Financial Markets: U.S. (Still) More Important Than China For Now

Markets are focused on China credit tensions, as well as the ongoing DM rate tightening story centred on the U.S. What will be most important into the autumn?

Market Implications: U.S. equities are out of line with the rise in bond yields and we see still see a correction for the S&P500 to 4200 by end 2023.2024 should bring Fed rate cuts and we forecast 3.90% 10yr U.S. Treasury yields for end 2024, which should help the S&P500 to 4700 by end 2024. Meanwhile, we no longer see China equities outperforming the U.S., as policy stimulus and rescues will likely be measured rather than aggressive and 2024 China growth is destined for 4%. A China hard landing would have more global spill over, especially for EM countries.

Figure 1: 10 and 30yr U.S. Treasury Yields Rise, 2yr Less So (%) 

Source: Datastream/Continuum Economics 

Rising U.S. Yields Risks Correction 

We feel the most critical focus for global markets in the next few months will remain Fed policy.10yr and 30yr U.S. Treasury yields (Figure 1) have seen a noticeable rise since the July 20 FOMC meeting for two reasons. Firstly, Fed communications have made it clear that one final hike is an option and also that Fed easing is too far away for the Fed to give guidance or the market to get overly optimistic on cuts. Secondly, the lack of recession in the U.S., plus the scale of the 10-2yr U.S. Treasury yield curve inversion, has seen a technical reduction in short 2yr and long 10yr – it is noticeable that 2yr has risen less than the long-end of the curve in the past 4 weeks. What next for the Fed? 

The August employment report and CPI/PCE releases will be most critical, though like the market we do not expect them to be game changers and we look for no hike at the September 20 FOMC meeting (here). Instead, it will be the Fed dots and economic forecasts that will be the key in terms of markets multi quarter thinking on the Fed.

One theme has been the resilience of the U.S. economy in the face of aggressive Fed tightening. Part of this is due a strong household sector. Unlike 2008/09, U.S. household wealth (Figure 2) has held up very well, as equity and house prices have been underpinned – net wealth has gone from USD56trn in 2009 to US140trn in Q1 2023. The 2010’s also saw U.S. households paying down debt, which has left the majority in a resilient position. A household savings ratio below the trend in the 2010’s shows this consumer resilience. Households demand for housing remains strong also, which is cushioning the downturn in residential property investment.

Figure 2: U.S. Household Net Wealth (USD Trns)

Source: FRED 

This means that Fed tightening needs to bite via corporate sector investment and employment; a strong USD to hurt exports and tightening financial conditions to have an impact across the weaker sections of Main Street. We do feel that this is occurring and is prompting some slackening of the labor market (Figure 3). However, the U.S. wage inflation slowdown is not enough yet to be consistent with the Fed 2% core PCE inflation target (Figure 4).The lagged effects of Fed policy tightening will come through but this will take months and thus leave financial markets in limbo on whether the Fed does one final hike and then firming up ideas for 2024 rate cuts – we still look for 75bps of Fed Funds cuts starting Q2.

Figure 3: Slowing Quits Normally Leads to Lower Wage Inflation (%)

Source: Datastream/Continuum Economics 

Figure 4: U.S. Wage Inflation Slowing, But Not Enough (% Yr/Yr)

Source: Datastream/Continuum Economics 

Does the picture outside of the U.S. and China matter for financial markets? Yes to a degree, though economic size means that the most important other is the EZ. Our view remains that the EZ is entering a shallow recession in Q3 and this will add to disinflationary forces, especially as the EZ labor market is not as tight as the U.S. The ECB is already focused on lagged effects of their tightening, where the deposit rate has come all the way from -0.5% and credit is ringing alarm bells (here). Thus the ECB is going into holding pattern on policy rates and this should be evident at the key September 14 meeting. Thus for global markets, the U.S. and China matter most.

China problems, but when 

We have written on the major cause of current China problems in the shape of the huge debt build up since 2007 (here). This has now started to impact financial markets with a further wave of concerns over property developers with Country Gardens in the spotlight. Additionally, shadow banks are also in focus with a Zhonghzhi enterprises wealth manager delaying redemptions and payments and a restructuring has been announced as of August 17. China authorities can manage these problems through restructuring/forced takeovers and bailouts (e.g. Yuan 1trn debt swap for LGFV announced last week (here)). However, these need to be done in a timely manner to avoid financial problems providing an adverse knock on effect on domestic consumer and business confidence. Additionally, what initially look like liquidity problems in some cases are solvency problems and bailouts or write downs are required all the way up the government and PBOC balance sheets, with China favouring bailouts and write-downs. This is one lesson from the 2007 GFC liquidity debate that turned into 2008 solvency problems. 

Are China financial markets critical for the world economy? In financial terms, overseas holders are only around 3-4% of the bond and equity market – though heavily skewed in bonds to the government and state policy banks. Thus switching funds out of China into U.S. Treasuries is itself not a big windfall, while overseas investor’s losses are likely to be painful but not systemic. China’s liabilities globally also remain manageable at 37% of GDP (Figure 5) and the net international investment position is positive at 14% of GDP. Alternatively could a China financial crisis cause a rapid rundown of U.S. Treasuries to provide government support at home? Unlikely, as the PBOC can print Yuan and launch QE if needed in a real crisis, while the government can issue more bonds to fund fiscal stimulus and rescues. However, belt and road loans could become a trickery issue, if China is focused on domestic problems.

Figure 5: 2022 Key China Balance of Payment Data (%)

Source: IMF External Sector Report (here)

China’s importance in global growth is greater however, which has been evident since China joined the WTO. Exports overshadow imports however, which means China growth problems could see China exports curtailing prices to substitute for weak domestic demand and this could help DM central banks. Imports into China are largest from Asean countries (Figure 6) and the EU (though smaller as a percentage of EU27 GDP). EM commodity producers are also more exposed than the U.S. and we shall return with a separate article on this issue next week. We have recently cut our 2023 and 2024 China GDP forecasts to 4.9% and 4.0% (here), with downside risks still existing. If downside surprises are modest, then this can occasionally hurt risk sentiment in global assets but the Fed/U.S. Treasury question will be more important. If policy mistakes are made, and we end up in a China hard landing of 1-3% growth, then we will all be talking about China as the critical issue into 2024. 

Figure 6: Imports Into China by Country (USD Blns 2022)

Source: General Administration of Customs China