The risks are rising that investors have begun to price in a potential slowdown in China’s growth—and by extension emerging markets.
It’s remarkable that, in this day and age when we can encode entire genomes and land spacecraft on comets, we struggle to answer basic questions about how big economies are doing.
Although I’m going to focus on China, my fellow Americans shouldn’t be smug: The U.S. enjoys a wealth of economic statistics—some of the most robust in the world—yet investors seem legitimately confused over whether the U.S. economy is weak, stable, or actually starting to see a cyclical pick-up.
In a contest for size and economic question marks, China may hold the crown. The speed and scale of its growth has been remarkable, making China an essential part of the global economic fabric. The country consumes 45% of the world’s copper, produces 50% of the world’s steel, and is responsible for roughly 12% of global trade. Yet this importance is coupled with a level of uncertainty. Most investors whom we meet believe China is extremely important to their outlook, and yet express a low degree of confidence in their ability to predict where it is headed next.
This lack of visibility is particularly relevant today. Early in 2015, in response to slowing economic growth, China eased monetary policy aggressively, cutting interest rates and ramping fiscal spending, while easing restrictions on the property market. These steps, with a lag time, have strengthened China’s economic numbers since the third quarter, 2015.
How long will this strength last, and how far ahead of that “turn” before markets react?
The good news: Policy easing has helped to stabilize growth. The bad news: This pick-up seems temporary, according to Chetan Ahya, our chief Asia economist, who recently flagged greater risks of a slowdown arriving even earlier than August.
This is largely due to two key factors. First, the spending or easing that was in China’s pipeline six months ago has played out. Second, the current pick-up also appears to be associated with an even larger increase in net borrowing. Given that it now takes 6.5 units of debt to produce one unit of GDP, additional gains from the lending channel are limited, in our view.
China’s data already suggest diminishing returns from a flagging stimulus. Our China economic activity indicator, the MS-CHEX, is at 3% vs. 10% in April, while property sales in top cities have slowed to an annualized 15% in the first two weeks of May, compared to 55% yearly in April.
If investors believe that China growth will soften again over the summer, how far ahead of this will market prices react? The risks are rising that the time is now. The U.S. Federal Reserve’s attempt to inject more risk premium into the front end comes at a most vulnerable moment for emerging markets, boosting the strength of the dollar and further limiting prospects of a fragile emerging-market recovery.
Fed futures are pricing a full interest-rate hike through December now, but the risk premium out the curve in the two-year to five-year sector is still low. Fed Chair Janet Yellen’s two coming speeches—on May 27th and June 6th ahead of the June 16th Federal Open Market Committee—become critical in shaping that risk premium. A reiteration of the hawkish recent minutes will likely nudge up short-term rates, which would push the dollar higher against other major currencies and set back the commodity and emerging-market universe.
Against this backdrop, it is no surprise that across our research team, we are pessimistic about assets tied to the commodity and emerging-market complex.
- Our emerging markets & Asia equity strategist, Jonathan Garner, believes that investors should fade the rebound in emerging market and “Old China” equities.
- Our emerging-market fixed-income strategy team has gone underweight local rates and sovereign credit, in addition to already being bearish on emerging-market currencies.
- In commodities, our metals team is cautious about prices for the second half (which would also fit standard seasonal patterns); our energy team believes that fundamentals remain much weaker than oil prices currently suggest.
- Our European equity strategist, Graham Secker, has turned to the safety of defensives, moving overweight last week.
- For U.S. equities, my colleague Adam Parker is increasingly convinced that the rally in low-quality names may be coming to an end, a dynamic that would help our preference for U.S. financials over energy.
- Finally, historical seasonal patterns suggest that May through November features a wider range of returns, with a more negative skew and higher volatility of volatility for many assets.
That is yet another reason—if you needed one—to own some volatility headed into this summer.