Cross Asset Strategy
Volatility remains elevated as markets continue to grapple with the war in Ukraine, another record inflation print in the U.S., and hawkish central banks. However, China equities stole the show. The week started with panic selling and substantial bearishness, only to see a massive rebound on Wednesday following a Chinese State Council statement in support of the market. As of writing, the Hang Seng Index is up 16% from its low, and HSTECH up nearly 30%. The statement addressed a long list of investor concerns as wide ranging as the property sector, tech regulations, and even U.S.-China negotiations over ADR listings. Our view is that it was certainly effective at boosting near-term investor confidence, but follow-through is what really matters. Despite attractive valuations, we think the challenges ahead remain significant, and that it’s still unclear what fundamental actions will be taken, or how they will impact the growth and earnings outlook. The macro environment in China remains challenging in light of the recent COVID resurgence and commodity price spike. Renewed lockdowns in major cities highlight further downside risks to earnings. Global risk-off sentiment due to geopolitics and stagflation risks will likely continue to weigh on multiples. That’s why we further reduced our outlook for relevant Asian indices – namely MSCI China reduced to a range of 69-71 (26% below previous), CSI300 reduced to a range of 4,400-4,500 (16% below previous), and MSCI Asia-ex Japan reduced to a range of 710-750 (18% below previous). Our thesis of overweighting onshore China over offshore China remains unchanged.
Outside of China, many markets still remain below their pre-Ukraine invasion peak. Financials had some of the largest rebounds after being one of the most heavily hit sectors, and with rates rising remains one of our top ideas in equities. A more sustained equity rally will depend on what comes next, and rallies are at risk of being short-lived without better news on growth, policy, or the Russia-Ukraine conflict. On the macro front, consumer sentiment remains bearish; the University of Michigan Consumer survey has fallen sharply, and is approaching Global Financial Crisis (GFC) levels. At the same time, upside risks to inflation have increased further, boosted by the sharp rise in commodity prices.
Markets have been pricing higher stagflation risks: inflation breakevens – which are normally closely correlated to growth pricing – have outpaced the performance of cyclical vs. defensive equities, and the gap has widened since the Russian invasion in Ukraine, particularly in Europe. The combination of 10-year breakeven rates surging to the highest levels since the 1990s in both Europe and the U.S., and low real yields point towards weak optimism on long-term growth, and concerns on sticky inflation. Risks to growth are at least in part reflected in equities: Europe cyclicals vs. defensives are pricing PMIs in the high 40s – consistent with a mild recession – and U.S. equities are pricing a 40% recession probability.
Despite the growth concerns, heightened inflationary pressures have pushed the market pricing of policy rates steeper than before the start of the war. The Fed moved 25bps (as expected), and as they are likely to prioritize inflation over growth, balancing risks/rewards in portfolios will be increasingly important but increasingly difficult.
Strategy Question: How do higher oil prices impact Asia?
Following the articles we previously published on global growth and inflation, this week we are turning our focus to Asia, particularly the commodity price spike. Although differentiated across countries, we think the spike in energy prices is becoming one of the biggest risks to the outlook. Both winners and losers could emerge due to their differing positions on the global supply chain and varying capabilities to absorb shocks from energy price spikes.
According to J.P. Morgan Investment Bank, disappearing Russian barrels could push oil prices to $120/bbl and stay there for months and incentivize demand destruction, assuming no immediate Iranian volumes.1 This would impact Asia in two ways. First, while Asia’s direct trade linkages to Russia and Ukraine are relatively small, most Asian economies are net energy importers, with only a few exceptions. It means that the world’s manufacturing hub is inevitably taking hits from rising costs emanating from higher global energy prices. Second, supply-driven inflation could force central banks into more aggressive tightening to maintain price stability, especially for the economies with already elevated inflation levels.
That said, the impact of the energy crunch could be vastly different for individual economies. The sensitivity of consumer prices to energy is a key factor as it tends to differ across countries due to varying price transmission mechanisms.
A lower sensitivity gives central banks larger leeway to balance growth and price stability. On the other hand, economies where inflation is highly sensitive to energy are more vulnerable to stagflation risks in the event their central banks are forced to tighten conditions amid a growth shock.
The winners: Australia, Indonesia
The case for Australia is an obvious one. As one of the world’s biggest exporters of oil, metals and wheat, Australia is poised to benefit from higher commodity prices. We expect a stronger current account surplus and increased earnings growth for commodity producers. There is also a higher chance of China lifting its import restrictions on Australian agricultural products in the absence of Ukrainian supply.
Indonesia will likely become one of the biggest winners in Southeast Asia. The country is a net energy exporter with adequate recoverable resources of coal, crude oil and gas. While the country has increased its reliance on oil imports in recent years due to falling domestic production, price increases in coal (its major energy export), crude palm oil, steel and nickel, will likely more than offset the impact – and the overall terms of trade may improve. It’s worth noting that Indonesia’s current account has moved into surplus even before this energy crunch, after running a decade of trade deficits. We think the surplus will likely further strengthen in the coming months. The country is also blessed with low inflation sensitivity to energy prices and a benign inflation environment to begin with – headline CPI has stayed at the lower bound of Bank Indonesia’s target range for the past 1.5 years. It leaves the country’s central bank with little urgency to tighten conditions at least over the short term.
China: margin squeeze for SOEs
The energy crunch could add an additional layer of downside risks to China’s already-challenging growth environment. As the world’s number one oil importer, China imports over 70% of the oil consumed in the country. PPI inflation is poised to further pick up from here. While the pass-through from PPI to CPI will likely be insignificant given retail prices are highly regulated, the loss will likely be absorbed by corporates – and primarily state-owned enterprises (SOEs) in this case. Refiners will likely take the most direct hit. Morgan Stanley estimates that most refiners will see profit margins reduced when oil prices breach $80/barrel, and margins would be minimal or negative if oil prices stay at current levels. 2 It may also cause repercussions from a fiscal perspective. SOE profits serve as an important source of financing for fiscal spending – and the profit squeeze could be a constraint on the size of fiscal stimulus to be carried out this year, which many hope can be a key driver of growth (discussed in our note last week). Increased stagflation risks in the U.S. and Europe also imply weaker external demand, weighing on export growth.
This could impact China’s energy strategy over the longer term. We could see an acceleration in efforts towards reducing oil import reliance (i.e. a transition to alternative sources of energy such as gas, nuclear, renewables), as well as potential setbacks to its decarbonization goals as it seeks to expand domestic coal production.
India: a worsened energy crisis
India may be one of the biggest losers in Asia. The country had already been experiencing a power crisis since late 2021 due to spiking costs of electricity, and things are now getting worse. Domestic consumption and corporate capex could further weaken on higher energy, food, and input prices. Exports could also be under strain as external demand weakens. India’s balance of payments and terms of trade will likely deteriorate. Unlike many central banks in the region, the Reserve Bank of India (RBI) has been reluctant to normalize policies over the past year, but the combination of high inflation and a high sensitivity to oil prices leave it with limited policy options. If the RBI insists on keeping conditions easy to cushion the growth shock, it will increasingly run the risk of being behind the curve.
What does it all mean for investors?
While the energy crunch is generally a headwind to Asia’s outlook, investors may find opportunities in the region. Commodity and energy producer names could be boosted by better earnings growth. The case for Indonesian equities is convincing in our view, supported by a stronger balance of payments and relatively more accommodative central bank policies. From an FX perspective, we favor the Australian dollar given the outlook of stronger trade surplus, while the INR may further weaken from here – making long USDINR a favorable trade, supported by a strong dollar environment.
1 Source: JPMorgan Investment Bank as of March 2022.
2 Source: Morgan Stanley as of March 2022.
All market and economic data as of March 17, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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• The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 740 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalization.
• The CSI 300 is a capitalization-weighted stock market index designed to replicate the performance of the top 300 stocks traded on the Shanghai Stock Exchange and the Shenzhen Stock Exchange.
• The MSCI AC Asia ex Japan Index captures large and mid cap representation across two of three Developed Markets countries (excluding Japan) and eight Emerging Markets countries in Asia. With 609 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. Developed Markets countries in the index include: Hong Kong and Singapore. Emerging Markets countries include: China, India, Indonesia, Korea, Malaysia, the Philippines, Taiwan and Thailand.
• The Hang Seng Index (HSI) is a freefloat-adjusted market-capitalization-weighted stock-market index in Hong Kong. It is used to record and monitor daily changes of the largest companies of the Hong Kong stock market and is the main indicator of the overall market performance in Hong Kong.
• The Hang Seng tech Index (HSTECH) represents the 30 largest technology companies listed in Hong Kong that have high business exposure to technology themes and pass the index's screening criteria.
Past performance is not a guarantee of future returns and investors may get back less than the amount invested. It is not possible to invest directly in an index.