Risk markets have cheered rising expectations of a growth acceleration in China and signs of a slowdown in US growth and inflation, hoping for an early pause in Fed rate hikes. We believe they are half right – there is room for a further rise in China and Asia assets but beware of chasing the US equity rally until the Fed indicates it will cut rates. Still-bearish investor positioning on US equities (bearish US equities remain a crowded trade for now) implies they could go higher in the near term, especially after data showed further cooling of inflation and wages. However, the rally is likely to falter as the US is likely at the doorstep of a recession, with the last leg supporting the US economy, its services sector, showing signs of buckling, while the Fed remains hawkish, given the still-hot job market.
US services sector business confidence (ISM Services PMI) in December surprisingly plunged to just below 50 for the first time since the depth of the pandemic. Except for the post-pandemic plunge, the December services PMI was the weakest since the Global Financial Crisis. Forward-looking new orders sub-indices have started contracting, following a similar contraction seen in US manufacturing sector activity. While a slowdown in US average hourly earnings has also raised hopes of a Fed pause, we believe they are premature, given still-sturdy job creation and a renewed decline in jobless claims.
Slowing wage growth and contractionary PMIs could, of course, lead the Fed to slow the pace of hikes to 25bps at the 01 Feb meeting, but it will need to see a steady decline in the core inflation to below 0.2% m/m for a few months (to bring annual inflation towards the Fed’s 2% target) and a consistent fall in job openings and a steady rise in jobless claims (to lower wage growth) before it pauses. Core inflation slowed to 5.7% y/y in Dec but on a monthly basis, it accelerated to 0.3% m/m.
US corporate earnings, which provided partial support to US equities last year, could be the other shoe to drop. According to Refinitiv estimates for Q4 22, S&P500 companies are expected to report the first y/y contraction in earnings since the peak of the pandemic. Ex-energy, S&P500 earnings are estimated to have contracted for the third straight quarter. The energy sector, which has been propping up earnings in 2022, is expected to report the second straight q/q decline. Although the consensus has been cutting forward earnings estimates, these have significant room to fall further if a recession hits.
Against this backdrop, we believe the growth and earnings outlook for China and Asia will continue to improve. COVID infections in Mainland China appear to have peaked in major cities, with infections now moving inland. As a result, mobility indicators are rebounding strongly in these cities. As mobility improves, we expect normalisation of activity to unleash a strong pick-up in domestic consumption this year, more than making up for a likely slump in exports. Although the monetary and fiscal policy is likely to ease further, investment is likely to lag due to challenges faced by local governments in raising funds from land sales. Thus, for the first time in the modern era, a China recovery is likely to be driven by domestic consumption.
Investment implications: The above outlook calls for: a) Fading the US equity rally. Those seeking to add exposure to US risk assets could consider less-volatile US High Yield bonds or alternative assets; b) Adding exposure to China equities, especially in consumer discretionary and communication services sectors; c.) Adding exposure to income assets and predominantly investment grade Asia USD bonds, which still offer a sizable discount to similarly-rated Developed Market corporate bonds, and d) Positioning for a likely USD bounce in the near term. Next week’s BoJ meeting (18 Jan) is likely to see it dampen calls for abandoning its yield curve control policy. However, we would refrain from adding JPY loans as we see it strengthening this year as the USD weakens further and the BoJ likely tightens policy after Governor Kuroda departs in April.
— Rajat Bhattacharya Standard Chartered
