Concerns about US inflation and tighter monetary policy continued to drive financial markets in April. A longer than expected lockdown in Shanghai aggravated concerns about China’s economic growth and further disruptions in global supply chain. Bond yields continued to rise and equity markets fell, especially in the US.
Written by George Lin
The war in Ukraine faded as a driver of financial markets in April as the war dragged on with some noticeable tactical victories by Ukraine. Continuing high US inflation data and hawkish comments by Federal Reserve officials convinced markets that the US central bank will aggressively “front load” rate hikes. The lockdown in Shanghai has shown a limited sign of containing the spread of the pandemic as the People’s Bank of China (PBOC) eased monetary policy but not to the extent expected by investors. Equity markets tumbled, S&P 500 declined by 8.8% while NASDAQ plunged 13.3% and the All Ordinaries retreated by a comparatively mild 0.8% as bond yields climbed. Australia 10 year bond yield finished at 3.12%.
CENTRAL BANKS TRY TO ANCHOR INFLATION BY RAISING POLICY RATES
Most major central banks escalated their rhetoric against inflation in April, with a number of developed central banks increasing policy rates. The Bank of Canada raised its overnight rate by 50 bps to 1.0% on 13 April while the Reserve Bank of New Zealand raised it policy rate by 50 bps to 1.5% on the same day, its fourth rate hike since October 2021. Financial markets focus on the US where the latest inflation data provided further support for an aggressive rate hiking cycle. US headline CPI rose a strong 1.2% month on month (mom) in March and climbed to an alarming 8.6% on an annual basis! As expected, energy prices rose a substantial 11% mom, due largely to higher retail gas prices but also with electricity prices rising again. Food prices also rose a strong 1.0% mom. The only consolation in the data is that core CPI rose 0.32% mom, softer than consensus at 0.5%, and resulted in a more modest but still alarming annual core CPI inflation of 6.4%. However, many analysts doubt the durability of the better than expected core CPI result, given that it was largely driven by a 3.8% fall in used car prices while most other components of core CPI, including air tickets, furniture prices and primary and owners’ equivalent rent all registered sharp increases. The tightness in the US labour market is a major concern for the Federal Reserve. US unemployment rate fell to 3.6% in March, the lowest level since the start of the pandemic, while non farm employment rose by 430,000. The result is growth wage growth with average hourly earning growing at 5.6% and an almost historical low of number of unemployed person to number of job opening.
The US economy unexpectedly contracted in March Quarter. Real GDP by expenditure declined by an annualised 1.4% quarter on quarter (qoq), weaker than the consensus expectation of a 1.0% increase. The decline in overall GDP is mainly driven by a sharp decline in net exports, reflecting a 17.7% annualized surge in imports from the prior quarter while exports contracted 5.9% qoq. Domestic demand remain robust with private domestic demand rising 3.7%, stronger than the ~2% pace over H2-2021. While the GDP data likely over states the weakness in the US economy, it is a rude reminder to investors of the risks of an economic recession as the Federal Reserve tightens monetary policy.
The broad US economic picture means the Federal Reserve has a fight to retain its hard earned inflation fighting credibility. Like other developed central banks, the Federal Reserve does not want inflation expectation to dis-anchor and will have to raise interest rates aggressively over the next 12 months. Federal Reserve Chair Powell commented in late April that a 50 bps hike will be on the table for the May FOMC meeting, emphasising that some front-loading of accommodation may be appropriate. Furthermore, when asked about the market pricing for three 50 bps rate hikes, Powell referenced that “many” on the committee supported one or more 50 bps hikes, and that markets are “appropriately processing” Federal Reserve’s communications around raising interest rates. Powell seems to be acknowledging, if not endorsing, the possibility of consecutive rate hikes of 50 bps.
Australia officially joined the list of developed economies where consumer price inflation (CPI) is above the relevant central banks’ target, with significantly higher than expected Australian March quarter CPI. On a quarterly basis, Australian’s headline CPI increased 2.1% and bought annual headline inflation to 5.1%. The RBA’s preferred measure of underlying CPI, trimmed mean, rose, 1.4% in March quarter, bringing underlying annual inflation to 3.7%, significantly higher than RBA’s 2.0 – 3.0% target band for the first time since 2010 and the highest level since March 2009! The sharp rise in CPI is broadly based. Automotive fuel rose for the seventh consecutive quarter, with the national quarterly average price for unleaded petrol increased to $1.83 per litre in the March quarter. Food rose 2.5% and housing rose 2.7%. The ABS noted that new dwelling prices have recorded their largest rise since September 2000, when the GST was introduced. Price rises were driven by high levels of building construction activity combined with ongoing shortages of materials and labour.
Markets have since brought forward RBA tightening expectations with futures now fully pricing in an initial 15 bps rate hike in May. While there had been some suggestions that RBA would wait until June so as not insert itself in an election campaign (election is scheduled for 21-May), the stronger-than-expected rise in inflation has intensified pressure and provide enough cover for Governor Lowe to act sooner rather than later.
CHINA’S ZERO COVID POLICY ALARMS FINANCIAL MARKETS
China’s COVID-19 lock downs accelerated in April, raising serious questions about the economic impact of the draconian policy. The Chinese economy entered 2022 with growth already decelerating following the energy crunch, regulatory concerns and property market correction in 2021. While episodic lock down of population centres has been a fact of life in China since the start of the pandemic; the latest round, which started with a brief 7 days lock down in Shenzhen in early March, is the most serious since 2020. Shanghai, China’s most populous and economically significant city, entered a supposedly brief lock down on 5 April, and has not yet re-opened despite a public declaration by the Shanghai city government that the pandemic was under control on 21 April. There are numerous unofficial reports of food and medicine shortage and even small scale civilian unrests.
The latest lockdown in China has the potential to have an economic impact as severe as the first Chinese lock down in March 2020. Shanghai’s economic importance to China is significant – it accounts for about 3.8% of China’s national GDP, with a higher share of 5.1% of China’s tertiary sector. Shanghai is important for China’s trade, being the 4th largest exporting province and 3rd largest importing province in China. Shanghai sits in the middle of the lower Yangtze River and its neighbouring provinces are economically important in their own rights, therefore increasing the risk of any spread of the pandemic. Finally, Shanghai is a crucial logistics hub—Shanghai Port is world’s busiest port, and accounts for 16.7% of China’s total container throughput in 2021. There are reports of a large number of ships anchoring offshore near Shanghai waiting for a berth at the port.
China has a target of 5.5% GDP growth for 2022, a target which most private sector economists considered “challenging” even before the Shanghai lockdown. The impact of the lockdown is difficult to estimate, given the lack of transparency and uncertainty on its duration. Private sector economists’ estimates are a detraction of around 0.70 percentage point from June quarter GDP growth. The International Monetary Fund recently reduced its growth forecast for China this year to 4.4% which is broadly in line with private sector forecasts. The Chinese authorities are well aware of the economic slowdown and has eased policies. On the administrative and political side, rhetoric about Common Prosperity have been toned down in an effort to re-assure investors. On the monetary policy front, the People’s Bank of China (PBOC) announced on 15 April a broad-based 25 bps Reserve Requirement Ratio (RRR) cut for all banks.
In a potentially significant development, a number of press reports published on the last two days in April indicated that the latest COVID-19 developments and weak economic data caused Chinese policy to change direction to support the economy. While the contents of the reports differ, they all pointed to more fiscal and monetary stimuli. One report suggested the scope of change is significantly wider and covers areas such as zero tolerance policy towards COVID-19, the regulatory campaign against large technology companies and even aspects of the policy on Hong Kong. The authenticity of the reports could not be verified but Chinese stocks rallied massively.
KEY MARKET DEVELOPMENTS
Rising bond yields dominated headlines in April. Concerns about inflation and increasing market expectations of aggressive rate hikes by the Federal Reserve in the rest of 2022 drove US yields significantly higher. US 10 year bond yield started April at 2.33% and rose 56 bps to end the month at 2.89%. The Australian 10 year bond yield rose from 2.83% to 3.12% in April. Markets further re-priced the Federal Reserve’s policy rate path. US 2 year bond yield rose from 2.29% to 2.71%. Currently, future markets have priced in 3 consecutive rate rises of 50 bps each by the Federal Reserve at the coming FOMC meetings in May, June and July. Incredibly, futures markets have now priced in a target Fed Fund Rate range of between 2.75% to 3.0% by the end of 2022!
Equity markets had a volatile and poor April. While equity investors have recovered from the initial shock of Russian invasion of Ukraine, the increasingly hawkish communication from the Federal Reserve and the Shanghai lock down led to a sharp increase in risk aversion. S&P 500 had its worst month since March 2000 and fell 8.80% in April; while NASDAQ plunged 13.3% over April, the worst monthly performance since October 2008 according to the Wall Street Journal. Large technology stocks led the way. Other developed equity markets also have poor return in April. EuroSTOXX fell 2.15% in April while FTSE fell 4.46%. Asian stocks have an extremely volatile April. While Hang Seng fell by a comparatively modest 4.13% over April, it rose 5.7% on Thursday and Friday on media reports of Chinese economic policy changes. Shanghai Composite fell 6.88% in April and followed the same dynamics.
The Australian equity market was one of the best performing developed equity markets in April. The All Ordinaries fell 0.83% in April.
The top of mind issue for investors is inflation and interest rate, especially in the US given the USD’s status as the global reserve currency. We think the US economy is probably close to a cyclical peak in inflation but inflation will likely stay significantly above the Federal Reserve’s target of 2.0 to 3.0% by the end of this year. US 10 year bond yield peaked at 3.15% in October 2019 in the previous cycle. Given that US inflation is significantly higher than in 2019, it seems reasonable that peak bond yield should be higher. The current market pricing of target Federal Funds rate of 2.75% by the end of 2022 is aggressive. The good news is this means bond markets have already priced in, at least at the short end of the yield curve, most of the bad news in terms of rate hikes by the Federal Reserve. In short, the upside risk in the Federal Reserve hiking risks has diminished, as least from a fixed interest perspective.
Monetary policy is a blunt instrument in managing inflation and it works by destroying demand. History suggests that a “hard landing” is a more likely outcome than a “soft landing”. However, timing is important and our view is that the US economy will likely remain strong in the near term and a 2022 recession is unlikely. Domestic demand is still resilient in the US, driven by both households and corporate spending. Higher interest rates will eventually translate into weaker economic growth and the housing sector is already showing some modest signs of weakness. As 2022 progresses and more rate rises eventuate, concerns about the health of the US economy will likely escalate and start to weigh on US equity markets.
On China, we think it is useful to differentiate between structural and cyclical outlook. On a structural level, China is on a long, painful and uncertain transition from a high growth economy to a more mature economy with slower economic growth. Structurally lower economic growth and the ideologically hard line policies of President Xi translate into a very cloudy longer term outlook for financial investors. The shorter term outlook is probably more positive. We are sceptical that Xi will abandon China’s zero COVID-19 policy – given that adherence to such a policy is now a litmus test of fidelity to Xi and is not driven by economic consideration. However, the Chinese Communist Party (CCP) is always very mindful of maintaining a certain level of economic growth. Chinese policy makers may have finally been spurred into action by recent poor economic data. This suggest more aggressive fiscal and monetary stimuli may be imminent which, combined with the inexpensive valuation of Chinese equities, provide a potent mix for a short term rally. However, China is more a tactical trading opportunity rather than a structurally long investment position.
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