The Big Conversation
Episode 104: Will China or the US matter most in 2022?
This week we look at the two biggest actors on the global stage. Both are at an inflection point. The US might pivot toward tighter policy, whilst China might roll back some of its tighter regulation. Political pressure may force the Fed to tighten faster than expected and that increases the risks for markets, even if China starts to loosen policy. The Chatter looks at China’s property sector in greater depth. Many of the issues that Joanna Davies, of Fathom Consulting, identified last year are now playing out and the impact might require a softer approach from China’s policymakers.
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Roger [00:00:00] As we look ahead into 2022, there are two regions whose policy will dominate the outcome for financial assets, and it should come as no surprise, that they are the US and China. But it's not the geopolitics that matters. Inflation, has been the driving narrative in the US, and this has just overtaken the pandemic as the number one concern for consumers. And at the same time, China is continuing to rebalance its economy, impacting performance across the broader EM space. So what should we watch for for next year? Well, that's The Big Conversation.
Roger [00:00:34] It's very easy to get sucked into the predominant narrative of one or the other of these regions and then forget the importance of how these economic behemoths interact on the global economic stage. Now, a very simplistic way of thinking about the two, is that US policy drives the narrative for global financial conditions, whilst China drives the narrative for global economic growth, especially within the emerging markets in the commodity sector. In this first section, we're going to focus on the impact of the US on financial conditions. And then China in the second part. Currently, financial conditions are close to their lows. U.S. assets are the benchmark for many global assets. The level and the rate of change of U.S. yields sets the tone for global yields. The US dollar is the lynchpin of financial markets. If it rises too quickly, it can tighten financial conditions, if it falls too quickly, it can compound inflationary issues. Now there has been some dramatic action across a number of U.S. dollar pairs. It's very easy for investors to dismiss bouts of apparently idiosyncratic dollar strength, as a domestic event. Governance problems, for instance, have been weighing on the Turkish Lira, and its acceleration to new lows is generally blamed on uncertainty within its central bank. Similarly, the growing lower for the Argentine peso is also blamed on long-term policy error. But when a whole host of idiosyncratic risks start to appear, then we may have to join the dots. The prelude to the Asia crisis of 1997 and the financial crisis of 2008 saw a series of isolated events impact a variety of regions. But these isolated events all had their roots in the same issue of leverage and reliance on the US dollar. Now, whilst the Turkish Lira has taken the headlines, the broad-based Emerging Market Currency Index, has also rolled over to a new low, against the dollar. Now there's not been the same drama here that we've seen in the Turkish Lira. But emerging markets have failed to generate meaningful growth over the last couple of years, despite the consensus narrative for global reflation at the beginning of 2021. And the different responses of China and the US to the pandemic was a major factor. The US focussed on demand. U.S. corporate profits finally started to accelerate, having lagged the US equity market for most of the previous five years, and they've been driven by a surge in profits of the global mega-cap tech stocks. And there can be no denying that the US labour market has become extremely distorted. Job openings remain at record highs and initial jobless claims, are at record lows. And yet the participation rate remains well below the pre-pandemic level. Current data is still prone to horrendous seasonality adjustments, and that masks reality and creates uncertainty. But like the US job market's, consumption looks strong in certain sectors. US imports have powered ahead, having nearly regained the previous trend. But that's not adjusted for inflation. But it reflects a US economy that looks to have successfully rebounded from the lows. However, when we look at US exports, we see a very different picture. US exports turned down again in Q3 of this year, and they're still significantly short of the pre-pandemic level. The global economy has not been anywhere near as successful as the US. And one of the main laggards has been the European Union. Imports are significantly below the pre-pandemic trend, for the eurozone bloc, that leaves the door wide open for loose policy next year. That should benefit the dollar. Though positioning is now far more neutral. Japan is another low-yielding nation which looks set to keep policy rates loose for the foreseeable future. The index of industrial production has fallen sharply over the last few months and is well short of those pre-pandemic levels. German industrial production has also struggled throughout the last 12 months. In fact, it should also be noted that industrial production was falling before the pandemic. Global growth was already impacted in 2019 by a policy shift in China. Furthermore, whilst today's US equity market has been making new high, after new high, led by just a handful of stocks, other exporting stock markets with open economies have been less successful. The Korean equity market, the Kospi 200 has struggled throughout 2021. And now as we head into year-end, investors will need to evaluate the likely path of policy for 2022, starting with this week's FOMC. And this will be the last one before January the 26th. Most expect the speed of tapering to be the Fed's main policy tool, even though there are a handful of hikes priced in for the next year. But so far, longer-dated U.S. government yields have drifted lower in response to higher expectations of tightening. If loose monetary and fiscal policy were the drivers of inflation expectations before, then tighter policy should act as a brake on long-dated yields going forward. And that should be a positive for global risk assets, because it will keep the lid on financial conditions. In fact, the response to the latest CPI data, which fell just short of 7%, was for longer-dated yields to drift lower. So that implied real yield remains at levels that exceed even the lows of the 1970s, when inflation reached double digits. So far, the bond market has been oblivious to these higher levels of inflation. Firstly, because the Fed was anticipated to remain on hold, and now because the Fed may be forced into tightening just as the economy is starting to be strangled by inflation. Record levels of US corporate margins could come under pressure. Now, if that scenario were to emerge, then the tightness in the labour market would evaporate. But what does this really mean for risk assets in 2022? But there are more political votes being impacted by higher prices today than there would be votes impacted if stocks took a dive. That means that the Fed put is probably much lower than expected. But if bond yields remain subdued, then the Fed put might not be required. Therefore, if there is uncertainty, one of the best strategies that investors can implement is stock replacement, where some of the stock portfolio is sold and is replaced by long calls. Now, volatility is not exactly attractive. Three month at the money vol is around 18% versus realised or actual vol on the S&P 500, that's around about 14.5%. But if you move up to the 105% strike in March 2022, then the implied and the realised volatility are comparable. And these replacement trades allow investors to book some profits from 2021, but also keep some skin in the game for next year. And it's far more attractive than buying very expensive puts against the portfolio. And if you think that the European market is well overdue a period of outperformance after lagging for most of the last decade, the long-dated calls on the Euro Stoxx 50 take advantage of the forward price on the index that because of low-interest rates is well below the current spot price. And that makes these longer dated options positions look optically attractive. But as we mentioned from the outset, the US is only one of the key determinants of global risk. The other arbiter of portfolio performance is likely to be China, and for most of the last 20 years, China has been a driver for cyclical economic growth. When China is hoovering up commodities, emerging markets have generally outperformed. But in 2018, China started to change course towards rebalancing its economy away from growth and towards consumption. And it's one of the main reasons why EM has struggled this year. 6% GDP growth in China today, has very different implications for global assets than 6% GDP growth a decade ago. The nature of China's growth is a key parameter for the global economy, and this is the topic of the next section. When I spoke to Joanne Davies of Fathom Consulting in July of 2020, she highlighted the risks of overcapacity in the Chinese property sector. Now wind on a year and those concerns have materialised. Evergrande may just be the tip of the iceberg. I spoke to Jo about the outlook for this sector in 2022.
Roger [00:08:10] And so I just wanted to kick off almost by stepping backwards a little bit just to sort of, could you reflect on just how central, how important the property sector is to the Chinese economy?
Jo [00:08:20] Yeah, absolutely. In short, massively important. So when you think about just kind of the direct aspects related to the property market in China it accounts for around 15% of economic activity. But once you factor in all of the other gubbins, so, the higher of removal vans, paint, sofas, everything like that, you're looking at something closer, some estimates put it around 30% basically. So, really quite a significant portion of economic activity can be linked back to the real estate market. But there's other reasons why it's massively important to China's economy, so local authorities rely on it heavily or rely on land sales, heavily as a source of income, to kind of augment the official income that they receive via revenues. So I think it adds sort of about 70% to quite kind of a vital boost to their budget, really.
Roger [00:09:14] Last year you were focused on this spare capacity. What are the ongoing problems there? Is it still spare capacity or are there other issues in terms of leverage that are really playing to the fore now?
Jo [00:09:23] I think fundamentally, the problem with China's housing market, what it all comes back to is this massive amount of spare capacity. But it's a bit more complicated than that. So just to kind of dig into that for a moment, if I may, I think it's been a policy choice that to help prop up the economy, they will use massive amounts of investment in construction of real estate. The problem with that, of course, is if you unleash all of that construction, all of that newly built housing onto the market, it would weigh on prices. So instead of doing that, what China has done, it's been mothballing, loads of real estate into the under construction phase. And that's what I knew about when I last came on this series. But what we've recently discovered that in addition to this massive amount that's under construction, there's also a huge wedge that's now being paused or postponed and never restarted, and combined those two now account for about nine billion square metres of floor space under construction or paused. That's enough to house around 200 million people, so the population of Brazil comfortably. And the problem with doing that is that by having that as part of an official policy, the spare capacity will just be, you know, not unleashed on the market. It means that you've allowed really, moral hazard like housing has become a one way bet, and its helped shore up property prices. So you now have house price to disposable income ratios of around nine in China. So what that means is that it takes the average household in China around nine years worth of disposable income to pay off the property. The equivalent metrics in the US and UK are around three to four, for example. So it's massive problems, and then of course, you know, combined with that is high and rising debt levels.
Roger [00:11:16] And China, it looked like China was trying to deal with this, it looked like, you know, China was aware there was a capacity issue, you know, for a while, I think in 2018 they started moving away from the sort of growth policy, build everything, suck in commodities, to more of an internal focus. But, but what did China actually trying to do to deal with these things? It seems like they've been trying to deal with it, but it's popped up issues elsewhere. What's the sort of, what's the solution that the Chinese been trying to kind of impose?
Jo [00:11:42] I think China's policymakers recognise that, that this is a bubble building, and bubbles invariably burst and therefore it's risky and the bigger it gets, the bigger those risks get. So it's definitely being concerned about it. And I think it's been making, you know, all the right noises and we've continued to hear the rhetoric about housing is for living, not for speculation. And we've seen some, some policies say, for example, the three red lines was implemented in August last year, so August 2020, and that was done to kind of force real estate developers like Evergrande to deleverage. And some of that has had an impact. But I think more recently, perhaps unnerved by the financial market impact of the fallout from the Evergrande, even though, in my opinion, the real economy impact was much more muted. And perhaps even recognising that if this implicit price guarantee that that's shored up China's housing market for so long was removed, that that could be really quite problematic in China, causing the whole house of cards if you like to collapse with massive ramifications. I think for that reason, we've actually started to see in recent weeks, China shifting towards kind of, more supportive policies towards China's housing market [00:13:03]again. [0.0s]
Roger [00:13:40] How does that allow for common prosperity? Maybe if you sort of could explain that and also maybe just explain what common prosperity is? Because it's obviously quite a big deal for Chinese policymakers as well.
Jo [00:13:51] Yeah, absolutely. So in my mind, what common prosperity is about, it's about a drive to reduce the widening wealth gap in China's economy, and in doing so help China inveitably to be able to rebalance towards a more consumer-driven economy and away from kind of the old model, which has typically been associated with exports and more recently, heavy investment and hence all of the spare housing construction that's been going on in China. Is it is it compatible? In my mind, unless you are really serious about allowing market forces to work in the housing market, then it's, bearing in mind that house prices are so high, some people, a lot of people can't even afford property. So the massive inequality there, so unless your serious about fixing that, really going there, which could be incredibly painful, then I don't really think they are compatible. And instead, I worry that what we're seeing is an increasingly heavy-handed state; so kind of forcing companies to toe the party line, to make charitable donations or else. And there's massive risks associated with that as well, insofar as it kind of it could damage sentiment and investment and therefore harm domestic [00:15:08]growth. [0.0s]
Roger [00:15:22] Can China actually achieve its goal of rebalancing? Because it seems that it's a rock and a hard place. It, it's going to really struggle to get the rebalancing that it set out a few years ago.
Jo [00:15:33] They can. China can rebalance. It's not impossible. Other economies have done it, but it is incredibly painful to do. Not only does short-term growth suffer, but when we've looked at other emerging markets that have managed to rebalance, we find that economic activity or GDP growth, as it officially known, is weaker by about two percentage points, even five years after that turning point. So in short, it's not easy to do. And I think under Xi what we've seen is that China has become, increasingly kind of short-termed i.e. preferred, preferring jam today so kind of prioritising short term growth over long term growth, even though making a sacrifice, suffering a hit to growth and choosing to rebalance, could actually shift China onto a better growth path down the line, so in the future. But I just think there's a real reluctance to go there and so what we, what we've seen and what we call at Fathom is China's 'hokey, pokey' approach, so it's kind of in/out, on/off in terms of policy reform. Never quite wanting to go there. It starts to, it hurts growth and it hurts too much. And therefore they backtrack and they end up doubling down again. And I think really, that's that's what to watch in China ahead of the National Party Congress next year as well.
Roger [00:16:57] When you say sort of in and out, do you think that the next, 2022, do you think they're going to come back with a little bit of support?
Jo [00:17:04] Yeah, absolutely. And I think the rowing back on the housing tightening, is the first signs of that in my opinion. I think they've reached an inflection point, they've kind of dipped their to in the water. They've seen yep this is painful, particularly on the financial market impact side of things, and they're backtracking from that.
Roger [00:17:22] What's fascinating here is that the issues that Jo identified over a year ago have still got to work their way through the system. There's still a huge amount of overcapacity, but so far, the attempts to fix the problems have created worse knock-on effects. And policymakers may well therefore increase their support for the economy, even as they increase regulatory oversight on the uber-wealthy. But this respite may provide an opportunity for Chinese equities to rebound in 2022 from what's been a fairly rocky road over the last year. And if you've got any questions about this episode, the economy or markets, please put them in the comments section or send them to TBC@Refinitiv.com.