NN IP: One month does not a victory make

NN IP: One month does not a victory make

Outlook
Beursvloer (01)

The combination of high inflation and falling growth explains why risky assets have suffered so much this year.

There has been good news on both fronts more recently, though, with US CPI for October substantially lower than expected and the Chinese authorities relaxing their zero-Covid policies and easing their property credit policies, triggering a sharp improvement in investor risk appetite. As a result, global equities rose by 5% and global high yield credit by 3% last week. Against this backdrop, we made no changes to our multi-asset model portfolio.

The US inflation reading – CPI rose by 0.3% month-on-month, while 0.5% had been expected – was clearly a welcome surprise, as were the Chinese announcements about Covid and real estate. But the questions now are whether upcoming inflation figures will also be positive and whether the changes to Chinese policy will be enough to kickstart a meaningful economic recovery. 

With the US labour market still tight and energy prices high, we do not expect global inflation to moderate enough for the Fed and ECB to become less hawkish, at least not in the short term. And with Covid infections accelerating in most Chinese cities, the authorities do not have much room to ease restrictions, even though the overall rules have been relaxed.

Meanwhile, we continue to believe that a broad-based recovery in confidence in the Chinese real estate market cannot be achieved through easier credit policies alone. So last week’s announcements, while positive, will not take the pressure off Chinese growth in the short term.

Fed close to peak hawkishness

Not only did US CPI rise by less than expected last week, but the PPI reading was also much better than expected. The most important takeaway was the broad improvement in core goods inflation as core services inflation only moderated because of lower healthcare inflation due to a one-off statistical adjustment.

Goods inflation is likely to decline further as supply bottlenecks are easing rapidly. Services inflation, by contrast, will probably remain high as labour markets are still tight. Wage inflation will probably remain close to its current pace of around 5%.

All in all, we think that one month of positive inflation surprises is far from enough for the Fed to conclude that the outlook for inflation has changed. The gap between labour supply and demand and underlying wage growth are not yet at levels that would make the Fed more comfortable about upside inflation risks.

The main reason the Fed has been so hawkish this year is that it wanted to minimize the risk of inflation expectations breaking out on the upside. This focus will not change in the short term. In the last FOMC meeting, Fed Chair Jerome Powell made it clear that it was “premature” to start thinking about pausing monetary tightening and that the Fed still has some way to go before reaching the terminal rate.

October’s inflation readings might have been a positive surprise, but they have not materially changed the overall inflation picture, with headline inflation still well above the Fed’s target of 2%. We need to see inflation fall further or a sharp rise in the unemployment rate for the Fed to adjust its hawkish policy stance. That said, we believe that we are now close to peak hawkishness – although this was already our view before the October inflation figures came out.

Troubles persist in China

We do not have much new to say about China. As we wrote last week, we think that with the number of Covid cases accelerating again – the cities currently in lockdown now account for 25% of China’s GDP – there is no room for restrictions to be eased. So in the short term, the announced relaxation of Covid rules will have no impact. But beyond the current wave of infections, we do expect the situation to change for the better.

We believe a more pragmatic and realistic approach to Covid will prevail, increasing the likelihood of full normalization of mobility and consumer behaviour in the first few months of 2023.

We are less optimistic about the prospects for China’s housing market as there are still no signs of it stabilizing. This week’s announcement of a new easing of property credit rules is important as it reflects the new government’s increased sense of urgency about the issue, but it is not enough to solve the crisis in confidence in the market. 

Potential home buyers are still reluctant to buy a new property from highly indebted real estate companies as they fear their house will never be completed. This explains why property transactions and fixed investments in the sector continue to decline.

What’s more, October data show that property sales and investments continue to slump (see figure). It will be difficult to break the vicious cycle of declining sales, falling prices, increased risk aversion among home buyers, liquidity problems for real estate developers and fewer new investments without more radical policy steps, including bail-outs of troubled developers or nationalizations.

China: land sales and new housing starts

square metres, yoy % change, 6 m ma

17112022 NN IP

Source: NBS

No changes to our multi-asset model portfolio

We maintain our moderate underweight in equities in our multi-asset model portfolio. Bond yields fell sharply on the back of October’s US CPI data, but we do not expect them to continue to do so. Declining yields have been the main driver of the equity market rebound over the past week, with long-duration equities in the technology and communication services sectors performing particularly well. This helped US equities to outperform stocks from elsewhere.

Central banks stressed the need to tighten further as inflation remains too high, so they deem a rapid easing of financial conditions as undesirable and that it may warrant a more restrictive monetary policy stance for longer. For there to be a sustained equity market rebound we need confirmation that the labour market is easing and that broader inflation measures are continuing to soften. This should put a floor under equity valuations.

But for now, the earnings outlook is still deteriorating, limiting the scope for a prolonged rebound.

We remain neutral in global rates as market participants continue to adjust their monetary policy expectations for both the Fed and the ECB. After the recent drop in yields, we see limited scope for further declines. Over the medium term, however, we are becoming more optimistic as central banks are likely to continue tightening at a somewhat slower pace.

Now that longer-term policy rate expectations have moderated – Fed Funds futures are now pointing to 50 bps lower rates by the end of 2024 than they were before the US CPI announcement – we believe Treasuries are trading close to fair value. This should lead to a reduction in interest rate volatility over the coming months.

Credit markets should also benefit, but we remain neutral in corporate bonds given the deteriorating macroeconomic backdrop, which still justifies higher spreads than at the beginning of the year.