Cross Asset Strategy
August marked a pivot in U.S. equities. While the strong summer rally extended into mid-month, August closed with the S&P 500 losing -4.8%. Hawkish central bank narratives were brought back by Fed Chair Powell’s speech at Jackson Hole. While the eight minute speech didn’t include anything new, the message was clearly against market pricing of a lower policy rate by late 2023. As a result, this week saw markets moving to price out dovish expectations that emerged following the FOMC meetings in June and July. Yields spiked, with the 10-year treasury hitting 3.2%, and the 2-year hitting a 15-year-high of 3.5%. Looking ahead, we think the longer end of the yield curve will likely be anchored, while the shorter end may continue to respond more sensitively to shifting market expectations of the policy path. It is in line with our view that it could be a good time to add duration as a downside protection. We’ve continued to advocate adding downside protection, warning expectations regarding a Fed pivot had run ahead of fundamentals.
Commodities had a volatile week. Crude oil prices fell as production concerns over unrest in Iraq faded, and European natural gas prices declined another ~7% on word of improving gas storage in the region. While stabilizing energy prices are welcome, we’d note that supply is still tight and prices may remain supported over the medium term. In the FX space, the dollar continued to strengthen against its major trading partners. With a hawkish Fed and a cloudy global growth outlook (especially in Europe and China), we think the dollar may stay strong for longer.
Another focus of the week is the agreement on an audit inspection that was reached between Washington and Beijing. It came as a surprise for many, and was welcomed by the market, with the MSCI China rallying 4% on the news, which brings us to today’s strategy question…
Strategy Question: Is the US-China agreement on audit inspection a game changer?
On 26 August, Washington and Beijing reached a preliminary agreement to allow the US Public Company Accounting Oversight Board (PCAOB) to inspect the auditsand personnel of US-listed Chinese firms, as part of a push to avoid the forced delisting of about 200 Chinese stocks from New York exchanges. This round of pilot inspections will reportedly take place in Hong Kong, and if successful, it could mark an important breakthrough after multi-year disputes between the two nations. It could in turn pave the way for a broader deal.
From September this year US officials are expected to travel to Hong Kong to start the process. Pilot inspections are the key test of whether the two sides can resolve issues that have long stymied a deal on audit regulation. These issues revolve around China’s concerns that audit inspections would expose sensitive information on national security or other confidential information to US regulators. If the pilot inspections go ahead, it means that the U.S. and Chinese regulators have in principle resolved key issues.
However, even if the two sides are on track for a deal, we believe Beijing will likely order some companies to preemptively delist rather than be subject to annual inspections. As a sign of what’s likely to come, five large Chinese state-owned firms already announced delisting plans in August. How they treat firms with large amounts of data is the key question – and it will next be important to see whether Beijing orders major tech firms to delist. It’s also important to note this is not a done deal – the full language in the deal has not been made public and the most important aspect will be how it is implemented.There is also a risk that both sides interpret the deal differently leading to implementation problems.
Will this development offset the systematic risk in the Chinese property and banking sectors?
Judging from the initial share price response, the market is taking this news very positively, and triggered a round of short covering. But we caution that it is still unclear how many companies can ultimately avoid ultimate delisting, especially among the tech giants. The inspection process is expected to take months, and there is some chance that the PCAOB may be disappointed about the restricted access to audit papers and personnel.
Although this agreement does not bring any fundamental earnings impact to the Chinese ADRs, it has led to a mild re-rating of China ADRs in the form of multiple expansion, which is a result of lower equity risk premiums. However, in our opinion, this should not be significant enough to make investors forget about the rising structural risk from China’s property and banking system. We have made an extensive discussion on this topic in our recent note published on 19 August 2022 – “Is China facing a hard landing?”
On a positive note, China’s interim earnings so far managed to mildly beat a low expectation, especially from the Chinese internet names. Earnings risk may be bottoming as companies collectively start focusing on restructuring and cost-cutting, with MSCI China 2022E earnings now revised down to 6% (from 14% in May) based on consensus forecast. But any recovery could be a slower trajectory due to economic weakness from a stagnant property market, rising unemployment and a consumption slowdown. A rare compromise by Beijing, this audit agreement suggests China’s eagerness to boost sentiment in China’s equity market. This is understandable given that a further market correction could lead to a negative spiral effect on China’s already-weak consumption rebound.
MSCI China is now trading at a mid-cycle valuation of 11x 2022E P/E (i.e. a 5-yr average) which we see as fairly valued in light of the challenging macroeconomics and low policy visibility in the second half of the year. News flows from any update on audit inspections – either positive or negative – will likely bring more volatility to the markets, especially to the offshore HK market where the China ADR are dually listed.
What would it take for us to turn more positive?
To change our view it would take a larger scale and a more coordinated policy stimulus package with strong commitment from the central government. The scale of the property slowdown is significant, and while a large factor is structural, efforts to deliver unfinished properties and deal with insolvent developers can stem the downward spiral and help to restore overall confidence. Unlike the piecemeal actions we have seen in the last few months, we need developments significant enough to turn around the general public’s weak confidence, which is not easy given the macro challenge and monetary constraints now faced by Beijing. Geopolitical tensions remain a potential black swan that cannot be overlooked. Hence, we continue to advocate trading the range (Hang Seng Index between 19000-22000/ MSCI China between 62-74), and use structured products to monetize current volatility in China equities. We maintain our base-case MSCI China year-end outlook of 69-73.
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