Chasing markets has been the story for a while, reflecting the dramatic response of central banks and governments in the wake of economic shutdowns.
Among big countries, global investors have also focused heavily on China. Firstly in terms of the country’s path out of Covid-19 and what lessons if any that entails for the rest of the world. Secondly, the scale of China’s eventual economic recovery.
Plenty of countries including Australia, Japan, South Korea, Germany and Sweden rely on Chinese demand returning, and that also has implications for broader emerging markets and commodities.
Already this week, China’s CSI 300 has surged 8 per cent, and tagging along in the slipstream, the renminbi has strengthened towards an old line in the sand of Rmb7 per dollar. Also of note, China’s 10-year yield has extended its rise above 3 per cent, after ending April below 2.5 per cent.
Analysts at BCA Research observe that a stronger renminbi “diminishes global deflationary pressures” and is therefore “bullish for global equities including emerging market stocks and commodities. In the past month alone, an index of industrial metals, comprising copper, zinc, nickel and aluminium has risen 8 per cent, a performance that has accelerated this week in tandem with the jump in Chinese share prices.
A wide interest rate difference between China and the US is a favourable backdrop for global risk assets. With a US 10-year Treasury yield around 0.65 per cent, the difference between these two benchmarks has climbed towards 2.4 percentage points and eclipsed the peak of September 2011.
The Federal Reserve is focused on containing US Treasury yields and stemming dollar strength — a reason why gold has broken above $1,800 an ounce for the first time in nine years.
Low US yields and a weaker tone for the dollar are very supportive for gold. The US 10-year real yield — adjusted for inflation — has been making new lows in recent weeks and the nadir of minus 0.87 per cent from late 2012 looms.
Another boost for the renminbi comes from foreign flows chasing the breakout in Chinese equities and against that backdrop, BCA note:
“Unsurprisingly, China’s FX reserves are rising moderately, despite the country’s small current account deficit.”
Before global investors fully embrace the maximum bullish ethos, Geoff Yu at BNY Mellon reminds us that “the long-term investment case for China and associated ‘input reflation’ lie in the consumer sector” and provides an interesting comparison between steel and beer production to make that case.
Geoff observes that in the event of the Chinese economy “normalising and reflating, there are many economies and asset classes which could also benefit”. But he also cautions:
“Although the improvement in demand is real, the distribution is very sector-specific and not every traditional ‘China-beta’ trade will work.”
This chart highlights a more consumer-orientated recovery for China.
Industrial production, cumulative (year-to-May)
Another consideration for investors and one that chimes with the explosive rise seen for Chinese shares in 2014 into 2015- and one fuelled by rising leverage — is that higher bond yields and a stronger currency are not ultimately welcomed. Or as Geoff notes:
“In the same way that earnings growth was ultimately not there to support domestic equities, deteriorating balance of payments could not justify the renminbi’s levels and a discrete adjustment was made in the summer of 2015, rattling risk appetite for many months.”
Looking at this chart via Brown Brothers Harriman does make you wonder how far these measures of equity market margin borrowing in China will rise before the alarm bell rings.
In the near term, further appreciation of the renminbi beckons and Alan Ruskin at Deutsche Bank says during past periods of a weaker US dollar, the People’s Bank of China has “tried not to get caught trying to draw a hard FX line in the sand at a key level, and ongoing market pressure has tended to see the authorities let big levels go”.
“The longer China holds the exchange rate steady against market forces, the more it is implicitly adopting US monetary policy, as net foreign assets inflate the PBOC’s balance sheet. This boost to global liquidity is also positive for risky assets.”
Quick Hits — What’s on the markets radar?
The UK economy faces a long recovery road and Rishi Sunak, the UK chancellor, outlined a £30bn package of stimulus measures via the summer economic update. These include the slashing of stamp duty, a cut in VAT for the hospitality industry along with a promise to pay companies for each worker they bring back from furlough. In terms of market reaction, housebuilders enjoyed a share price pop.
Paul O’Connor at Janus Henderson Investors says:
“While today’s mini-budget included many eye-catching policy initiatives, the market impact has been modest, reflecting the fact that a £30bn fiscal package is not going to transform the outlook for a £2.1tn economy that’s expected to shrink by 8 per cent to 9 per cent this year.”
And there’s also the prospect of payback later from the autumn budget later this year. Tom Selby, senior analyst at AJ Bell notes:
“With Boris Johnson ruling out a return to austerity, a tax-grab seems almost inevitable as the Treasury seeks to balance the books.”
There are a couple of warning signs flashing among markets. Equity volatility remains elevated, while risk premiums for US investment grade corporate debt in aggregate has narrowed to a record low. The presence of the Federal Reserve as a buyer of last resort in corporate credit helps explain the dramatic rally seen for investment grade debt, but this provides little cover should defaults pick up in the coming months. Typically, any eruptions among the weaker areas of the credit universe tends to spur a large exit trade from the asset class. It will certainly be interesting to see whether the Fed has altered that dynamic into the autumn months.
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