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Active Thinking

As central bankers head to Jackson Hole for their annual symposium, David Dowsett offers his views on August’s market events, and discusses the decoupling of the world’s two biggest economies.

23 August 2023

We typically associate August with thin trading volumes, usually with languid, range-bound markets. But while some investors have been on the beach this month, financial markets have been anything but laid back.

In fact, so far, August has by no means been a good month for financial markets. Stock markets have sold off, not dramatically, but at least enough to test June’s lows. Bond markets have fallen more significantly, with 10-year US Treasury yields almost 50 basis points higher so far this month.

While it still feels like we are already well beyond the cycle high in yields, it is interesting that real yields are rising – so yields are rising even as headline inflation falls – quite markedly in some countries. And if that is not enough to contend with during peak holiday season, investors are also closely watching events unfold in China.

From the perspective of central bankers, higher market-driven yields reflect investors’ expectations that interest rates are set to remain ‘higher for longer’. And that means some of the rate cuts that had previously been priced in for 2024 are coming out of the market as investors reassess their outlook.

So that is one factor driving yields higher. Another is that due to the scale of the ongoing fiscal expansion, particularly in the US, there is much more bond supply coming to market, something that is hitting the market in a traditionally quiet month.

Central bankers meeting at Jackson Hole

Interestingly, all this has been happening in the run-up to the Jackson Hole Symposium, where the G7 central bank governors, including Federal Reserve (Fed) Chair Jerome Powell and European Central Bank President Christine Lagarde, are gathering. So we should get some kind of signal, particularly from Powell, about how central bankers think they are faring in the current fight against inflation. Of course, he is’s unlikely to talk in definitive terms about policy moves for 2024 but instead should share his view on progress in the inflation fight. That, I think, will be an important sign for markets, not least because should the recent rise in yields continue then that would set up a tricky September for risk assets as market participants return.

China’s problems are building, but remain contained, for now at least

August’s other key events have centred on China, where the economic growth figures have been much worse than expected. We have seen credit problems building in the system – we had the shadow banking failure last week and troubled real estate firms Evergrande and Country Garden also fell further into bankruptcy proceedings.

So far, we have observed limited levels of support from China’s policymakers. But, in my opinion, the Chinese authorities need to show a far more decisive policy response than they have so far – one that will probably need to be both fiscal and monetary. China’s real estate overhang is very significant in terms of depressing both demand and investment. It is certainly having a bigger effect on the real economy now than we probably expected only six months ago. There is still a massive overvaluation, and probably over-ownership too, in the real estate sector, something that the economy just cannot escape from.

Whether we get more ‘drip, drip’ support or more dramatic ‘shock and awe’ measures, a secondary question is how much of a problem all this represents for the rest of the world. It is a big issue for China, but for the rest of the world, some investors are worried that there might be a spill-over effect, creating a payments problem that could hit the Western financial system.

I am relatively sanguine on this issue, taking the view that the Western financial system has had time to adjust to increasing stress emanating from Chinese real estate, something that is already reflected in valuations. In my view, the rest-of-the-world’s banking sector does not have high enough exposure to China to create any discontinuity. Therefore I would be surprised if events thus far in China have any significant effect on the Fed’s outlook for interest rates.

Decoupling before our eyes, but the Fed remains in the driving seat

It is not so long ago that the world economy was largely driven by one interest rate cycle and one growth effect. But that is no longer the case as the world becomes less globalised, and the global economy is decoupling. The world’s two biggest economies are simply less correlated nowadays – so we can have the US surprising to the upside, driven by domestic demand factors and very expansionary fiscal policy, and, at the same time, the Chinese economy not doing well. In my view, China will be a source of uncertainty, but it will not derail global markets. It goes without saying that events in China do matter for the rest of the world but I think it is unlikely that any downturn in short-term sentiment will turn into anything more worrying, such as a real credit crunch. I am not downplaying the risk that the present environment could deteriorate, and we certainly need to remain vigilant. Of course, a softer Chinese economic is not helpful for some emerging markets, particularly the commodity intensive ones. But I think what will truly set the risk tone for the rest of the year will be the Fed, and what happens to US interest rates.

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