Is the glass full? Or half empty?
In brief
- Economic data are showing both positive and negative signals. Labor markets remain strong, while home sales and goods orders remain firm. On the other hand, PMI has weakened while lending standards have tightened sharply.
- We expect the U.S. to fall into a recession given the significant tightening in credit conditions, but a strong consumer market should help soften the economic slowdown.
- China’s recovery is driven by a rebound in consumption. We expect further policy guidance to support business confidence, foreign investments and trade. From a global context, China’s economic growth should offset some of the slowdown in the U.S.
- Asian central banks are coming to the end of their policy hiking cycle.
Economists are often (rightfully) criticized for sitting on the fence. One piece of economic data can be interpreted differently by different economists or analysts. Recent economic data from the U.S., Europe, Asia and China tells different stories depending on the interpretation. While we remain committed to our overall asset allocation recommendation, it is important to appreciate some of the counter-arguments proposed by the data.
Crying the recession wolf?
There are skeptics who are still arguing that the U.S. economy should avoid a recession. Job numbers are indicating strong demand for workers and steady wage growth, which in turn supports consumption. March new home sales and durable goods orders also came in stronger than expected. Economic activity data shows that the U.S. economy is still in firm expansion mode.
The more cautious observers would argue that business confidence surveys are showing signs of weakening. The March ISM manufacturing index fell to its lowest level since the pandemic. Even the ISM services index, which is supposed to reflect resilient consumer spending, disappointed relative to market expectations. The economy grew in 1Q 2023 only by 1.1% annualized, much weaker than the market consensus of 1.9%.
Meanwhile, the prospects of tighter bank lending standards are raising the risk of an economic recession later in the year. Banks could become more conservative for various reasons. They could be making an active decision to slow down lending in anticipation of weak growth and higher default risk. They could also be pulling back involuntarily due to reduced deposit bases or capital positions. Growing concerns over commercial real estate could also persuade lenders to be more conservative.
Overall, we still see the U.S. economy falling into a recession later this year, but resilient consumers should help limit the damage. After all, this is the expected outcome following a very aggressive period of policy tightening. For the Federal Reserve, inflation is coming down, yet it is still a long way away from its 2% policy target. This implies the end of the hiking cycle should be near, but it might take more than a mild recession to persuade the Fed to cut rates.
China’s economic growth needs more engines
In contrast with the slowing U.S. economy, China’s economic momentum is improving, led by consumption. Yet, its equity markets, both onshore (CSI300 down 0.5% in April) and offshore (MSCI China down 5.2%) have underperformed the U.S. market. The economy expanded by 4.5% in 1Q 2023, and this could accelerate further into 2Q with household spending making a comeback. Retail sales grew 5.8% in the first quarter of 2023 and 10.6% in March.
The pessimists would argue that China’s current recovery is too dependent on “revenge spending” and this momentum should fade later in the year. This is a valid concern, and we argue that business investment and the real estate sector would need to do more of the heavy lifting. While March exports significantly outperformed expectations, up by 14.8% y/y versus market consensus for a contraction of 7.1%, there are still considerable headwinds in the months ahead. The geopolitical tension between the U.S. and China is likely to remain for the foreseeable future.
With this in mind, the April 28 Politburo meeting focused on several priorities, including coordinating fiscal and monetary policy to boost both consumption and stimulate business investment. There are calls to open up foreign trade and attract foreign direct investment. It also aims to improve social welfare and employment issues. In the longer term, there is a desire to promote industry upgrades, especially in new energy cars, power grids and AI technology.
Overall, we do see China’s economic momentum and policy support as opposite those of the U.S. Growth has more room to accelerate in China, while the People’s Bank of China and the government could potentially relax policy more to support growth. Lending growth is already accelerating in China, and this reflects more confidence in both businesses (borrowers) and banks (lenders).
Asian rate hike coming to an end?
While investors continue to debate whether the Fed is approaching the end of the hiking cycle, several Asian central banks seem to be there already. Australia, India, South Korea, and Indonesia all decided to keep their policy rates unchanged. New Zealand is the odd one out with a 50bps increase in April. Singapore’s central bank also kept its exchange rate policy unchanged, contrary to the market’s expectation that it would allow for more currency appreciation to cool inflation.
Japan is under the spotlight, with the incoming Bank of Japan (BoJ) governor, Kazuo Ueda, under pressure to review and revise the central bank’s Yield Curve Control policy. Japan is facing a fresh round of inflation, including a substantial wage rise following the Shunto spring wage negotiation. Moreover, the central bank’s purchase of government bonds is creating considerable distortions in the fixed income market, and this needs to be adjusted. In Ueda’s first meeting, the central bank kept its policy unchanged but removed the forward guidance of its policy to remain at its present or lower levels. The central bank is still expecting inflation to fall back below 2% later in the year. The possible shift in the BoJ’s policy in the months ahead could strengthen the Japanese yen as well as persuade Japanese financial institutions to repatriate some of their overseas investment back home.
Investment implications
April was a good month for developed market equities. The S&P 500 was up 1.6%, while European and Japanese equities also gained in the month. In the U.S., despite recession concerns, 1Q corporate earnings are holding up. Companies are still able to defend their profit margins, but this looks increasingly challenging down the road. Considering the relative valuations of stocks and bonds, we still lean towards high quality fixed income in preparation for more volatility in economic growth in the west.
As for China, its market performance has been disappointing so far, but we still see more room for upside surprises in economic and earnings growth. For the rest of Asia, economic data, such as PMI purchasing manager indices, are also showing challenges for exporters. Yet, more domestically driven economies, such as India and Indonesia, are showing signs of resilience. This fits in with our argument for a greater focus on China and domestically driven Asian companies that could benefit from economic reopening.
Government bond yields have been largely rangebound since falling in March as a result of the banking sector's stress. The lack of fresh news on the direction of the economy also meant that the corporate credit spread did not change much in April, implying that yield and income did most of the work in generating income for the month. We still see that the current credit spread for high yield corporate bonds has yet to appropriately reflect recession risk and the possibility of a modest rise in defaults.
Global economy:
- The U.S. economy slowed more than expected in 1Q23, reporting 1.1% real GDP growth annualized, versus 2.6% in 4Q23. We saw strong consumer spending while inventory was a major drag. March CPI was cooler than expected with headline inflation at 0.1% month-over-month (consensus, 0.3%), while core CPI met expectations at 0.4%. Moderation came from falling food and energy prices, while the rise in shelter costs slowed compared to February. Weaker growth and slowing inflation, coupled with the tightening in financial conditions and softer job numbers, reinforce our expectation of a likely pause after a 25 basis points (bps) hike by the Federal Reserve in May.
(GTMA P. 20, 25, 26) - China’s 1Q23 GDP surprised to the upside at 4.5% year-over-year (y/y), noting strong services growth. The positive data diminishes prospects of substantial liquidity easing in the near term from policymakers. March activity data was relatively mixed -- industrial production picked up while property investment remained a drag in fixed asset investments. On the bright side, RMB loans in March surprised to the upside, with loan growth accelerating to 11.8% y/y from 11.6% in February, indicating more capital is available for corporate investments. April’s Purchasing Managers’ Index (PMI) came in below expectations, with NBS manufacturing PMI declining to contractionary territory of 49.2, from 51.9 in March, while non-manufacturing PMI remained elevated at 56.4, reinforcing the current recovery is largely services-driven.
(GTMA P. 5, 6)
Equities:
- The MSCI All Country World Index rose 1.3% in April, putting year-to-date gains at 8.2%. Europe continued its relief rally since October, with MSCI Europe up 3.6% in U.S. dollar (USD) terms, outperforming most markets. Emerging markets (USD) underperformed, returning -1.3%, while Asia Pacific ex-Japan (USD) returned -1.8%. China and Hong Kong displayed weakness, with the CSI 300 and Hang Seng index falling by 0.5% and 2.5% respectively.
(GTMA P. 31) - The S&P 500 returned a modest 1.6% in April, lifted by communication services, energy, health care and financials, all returning over 3%. Year-to-date, technology stocks returned 22%. This narrow market breadth had investors questioning the sustainability of this rally. During the S&P 500 1Q23 earnings season, nearly 80% of reporters beat estimates, although EPS growth remained negative y/y. Similar to previous quarters, consumer strength was a bright spot while guidance remained cautious, with companies announcing cost-cutting efficiency plans.
(GTMA P. 44)
Fixed income:
- The U.S. Treasury yield curve inverted further in April. The long end of the Treasury yield curve remained relatively flat, with 10-year Treasury yields falling 5bps to 3.45%. Relative minute movement in the back end of the yield curve likely reflects the pessimistic outlook on U.S. economic growth. On the other hand, 3-month Treasury yields, more interlinked with the Fed’s policy rates, gained 32bps to 5.07%. The MOVE index, a measure of interest rate volatility, continues to be elevated. Similarly, yield curves also inverted further in the euro area and for German Bunds and UK Gilts.
(GTMA P. 53) - Fixed income performance was flat in April following a strong month in March. U.S. high yield outperformed, returning 1.0% as U.S. high yield spreads narrowed slightly. On the other hand, Asia high yield underperformed, declining -0.8%, with spreads widening close to 60bps in April. U.S. Treasuries returned 0.5% while U.S. investment grade (IG) returned 0.8% as long-end Treasury yields fell and IG spreads narrowed.
(GTMA P. 48, 52)
Other assets:
- The drop in U.S. Treasury yields saw the U.S. Dollar Index down 0.8% in April. For major currencies, the British pound and euro gained 1.7% and 1.5%, against the green back. Euro area and UK Gilts gained 2bps and 20bps, respectively in April, while U.S. 10-year Treasury yields fell 5bps. For emerging market currencies, the Indonesian rupiah gained 2.2% against the dollar, while the Brazilian real gained 1.3%. Major detractors included the Japanese yen, Korean won, and South African rand, declining 2.3%, 2.7% and 3.0% against the U.S. dollar, respectively.
(GTMA P. 64, 65) - Commodity prices were mixed across the board. Oil prices recovered slightly in April following a sharp decline in March, gaining 0.44%. Oil prices initially surged as OPEC+ unexpectedly cut production by more than 1 million barrels per day, but erased its gains as concerns over the health of the economy and low consumer confidence curbed the demand outlook. The S&P Industrial Metals Spot Index fell 3.1% in April. Iron Ore was down 8.59% followed by Copper (-4.07%), while Aluminum was flat (+0.24%). Steel (+15.9%) and Nickel (+2.3%) posted positive returns.
(GTMA P. 67)
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