elongation of the rates cycle.
Rahul Mathur, Investment Manager, Global Macro & Currency Fixed Income
The near-term outlook remains choppy. Terminal rates in the US have repriced from approximately 5% a month ago to 5.4% currently. Looking at the profile for the US and the overnight indexed swap (OIS) market or the futures market, the market is still pricing around 25 bps of rate cuts between the summer of this year and January 2024. On its own, this does not seem like a lot but in the context of reasonably better data in the US and firmer inflation prints, we think there is still some scope for markets to be surprised if those rate cuts are taken out later this year.
From our perspective, this volatility encourages us to be a little bit more cautious. However, there are some markets that really stand out to us.
The eurozone – while there is approximately one rate cut priced in for the second half of this year for the US, the futures market implies that we do not see any rate cuts priced in until next June in the eurozone, with only about 10 bps of cuts off the peak priced in by then. Europe is looking fully priced in our view it is notable that the market expects the Fed to be potentially easing well in advance of the European Central Bank. We think this creates some very interesting relative value trades which suit a cautious approach. We also think that there may be tactical opportunities to take a little more constructive or positive duration exposure, particularly in markets that are looking quite rich and we would argue that Europe is one of them.
The UK – One of the standout markets for us continues to be the UK. In the UK, the 3-month Sonia Futures market is pricing in another 85 bps of rate hikes this year, and around 60 bps of rate cuts in 2024. We think that either the Bank of England (BoE) will be forced into doing more or that term premium is going to be priced back into the gilts market, as the bank is increasingly perceived to be behind the curve. In the press and some commentaries, we are seeing a shift in the voting pattern of the Monetary Policy Committee (MPC) with a couple of members favouring no changes or even potentially cuts earlier than we might anticipate. As a result, it is a market that looks very interesting to us. The futures market is currently pricing rates in the UK to be around 70 bps higher than in Europe by this time next year which we disagree with. We think that spreads should be materially higher either on the back of a pickup in risk premium in the UK or an acknowledgement that the bank potentially needs to do more. The BoE has been fairly downbeat on the growth outlook in some of their recent discussions but the PMI data that we saw early last week and the business survey data could start to challenge that negativity. In fact, the PMI data signalled a much more powerful swing in business sentiment that we think will dominate the weaker signs from the consumer that we have seen recently. Breaking down the drivers of those business surveys, they seem to have their roots in global factors such as improving supply chain dynamics and lower regional gas prices. But the upswing in those surveys also seems to us to be a lot stronger than the mechanical impact of those drivers alone and to us, it suggests that there is a much broader lift in confidence which we are monitoring very closely. There are also continued signs of resilience in the UK labour market when we look at vacancies. To some extent, we think the BoE’s message is somewhat inconsistent given that it characterises the current inflation risks as historically elevated but at the same time it is trying to suggest that it does not need to do much further in terms of rate hikes. Going forward, we would be looking for UK growth surprising to the upside and inflation remaining much more stubborn.
Japan – The incoming Bank of Japan (BoJ) Governor Kazuo Ueda gave a testimony on Friday and there are a few points from this worth highlighting. Ueda referenced the current inflationary bout as being primarily cost push due to rising food and energy import prices and the weaker currency, and not specifically due to strong demand. The testimony indicated that at least in the near-term the BoJ will retain its yield curve control framework which caps longer term yields at half a percent until there are more solid signs of a recovery, potentially towards the latter part of this year. Ueda also said that it is appropriate to continue easing while seeking to mitigate the side effects. Like many central bankers today, Ueda is trying to imply that he is going to take a much more data driven approach to deciding on policy shifts. Our expectation is that over time, the BoJ will probably tweak forward guidance to neutral and we believe Ueda could announce a special policy review for June which could result in adjustments in some of the more redundant BoJ tools, including its inflation overshooting commitment. In the near term, our sense is that YCC is likely to stay intact and if we see a shift from here, we expect it to be more baby steps than anything immediate or show stopping. Looking at Japan’s economy, and inflation in particular, CPI inflation in January accelerated to 4.3%. The main drivers continue to be food and energy and they collectively contributed three percentage points to the 4.3% CPI increase. This indicates that inflation is still narrowly based. It has been showing signs of broadening in recent months but 3% out of 4.3% is still material and it is enough for the BoJ to retain the view that some of the major drivers are likely to be transitory.
Brazil – Export earnings continue to hold up well, the budget is in much better shape than it was a year ago, inflation is falling and the central bank is keeping nominal and real rates stable at the moment. Brazil has some of the highest real rates globally. All of this has been very good for the currency and also for the rates market. We think that rate cuts are likely to come later this year, provided that the fiscal backdrop is benign, political influence remains curbed and also assuming that inflation remains under control. Looking at economic data in Brazil, we think there is already a compelling case for policymakers to cut interest rates but political risks are elevated as the new administration is being bedded in. The early signs of that from reported discussions seemed constructive and indicate the government recognises the importance of preserving the central bank’s independence.
Wendy Chen, Senior Investment Analyst, Disruptive Growth
China’s sharp reversal of its three year zero Covid policy has been much talked about. However, the key question is: what is the effect so far?
Based on our recent field trip, we believe that zero Covid is firmly behind us. From what we saw, the word Covid has simply vanished from people’s daily life. For example, for the past three years, to go anywhere a valid Covid test was required. Now, that has been completely abandoned and all the barricades in hotels, the airport, train stations have gone. As a result of this policy reversal, together with the Chinese New Year holiday, we are seeing revenge consumption and booming crowds everywhere to the extent that a “two-hour rule” has emerged, whereby there is generally a two hour wait for restaurants or transit around tier 1-2 cities. The lifting of travel restrictions has also led to a revenge resurgence of business activities, meaning during our trip, we attended many conferences with hundreds of investors in Shanghai and Beijing that have previously only taken place online.
What impact is this having on the Chinese stock market?
We have seen a V-shaped recovery in Chinese equities since the Party Congress in October 2022. Since then, the stock market has reflected market optimism around the lifting of zero Covid restrictions and China’s reopening in 2023.
However, there are some questions about recent weakness since the Chinese New Year holiday, especially compared to the US market indexes such as the NASDAQ.
Through our conversations with local investors, China’s performance in 2023 has become a topic of debate. While the bulls say that it is natural for the economy to recover after the harsh restrictions, the bears argue that China’s 5% plus GDP growth target for 2023 will be purely relying on consumption as the key support. Net exports are likely to be hit this year, due not to the supply side as in previous years, but due to overseas demand. There are fears that the strengthening Chinese RMB, geopolitical conflict, as well as a potential recession in the US and developed markets, could result in less demand from overseas. Meanwhile, government expenditure is limited because of land sale weakness and excess spending on Covid restrictions. As a result, there are questions around whether a consumption-based model can support the targeted GDP growth of 5% plus in China. Therefore, investors are waiting for more fundamental support or execution on consumer related and real estate policy in the upcoming ‘Two Sessions’ in mid-March. We do not think they will be dispatching money or consumption coupons as they did in Hong Kong, but hopefully we will either see some lifting on real estate deleveraging or support to local governments which could have a similar effect.
The government is certainly becoming more pro-market this year. For example, the sectors that have been previously targeted by regulation, such as gaming, have been recovering since the beginning of the year, suggesting the regulator is highly incentivised to boost the market. We do not think they will crackdown on sectors as they have done previously, unless there is proof that they are posing risk to political stability.
As a result of the lifting of the zero Covid policy and the complete reversal in the policy regulation tightening cycle, we see more upside than downside in Chinese equities.
Valuation-wise, the MSCI China Index is at an 11.5x 12-month forward price-to-earnings multiple which is still at a discount both historically and to the MSCI Emerging Market Index. On the liquidity side, we are seeing more investors returning to China including global long-only.
The biggest remaining question mark is on US-China relations, which seem to be tightening. For comparison, with Covid resolved but US-China relations unresolved, this creates a similar setting for equity investments as in 2020. From a liquidity and policy perspective, there is a much more level playing field so we believe it is a good time for stock picking and thematic investment.
Four major findings from our trip:
- Consumption: Both from our own store checks and those in the media, we can see a rebound in revenge consumption in China, most obviously in discretionary and local services, such as domestic travel, restaurants or cinemas. Cinema income during Chinese New Year has already exceeded that of 2019. As we have mentioned above, high demand has led to the “two-hour rule”. Travel has begun to recover with domestic travel during the Chinese New Year already reaching 88% of 2019 levels, while Hainan duty free shopping consumption has seen 20% growth year-on-year. As we previously mentioned, consumption is going to be the major support for GDP this year. The consumption story is also supported by the amount of excess savings in China. Before Covid, the average savings rate in China was around 30%, but during the pandemic (2021-2022) that ratio rose to 40%. This means a collective saving of RMB 3-4 trillion since the pandemic started, with some arguing that this could be a major pocket of consumption growth from this year onwards.
- Internet: The China internet story at the beginning of this year was more of a sentiment play as the DiDi probe was reversed and many of the restrictive policies were lifted. However, from our visits to mega caps like Tencent and Baidu, every company is aware that they need to deliver a good bottom line or EPS growth to support their story going forward. The travel internet companies like Ctrip are optimistic with robust consumer recovery and revenge travel behaviours (evidenced by surging demand and pricing for flights/hotels). The same can be said for advertising companies such as Tencent and Baidu which see a recovery in advertising demand alongside the macro recovery. The enthusiasm surrounding AI and ChatGPT has been playing out in many Chinese companies which are promoting their own commercialised AI to follow this trend. In our view, each year, there is a new theme in the internet world. For example, last year we saw the metaverse rise in popularity and the year prior, blockchain. Whether these themes can last for longer, in our view, depends on whether these companies put real money into them. AI is quite a cash burning business and looking at China internet mega caps, their investment in research and development suggests that they have the capacity and cumulative resources to expand this AI development and commercialisation.
- Electric vehicles (EV) and auto: This is a sector where we are more conservative after our field trip. The recent price cuts enforced by Tesla are forcing local car manufacturers to also lower their prices, a hazard practice as many of the EV manufacturers are still loss making. Furthermore, China’s EV subsidies have retreated since the end of last year and these two factors are leading consumers to wait for further price cuts and to see whether the EV companies are willing to pay more subsidies from their own pocket to reimburse the national subsidy. As a result, most consumers are searching for cars, but not paying yet. From a product perspective, many of the new EV models from Chinese companies such as Li Auto are very high end with multiple screens, autonomous driving and a world class designed interior. Despite the lavish interiors, many of the new models have similar offers and it is hard to differentiate one player from another. Some of the very early EV players are diminishing while the new players are easily catching up. Going forward, we see strong competition between China EV players as the technology and service are already maximised, while EV penetration in the China auto industry is already high above 20%. The OEM (Original Equipment Manufacturer) supply chain echoes their concerns because many are suggesting that from a cost efficiency perspective, Tesla still has at least 10% downside to go if they want to further cut their price.
- Hardware: There has been a lot of discussion about this sector due to US-China tension, as well as the Chip Act. We think it is important to separate hardware from semiconductor investment cycles. Hardware, especially the Android supply chain, is being more bullish as many companies have already seen the worst of the oversupply issue in 2022 and now it could be a case of ‘first in, first out’ in terms of turning around performance. For example, phone manufacturer Xiaomi is very optimistic about its smartphone margin, as well as EPS recovery for this year. Manufacturers of AIoT (Artificial Intelligence of Things) and many other home devices also suggest a similar level of enthusiasm in stepping out of the 2022 down cycle and riding the revenge consumption tide.
On the semiconductor side, we think the oversupply has played out since the end of last year. This year, management are suggesting the cycle turning around and demand returning in the second half of 2023. The domestic replacement cycle is very controversial, yet during our visits to some of the fab and manufacturing foundry companies in China, we see that at least 80% of their machinery is still US or European imported. This suggests that there is still quite some way to go if China wants to become self-sufficient in semiconductor production. While some factories are changing their place of production from China to Southeast Asia, or in some cases the US, most management say that the cost of producing in China is still attractive due to the manufacturing scale and talents reservoir.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. Past performance is not a reliable indicator of future results or current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. There is no guarantee that forecasts will be realised.