Cross Asset Strategy
Welcome to the final edition of Asia Strategy Weekly for 2022. It has been a tough year for investors – adverse supply shocks pushed global inflation dramatically higher, and the fight by central banks against inflation led to significantly higher interest rates and tighter financial conditions. Economic growth also disappointed across developed and emerging markets. This challenging macro mix resulted in one of the worst years ever for multi-asset portfolios. Both stocks and bonds suffered big losses, leaving investors virtually no place to hide. Heading into 2023, we see many of the dynamics that have driven markets this year shifting – the reset in valuations will likely create the one of the most attractive entry points for multi-asset investors in over a decade. Check out our 2023 Outlook for more.
This week, risk assets were initially higher on the back of lower-than-expected inflation data in the U.S. but finished lower as attention back shifted to recession concerns. November headline CPI in the U.S. posted its smallest month-on-month increase in 15 months. Stripping out food and energy, “core” inflation also came in below market expectations. Details in the CPI report suggest that supply chain issues continued to recede – used car prices fell 2.9% on the month, driving overall goods inflation negative. Shelter inflation also slowed from the previous month, though mostly driven by a drop in hotel prices. Rents continued to edge up, though some leading indicators suggest that rental inflation may have passed the peak. This print supports our outlook that inflation in the U.S. will likely continue to cool as the impact of higher rates feeds through the economy.
Despite the optimistic inflation data, Chair Powell’s statements at the Wednesday press conference still skewed hawkish. He continued to signal that more hikes are on the way, and that cuts will not be considered until inflation is sustainably heading lower. He also didn't think the past two encouraging CPI prints were a reason to shift the outlook on inflation, and repeatedly came back to the risk of strong wage growth driving entrenched inflation. This view is based on the fact that service prices remain strong and if not for the fall in car prices and airfares, core inflation would have stayed in the range of 0.4% MoM. The updated dot plot also suggested an increase in hiking expectations. Despite the hawkish tone, rates actually fell across the curve. Interestingly, two-year yields are now below the mid-point of the current funds rate – and effectively the bond market isn’t ready to buy the idea that the Fed will actually get the policy rate to what the dots currently show.
Elsewhere in the market, the dollar continued to fall on upbeat risk sentiment. Crude oil reversed last week’s torrid performance as investors reacted to positive news regarding re-opening in China, as well as supply uncertainty – namely the shutdown of the Keystone pipeline in the U.S. and the recently imposed G7 price cap on Russian oil exports. We expect energy commodities to be higher in 2023 despite recession risks, and China will likely be one of the dominating factors in play.
Strategy Question: What is the market impact of China reopening?
Since late November, China’s Covid control measures have been eased at a rapid pace with further relaxations announced almost on a daily basis. Implementations do vary at the local level, but broadly speaking, mandatory mass nucleic-acid tests are quickly being phased out, intra and inter-city travels are resuming without quarantine and testing restrictions, and contact tracing has more or less ceased. The policy focus has shifted to managing healthcare resources for severe cases and educating the public on at-home recovery for light symptoms.
While there are still some uncertainties – for example, when cases will peak, and whether the healthcare system can manage the rising caseload, it is nonetheless important to recognize that changes are happening. The speed and manner of China’s exit from Zero Covid will likely mean that the Chinese economy is turning the corner. While we have previously assumed some degree of consumption recovery in 2023, the gradual re-opening underway right now will likely have a more positive impact on consumer as well as business sentiment.
After this winter, mobility restrictions will likely be further rolled back substantially. Consumption will likely recover as consumers resume gathering with friends, and businesses trips restart. Healthcare spending could also grow again, after three years of exclusive focus on Covid. But goods spending growth, particularly household goods will likely remain weak due to the drag from the housing sector.
With re-opening, economic growth will likely bottom this winter, across Q4 2022 and Q1 2023. In 2023, economic growth will likely be driven by the recovery in the capacity utilization rate in the service sector. As demand improves, spare capacity across various service sectors, from transportation (flight, metro, road), to retail, wholesale, and logistics will likely normalize from the currently depressed state (most are operating at below 50% of pre-pandemic levels). The offsetting factors are a still weak housing sector as well as the export slowdown. Recently there have been a lot of policies aimed at helping developers refinance in order to continue with home construction. While these have not lifted home sales, with falling mortgage rates and more economic stability afforded by the exit from Zero Covid, housing sales could gradually find a bottom through the course of 2023. On the export front, our expectations are for a bigger downturn in global growth in 2023 (with a U.S. recession starting in Q3 2023). Both the housing downturn and exports are likely going to be a net drag on growth in 2023, but could start to fade out in 2024.
RMB: balance of payment challenges and unattractive carry could continue to pressure the currency
The RMB has been benefiting from positive growth sentiment related to re-opening. But as we head further into 2023, it could become less of a tailwind as international travel resumes, bringing more outbound tourism. The global growth downturn will also likely accelerate in 2023. Since the PBOC will likely maintain an accommodative policy stance, the low/negative carry of RMB will likely continue. These imply that the RMB will likely trade weaker, relative to a basket of currencies.
China equities: Near-term upside mostly front-loaded; consider accelerating phase-in after an 8-10% pullback
With the positive policy development, the light at the end of the tunnel is more visible and China equity markets have turned from a bear market into a trading market, and with an upside bias. However, we also believe that most of the near-term positive news could have been priced in or even front-loaded, leaving limited near-term upside. This sharp U-turn of Covid policy at a much faster-than-expected pace has led us to raise our China index outlook. For MSCI China, our new year-end 2023 index outlook is 66-69 (from 58-62), implying a mild 2-8% upside. As for CSI 300, our year-end 2023 outlook of 4,000-4,250 (from 3,800-4,100) implies 1-7% upside. We expect the A-share market to maintain its relative defensiveness and highly policy-driven nature in 2023.
Although we expect a continuous easing of Covid measures, corporate earnings are likely to be subdued in the next 1-2 quarters as the re-opening effect takes time to carry over. Our 2023E MSCI China EPS growth forecast stays unexciting at ~5% for now. Looking beyond Covid-related re-opening, in the coming months investors will likely refocus on the pace of growth reacceleration and property recovery, which are less controllable than Covid policies. Post-opening, hospital loads and mortality rates are also key indicators to closely monitor. Nonetheless, we are increasingly of the view that 8-10% pullbacks will likely be bought as a critical corner seems to have turned.
Turn your attention to the next stages of re-opening
Investors may focus on China re-opening names to ride on this faster-than-expected change. There are three stages to a full re-opening: Stage one – domestic re-opening; stage two – re-opening to Hong Kong and Macau; and stage three – re-opening to the world. As the stage one domestic re-opening is largely played out, we recommend positioning for the second and third stage of reopening. We don't favor chasing the high-flyers, but to accumulate the laggards. Even after the recent strong rebound, many of the re-opening plays remain inexpensive and trade on a 30%+ discount to their pre-Covid levels. Broadly speaking, investors may raise cash and get ready to accelerate their investments after seeing an 8-10% pullback (or utilize structured products to start positioning).
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Index definitions:
CSI 300 Index: A free-float weighted index that consists of 300 A-share stocks listed on the Shanghai or Shenzhen Stock Exchanges.
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