Now that the US seems to have avoided banging its head into the debt ceiling, market attention is turning back to the macroeconomic data.
The latest data has not eased concerns about the consequences of central banks tightening monetary policy at a time when economic growth is already slowing. In addition, China’s recent economic data has renewed worries about the strength of its recovery.
With this backdrop, our multi-asset team has turned more defensive on developed market equities by downgrading US equities to ‘dislike’. They remain underweight Europe but ‘constructive’ on emerging market (EM) Asia stocks.
Inflation and activity data is not helping
Recent inflation and growth data has done nothing to alleviate concerns about the risk of stagflation. The US Federal Reserve’s preferred gauge of inflation, the Personal Consumption Expenditures (PCE) index, rose by more than expected in April. The headline rate hit 4.4% year-on-year (YoY) from 4.2% in March and the core rate increased to 4.7%.
In the eurozone, core inflation rose by 5.6% YoY, boosted by a sharp jump in negotiated pay increases to 4.3% YoY in first quarter 2023 up from 3.1% in the final quarter of 2022.
Core inflation in the UK also came in higher than expected, rising to 6.8% YoY in April from 6.2% in March. The surprise rise prompted the market to reassess how many more rate hikes the Bank of England may deliver and for how long policy rates will have to remain in restrictive territory.
Meanwhile, there are fresh indications of softening activity in the eurozone, with Germany now in a technical recession after two consecutive quarters of GDP contraction. The ifo survey of German companies suggested that business expectations for the next six months have turned down sharply.
Although the most acute phase of the energy crisis is over, persistent weakness in manufacturing activity and slowing momentum in services imply that the growth outlook for Germany – and to some extent the eurozone overall – looks set to soften, especially with tight monetary policy continuing to bite.
Beyond the debt ceiling
On 23 May, Fitch Ratings placed the AAA rating of US sovereign debt on negative watch due to the brinkmanship over the debt ceiling negotiations and the potential policy, economic and financial effects on US creditworthiness. It is worth remembering that S&P downgraded US sovereign debt to AA+ even after the resolution of a similarly fraught debt ceiling drama in 2011. So even if a US default is averted this time around, a ratings downgrade could still happen.
There are near-term risks stemming from the US Treasury’s need to replenish cash in the Treasury General Account (TGA), the federal government’s operating account maintained by the US Federal Reserve to handle day-to-day public sector transactions.
The debt negotiation stand-off has left the TGA balance uncomfortably low at only around USD 50 billion in recent weeks (Exhibit 1), compared to the normal average of USD 600 billion. Treasury Secretary Yellen has repeatedly warned that the government would run out of cash to pay its bills by the X-date.
Once – and assuming – the debt ceiling impasse is resolved, the Treasury will need to replenish the TGA by issuing Treasury bills (T-bills) to the tune of more than USD 1 trillion in the second half of 2023, according to some estimates. Such a surge of issuance could drain liquidity from the US financial system and contribute to tighter financial conditions in the US economy.
Money Market Funds (MMFs) are key buyers of T-bills. If there is a deluge of new T-bill issuance, the yield on them will have to rise above the prevailing rate of return for MMFs to keep buying them. This would mean higher funding costs in the short-term money markets, which in turn would add to banks’ liquidity challenges.
The prospect of lower market liquidity together with hawkish Fed policy expectations are likely to be strong near-term headwinds for stocks.
Concerns about China’s growth
After the first quarter 2023 rebound in China’s GDP growth, the recovery seems to have lost momentum. This reflects two inter-related problems: Policy-easing failing to turn around public confidence and poor consumer confidence weighing on spending.
Recent official surveys on Chinese households’ willingness to spend show only a nascent recovery; the intention to save has not declined. It is a combination that reflects a lack of consumer confidence, which is not a switch that can be flipped on and off. It needs time to recover.
Beijing’s hesitant policy-easing stance is not conducive to a quick rebound in confidence, however. The effect of the authorities’ timid approach can be seen in the high real policy rate that still hovers above the long-term average (Exhibit 2). The lack of policy easing conviction has kept Chinese stocks weak following the strong rally between November 2022 and February 2023.
To boost China’s economic recovery momentum sustainably, the incremental policy easing that the market is pricing in may be insufficient. Beijing may have to ease policy more aggressively and employ more targeted measures to boost consumption and private sector investment.
If the next round of easing is broadly implemented and done with conviction, it should help boost both macroeconomic and earnings fundamentals and revive the A-share market rally. With that in mind, we remain constructive on Chinese stocks alongside our positive stance on EM Asia stocks.