Cross Asset Strategy
Markets this week have been choppy as they digest a slew of economic data and Fed communications. Last Friday’s U.S. jobs report was a major market mover – nonfarm payrolls surged a shocking 517k (vs estimates of 190k) with strength across the board. We think this print makes it less likely that the 25bps rate increase on the February FOMC meeting was the last hike. This reinforces our base case outlook of a recession in the U.S., as rates are more likely to stay restrictive and continued tightness in the labor market makes the Fed's job difficult. Markets reacted quickly with a 20bp-bounce in 10-year Treasury yields, and a stronger dollar.
In equities, the S&P 500 hovered just below the 4,200 level after finishing one of the strongest Januarys in decades. This has left the valuation of the index stretched at 18.4x forward P/E, which is far above its 25-year average of 16.5x. Hence, we advocate considering protecting gains with structured products when it comes to broad U.S. markets. The tech-heavy Nasdaq 100 index has also rallied approximately 15% year-to-date, at which level we would advocate considering taking some profits in mega-cap tech, particularly given the potential for upcoming earnings disappointments. It could also be a moment to revisit overall strategic asset allocations and shift into areas where we have higher conviction, i.e. Chinese equities (read on for more details), European equities, and core fixed income strategies.
Strategy Question: How strong is China’s reopening recovery?
After a rapid exit from Zero Covid policy, infections across China spiked over the course of December. Although case numbers can’t be compared with rates seen during periods of mandatory mass testing, anecdotal evidence suggests the infection curve has flattened. During the Chinese New Year holiday period a consumption rebound was evident across many sectors. Relative to pre-COVID times (using 2019 as the benchmark), domestic tourism recovered to 89% by number of trips, and 73% in terms of total revenue. Spending on restaurant dining fully recovered, while box office revenues already exceeded 2019 levels. While Macau’s visitation only recovered to ~45% of pre-COVID levels during Chinese New Year holidays and the first five days of February, gross gaming revenue showed a larger 60%+ recovery vs. pre-COVID levels for the mass market. This bodes well for further recovery and normalization. In addition, Hainan offshore duty free store sales grew 20% YoY during the holidays, illustrating a strong travel rebound for the island. As the road to recovery continues we expect the market performance to be resilient, while any additional pent-up demand could translate to meaningful upside. In contrast, while goods spending continues to grow, big ticket items like car sales are down double digits (partly due to a phase out of car purchase subsidies). Housing sales continue to remain very depressed (around one third of 2019 levels), which weighs on durable goods sales.
The strong bounce back in service sector consumption could support our view that economic growth likely bottomed this winter. The January non-manufacturing PMI recovered to 54.4, while service sector PMI rose to 52.9, from contraction territory since the summer of 2022. We expect growth to start improving sequentially in the first quarter of 2023, led by continued recovery in the service sector. While we expect that consumer services such as healthcare, leisure and tourism could grow at an even faster pace compared with pre-COVID years, given the drag from reduced spending on big ticket items, we expect overall consumption growth could improve compared with 2022, but still fall short of 2019 rates of growth.
Meanwhile, the economy is still not firing on all cylinders. Housing sector-related data is still quite weak. While mortgage interest rates have declined meaningfully, and home purchase restrictions continue to be loosened, income growth will likely recover with a lag. It still continues to be a question of confidence in the sector, lack of certainty over future price increases and concern over the health of developers are keeping many would-be buyers on the sidelines. Given the considerable debt burden among almost all property developers, regulators are encouraging financial institutions to meet reasonable liquidity demand from developers. Nonetheless, a sector-wide recovery will likely take time, given the continued de-leveraging trend. The manufacturing sector stands to benefit significantly from an end to Zero COVID and rolling lockdowns, but demand from consumers in developed markets could slow more in 2H 2023, in our view. Export data is also weakening at a rapid pace. Recent manufacturing PMIs suggest that consumer demand from developed markets is still slowing. Lastly, the labor market is at the early stages of recovery. On the one hand, re-opening has led to some labor shortages in coastal cities, and in manufacturing hubs employers are asking for earlier return to work. On the other hand, companies in growth sectors like healthcare, clean energy and smart manufacturing generally have cautious hiring plans.
As we head into the official policy planning season, there will be more chatter around the macro policy stance and GDP targets for 2023. We expect the government to maintain a similarly expansionary fiscal policy stance this year, as they did in 2022, but mostly to support local governments in an environment of dwindling land sales. In addition, as the government has shifted into a more pro-growth stance, we will likely see some easing of regulations, as evidenced by recent relaxations in the internet space.
All in all, recent data suggest that economic growth has likely bottomed this winter and may start to sequentially improve in the months ahead. We expect a service sector-led recovery, which may be partly offset by stagnant housing market activity and a weakening export outlook. Overall, policies will likely stay supportive, with a focus on easing sector regulations.
Following the equity rally, many are now questioning what to do next? We retain our constructive view on both offshore and onshore Chinese markets due to modest valuation re-rating potential, and a consumer-led consumption recovery that has the potential to drive earnings upgrades. Our preference remains towards both the Consumer Discretionary and Communication sectors, which are key beneficiaries of China consumption recovery with the country’s full re-opening. After the robust rally over the past three months, we prefer names with re-opening themes linked to HK/Macau or Europe (instead of just domestic re-opening), where we see further upside to earnings, or laggards to play catch-up.
On the Renminbi (RMB) as we laid out in a recent piece, we have a stable outlook on the exchange rate (USDCNY) from here. The currency recently had strong support from improved sentiment thanks to the rapid reopening and capital inflows as global portfolios close their large underweights in Chinese assets. We expect portfolio inflows to moderately continue, however, we are wary that the negative carry against the dollar and risks of further deterioration in the balance of payments could continue to pose pressure. As the slowdown in goods demand from U.S. and European consumers continues, China’s exports will likely deteriorate from the high teens growth of the past two years to a significant contraction this year. At the same time, current account outflows could see a boost if outbound tourism resumes. Given this confluence of factors and how fast the RMB has moved, we don’t favor long RMB as a way to express the China reopening theme. For dollar-based investors looking to add exposure to RMB-denominated assets (i.e. onshore Chinese equities), one strategy could be to hedge out FX risks and lock in a positive carry.
All market and economic data as of February 9, 2023 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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