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.

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.

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!

FORWARD-LOOKING VIEWS

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.